IAN McAULEY. Reclaiming the ideas of economics: Privatisation and prices

The last thirty years have seen a massive sale of government business enterprises, which, on privatisation, have set prices in line with corporate profit-maximisation. Contrary to conventional wisdom, the consequent allocation of resources is probably less efficient than would have been the case had governments retained ownership and control over prices.

Up to around 1990 government business enterprises were major economic players. The Commonwealth owned a shipping line (ANL), the country’s overseas airline (Qantas),one of the country’s two domestic airline (TAA, later merged with Qantas), all capital city airports, the telecommunications monopoly (Telecom), a major bank (the Commonwealth), a rail freight and passenger company (Commonwealth Railways), a private health insurer (Medibank Private) and a pharmaceutical firm (CSL). State governments owned vertically-integrated electricity, gas and water corporations, ports, and some banks and insurers.

Don’t worry: it’s a fake

Over subsequent years all of those Commonwealth enterprises and most of the state enterprises have been privatised, and those state enterprises that have not been privatised have been corporatised: that is they are directed to operate along the same lines as would apply to profit-maximising private firms.

Privatisation has generally been supported by both the Liberal and Labor parties, but has met with much less enthusiasm from the general public. In 2012, for example, the Labor Government in Queensland lost office in a landslide, largely in reaction to the government’s decision to sell state assets during its term in office.

Two ideas have driven governments to privatisation.

One is a desire to support government budgets. Proceeds of privatisation have provided a cash injection to state coffers, and newly-privatised entities have been able to go to private financial markets to finance capital investment, alleviating the need for governments to go into debt to fund new assets.

Anyone with a grasp of the basics of accounting would know that this is about impression management and the neoliberal obsession with “small government”. Selling assets to finance current expenditure or tax cuts is economically irresponsible, and substituting expensive private debt for lower-cost public debt makes no sense at all. To use a domestic analogy, most Australians don’t need to be convinced about the stupidity of selling their house and renting it back from the new owner.

The other idea, which has some validity, is that private entities, driven by the profit motive, are likely to achieve more efficient resource allocation, because they are subject to the harsh discipline of market competition.

In some cases, this may have been the outcome. Entities such as TAA and Qantas have been sold into competitive markets where there are other players. Few would argue for a re-nationalisation of airlines.

But even the presence of competition does not always result in privatisation bringing net benefits. It would be stretching the bounds of credibility to assert that sale of the Commonwealth Bank has been in the nation’s economic interest. As rather unexciting enterprises lending to small businesses and housing, government-owned banks probably served a useful function in keeping the other bastards honest.

Otherwise many privatisations have been of natural monopolies, and the markets in which they operate, of necessity, are highly regulated, bearing little in common with the markets guided by Adam Smith’s invisible hand. In many cases they have achieved productivity improvements by shedding staff and through becoming free from some of the (unnecessary) hobbles imposed by government agencies. But these cost savings have been partially or fully offset by more generous executive pay and the need to pay a high cost of capital. The return on funds the government regulator allows electricity distributors, for example, is much higher than the government borrowing rate to which the state utilities had access.

Enthusiasts for privatisation forget the basic economic principle that markets achieve efficient resource allocation not simply by virtue of being markets, but rather because the prices they set determine how resources are allocated. It’s the operation of prices that allows Smith’s butcher, baker and brewer to serve the public interest, but that’s only when the markets for meat, bread and beer are competitive.

In contrast with Smith’s ideal markets in which our privatised utilities operate are regulated monopolies, and the prices they set may achieve much poorer outcomes than governments could if they were to set prices. Three examples – privatised toll roads, private health insurers and electricity companies – illustrate the point.

