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A sample of observations on comparative prices in public and private enterprises
Journal
of Public
Economics
11 (1979) 353-368.
0 North-Holland
Publishing
Company
A SAMPLE OF OBSERVATIONS ON COMPARATIVE PRICES IN PUBLIC AND PRIVATE ENTERPRISES Richard University
FUNKHOUSER*
ofPuerto Rico, Rio Piedras, Puerto Rico Paul W. MacAVOY
Yale Unioersiry, Received January
New Haven, CT 06520, USA
1977, revised version
received
February
1979
Assuming imperfect competition and economy-wide welfare maximization, public should have lower profit margins and thus with comparable costs should have lower private companies carrying on the same activity. Data from a sample of comparable public and private enterprises show lower public enterprise profit margins, but they higher costs, so that public enterprise prices were not lower than private enterprise attempt is made to explain and generalize on these results.
enterprises prices than Indonesian also show prices. An
1. Introduction The nationalization of private enterprises has occurred for many reasons, such as the desire to decrease prices or to reduce price variation or to redistribute income. Given this range of reasons, so many companies have been nationalized in different countries that there is now a large sample of government companies in industries containing private companies. The performance of the public companies can be compared with that of private companies operating under similar market conditions. Thus the results in terms of achieving the goals of nationalization can be at least roughly evaluated. Most of the results of interest would imply changes in price levels consequent from nationalization. Based on assumptions about the goals of public enterprise, models of relative (public versus private) prices can be constructed to evaluate the results from any one nationalization action. One *The collection of the sample took place while the authors were consultants to the Indonesian Minister of Finance, as members of the Harvard Development Advisory Group in Jakarta. Indonesia. No such effort could have taken place without the financial assistance of the Ford Foundation and the material assistance in Jakarta of Wilhelm Boucherie (Harvard), William Hollinger (Harvard), Julianto Moeliodihardjo (Ministry of Finance) and Eben Walker (First National City Bank). At various times our colleagues E.E. Bailey, ;W.J. Baumol, Martin Feldstein, Lester Gordon, A.B. Atkinson and an anonymous reader have helped with both the mathematics and the economics. We are grateful to all of them.
354
R. Funkhouser and P. W. MacAooy, Comparative prices
important model sketched below shows that with lower price-cost margins and comparable costs, the public companies should have lower prices than would private companies in the same market. These theoretical price differences are tested against data from a particular sample of public and private corporations. The data come from income statements of more than 100 Indonesian public and private corporations in the early 1970s. The pattern of nationalization that took place in Indonesia in the 1950s and 1960s resulted in public and private companies operating in the same industries. Examination of the data, as described below, show some conformity between theoretical and actual pricing for the Indonesian sample in that the public companies had lower price-cost margins, but some disparity as well in that the public companies with low margins also had higher costs in a number of cases. Thus margins were squeezed by cost increases rather than by price reductions. This pattern is rationalized in an expanded version of the model by means of the insertion of a public enterprise ‘tax’ on costs levied for other political and social reasons.
2. Pricing theory Social or private goals and market conditions under which both public and private companies operate are so varied that no single model can be used for comparing public and private company prices. For the comparisons we undertake here, with respect to market conditions, it is assumed that public and private companies each make pricing decisions without considering the pricing reactions of firms in the other sector, so that the pricing decision of the public firm does not depend on a price reaction of the private firm, or vice versa. Also it is assumed that potential entry of a private firm does not determine the pricing decisions of a public firm. Thus the analysis is based on assumed market conditions ranging from blocked-entry monopoly to free-entry imperfect competition, but not including oligopoly. We now set out the models and pricing rules for the relevant firms. 2.1. The profit
muximizing
For a company
selling n products,
IZ = C Piqi -
and
private firm
c(qi),
the profit equation
where i=1,2 ,..., n,
n = profit, pi = price of the ith product, qi = quantity of ith product, C(q,) = cost equation, Cp,q, = revenue equation.
to be maximized
is
R. Funkhouser and P. W. MacAvoy, Comparative
The company’s (Pi
pricing -
rule to achieve maximum
acl~dh
=
-
prices
355
profit is
11%
where e, =price elasticity of the ith product. In order to compare the behavior of actual companies using balance sheet and income statement accounting, this pricing rule leads to an observable net cash flow as a percentage of sales of (PiYi
-
Wli)lPi4i
=
-
llei
+
(9ilPi)(dW%ih
where mi= average variable cost of production, with no provision made for interest and depreciation. From the right-hand side of eq. (3) we can see that this margin will be greater than or equal to zero since all terms are positive. Even for the imperfectly competitive private firm there should be a positive margin of prices over unit production costs.’
