The Impact of Privatization

Ownership and Corporate Performance in the United Kingdom

Stephen Martin, David Parker

• Publisher: Routledge
• Year: 1997
• ISBN:
  9781134766116
• Edition: 1
• Topic: Commerce
• Subtopic: Commerce Général

Are resources allocated more efficiently through private ownership than through the public sector? The experiences of eleven newly privatised companies are examined to evaluate this hypothesis. With the Government's pro-privatization policies in place for over a decade, this is a prime time to evaluate theory versus reality.

1
PRIVATISATION

The conceptual framework

INTRODUCTION

In the last decade many countries have introduced privatisation programmes. In 1995 the value of state selloffs is reported to have reached a record figure of US$73bn with at least forty-five countries in the process of privatising some industries (Economist, 13 January 1996, p. 5). This figure may exaggerate the degree of true privatisation since some governments choose to describe the sale to the private sector of only a small part of the total shareholding as a privatisation. Nevertheless, there can be no doubting the profound effect of world-wide privatisation on industrial organisation both in the developed and the developing world.

Table 1.1 UK privatisation proceeds

This book is concerned with privatisation in the UK where, since 1979, over £60bn of UK business assets have been transferred from the state sector to the private sector. At first the annual value of sales was low but, as reflected in the figures in Table 1.1, since the mid-1980s sales have regularly exceeded £5bn per annum, reaching a figure of over £8bn in 1992–3. Table 1.2 provides a summary listing of the main industrial privatisations since 1979 in the UK. Whole industries, such as water, electricity and gas supply, have been affected, along with large sections of the transport, aerospace and telecommunications industries. Because of the size and scope of the privatisation programme, the UK is an obvious candidate for studying the economic effects of this policy. Also, sufficient time has now passed since the early privatisations to begin to assess their longer-term economic impact.

Table 1.2 Major privatisations in the UK

In the UK, as in many other countries, the political pressure for privatisation came from a combination of disillusionment with the results of state ownership and from a belief that private ownership would bring substantial economic benefits. State-owned industries were viewed as highly inefficient, slow at developing and introducing new technologies, subject to over-frequent and damaging political intervention and dominated by powerful trade unions (Veljanovski, 1987). Privatisation seemed to offer a means of ridding the state of the financial burden of loss-making activities, while at the same time spreading share ownership and curtailing union power (Arbomeit, 1986). Moreover, privatisation sales offered a tempting source of state funding at a time when economic policy was geared to reducing the public sector borrowing requirement (PSBR).

From the beginning, government ministers have stuck tenaciously to the argument that the privatisation programme has been an outstanding success story, especially in terms of increasing efficiency. For example, John Moore, the Financial Secretary to the Treasury in charge of the privatisation programme in the mid-1980s, stated in a speech in November 1983 that:

The privatisation programme is coherent, and well thought out. It holds substantial advantages for the management of the industries, their employees, the consumer and the taxpayer. And it also, of course, brings benefits to the PSBR and furthers our objectives of reducing the size of the public sector. But these important by-products are secondary to the main theme. Our main objective is to promote competition and improve efficiency.

(Moore, 1983)

In a later statement he returned to the subject now certain that the source of performance gains lay in the nature of state ownership:

To begin with, the priorities of elected politicians are different from and often in conflict with the priorities of effective business managers. Yet, in state-owned industries politicians are in charge, which means that whenever politicians cannot resist getting involved in what should be management decisions, political priorities take precedence over commercial ones. Politicians may overrule commercial judgements in order to build a new factory in an area where voters need jobs or they may refuse to close an uneconomical plant. They can become involved in policies affecting the hiring and the size of the workforce.

(Moore, 1992, p. 117)

Inefficiency is, allegedly, the inevitable result. Similarly, Tim Eggar, Minister for Industry and Energy, felt able to summarise recently the certain and enormous economic benefits that had resulted from the government’s privatisation programme as ‘price reductions; the shake up of old management practices leading to large efficiency improvements and dramatically falling costs; and…improvements in standards of service’ (Eggar, 1995, p. 7).

