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Essay on Privatization: Meaning, Reasons and Effects

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Essay on Privatization: Meaning, Reasons and Effects!

Essay on the Meaning of Privatisation:

Privatisation has become an integral part of pro-competition programme and has now become a familiar feature of new consensus economic policy.

It is defined as the transfer of state owned resources to private control.

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This can be achieved through direct sale of the assets to the private sector.

The move to privatize began in the UK and New Zealand in the 1980s; it spread to continent in the 1990s and now taking a front seat in the large number of less developed countries. The US was a significant absentee from this trend, mainly because it has very few nationalized industries to privatize. World-wide revenue from privatisation amounted to $600 billion between 1990 and 1999.

Essay on the Reasons for Privatisation:

There are many reasons for privatisation. The most important of them has been a disillusion with the capacity of the nationalized industries to deliver effective and efficient services to the public and to achieve social goals they were set up to attain. For nationalized industries the principal agent problem was particularly acute.

The objectives of the politicians who owned the companies were often conflicting, the government department in charge of the company added another layer of complexity, with the result that management has no clear objectives and no sustained incentive to perform. One major objective of privatisation was to make the company more efficient.

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Second, closely related to the above, governments wished to introduce competition into the sectors hitherto dominated by the state ownership. If this was done while the companies remained in the state ownership, their chances of successfully coping with competition would be increased by being run by the private sector rather than public sector.

Third, many nationalized industries were notorious losers. The liberalisation of trade threatened even further loses. Selling them was seen as a way of reducing or eliminating budget deficit. Fiscal benefits could also accrue on the state’s capital account from the sale of the assets.

Obviously the proceeds from the sale of profitable state companies or from those with potential to earn more under private sector management such as telecom and energy utilities promise to be especially large.

The proceeds from privatisation yielded £65 billion in 1997 to the UK exchequer. During the 5 years, 1995-99, Italy’s privatisation proceeds came to $80 billion. According to OECD estimates, revenues from privatisation between 1990-98 amounted to 24% of Hungary’s GDP in 1998, 20% of Portugal’s GDP and 15% of New Zealand’s.

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Many less developing countries saw privatisation as a golden one-off opportunity to reduce public sector debt and to set motion a lower tax environment without damaging increases in budget deficits. Fourth, politicians came to the conclusion that the balance of the mixed economy has shifted towards the public sector.

This belief was fortified by the abuse of power by many public sector trade unions with frequent use of the strike weapon.

Former communist countries have been profoundly affected by the privatisation of their economies. However, the origin of their privatisation programmes and the context in which these are being implemented are obviously very different to those of the west. For one thing, these countries where being transformed from a situation in which almost the entire economy was state-owned.

For example, East Germany had privatized some 12,000 firms, about 85% of all firms in the previous regime operating under state-ownership. In many of these countries, governments had large budget deficits and a limited capacity to raise revenues through higher taxes. Thus, privatisation, to them, was a way of disposing of all loss-making companies and providing desperately needed revenues to the state.

There is something paradoxical about privatisation of state-owned companies in Western countries. After all, these companies were originally set up to resolve some economic problem not to cause one. Many were established to deal with the problems created by private monopolies and to create competition among them so that monopoly profit and social cost of monopoly can be done away with.

Nationalisation was designed to encourage exploitation of scale economies and to ensure that monopoly profits, if any, would accrue to the state, which they would be able to distribute them in a socially optimum way. In retrospect these expected advantages fail to materialize. Too often nationalized industries abused their monopoly power. They provide bad services at higher prices.

They suffered extensive x-inefficiencies.

Their industrial relations were surprisingly very bad. Against this background, it is easy to believe a European Commission estimate that complete liberalisation of the European airline would bring about a 10% decline in costs and prices which will bring benefits of some $1 billion per year, obtained through lower pay costs, more efficient deployment of the workforces and lower overheads.

Essay on the Effects of Privatisation:

Privatisation came in diverse form and many are of very recent vintage to determine their success or failure. Studies of the UK experience suggest a mixed bag of results. Some privatized companies have achieved a successful turnaround, notably BT and BA, but the verdict on the privatisation of British Rail and Water industry is far from success.