2.2. The utility maximizing
public enterprise
A central concern of the public enterprise pricing literature has been the establishment of necessary conditions for achievement of a Pareto optimal allocation of resources. In this request early notions of the efficacy of marginal cost pricing have been superceded by models incorporating secondbest considerations and redistributional goals. But many of the newer models have been developed in a normative context and their operational usefulness is limited. One of the more important recent models with operationality is that of Baumol and Bradford’ who assume the public enterprise is operating to add to consumers’ benefits (over what would be forthcoming from paying private prices). With existing data the implications of this model can be tested against the experience of public enterprises to determine whether or not they are achieving such public goals. In the Baumol-Bradford public firm the social utility CJ=U(q,,r) of producing n products in simple firms using one resource, r, is maximized subject to two constraints:3 (1) do not use more than the initial resource endowment, R:
‘Except of course for the case of the firm operating under perfect competition with constant marginal costs. ‘W.J. Baumol and D. Bradford, Optimal departures from marginal cost pricing, American Economic Review, 60, June 1970. 3This is a simplification of Baumol and Bradford, provided by W.J. Baumol in a letter to P.W. MacAvoy of 28 February 1973.
356
R. Funkhouser
(2) earn M dollars
The pricing
rule under
and I’. W. MacAl;oy,
Comparatiae
prices
in profit:
these conditions
is
(pi - ~C/~qi)/pi = - ~/( 1 + ~)ej. Or, in terms of cash flow as a percentage
(4) of sales,
(PiYi - miqi)lPiqi = - j-/t1 + 2-)ei + (qi/Pi)(Zmi/c7qi).
(5)
This margin is the same as that of the private company if ei is the same and if i-/(1 +A)= 1, which would occur only when A= m. Otherwise the public firm’s margin is less than the private firm’s margin, since A< x implies A/(1 + 2) < 1. When A =O, the public firm’s price-cost margin equals zero because the public firm is maximizing consumer welfare. In summary, profit margins for the private firm and Baumol-Bradford public firm are, respectively (PiYi - miPi)lPiYi = - 1/ei + (qilPi)tamilFqi)
(6)
(PiYi - Vli)lPiqi
(7)
and = - ELl(1+ i)ei + (qilPi)(amilaqi).
The predictions of differences implied by these models are: profit margins will be higher for the private firm than for the public firm with the size of the difference dependent on the severity of the profit constraint; prices will be higher in the private firm given that costs of production are assumed to be the same in each comparable company. 3. Data on pricing in Indonesia Nationalization of Dutch companies in Indonesia upon the gaining of political independence resulted in central government ministries becoming the controllers of corporations in transportation, agriculture, manufacturing, finance and distribution. Private companies, both domestic and foreign, continued to operate in these sectors, especially in agriculture, manufacturing, finance and distribution. In some cases, private and public companies sold in the same markets; in others, they sold the same products but in different parts of Indonesia. Throughout the 1960s and early 1970s production conditions, public policies on import licensing and local taxes, and demand conditions were roughly the same for public and private operations on Java, Sumatra and Bali.
