The Political Economy of Privatization

Thomas Clarke, Christos Pitelis

• Publisher: Routledge
• Year: 2005
• Topic: Economics
• eBook ISBN:
  9781134799015
• Subtopic: Business General
• Index: Economics

In The Political Economy of Privatization the authors assess the success of privatization. The work is an international study of the extensive privatization, and the pressure towards privatization, in different parts of the world. The book includes:
* A study of the relationship between ownership and performance;
* An assessment of the importance of market structure and regulation;
* A discussion of privatization strategies within the public sector;
* Individual country case-studies, looking at the experience of different countries engaged in the contrasting approaches to privatization.
* A critical assessment of the much vaunted relationship between ownership and efficiency.

1: INTRODUCTION
The political economy of privatization

Christos Pitelis and Thomas Clarke

Privatization of state-owned assets became a major economic policy of many countries in the 1980s, and in some cases amounted to a conscious attempt to roll back the frontiers of the state and return to the market. This was part of a reconsideration of the nature and role of the state sector in developed and less developed market economies that was resolved in favour of the view that government involvement had been excessive. At the end of the 1980s the demise of central planning in Eastern Europe led to an artempt to create markets there and, in a sense, to privatize whole economies. It is tempting to conclude from these developments that state or government failure is the norm, and that the free play of market forces is the solution to such government failures. Much of the neo-liberal theory and ideology, which received wide acclaim and influence during the 1980s, makes exactly this point. However, careful consideration of the theory and evidence of the ‘market versus government’ issue makes this belief less self-evident.

THE GROWTH OF THE STATE

The state is widely acknowledged to be one of the most important institutional devices for resource allocation (or for others for the division of labour), along with the market (price mechanism), and the firm. In centrally planned economies the state has in fact been the primary such device. However, in market economies too, the role of the state has been increasing steadily since the Second World War. In most OECD countries today government receipts and outlays as a proportion of GDP is very high—in some cases as high as 60 per cent (Mueller 1989). A multitude of theories have tried to explain the growth of the public sector in market economies, the so called ‘Wagner’s Law’, originating from a number of different ideological perspectives. In brief, neo-classical theories tend to consider such growth as a result of increasing demand for state services by sovereign consumers, while public choice theorists regard it as a result of the utility-maximizing policies of state officials, politicians and bureaucrats which tend to favour enhanced state activity. In the Marxist tradition, the growth of the state sector was linked to the ‘laws of motion’ of capitalism—increasing concentration and centralization of capital, and declining profit rates—which generate simultaneous demands by capital and labour on the state to enhance their relative distributional states, for example through infrastructural provisions and increased welfare services respectively. There are variations on these views within each school, Pitelis (1991) has a detailed discussion.

Besides explaining why states increase their economic involvement over time, many economists in the 1980s focused their attention on why states fail to allocate resources efficiently, and more particularly to the relative efficiency properties of market versus non-market resource allocation. Particularly well known here are the views of the Chicago School, in particular Milton Friedman (1969) and John Stigler (1988). In a number of papers Freidman has emphasized the possibility of states becoming ‘captive’ to special interests of powerful organized groups, notably rich business people and trade unions. Stigler among others, on the other hand, has pointed to often unintentional inefficiencies involved in cases of state interventions. Examples are redistributional programmes by the state which dissipate more resources (for example, in administrative costs) than they redistribute, suggesting the possibility of direct market-based redistribution as a more efficient solution. For these reasons, and the tendency generated by utility-maximizing bureaucrats and politicians towards excessive growth, rising and redundant costs tend to lead to government failure. Wolf (1990) has a classification of such failures in terms of derived externalities (the Stigler argument), rising and redundant costs due to officials’ ‘more is better’ attitude, and distributional inequities due to powerful pressure groups as in Friedman.

THE CASE FOR PRIVATE OWNERSHIP

On a more general theoretical level, the case for private ownership and market allocation has been based on three well-known theories. First, the neo-classical property rights school, which suggests that communal ownership (the lack of private property rights) will lead to dissipation—the ‘tragedy of the commons’. Second, Hayek’s (1985) view of ‘dispersed knowledge’. According to this, knowledge is widely dispersed in every society and efficient acquisition and utilization of such knowledge can only be achieved through price signals provided by markets. Third, Alchian and Demsetz’s (1972) ‘residual claimant’ theory suggests, much in line with the property rights school, that private capitalist ownership of firms is predicated upon the need for a residual claimant of income generating assets in the absence of which members of a coalition, for example a firm, would tend to free-ride, thus leading to inefficient utilization of resources.