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The economists described the Railway privatisation as a disaster. Experience also differs between countries. In a highly generalized way one can say that privatisation has been more or less successful in the UK while unsuccessful in Russia. The effect of privatisation can be evaluated under many headings effects on efficiency, on government revenue and income distribution.

A key consideration is the effect on efficiency, IE. On total factor productivity. The resultant fall in unit costs can be passed on to the consumer in terms of lower prices and better quality In the UK, it was estimated that telephone charges fell by 35% in real term between 1984 Electricity charges also declined in real terms.

As a general rule, experience shows that the more competition in the privatized companies the greater the likelihood of positive outcome This just what the economic theory would predict A policy environment that encourages long- run investment in the privatized industries is also important.

The effect on government revenue is more complex than it might appear. In the case of an outright sale, the gain to the state cannot be equated with the sale price. The state has replaced one asset (the state-owned company) with another (cash).

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To calculate the net financial gain to the state, we must compare the PV (Present Value) of the stream of revenue expected from the firm had it remained in state ownership with the proceeds from the sale.

The price paid for the company is thus a crucial variable. If under-paid, the privatisation programme could end up worsening instead of improving government finances in the long-run. Also there must be some assessment of how this extra cash accruing to the government is being used.

It is being spent on building up military power or on consumer hand-outs or on long-term investment for the future. The last one must have an income distribution effects.

There are at least 4 parties to be considered: the state, employees of the privatized firms, the consumers, and the new owners. The mode of privatisation has an important bearing on the outcome. Share floating is one way, often associated with a certain predetermined allocation to the existing employees (BT – 1984, BG – 1986 and so on).

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Direct sale to private sector has also been used (NCB 1994, Rover cars to British Aerospace). Management buy-outs are another possibility (NF Corporation 1992 and several Bus Companies in Britain).

In each case, a careful analysis is needed in order to assess the resultant income distribution effect. It is obviously for the state that is strapped for cash to be included into selling too cheap (Russia and other East European countries). Also share can be sold too cheaply to the public in order to carry popular favour or to ensure that the floatation will be a success as happened in several west European countries.

There is still doubt that in most instances privatisation has brought benefits to the consumer, not just in terms of lower price but also in terms of improved quality of services and efficiency. There are areas of the economy to which the ethos of a state company is particularly unsuitable and where privatisation might have yielded some benefits.

For example, state-owned hotel and restaurant and some manufacturing companies, where prompt decisions are needed and also some industries created on the ground of economies of scale, have never become very successful enterprises. The number and scope of privatisation programme around the world shows that finance ministers are convinced that the potential benefits exceed any potential losses.

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But it will take time before the dynamic efficiency effects of privatisation can be fully evaluated.

Regulation: Regulatory Reform and Natural Monopolies:

Regulatory reform is designed to promote competition, regardless of whether the industry is in state ownership or private ownership. It is a separate issue from privatisation. Yet, in practice, reform of government regulation of industries, particularly state-owned utilities such as electricity, gas, water, etc. has been associated with the issue of privatisation. Thus, we introduced the subject here.

Suppose a state-owned company exists where competition is not possible. Economics of scale are so great that is not possible for more than one company to operate in the industry. This is the case of natural monopoly.

The state may still wants to privatize in the hope of securing a change in the management culture of the organisation, or to add to government revenues, even though the privatized firm will continue to retain monopoly power.

How the costs and benefits back up in this instance? Clearly there are benefits from privatisation, but these will be achieved only if there is also some state regulation here. How should the privatized monopoly be regulated? The economics of regulation now enters in the picture.

Natural monopolies were until recently regarded as dominant in the energy, transport and telecommunication and so on. In addition, private sector competitors were excluded by law from trying to compete with the state monopoly in these sectors.

But banning competitors would be redundant if the economies of scale were really powerful, so the existence of legal restriction suggests that the monopoly was not so natural after all.