R. Funkhouser
und P. W. MucAvoy,
Compurcrtiue
prices
351
Data were collected from the records of more than 100 public companies on the islands. These data for 1971 were compiled for public companies from reports made by them to the Minister of Finance acting as public stockholder. They provided income information for calculating profit margins on sales for 64 companies, average production costs for 56 companies, and measures of labor productivity for 49 companies. The company-wide information and some of the individual statistics on particular operators were checked against information from state banks making loans to these companies, and inconsistencies were removed by establishing through interview which were the correct estimates. Comparable private company data were very difficult to obtain. Most private corporations in Indonesia have been privately owned and reports on performance not publicly distributed. Moreover, bank or public debt holders in many companies were inaccessible, since they were sources in Hong Kong or Singapore. But requests made by Harvard Advisory Group members directly to companies for cooperation on this research project eventually produced data on more than 50 privately-held companies operating in the same industries as the government or public enterprises. The financial information was checked against the tax records of these companies and against independent estimates of a private investment banking group also collecting company data for investment purposes4 Differences were dealt with in subsequent interviews until samples of size 30 to 40 observations remained.5 Recent performance statistics for private and public companies are shown in tables 1 to 3. ‘Profit margins’ in table 1 indicate company sales revenues minus direct expenses divided by sales revenues, as representative of (piqi --w~~q~)/~.+q~ in eqs. (4) and (5). Average, high and low profit margins are shown for public and private companies in 11 industries. The coverage includes firms in most sectors of the economy and in most ministries. Both highly competitive conditions (in agriculture) and monopoly conditions (in cement and fertilizer) are represented although domestic monopolies were subject to competition from abroad. A first examination of table 1 shows
4The banking group collected data from companies in 1972 via interview, for the purpose of determining whether it was feasible to establish an international private investment bank in Jakarta. Companies cooperated with the group by providing detailed current financial and investment planning information. Those cooperating most fully presumably did so in anticipation of loans or investments from the bank after it was set up, so that then information if biased would have indicated recent performance supporting ‘good’ prospects for further investment. 5Tax records for a number of companies showed sales and profit margins lower than reported to the investment banking group. When the differences could be reconciled as terminological differences (as in ‘costs’ for purposes of taxation) or could be eliminated by the corporate manager by showing that one estimate was more ‘accurate’ than another, then the observation was included in the sample. The sample sizes are 35 (profit margins on sales), 40 (unit costs) and 30 (productivity).
communications communications agriculture agriculture agriculture industry industry trade linance finance public works
Supervising ministry
‘Profit margin: sales minus direct expenses for insurance and trading.
Shipping Airlines Rubber Palm oil Sugar Cement Fertilizer Trading Banking Insurance Construction contractors emgineers architects
Industry
as a percentage
Table
1
5 2 *
4 4 3
7 10 25
15 19 31 65 54 42 21 58 49 89
High
(7”)
49 43 _
3 9 17
31 48 43
3 -32 50 4 2 14
(u,,)
23 34 39
35 69 42
_
32 43
16
15 21 36
51 29
10
25 43
-3
Low
of value-added
Average
as a percentage
_ 54 85 67
30 27
49
40 _
High
Profit margin (private)
0
Low
minus direct expenses
5 6 18
6 64 16 46 33 37 27 24 13 68
Average
Profit margin (public)
firms.
Value added
firms firms tirms
firms
of sales revenues.
‘
6 no 5 1 no no no 5 5 4
Private
3 2 10 6 I 3 1 11 6 4
Public
of
in public and private
Number firms
Pricing
in the early 1970s approximately
av.cost/ton cargo DC/ton km sold DC/kg DC/kg DC/ton DC/ton DC/value-added DC/net revenue DC/value-added DC/sales
Shipping Airlines Rubber Palm oil Cement Fertilizer Trading Banking Insurance Construction contractors engineers architects
‘Rp=rupiah,
Measure
Industry
Table 2
5 2 2
4 3 3 415 to the dollar.
