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Regulation of Privatised Industries
A market in which there are large economies of scale is almost always likely to become a natural monopoly because the largest firms can exploit these economies of scales and undercut any smaller rival firms. If the monopoly opts to maximise profits it will set MR=MC and product at P1Q1. Such industries tend to have low marginal costs (variable costs) but high fixed initial costs, usually associated with developing an infrastructure. This means that to begin with there are high costs (usually expensive infrastructure and networking is required) but once these costs have been met it is relatively cheap to produce another (marginal) unit.

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