When such is the case, one solution is to remove the restrictions on entry, subject to the new entrants satisfying some basic minimum operating criteria such as prudential reserve ratios, safety provisions, and so on. Privatisation can then proceed, though whether deregulation come before or succeeds privatisation can have an important bearing on how much revenue is obtained from the sale.

Deregulation has been applied to many industries in addition to those controlled by the state monopolies. Major changes has been made in the rules governing banks, stock broking, and so on. These initiatives were inspired by belief in the merits of the free market. No less important was technological change.

In some industries, it has made restrictions on new entrants unenforceable, in other it has made small production units more efficient. For example, technical advance has made even very small electricity generating plants more efficient then previously.

The combine effects of deregulation and technological advance opened up many hitherto restricted markets. The resultant increase in contestability has bought about huge improvements in efficiency.

However, there remain some sectors where the monopoly proves to be genuinely natural and where the degree of competition is limited. There are two major steps in dealing with the situation. The first step is to break down or unbundled the services provided by the monopoly into component parts so as to isolate the core natural monopoly element is the industry.

In electricity through a network. By unbundling the industry into its different potentially competitive and natural monopoly components, efficiencies can be secured through the market system. The potentially competitive parts can be sold to the private sector.

The second step is how to deal with the natural monopoly element. This involves three interrelated strands pricing, access and quality of service. We briefly review each of these.

Pricing:

Incentive regulation refers to the design of incentives to ensure that producers keep prices and costs as low as possible. The underlying assumption is that costs are not given but are influenced by the incentives set by the regulatory authorities.

If there was no regulation the privatized monopoly might well slip into the same bad habits as the state company it replaced. Where the new regulation achieves a superior outcome to direct provision of the goods or services by the state company depends on the effectiveness of the regulatory system.

In the UK following the privatisation of state-owned companies (BT, BG, Water, etc.) regulatory bodies were set up for each industry. Their task was to prevent the abuse of monopoly power and find ways of promoting competition. This sound easy, but the regulator frequently get into hot water in trying to achieve this objective.

There are several ways of regulating a privatized industry with strong monopoly elements.

(a) MC pricing:

One simple way would be to oblige the monopoly firm to charge a P = MC, and provide a subsidy for any ensuing loss. The drawback is the cost of the subsidy and the difficulty of determining MC.

(b) Break-even or average return to capital:

Alternatively the regulator can insist on a price that allows the firm to just break-even. This eliminates the monopoly profits but leaves wide open the opportunity to reap the benefits of monopoly in other guises. Some regulators use a formula related to rate return on capital which the monopoly would not be permitted to exceed.

This avoids the problem of direct price control, but has the disadvantage of reducing the incentive to firms to minimise costs, once the permitted profit rate has been attained. Rate of return controls have been applied extensively in the US. Not surprisingly there has been frequent disputes over the definition and measurement of rates of return in these cases.

(c) RPI-minus X:

Another possibility is to set maximum prices.

The UK authorities have taken this approach.

And various types of price-capping formulas have been used, known as ‘RPI-X’, whereby the regulator permit’s the firm’s price to rise by no more than X% points below the retail price index (RPI). I a multi-product monopoly, such as telecommunications, the regulator may opt for a tariff-basket method, whereby the authorities decide which products are placed in the basket and how the various prices are to be weighted.

This means permitting lower prices for price-elastic services and relatively higher prices on price-inelastic services. While providing flexibility, regulation could be highly controversial. The public will often perceive such pricing structures as unfair, even if based on sound economic principles.

Where the output is homogeneous, such as gas and electricity, the regulator may use an average revenue target, whereby the predicted rise in average revenue in the firm is not permitted to exceed RPI-Z. A key problem of incentive regulation is to determine the efficiency factor X. If X is set too low, the firm will make excessively high profit and regulator will lose face. If it is set too high, the firm will become unviable.

In deciding on the right value of X, the regulator may have to be guided by the expert, with the inside knowledge of the firm. Relations between the regulated and the regulator may become too close and cordial. Another problem is that the formula could act as disincentive to efficiency if more efficient performance were to lead to subsequent upward revision of X.

In practice, rate of return considerations are implicit in setting the value of X.

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