6 none 1 4 5 1 5 5 4
Private Rpa USS RP RP RP RI,
96 98 86
12 700 0.16 114 56 6546 20601 97 132 51
High
Cost (public)
costs in public and private
3 2 10 6 3 1 11 6 4
Public
EYirzber Of
Unit production
96 94 81
6967 0.12 91 39 6148 20601 76 87 32
Average
enterprises
93 89 75
3600 0.08 69 27 5474 20601 42 51 11
Low 9500 _ 69 40 6363 18896 90 49 71 85 79 64
RP RP RP RP RP
%
High
Cost (private)
77 66 60
69 33 4600 18896 65 31 58
4195 _
Average
69 52 54
69 28 2697 18890 46 15 33
1020
Low
contractors engineers architects
Construction
Insurance
dwt/EE ton/km/avil/EE
Shipping Airlines Rubber Palm oil Cement Fertilizer Trading
kg/FE kg/EE tons/capac/EE tons/capac/EE value-added/EE (Rp thousands) value-added/EE (Rp millions) sales/EE (Rp millions)
Measure
Industry
Productivity
1
3 2 10 3 3
Pubiic
Number firms
5 4 3
4
11
Table 3
of
5 2 2
4
5 none 1 3 5 1 2
Private
in public and private
9.940 9.3 1.3
6.1
38 60516 1312 6204 416 63 1056
High
7.0 3.4 0.8
3.4
24 44 164 890 4901 251 63 672
Average
Productivity (public)
enterprises.
4.570 0.7 0.4
0.5
14 21811 528 3144 171 63 417
Low
10.7 7.3 3.2
1.4 4.0 1.8
1.0
2275 13045 1545 273 153
2215 16817 1717 273 1061 1.3
25
Average 36
High
Productivity (private)
3.1 0.6 0.5
0.4
2215 1711 1380 273 444
13 _
Low
P K‘ Z
2 2 ? i? $’
Z b S Y
;
?J * f Z 9 5 a 6
R. Funkhouser and P. W. MacAvoy, Comparative prices
361
higher average profit margins for private companies in most industries where there are data for both. Tables 2 and 3 provide summary indicators of public and private company costs and productivity. With less data available in these areas, the sample is smaller for comparing public and private companies in the same industries. There is only one observation of a private company in fertilizer, which was obtained by using data from companies in this industry in adjoining Southeast Asian countries. Local private company data in cement were also supplemented in this way. A first examination would seem to indicate higher costs and lower productivity on average in public companies than in private companies in the same circumstances. 4. Comparing prices of public and private firms More systematic examination should establish whether, in keeping with Baumol-Bradford theory, profit margins in Indonesian public enterprises were systematically lower than those of comparable private enterprises. If comparisons are limited to firms strictly operating under the same market conditions, the sample size becomes too small to permit any conclusions. However, some comparisons are possible within four subsamples as follows: (1) all public and private firms; (2) all public and private lirms from those industries in which there are both types of companies; (3) public and private firms of comparable size only; and (4) public and private firms ‘paired’ on the basis of comparable levels of sales of the same products. The first sample is put together on the assumption that demand and cost conditions are much the same not only across firms but also across industries. Given the variety of firms and industries we cannot state that this is indeed the case, but many of the products are broadly defined and (except in agriculture) are all sold in domestic markets of about the same degree of imperfection in competition, so that the companies may face about the same demand elasticity conditions. For this sample the firms are viewed simplistically as one-product firms acting independently of each other such that the cross elasticities of products of all firms are zero and demand elasticities for their products approximately equal to minus one. In an economy centering on tropical agriculture, there are no recognizable economies of scale or special conditions for purchase of input factors, so that dmi/dqi is approximately the same for firms across processing and trading industries. To the extent that this holds, profit margins can be compared across industries simply by averaging those of all private firms and those of all public firms and analyzing the differences.6 6For the Baumol-Bradford conditions, all companies set profit margins on sales so that (piqi - miqi)/piqi= pi = I/( 1+ I)ei + (q,/p,)(dmJdq,).The public firms are assumed to have the same values of I, ei and (ami/dqi). The private firms are assumed to have the same values of ei and dm,/dq, as the public firms, but with I.=co. The comparison for the public and private firms should show the profit constraint for the public firms by a lower average pti
362
K. Funki~user
and P. W. MrrcA~~q.