Toll roads

In Sydney, Melbourne and Brisbane most major roads that have been built over the last thirty years have been privately-owned toll roads. These are high quality roads in an otherwise “free” road system. Those who don’t mind taking a slower trip tend to avoid toll roads. An example is the Cross-Sydney tunnel: while the tunnel is lightly used, in the streets above are the cars and trucks driven by toll-avoiders, contributing to the congestion and pollution that would be avoided if they used the tunnel. Economists recognise that mixing tolled and free roads leads to “deadweight” loss – that is a situation where no-one benefits.

A solution would be to set charges for all roads in order to achieve better system-wide outcomes: perhaps the tunnel could be free while the roads above attract a toll. Charges could be set at rates that pay for transport infrastructure and make better use of that infrastructure, for example higher charges to discourage peak-time road use. Governments, with system-wide responsibility, can design and administer efficient and equitable road user charging. Private toll-road operators have responsibility only for their own pieces of infrastructure, not for the cities’ transport system. Yet, when road user charging has been recommended by economists, governments, including Coalition governments ostensibly committed to using market mechanisms to allocate resources, have baulked at the suggestion.

Private health insurance

In Australia Coalition governments, and in recent times Labor governments, have been supporting private health insurance, with little economic justification other than an idea that when people pay for health care through private mechanisms they are likely to be more responsible than when health care is funded through the comparatively indirect mechanism of taxes. But, once an insurance premium has been paid, there is no difference between the notion “Medicare will pay for it” and “BUPA/Medibank Private/HCF will pay for it”; in both situations there is suppression of the price signals that are the normal mechanisms that ration scarce resources. (That’s called “moral hazard” in the quaint terminology of insurers.) A single government insurer can design and administer a health care funding system that attends to efficient and equitable use of scarce health care resources in a way that private insurers cannot.

Electricity tariffs

Privatisation of electricity “retailing” has seen the price of connection fees (the price you pay for simply having the electricity connected) rise much faster than the price of energy (the price you pay per kWh of electricity used). This makes sense for a firm trying to maximise profits: an electricity connection is a “must have” item (low price elasticity in economists’ terms), while electricity use is discretionary and therefore more sensitive to price (high price elasticity). But in terms of equity, and reducing the CO2 emissions from electricity use, it’s entirely the wrong pricing structure. A government utility, with a charter to avoid disconnections and to reduce emissions, could develop a much more equitable and economically efficient tariff structure – perhaps a free connection (there would be no resource misallocation because demand for connection is inelastic) and a steeply rising price for electricity use

These are cases where privatisation has led to prices, set in line with corporate profit-maximising objectives, which result in poorer equity and efficiency outcomes than prices that could be set by a government with system-wide responsibility.

The most striking case where a government has forgone the opportunity to use prices to achieve allocatively efficient outcomes has been in the Coalition Government’s consistent determination not to set a price on carbon to drive CO2reductions, choosing instead to use high-cost and distortionary specific interventions, generally resulting in high and inconsistent prices per tonne of CO2 saved.

The contrast between the Gillard Government’s use of a carbon price and the Coalition’s use of central planning measures appears to be a weird 180-degree departure from the general ideologies of left-right political parties.

Indeed it is inconsistent with the rhetoric of the Liberal Party, but it is not inconsistent with its established practice of keeping in its armoury the means to grant special privileges to its supporters. It was a Labor government that pulled down tariff walls, while the Coalition sought to retain opportunities to protect particular firms and industries. It was a Labor government that introduced effective trade practices legislation, while the Coalition supported anti-competitive practices such as retail price maintenance. While Labor has, at times, been too close to corporate interests, in general it has far fewer debts to firms and business lobbies than the Coalition, and is therefore freer to step back and let prices do their job in achieving equitable and efficient resource allocation.

It’s a fair generalisation to say that in Australia the party of the “left” is more inclined to use the neutral mechanism of prices to allocate resources than the party of the “right”, which is more comfortable with an opportunistic blend of central planning and crony capitalism.