A more critical commentary, however, would note that the programme has been dogged from the outset by some incoherence. In particular, the government had a number of objectives for privatisation that are potentially contradictory. For example, the promotion of quick and successful asset sales sits uneasily alongside a desire to promote competition in industries previously supplied by state monopolies and to raise funds to reduce the PSBR. Monopolies with their more or less guaranteed profits fetch a higher price in the stock market than an identical firm facing intense competition in the product market. In addition, the promotion of small shareholdings, by favouring the small investor during flotation sales, may be inconsistent with the imposition of an effective capital market constraint on managerial behaviour. The government has based its case for privatisation largely on the benefits that it produces in terms of competition in the product market and the pressure private investors place on management to manage efficiently. However, a number of state-owned companies were already operating in competitive markets and others retained their monopoly at privatisation. Moreover, large shareholders are arguably more likely than small investors to manage their share portfolios actively to maximise income and capital gains; a point we return to later.

This book is concerned with the primary rationale for privatisation both in the UK and elsewhere and as evidenced in the above statements by government ministers, John Moore and Tim Eggar, that is to say, the impact of privatisation on efficiency. The remainder of this chapter is concerned with developing a conceptual framework for the analysis of privatisation and efficiency, in which some of the above contradictions will feature. The concern is with why ownership may matter from an economic point of view. Chapter 2 provides a brief history of each of the eleven organisations that are the subject of this study. In chapter 3 the principles and method of performance assessment are discussed, including the meaning of ‘efficiency’. Chapter 4 is concerned with a review of earlier studies of public versus private efficiency and the effects of privatisation.¹ Chapters 5– 8 provide a detailed investigation of pre- and post-privatisation performance for a selected group of eleven enterprises privatised in the UK in the 1980s. Performance is assessed using a variety of performance measures: labour and total factor productivity, value-added, the rate of profit, and an efficiency frontier method. Data are also provided on the distribution of business income, wage relativities and employment pre- and post-privatisation. Chapter 9 looks at how privatisation has affected the internal organisation of the firms in this study. Chapter 10 provides conclusions and draws lessons for industrial policy in the UK and overseas, especially for other countries pursuing privatisation policies. The chapter also attempts to answer the central question: has privatisation been successful in improving efficiency?

PROPERTY RIGHTS, PUBLIC CHOICE AND INCOMPLETE CONTRACTS: AN AGENT-PRINCIPAL FRAMEWORK

In the privatisation literature state enterprises are said to be inefficient because:

1. state-owned industries suffer from excessive political intervention;
2. management in state industries have vague, fluctuating and often conflicting objectives. Political time frames are often incompatible with the longer time cycles that successful investment needs;
3. politicians and civil servants fail to monitor managerial behaviour as effectively as the private capital market and, amongst other things, this leads to over-investment (Rees, 1989; Pryke, 1981) and the trading of more output for lower profits (Pint, 1991);
4. trade unions in the public sector are able to succeed in obtaining above market wages, employment levels and conditions of work at the expense of consumers (so-called rent-seeking behaviour) (Windle, 1991);
5. bankruptcy is not a credible threat when there are seemingly unlimited taxpayers’ funds to call upon;
6. managerial salaries in the public sector are politically determined and rarely compare well with the pay of equivalent jobs in the private sector. Consequently, the quality of management suffers;
7. there is a lack of performance related rewards in the public sector;
8. public sector firms are insufficiently consumer orientated when operating in monopoly markets; and
9. state ownership confuses the regulation of the activities of industry with the role of ownership so that state regulation is less effective.

Clearly, there are some difficulties with these arguments. For example, the suggestion that some labour groups (workers) receive an above market wage while others (managers) earn a below market rate seems slightly contradictory. Or if paying a below market rate to one group reduces their quality, then paying an above market rate to another group would presumably lead this part of the workforce to be of a better than average quality. Nevertheless, research suggests that the record of state ownership in the UK accords with a number of these weaknesses, including politically motivated pricing, distorted investment programmes and uneasy industrial relations (NEDO, 1976; and see chapter 4). In their influential study of privatisation Vickers and Yarrow conclude that:

The history of the nationalized industries has shown that…a system of control that relies heavily upon agents’ internalization of the public interest objectives is unlikely to produce good performance. In the event…the results of the policy failure have included widespread goal displacement, lack of clarity in corporate objectives, overlapping responsibilities and excessive ministerial intervention in operational decisions. These in turn have had detrimental effects on the pricing, investment and internal efficiency performance of the nationalized industries.