Compuruticx
prices
The comparative performance of public and private companies in this first sample is shown in table 4. The average profit margin for 62 public companies was 26 “/: and for 37 private companies was 36%.7 The hypothesis that the difference of 10% is insignificant is rejected given that the standard deviation of the difference of means is 4.6 “/I. To the extent that the assumptions held as to cost and demand conditions, and thus this sample can be considered relevant, then public companies had a significantly lower average profit margin on sales than private companies. The lower margin for public firms could be due, however, to departures of actual demand and cost conditions from those assumed. By eliminating from the sample those public companies from industries in which there are no the costs and demand conditions of the comparable private companies, remainder would likely be more similar. This modification was made for sample two, and the reduced sample shows differences in profit margins even greater than in sample one, suggesting that the margins for public firms have been greater in those industries in which there are few private firms. By eliminating all observations for which public and private firms are not of comparable size, so that the cost conditions implied by the term (qi/pi)(&ni/i$,) are more comparable, a third sample has been constructed. Here the average profit margin of public companies is 1.5 percentage points lower than private companies, and the difference is statistically significant. Thus some of the higher profit margin companies in the public sector were ‘out of scale’ (and primarily larger) with respect to private companies. By pairing public and private companies in the same industry on the basis of comparable levels of sales, repeating an observation for either a public or a private company to complete all pairs, the fourth sample has been constructed. The 31 paired observations indicate that public companies have profit margins on average 14 percentage points lower than private companies, a difference that again is statistically significant. Although all four samples overlap, they together indicate that public companies have lower profit margins than private companies.* Were public-private differences in profit margins the same in different industries? This possibility has been investigated as follows. By subtracting the private company profit margin from that of the public company in the ‘The sample sizes depart from those shown in table 1 because of two changes. One public company half-owned by a foreign private company was reclassified as a private company. Two public insurance companies were ‘merged’ for purposes of comparison because the business of one of them consisted of servicing the other. sFurther assessment of this difference between public and private company profit margins can be gained by means of chi-square analysis. Using observations from sample two, in which data are included only for those industries where there are both public and private companies, a contingency table has been constructed by classifying the firms according to whether they had profit margins higher or lower than their industry average. The chi-square test performed on this basis gives the result x2 = 11.87 > ,x20.95 = 3.85, which indicates that the profit margins of public firms are significantly lower than those of private firms.
and
private
“Note: ex a_R 0is the standard
public
deviation
31
19
3. Public and private firms of comparable size only 25
4. Paired firms
36
49
in inpublic
2. Observations only dustries with both and private firms
37
62
in both private
1. All observations public and enterprise
of the differences
0.23
0.24
0.22
0.26
Public
Average margin
of means.
0.37
0.39
0.36
0.36
0.063
0.080
0.050
0.046
ox.-X,
between
Table 4 differences
Private
profit
costs and productivity
Private
Public
Sample number and description
Sample size
Profit margins,
0.888
0.929
1.015
1.016
Public
Average costs
0.895
0.925
0.877
0.818
Private
direct
public and private
0.076
0.098
0.075
0.086
OR.-Xp
enterprises,
0.796
0.851
1.002
0.949
Public
1.153
1.111
0.992
1.134
Private
0.224
0.236
0.189
0.159
“X.-X,
productivity average)
(7” of industry
Labor
1971.”
364
R. Funkhouser and P. W. MacAvoy, Comparative prices
same industry, assuming the same marginal cost functions for the two companies, the expression do - pP = l/( 1 + n)e, + (qG - qp)ami/lTqi is obtained where po and p,, are the government company and private company margins, respectively. Assuming ami/i3qi is a constant, it can be estimated as a parameter (b) in the regression equation ho - pP = a, + C aid, + b(q, -4,) with qG and qp being government and private firm sales, respectively. These regressions have been fitted for the sample of 31 paired public and private companies, where di is an industry dummy variable to capture the effect of variations in demand elasticities ei and profit constraints from industry to industry. Successive regression equations indicate that the coefftcient b is not significantly different from zero. The dummy variables for industry were signilicantly different from zero only for banking, insurance and construction. The regression equation pG -pp=
