If the firm was regulated and forced to set a price equal to
the marginal cost (P*) then it would make a loss (P*-AC) [red] and hence the
business wouldn’t be viable.
Previously the government wouldn’t have allowed firms to
profit maximise on natural monopolies and no firm would want to make a loss so
the government may have nationalised such an industry. The nationalised firm
adopted the pricing strategy of a 2 tier tariff. Under this all consumers paid
a monthly charge for being connected to the supply which covered the difference
between AC and P and a variable charge (reflecting the marginal cost) on top of
this depending on usage.
This system was heavily criticised as were the managers of
the nationalised firms. It was believed that a principal agent problem arose
leading to widespread X-inefficiency.
During the 1980s there was a wave of privation of
nationalised industries, under Thatcher and Reagan, with the belief that
markets would be more efficient as managers would be constrained and
accountable to their shareholders.
To resolve the problem that they were still natural
monopolies, regulation was imposed to ensure that private firms didn’t abuse
their monopoly powers at the detriment to consumers. In some industries where
multiple firms could exist and still gain from economies of scale competition
was greatly encouraged. This is more feasible than expensive regulatory
watchdogs.
Regulatory bodies focused on price and one method to set
price was to allow price increases each year at a rate below changes in the
RPI. The RPI-X rule as it became known was meant to force companies to look for
gains in productivity to reduce the X-inefficiency in the firm. The X variable
of the formula was the percentage change in average costs that the regulators
believed could be saved. For example if RPI was at 8% and the regulators
believed there were efficiency savings of 2% (X=2) then the firm was able to
increase prices only by 6% (8%-2%). In theory it could make the other 2% by
making cost savings in order not to lose money in real terms.
The problem with this approach is how the regulators
determine the value of the variable X. There are problems of asymmetric
information and firms may meet their X target by reducing investment (causing
long-term problems) or by reducing the quality of the product. In the long run
X will fall as X-inefficiency is reduced and it becomes harder to achieve
productivity gains.
Regulatory capture may occur when a regulator becomes so attached
and involved with the firm that it is supposed to be regulating that it begins
to champion it. This may lead to problems for consumers if they have to pay
higher prices or get lower quality services.
An alternative to the RPI-X approach is to limit the rate of
return and hence supernormal profits to encourage the firm to reduce prices.
However this may lead to inefficiencies or to the firm giving away profits in
the form of managerial profits or perks.
Public
Private Partnerships (PPP)
Public Private Partnerships are a way for the government to
effectively provide public goods without necessarily doing this through the
public services. PPPs are an engagement by the public sector with the private
sector to provide certain projects.
One way this can occur is through contracting out. The public
sector awards a contract (after a lengthy auction) to a firm for the supply of
a good or service. Firms compete for the contract and can do this by reducing
the price for the contract. The public sector can then select the most
competitive bid and award that firm the contract. A PPP is a venture between a
government service and a private business.
Private
Finance Initiatives (PFI)
Another partnership model is the Private Finance Initiative which
was launched in 1992 to try and increase the involvement of private firms in
the distribution of public services. The public sector specifies what it needs
and asks firms to approach it to design, build, finance and operate the scheme.
Some of these schemes may be free standing, where the firm undertakes the
project and then directly charges for its use.
The scheme may also be a collaboration between the public and
private sectors. The public sector may be involved to ensure there are wider
social benefits which may not be included in the market price. Alternatively
the private sector may complete a project and then sell it to the public
sector. The aim of PFIs is to improve the financing of public sector projects.
This can be achieved through the competitive tendering process as well as the
shared risk.
PFIs reduce the amount of borrowing the public sector needs
to undertake as this is instead done by private firms. But it could be argued
that this may increase the cost of borrowing as the public sector may have been
able to borrow more cheaply. The private sector also has less incentive to
spend many resources on health and safety issues compared with the public
sector. However the private sector may have more experience and knowledge in
certain sectors than the government has. The government also wouldn’t have to
concern itself with the day to day running of operations as this would be
conducted by the private firm. However problems could arise and the firm may
drop out, leaving the services un-provided.
Page last updated on 20/10/13
