Privatisation – Good or Bad?

Privatisation (also known as denationalisation) is a policy undertaken by a government, whereby an industry owned by the government (thus the nation) is placed into the hands of the private sector. This is often done through an Initial Public Offering on a stock market, but could be also done through a sale to a single entity. There are a number of reasons why a government may decide to privatise a holding:

  • Sell off loss making enterprises – if the government is making a loss on a firm it owns it may wish to sell it. By doing this it reduces the amount it has to pay for the loss, and a private firm may be able to turn its fortunes around, and turn it into a profit making firm, potentially increasing government tax revenue and reducing unemployment (and thus unemployment benefit spending).
  • To make money for the government in order to reduce debt or a deficit, or to offer people a tax relief or to fund an increase in government spending (this often happens before an election in order to gain votes).
  • Political and economic beliefs – some people believe that the private sector can do a better job of running a business than the state can, this belief is mainly justified due to the profit motive, whereby in private hands the owners will try to maximise profits by cutting costs, raising prices, and improving service/quality in order to make more sales. However in the government’s hands this motive doesn’t exist, and therefore some believe, that costs will be higher and the performance/quality of goods and services may be reduced. Hence privatisation may lead to an increase in efficiency (both productive and allocatively) and to reduced prices for consumers.

However, there are reasons why the above points may not be valid or as successful as hoped:

  • By selling off public assets the government is forgoing future earnings – a profitable company is an asset, and brings in money for the government, if it decides to sell this asset it would no longer receive this income stream (which can be seen as a dividend payment). When selling the asset, the cost is normally very high and in the billions, but the government may not actually be receiving the full price for such an asset and may loose out. For example lets say the government sells a firm (which makes annual profits of £1bn) for £10bn. If the government had held onto this firm (asset) for 10 years then even at the current profit rate it could make that £10bn for which it sold the company for, and that is only assuming that the firm maintains the profit rate of £1bn, it may in fact increase profits over the years (but there is also the potential that profits may fall). So by selling the asset the government is making less money than if it held on to it, because the government can be seen as a long-term investor, who could receive a lot more income from the asset than if they sold it. The reason for which they may sell it, is because they either think that it is going to make a loss in the future (in which case the private buyers would know this and would have already priced this into their bid for the firm) or because they need the £X immediately, perhaps to pay creditors (however a sovereign state could just issue more debt, or print money to pay off creditors).
  • Maintaining a deficit – Furthermore to the previous point, by retaining the asset the government could use the income stream from it to increase its deficit to allow for lower taxes and/or higher government spending. The following example demonstrates this point – A government owned enterprise generates annual earnings of £60mil. The interest rate for government bonds is 2%. Therefore the government could have debts of £3bn, by keeping this enterprise (worth £60mil) in government hands. The government could use the income from the firm’s profits to finance that debt of £3bn, and would therefore not need to borrow this money on bond markets. The equity premium is the amount of return investors want for having a shareholding in a company. In the stock market this is 6% (whereas investors only want a risk premium of 2% for government debt, in reality this is currently lower for the UK government), hence this firm which produces £60mil in profits could only be sold for £1bn (due to the different rates of returns demanded by investors – 2% for government debt, but 6% for equity holdings). If the privatisation goes ahead, then the government will receive £1bn which it may use to pay-off an equal amount in debt. This would save £20mil a year in interest repayments. However it now has a gap of £40mil in its finances due to the privatisation (before the privatisation, it received an income stream of £60mil p/a, but the privatisation has only resulted in a saving of £20mil on the interest repayments p/a). The only way such a privatisation would be successful (and leave the government with a surplus, and this is assuming that the gov uses the money to repay its debts, and not to reduce tax or increase spending) is if the private sector may £5bn for the firm (in this example). If this were to happen then the government would save £100mil on interest repayments p/a and would make a £40mil surplus p/a, hence making the privatisation successful for the taxpayers. But the private sector would only pay this amount if they could increase profits to £300 million (due to the 6% rule). Thus, this example shows that unless firms think they can increase profits at a firm (if it were privatised) they wont pay a price high enough to result in a fiscal benefit for the government/tax-payers.
  • Political and economic beliefs – although privatisation has the potential to reduce costs and increase efficiency, it may not in certain circumstances:
  • Natural monopoly – A natural monopoly is a situation in which a firm has lower long run average costs (LRAC) the more it produces. Generally in such a situation the marginal costs (the cost to produce an extra unit of good or service) are very low, or non-existent but the initial fixed (and sunk) costs are extremely high. Thus, the more quantity sold, then the lower the costs for the firm. This means that it can offer lower prices, or increase its profits. What this means in practice is that firms which operate under a natural monopoly normally experience high profits at the expense of consumers. Competition in these industries are low, due to the extremely high fixed costs initially. It is also normally the case that such firms are only in the hands of the government, because they were the ones responsible for investing in the industry, due to the high start-up costs. Hence if a firm which operates under a natural monopoly is privatised it could result in higher prices for consumers, due to lack of competition X-inefficiency may arise, and costs may not fall as much as in a situation of perfect competition. To counter this, in recent times, there have been moves to introduce public watchdogs to ensure that prices don’t rise by too much and to ensure that privatised firms increase efficiency and reduce costs, however there are additional costs imposed on the taxpayer for these watchdogs, and they may not be that good at their job (for example some are complaining of the exorbitant price increases in gas and electricity at the moment) or may suffer from regulatory capture. Alternatively the government may decide to sell a state-owned firm, but in the process break the firm up and sell it to different entities in order to promote competition. But by doing this they may reduce the sale price, and also reduce the LRAC benefits (i.e. economies of scale) of having a natural monopoly.
  • Asymmetric Information – some argue that the private sector has a better understanding of markets and can run a business better as it knows what it is doing. This argument is true to an extent; firms may be able to reduce costs due to the profit motive, and they also don’t have such an issue with bureaucracy and having to tender all contracts out (which in itself costs money, but also doesn’t result in obtaining goods as cheaply as if they were purchased directly on the market). However if the government has been running an industry for a long time then it may know better than a private firm how to do so. This is especially the case if the government-firm is the only such firm in a market, as the private sector will have no experience of operating such a firm. Additionally, if a firm is privatised, skilled employees and managers (who do know how to run the business) may be pushed out (for example the top management may be replaced by the management of the purchasing firm) or resign (they may prefer to work in the public sector due to pension benefits or altruistic reasons).
  • Crowding Out and Ideology – there is an argument that too much government involvement reduces the ability of the private sector to operate due to financial crowding out (when the government borrows so much money that it causes interest rates to rise for private firms, who then have increased costs) and because of resource crowding out (the government increases demand for things such as labour, resources and land, thus causing higher prices for all, including private firms). But this problem is only an ideological one, a country has to decide the balance between the state sector and the private sector. Some countries such as Sweden manage to do this successfully, having a large state sector and a smaller private sector co-existing. However on the other hand, a country doesn’t want to increase the state sector so much that it becomes a communist state, as this opens up a whole can of worms. Similarly having a completely laissez-faire free market can cause problems, mainly in the distribution of income and for consumers as well as the environment. If this balance is successful and the government does a good job of running the industries it owns then there shouldn’t be a problem with crowding out. Furthermore the issue of crowding out should only become a problem at or near to full employment. If the economy is operating at slack then there should be room for demand to increase without increasing the price (or not by very much). Additionally, the government can borrow at a rate much lower than the private sector, which would result in lower costs.
  • Public Good – the government may own a firm to provide a public good. Such goods are often loss-making enterprises, but they provide a useful function in society and benefit people, which may in turn boost the economy. For example, if the National Health Service (NHS) were in private hands, then the cost of medical attention would be higher (even if the system were replaced by an insurance scheme) and not available to everyone, this could result in lower health which means people can work less, which would detrimentally affect the economy. Hence the government must hold on to such industries in order to provide the public good.
  • Asset Stripping and Redundancies – the private sector may decide to make large-scale redundancies at the privatised firm in order to reduce costs, worse still they may decide to asset strip – this is a process of taking the good parts of a business, the assets, and selling them off to maximise the amount of money from a business, in the end the firm would collapse as all of its assets would have been sold off. Although this may increase efficiency, it is likely to result in an increase in unemployment (and hence benefit payments by the government increasing government spending, whilst tax revenues fall, thereby increasing costs of the sale which may not be taken into account of the sale price) and may not be in the long term interest of the firm or the economy. This problem could be exacerbated by a lack of investment by the private sector, which means the firm runs into trouble in the future. This is a problem if the privatised firm produces a public good (like health – without investment into medical machinery and the like, people’s health in the future may be affected) or operates in a natural monopoly (for example a railway firm, which needs to invest in track etc to stay viable).
  • Too big to fail – there are also some firms which are too big to fail, in the sense that if they collapse, the government would have to step in and prop them up, or renationalise them in order to support them. The obvious example here is banks, which during the Great Recession, collapsed and brought the economy down with them, they had to be bailed out to prevent a far worse calamity occurring. These firms can hence take as many risks as they want and attempt to profit maximise as much as possible, without needing to worry about the future implication of their actions, if they are certain that they will be bailed out by the government. Not only does this cause huge costs to the government (and not just the obvious costs of the bailout, but also the costs of the automatic stabilisers needed to support the economy when such firms collapse and take the economy down with them) but also to consumers, and it results in an inequal distribution of income and wealth. This point alone deserves an article in itself (which it may in the future!).

The above points aren’t exhaustive or inclusive, but are just some of the reasons against the traditional wisdom of privatisation. Although, it is important to note, that I am not saying privatisation shouldn’t happen full stop, only that in some situations it wouldn’t be viable to privatise a firm, or if it is the price needs to take into account other factors, and not just the immediate value of the business. Some firms, such as underforming or loss making ventures, ought to be sold. If the government nationalised a previously private industry to support it (for example RollsRoyce), but the firm could operate successfully on its own, then it should be sold to private sector and should make a profit for the taxpayer as a reward for bailing out firms in times of need and for turning them around. But other firms, mainly ones which operate in a natural monopoly, provide a public good, or are too big to fail, shouldn’t be sold as they aren’t likely to be more successful in the hands of the private sector.

Leave a Reply

Your email address will not be published. Required fields are marked *