-6.23 -53.56 bank. +41.73 insur. - 15.35 constr. (5.15) (10.30) (15.01) (4.13)
R= = 0.625
shows these interindustry variations in margins, with standard errors given in brackets. The four ‘base’ industries show public company margins 6.2 percentage points lower (an insignificant difference), but public banking company margins were 53.5 percentage points lower, public insurance company margins 41.7 percentage points higher, and public construction company margins 15.4 percentage points lower than margins for private companies. Thus the answer to the question is that margin differences vary greatly across industries, and the average difference is mostly associated with finance and construction industry behavior. Are the observed differences in profit margins between public and private enterprises due to demand conditions (differences in e,), the cost conditions (the differences in &ni/dqi assumed away in the regression analysis), or to degrees of zeal shown by the public authority in keeping prices down to the consumer’? The answer would require information on e, and tTjm,/dq, by firm and industry that is not available at the present time. But some indicative cost information is available. Table 4 indicates attempts to compare unit operating costs between public and private firms in the same industries. Taking all public and private firms as the full sample (sample one) public company costs are above average and private company costs below average, as shown by the ratio of public company to industry average costs, m&i, exceeding 1.0 while the ratio of private company to industry average costs falls short of 1.0. When only pairs of public and private firms of the same size are included in the sample (samples three and four) the cost difference disappears. Both public and private companies have unit costs from 88 to
R. Funkhouser and P. W. MacAvoy, Comparative prices
365
93 % of the industry average, because very large public companies with unit costs closer to the average of the industry costs (in fertilizer, cement, airlines and sugar) have been excluded from the samples, as have some very small public companies (in rubber and trading). Thus the public companies ‘out of scale’ with respect to their industries appear to have had higher costs as well as lower profit margins.g Of particular interest are costs in banking, insurance and construction. By subtracting private from public company unit costs, m, - m,=(X/d, -dC/dq,)-(qc -q&?m/dq, where again it is assumed that the slopes of the unit cost functions are the same for public and private firms. Regression for in, - mp = a0 + C aid, + b( qG -qp) should indicate higher marequations ginal costs in the public firms in industry i by a significant positive coefficient a, on the industry dummy variable di. Successive regressions indicate an insignificant value for b and insignificant values, as well, for coefficients for dummy variables for most industries. The coefficients for banking, insurance and construction have the highest levels of significance, as follows (with standard errors given in brackets): mo - mp = - 6.21+ 66.01 bank. - 28.29 insur. + 27.41 constr.. (8.33) (16.67) (24.30) (14.77) R2 = 0.444. Here it is shown that the costs of government banking and construction companies are significantly higher than for private companies in those industries,” and public company costs in the insurance industry are insignificantly lower than costs for private companies in that industry. There would appear from all of this to be a pattern for public versus private enterprise costs and profit margins. The various tests support the hypothesis of lower public profit margins and higher public unit output costs for industries where there are both public and private companies. These differences are further defined in the regression analysis indicating that public ‘The hypothesis that public enterprise costs are higher is supported by the results of a chisquare analysis. Taking industries in which both public and private firms operate (sample two), a contingency table was constructed by classifying the public and private firms according to whether they had higher or lower than industry average costs. A chi-square test performed on this data shows that unit output costs of public firms are significantly higher than those of private firms, the result being x2 = 26.07 > ,x20.95 = 3.85. “‘One question that arises for these industries is whether the high cost is accompanied by lower labor productivity, as would be expected if the public enterprise is redistributing income by overpaying and overhiring labor. The question cannot be answered conclusively due to a lack of productivity data for private firms in the banking industry. However, in each area of the construction industry (i.e. contractors, engineers, architects) average labor productivity in the public firms is exceeded by that in private firms, as seen in table 3. Labor productivity differences also appear for samples 3 and 4 in table 4, where it can be seen that private firm labor productivity exceeds the industry average while that of public tirms is significantly lower than the industry average.