There is now a huge literature on the merits and limitations of these theories— see, for example, Eggertsson (1990) for an extensive coverage. Some significant weaknesses have been exposed in each defence of private ownership and market allocation. Concerning the ‘tragedy of the commons’, it has been observed that historically communal ownership has often had efficiency enhancing effects. Hayek’s critique of pure central planning loses much of its force when one considers choices of degree, which is virtually always the case, at least in market economies. Lastly, the residual claimant theory downplays the potential incentive-enhancing attributes of co-operatives and moreover becomes weaker when applied to modern joint-stock companies run by a controlling management group.

Other well-known mainstream arguments relating to the problem of government failure are Bacon and Eltis’s (1976) claim that services, including state services, tend to be unproductive; and Martin Feldstein’s (1974) view that pay-as-you-go social security schemes tend to reduce aggregate capital accumulation. The alleged reason for this is the view that rational individuals consider their contributions to such schemes as their saving, and thus reduce their personal savings accordingly to remain at their optimal consumption-savings plans. Given, however, that the schemes are pay-as-you-go (that is, contributions are used by the government to finance current benefits), no actual fund is available, so that the individual’s reduction of personal savings represents an equivalent reduction of aggregate saving, equated by Feldstein to capital accumulation.

Some of the above reasoning is reminiscent of (and finds support by) that of some Marxist critics of the role of the state— for example, the view that the state is ‘captive’ of capitalists’ interests (Miliband 1969), and that some state services involve unproductive (that is no surplus value generating) labour (Gough 1979). This is often linked to the falling tendency of the rate of profits, which provides a feedback from government failures to private sector crises. A more specific theory of state failure (‘fiscal crisis’) in this tradition is that of O’Connor (1973) who identifies a tendency of government spending under advanced capitalism to exceed government receipts for reasons related to demands by both capital and labour on state funds and resistance on both sides to taxation, which are particularly intensified under conditions of monopoly capitalism (see Pitelis 1991 for a critical assessment).

The near universality of the attack on the state, from both ends of the political spectrum, as reflected above, is informative of the general theoretical case underlying the drive to privatize (for one of the few effective attempts to defend public provision in this period see Heald (1983)). Concerning specifically the relative efficiency properties of private sector versus public sector enterprises, the focus of attention has been in the main on issues of managerial incentives, competitive forces and differing objectives. It is alleged that public sector enterprises achieve inferior performances in terms of profits or the efficient use of resources. While private sector managers are subject to various constraints leading them to profit-maximizing policies, this need not be the case with public sector managers it is claimed. Such constraints arise from the capital market, the ‘corporate control’ (that is the possibility of the take-over of inefficiently managed firms by more efficiently run ones), the market for managers (that bad managers will be penalized in their quest for jobs), and the product market (the view that consumers will choose products of efficiently run firms for their better price for given quality).

Among other factors which tend to ensure that private sector ‘agents’ (managers) behave in conformity with the wishes of the ‘principals’ (shareholders), by maximizing profits in private firms, are, for example, the concentration of shares in the hands of financial institutions; the emergence of the M-form organization which tends to ensure that ‘divisions’ operate as profit centres; the possibility of ‘contestable markets’, that is markets where competitive forces operate through potential entry by new competitors, given free entry and costless exit conditions. It is assumed public sector enterprises are not subject to such forces, not to the same degree anyway, which implies the possibility that managerial incentives for efficient use of resources and profit maximization may be less pressing in public sector firms.

Many of the above factors are linked to the concept of competition and competitive forces, where again the claim is that public sector enterprises may be more insulated from such forces and thus less likely to pursue efficiency and profit maximization. The latter will also be true if public sector enterprises simply do not aim at such policies—for example, because they are used as redistribution vehicles by the government; and/or for other non-economic reasons such as the need for electoral support; and/or because they aim at correcting structural market failures (for example, the high prices of private sector monopolies). All these factors tend to establish the economic theoretical rationale for the efficiency of private firms and therefore for privatization (Vickers and Yarrow 1988; Kay et al. 1986, offer extended discussion on the assumed superiority of private versus state run firms).