(Vickers and Yarrow, 1988, p. 151)

Given these perceived failures of state ownership, Rees (1989, p. 108) predicts that privatisation will lead to ‘higher prices, lower outputs, higher labour productivity, lower employment, and lower wage rates, since these are the consequences in the model of tightening the profit constraint’. Other results of privatisation are said to be: more commercial management; greater consumer focus and more imaginative marketing; improved capital usage; less damaging state interference; and more effective regulation of industries in the public interest (Veljanovski, 1987).

A useful starting point for the economic analysis of privatisation is agentprincipal theory. Agency situations arise when one party (principals, such as shareholders) delegate to another party (agents, such as managers) decisions over the use of their property or property rights (Jensen and Meckling, 1976; Arrow, 1985; Fama and Jensen, 1983). This arrangement may be economically efficient from a specialisation or comparative advantage perspective, but agency relationships raise the prospect of divergent goals. The agenda of the agents may well not be the same as those of the principals, especially since agents can be expected to be self-interested. In particular, principals are at risk of slacking and other dysfunctional behaviour by agents that reduces the underlying value of the property rights.

This can be illustrated as follows: in both the public and private sectors managerial utility can be expressed as a function of profit (II) and quantities of inputs. Hence U=U(, I) where U (.) takes the usual shape and is a twice continuously differentiable concave function and I is a vector of inputs. The manager’s utility will be related to profit if he or she owns shares, benefits from profit-related pay, gains prestige from high profit or where higher profit improves job security. Inputs enter the utility function because the manager’s income may rise when there are more employees and a larger capacity to manage or extra employees may mean more free time. Profit is the product of costs deducted from revenue. The cost efficiency of the firm will be weaker the smaller the relationship between the manager’s utility and profit, and the stronger the relationship between the manager’s utility and the volume of discretionary inputs. Assuming that managers in the public and private sectors pursue either profits or output (or some combination of the two) expressed as Փ , and both require management effort, the management objective is to maximise

where E is managerial effort and

reflects the disutility of such effort.

The aim of principals wishing maximum profits must therefore be both to maximise E and to ensure that management effort is directed at maximising profit and not at maximising output and employing discretionary inputs. In practice, the agent knows the amount of useful effort he or she puts into the management of the business. The principal, however, knows the outcome but cannot monitor effort directly. Assuming that costs depend upon (a) environmental random variables that represent factors impacting on the performance of the firm that are outside the agent’s control, such as the business cycle, Mi, and (b) the agent’s effort at controlling and reducing production costs, E, then total costs, C_i, take the form

The principal monitors Ci but in a world of imperfect information cannot be certain whether an inflated C_i is the result of changes in M_i or E. To ensure that E is maximised the principals must write and enforce a contract with the agent to maximise effort. Given that E is known to the agent but not the principals, an incentive system must be designed to maximise E irrespective of the Mi states so that agent maximisation of effort becomes the dominant strategy. The differences between public and private ownership, therefore, can be reduced to the efficacy of the incentive mechanism.

This discussion suggests that if privatisation is to lead to more managerial effort leading to efficiency gains in the organisation, it must involve improved policing of agent behaviour or more constraints on managerial discretion. In other words, a change in ownership involves a new agent-principal relationship with new forms of information and incentive regimes in a world of incomplete contracts.

Ownership and competition

When a state-owned monopoly is privatised, the government might also introduce competition into the product market (that is, remove the company’s monopoly). Economists have a predilection for competition. The first fundamental theorem in welfare economics states that, under certain conditions, a competitive equilibrium in a market economy is Pareto efficient since when this exists no one can be made better off through a resource reallocation without making someone else worse off. The second fundamental theorem broadly states that most such Pareto-efficient outcomes can be achieved in a perfectly competitive economy, provided redistribution is dealt with first.

As with all theorems, certain assumptions have to be made if the theory is to hold. In particular, the first theorem assumes the absence of externalities in consumption or production, and the technical conditions required for the second are relatively onerous. But broadly speaking the two theorems together amount to saying that competition produces efficiency and, if the outcome is inequitable, this can be dealt with as a separate issue.