366
R. Funkhouser and P. W. MacAvoy, Comparative
prices
companies in banking and construction had lower profit margins and higher costs than their private counterparts. (In insurance, where the public companies’ average profit margin was higher than the private companies’ average, public company unit costs were significantly lower.) Thus where there were public-private differences, public prices were not reduced closer to the industry-wide cost level, but rather public firm costs were increased to the industry-wide price levels. The rather startling conclusion that lower public company margins were due to higher costs should be discussed. With the exception of insurance, the highest cost firm in every industry was a public firm. The second highest cost firm in 8 of 11 industries was also a public firm. Moreover, of the three public firms in shipping, the highest cost firm had a negative profit margin. Out of ten public trading companies, the four highest cost firms had operating losses. The two highest cost firms in the banking sector were public banks, each with operating or variable costs that exceeded current revenues. The three highest cost firms in the engineering sector were public, one of which suffered operating losses. The public enterprises with the highest unit costs departed from average costs in their industries more widely than did the ‘higher cost’ private firms. A possible explanation for this is the lack of an internal government institution for public firms comparable to bankruptcy proceedings for private companies. Ailing enterprises on a downward spiral of sales and profitability continued to operate with negative profit margins without any ‘benchmark’ process leading to their reorganization and restoration to financial health. Thus the variations between Indonesian public and private company pricing go beyond those predicted from the theory of public versus private enterprise. There was a tendency for public enterprise profit margins to be lower, but the lower margins were dictated by higher costs rather than by lower prices under public control in a number of important industries.
5. Rationalizing
pricing practices in light of the empirical findings
There could be any number of reasons why operating costs have been higher and profit margins lower in the public enterprises. If the public firms had different relative factor costs than private firms, they could be operating at similar output levels but at a different point on the transformation curve, with higher variable costs and lower profits. Alternatively, the public and private firms could be utilizing the same factor input ratio but with the public firm operating at a higher output level with higher unit costs (and charging a lower price) in order to supply greater amounts to consumers. For the public enterprises in question, higher costs and lower profits cannot be traced either to their operating with different factor input ratios or their desire to provide more output. Instead, it seems that all cost elements
R. Funkhouser and P,W. MacAvoy, Comparative prices
361
in the public firms are higher, and it is this phenomenon which requires explanation. In the Indonesian case the ministries that set the usual ‘public welfare’ goals for public enterprises did not have the control mechanisms to establish these goals for operations of management out in the field. With only schematic controls being exercised by the central administration, the local company was subject to pressures from other central government agencies, from local government and from its employees to pursue other goals. For instance, the local governments in some cases sought to raise local employment, or required the local purchase of materials from certain suppliers at higher prices. In one case an army brigade was garrisoned in the middle of a complex of government plantations to be ‘employed’ on a palm oil plantation. The nature of such locally established goals is such that the public enterprise is required to increase disbursements to the factors of production it employs, so that the goals are met by payments to factors - resulting in higher operating costs - rather than by increased dividend payments. These pressures can be rationalized with a simple model that takes account of the assumed goals of the ministry but that also imposes a ‘tax’ on operations to meet the requirements of local political organizations. The ministry wants to maximize the social utility function U = U(q,, r) subject to a budget constraint and a profit constraint, so that the Baumol-Bradford utility function and constraints (1) and (2) hold. But assume a cost function of the form C* = (1 + cC)C(qi),
(8)
in which alpha is a measure of the local ‘tax’ to meet other goals and C(Q) is the cost function of the comparable private firm, which we assume is the ‘truly efficient’ cost of producing. When there is local interference in the public enterprise and the costs of the public and private firm are the same, alpha is greater than zero. The pricing rule under those conditions is (Pi - (1 + a)X/dqi)/Pi
= -A/( 1 + A)ei
or, in terms of cash flow as a percentage
(PfJ-(l
(9)
of sales,
+a)m,/pi4,)= -E-/(1 +A)ei+(l
+@)(L/i/pi)(?mi/i~i),
(10)
Thus the pricing of the public firm differs from that of the private firm operating under the same market conditions. Profit margins in the public firm will be lower than in comparable private firms, because of the income constraint on public operations. But costs in the public firm will be higher by the factor (1 +u). With lower margins but higher observed costs (1 + cr)C(q),
368
R. Funkhouser and P.W. MacAvoy, Comparative prices
prices in the public firm could approach the level of those in private firms, depending on the actual extent to which costs of public firms are higher. This simple model has two positive attributes. (1) Although derived from the general Baumol-Bradford approach, it has been changed to reflect empirical regularities in the one country to produce data. (2) It can be used to test the proposition that public enterprises operate at higher costs. If in further empirical studies profit margins of public companies tend to be lower while prices are not lower than in comparable private enterprises, then the alpha tax vitiates the economy-wide gains from public ownership. The ‘CI’tax on public operations need not be very large to eliminate any price reduction from public ownership; with I= -2 and A= 10, then TVneed be only 20 % to cancel out the price reducing proclivities of the public company. The question is whether the ‘tl’ tax prevails to the extent that the price-reducing targets of public corporations are not reached because of an equally strong tendency towards cost increases in those companies.
of Public
Economics
11 (1979) 353-368.