THE FAILURES OF THE MARKET

Various limitations can be identified in the case for the relative efficiency of the private sector. One limitation arises from the possibility that the various constraints on private sector firm managers are not as strong as they are often suggested to be. For example, large size may protect inefficient firms from the threat of take-over; it may be hard to tell when a manager has performed well, given the often long-term nature of managerial decisions; and bounded rational consumers may often fail to tell differences in the quality of similarly priced products. Concerning competition, a private sector monopoly is as insulated from it as a public sector monopoly, ceteris paribus (assuming no difference in the forces of potential competition). Furthermore, the absence of competition is not per se, a reason for privatization; it could well be a reason for opening up the public sector to such forces, for example through competitive tendering and franchising (Yarrow 1986). Such considerations have led serious commentators to the conclusion that the issue is not so much that of the change in ownership structures as it is that of the nature of competitive forces and of regulatory policies (Vickers and Yarrow 1988, Yarrow 1986, Kay and Silberston 1984).

An important issue often downplayed by proponents of privatization policies is that the very reason for public sector enterprises has often been market not government failure (Rees 1986). It is worth reminding ourselves of the issues here. In mainstream economic theory, the first fundamental theorem of welfare economics shows that markets can allocate resources efficiently without state intervention, provided that market failures do not exist. Such failures, however, are widely observed, famous instances being the existence of externalities (interdependencies not conveyed through prices); public goods (goods which are jointly consumed and non-excludable); and monopolies, which tend to increase prices above the competitive norm. The observation among others that efficient government itself is a public good, has led to the idea of ‘pervasive market failure’ (Dasgupta 1986), which is viewed as the very raison d’être of state intervention (Stiglitz 1986). The very reason public sector enterprises are run by the state is that they have been seen as ‘natural monopolies’ (firms in which the minimum efficient size is equal to the size of the market as a result of economies of scale, leading to declining costs). If private, it is assumed these firms would introduce structural market failure in terms of monopoly pricing. The undertaking of the activities of such natural monopolies (often known as public utilities) by the state could solve the problem through, for example, the introduction of marginal cost pricing policies. Although such policies need not necessarily re-establish a firstbest Pareto optimal solution (given imperfections elsewhere in the economy), they could at the very least protect consumers from paying monopoly prices. This in itself would point to the limited value of any claims that public utilities do not maximize profits, given that this was not their objective to start with.

Theory and evidence seem to be less clear-cut on the issue of the relative efficiency properties of different ownership structures than would appear to be the case on the basis of the privatization mania of the 1980s. This is not to say that ownership structures do not matter, but rather that the issue of market versus non-market allocation is far more complex than is often allowed by the proponents of privatization. This conclusion need not be true if the very reason for public enterprise was misplaced to start with. Neo-classical, Chicago and Schumpeterian perspectives point to this conclusion. From the Chicago school it has been suggested by Baumol (1982), for example, that markets may be contestable—that is, characterized by free entry and costless exit. If so, potential competition will tend to ensure profit-maximizing behaviour, therefore there is no market failure and no need for public sector ownership. In the same tradition, the Coase (1937) and Williamson (1975) perspective of ‘transaction costs’, suggests that the growth of firms can often be the result of transaction costs minimizing (efficiency enhancing) strategies. If so, private monopolies are efficiency enhancing and therefore need not be nationalized. In the Chicago perspective, well known is Demsetz’s (1973) ‘differential efficiency’ hypothesis. According to this, it is higher efficiency that allows firms to grow and thus monopolize markets; again, therefore, there is little reason for seeking to nationalize large efficient firms. Lastly Schumpeter’s ‘differential innovations’ hypothesis points to a similar picture. Here, firms grow large because of successful innovations and, moreover, larger firms tend to be more innovative due to access to funds, scientific personnel, etc. For all these reasons, profit should be considered as the just reward and incentive to successful entrepreneurship, therefore the very sources of efficiency should not be removed by nationalization.

The immense literature on the issues of contestable markets, differential efficiency and differential innovation, is at best indecisive however (see Pitelis 1991 for a survey). Furthermore, and importantly, the transaction costs theory is predicated on the existence of firms as solutions to transactional market failures, and therefore strongly questions the alleged efficiency of the market. These would appear to question the simple view of the effici...

Table of contents

• COVER PAGE
• TITLE PAGE
• COPYRIGHT PAGE
• FIGURES
• TABLES
• CONTRIBUTORS
• PREFACE
• 1. INTRODUCTION: THE POLITICAL ECONOMY OF PRIVATIZATION
• PART I: OWNERSHIP AND PERFORMANCE
• PART II: MARKET STRUCTURE AND REGULATION
• PART III: PRIVATIZATION STRATEGIES WITHIN THE PUBLIC SECTOR
• PART IV: PRIVATIZATION IN ADVANCED INDUSTRIAL ECONOMIES
• PART V: PRIVATIZATION IN EASTERN EUROPE
• PART VI: PRIVATIZATION IN DEVELOPING COUNTRIES