 

This is the twelfth of a series of articles in Pearls and Irritations  on reclaiming the ideas of economics. Others so far have been:

General introduction (September 19)

Aspiration (September 26)

Jobs and Growth (October 3)

Society, economy and the environment (October 10)

Regulation and deregulation (October 17)

Taxes (October 24)

Globalisation (October 31)

Debt and deficits (November 7)

Wealth (November 14)

Competition (November 21)

Socialism (November 28)

 

Ian McAuley  is a retired lecturer in public finance at the University of Canberra and a Fellow of the Centre for Policy development.

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Ian McAuley is a retired lecturer in public finance at the University of Canberra and a Fellow of the Centre for Policy Development.

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4 Responses to IAN McAULEY. Reclaiming the ideas of economics: Privatisation and prices

  1. Avatar michael lacey says:

    The last thirty years have seen a massive sale of government business enterprises, which, on privatisation, have set prices in line with corporate profit-maximisation. Contrary to conventional wisdom, the consequent allocation of resources is probably less efficient than would have been the case had governments retained ownership and control over prices.
    That is correct!

    Look at an important economist in the United States who discussed it. Simon Patten. He was the first economics professor at the first business school in the United States, the Wharton School at the University of Pennsylvania.
    Patten said that there are four factors of production. Classical economics talks about three factors of income — land, labor and capital. But there’s a fourth factor of production, and that’s public infrastructure. However, its function, Patten said – and this is a pro-capitalist saying it, this is the business school – the function of public infrastructure, roads and schools is not to make a profit, like a private investor would do. The public aim is to lower the cost of living and doing business, so as to make the economy more competitive.
    We have been given the snake oil !
    Privatisation and foreign investment in Britain, which was meant to reduce state control of this sector, has led to the state still being dominant in electricity production. The only problem for the British is that the French government now owns a large swathe of the ‘privatised’ British electricity industry.

  2. Avatar Rob Stewart says:

    Enjoyed the article Ian, couldn’t agree more with you on the hypocrisy of the LNP in (not) using market mechanisms and the generally miserable performance of many privatisations. However, I think in many cases the outcomes, destructive and inefficient as they can be, are known ex ante and desired by their architects – eg. lower than socially desirable output levels, high profits, excessive executive remuneration, market power and price gouging are the real objectives. So, perhaps in the eye of the designer failures are actually seen as successes.

    The only issue I have is the invisible hand referencing with Adam Smith and Wealth of Nations. As you would know Smith mentions the invisible hand only once in Wealth of Nations, and the full context of what he was actually arguing is so often not fully explained. He was actually making an argument, in part, about the owners of capital favouring the domestic (home) market for investment, rather than foreign investment, even if the investor would gain more personally from foreign investment. In this respect the “invisible hand” was actually at least in part an argument in favour of economic nationalism and patriotism, and almost irrational behaviour in the strictest sense, guided by an intrinsic understanding of society and the greater good. Of course all of this is anathema to notions of laissez faire, modern globalisation and neoliberalism, but Smith and his invisible hand still gets wheeled out to support neoliberal arguments all the time. He would be turning in his grave. Sure, Smith was pro market forces but the invisible hand argument wasn’t as simple as the butcher and baker anecdote. An exchange between Easton and Rankin in History of Ideas, Methodology, Philosophy (1998) makes this point far more eloquently than I ever could.

    In any case my favourite quote on the invisible hand comes from Chomsky: it’s called the invisible hand for a reason – that’s because it doesn’t exist.

  3. Avatar David Brown says:

    thank you for this article… I have always believed governments have foolishly sold natural monopolies and it is refreshing to read a thoughtful analysis

  4. Avatar Wayne McMillan says:

    Ian, From my own limited research reading John Quiggin’s
    https://economics.uq.edu.au/profile/2249/john-quiggin
    and Graeme Hodge’s work
    https://research.monash.edu/en/persons/graeme-hodge
    there a very few cases that warrant privatisation or contracting out. In fact internationally there is a body of well researched evidence that indicates the majority of privatisations have been failures and that in most cases the public citizen has suffered with higher costs and poorer services.

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