(Waterson, 1995, p. 132)

Figure 1.1 Alternative ownership and competitive regimes

Empirical study of the effect of competition on productivity in manufacturing has borne out that it affects both the level and growth rate positively (Nickell, 1993). Competition sharpens the incentives for management to manage the firm’s assets efficiently. Also, where there is competition, the firm’s profits reflect and identify differences in managerial ability creating a link between the product and capital markets. At the same time, however, privatisation may have no effect on competition. Monopolies might be sold-off with their monopoly powers wholly or largely intact while many state-owned firms have traditionally operated in competitive markets. Thus conceptually, the impact of ownership and competition (in the product market) are quite distinct, and while the positive effect of competition on performance is a relatively uncontroversial one in economic theory, the impact of ownership per se is much less well determined. In this book, the primary focus is on the impact of ownership (although where competitive conditions change this is noted since the results may be influenced by the change in the product market).

If competition in the product market does not alter when privatisation occurs then the source of any performance improvement will lie in a change in the capital market, that is to say directly in the change of ownership. Privatisation subjects enterprises to the discipline of the competitive capital market, which many believe imposes a more effective constraint on managerial discretionary behaviour than political control (Crain and Zardkoohi, 1980; Pera, 1989, p. 181). The result, it is claimed, is higher efficiency even under similar product market conditions.

The argument is that in the private sector owners can trade their shares in the capital market and this constrains managerial behaviour. If management lose the confidence of their shareholders the share price falls, which may trigger a hostile takeover bid (Alchian, 1965; Jensen and Meckling, 1976; Fama, 1980). Alternatively, management may be deposed by large shareholders when performance disappoints at company annual general meetings (AGMs) or on other occasions (Aoki, 1983; Leech, 1987). In contrast, in the public sector there are no shares to trade and managerial appointments depend upon government decisions which may not be heavily weighted by economic results (Zeckhauser and Horn, 1989, p. 35).

The possible impact of both the product and capital markets on performance can be discussed with the aid of Figure 1.1. Position A represents a monopoly supplier in the public sector. With no or very limited product market competition and taxpayer funding, incentives for management to achieve high efficiency in their firms are poor. Hence the expectation is that efficiency will be low. By contrast, position D represents a competitive firm raising funding from the private capital market. Here the expectation is that there are high incentives for management to operate their firms efficiently. Both the product market (competition) and the capital market (tradeable shares) constraints apply. B and C are in effect intermediate positions, they represent mid-way states in which either the product market or capital market constraints on behaviour are limited. The expectation would be that the performance of firms in positions B and C will be higher than firms in position A but not as high as those in position D. The expectation would be that maximum Monopoly Competition Public Ownership A B Private Ownership C D Figure 1.1 Alternative ownership and competitive regimes efficiency gains will arise when privatisation is combined with the introduction of competition in the product market; that is, where there is a move from point A to D. Smaller gains might be anticipated when the movement is from position A to C (privatising a monopolist) or from B to D (privatising a firm in a competitive market). Gains would also be anticipated when exposing a state-owned monopoly to competition (moving from A to B) or when exposing a privately owned monopoly to competition (moving from C to D).

Differences in behaviour under state and private ownership may be compounded by differences in objectives. In the private sector although profit may not always be pursued rigorously and consistently there is, nevertheless, a clear bottom line. If losses continue to be made ultimately the firm will fail. In the state sector, however, objectives are often vague and tend to change according to the political climate, leading to uncertainty about long-term strategy within the industries. Public enterprises pursue multiple and often blurred or ill-articulated objectives which may help to mask inefficiency. Privatisation should change and clarify the objectives of the enterprise as well as affecting managers’ incentives to achieve these goals (Bös, 1991). At its most simple, profit maximisation will replace wider and less well articulated goals to do with welfare maximisation. But it is important to...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Preface
• Abbreviations
• 1: Privatisation: The conceptual framework
• 2: Brief Histories of the Organisations Studied
• 3: Assessing Performance: Principles and method
• 4: Comparative Efficiency and Privatisation: The evidence so far
• 5: Privatisation and Productivity
• 6: Accounting Ratios and Performance Measurement
• 7: Estimating Technical Efficiency Using Data Envelopment Analysis
• 8: The Impact of Privatisation on Employment and the Distribution of Business Income
• 9: Privatisation and Business Restructuring
• 10: Summary and Conclusions
• Appendix
• References