0 North-Holland
Publishing
Company
A SAMPLE OF OBSERVATIONS ON COMPARATIVE PRICES IN PUBLIC AND PRIVATE ENTERPRISES Richard University
FUNKHOUSER*
ofPuerto Rico, Rio Piedras, Puerto Rico Paul W. MacAVOY
Yale Unioersiry, Received January
New Haven, CT 06520, USA
1977, revised version
received
February
1979
Assuming imperfect competition and economy-wide welfare maximization, public should have lower profit margins and thus with comparable costs should have lower private companies carrying on the same activity. Data from a sample of comparable public and private enterprises show lower public enterprise profit margins, but they higher costs, so that public enterprise prices were not lower than private enterprise attempt is made to explain and generalize on these results.
enterprises prices than Indonesian also show prices. An
1. Introduction The nationalization of private enterprises has occurred for many reasons, such as the desire to decrease prices or to reduce price variation or to redistribute income. Given this range of reasons, so many companies have been nationalized in different countries that there is now a large sample of government companies in industries containing private companies. The performance of the public companies can be compared with that of private companies operating under similar market conditions. Thus the results in terms of achieving the goals of nationalization can be at least roughly evaluated. Most of the results of interest would imply changes in price levels consequent from nationalization. Based on assumptions about the goals of public enterprise, models of relative (public versus private) prices can be constructed to evaluate the results from any one nationalization action. One *The collection of the sample took place while the authors were consultants to the Indonesian Minister of Finance, as members of the Harvard Development Advisory Group in Jakarta. Indonesia. No such effort could have taken place without the financial assistance of the Ford Foundation and the material assistance in Jakarta of Wilhelm Boucherie (Harvard), William Hollinger (Harvard), Julianto Moeliodihardjo (Ministry of Finance) and Eben Walker (First National City Bank). At various times our colleagues E.E. Bailey, ;W.J. Baumol, Martin Feldstein, Lester Gordon, A.B. Atkinson and an anonymous reader have helped with both the mathematics and the economics. We are grateful to all of them.
354
R. Funkhouser and P. W. MacAooy, Comparative prices
important model sketched below shows that with lower price-cost margins and comparable costs, the public companies should have lower prices than would private companies in the same market. These theoretical price differences are tested against data from a particular sample of public and private corporations. The data come from income statements of more than 100 Indonesian public and private corporations in the early 1970s. The pattern of nationalization that took place in Indonesia in the 1950s and 1960s resulted in public and private companies operating in the same industries. Examination of the data, as described below, show some conformity between theoretical and actual pricing for the Indonesian sample in that the public companies had lower price-cost margins, but some disparity as well in that the public companies with low margins also had higher costs in a number of cases. Thus margins were squeezed by cost increases rather than by price reductions. This pattern is rationalized in an expanded version of the model by means of the insertion of a public enterprise ‘tax’ on costs levied for other political and social reasons.
2. Pricing theory Social or private goals and market conditions under which both public and private companies operate are so varied that no single model can be used for comparing public and private company prices. For the comparisons we undertake here, with respect to market conditions, it is assumed that public and private companies each make pricing decisions without considering the pricing reactions of firms in the other sector, so that the pricing decision of the public firm does not depend on a price reaction of the private firm, or vice versa. Also it is assumed that potential entry of a private firm does not determine the pricing decisions of a public firm. Thus the analysis is based on assumed market conditions ranging from blocked-entry monopoly to free-entry imperfect competition, but not including oligopoly. We now set out the models and pricing rules for the relevant firms. 2.1. The profit
muximizing
For a company
selling n products,
IZ = C Piqi -
and
private firm
c(qi),
the profit equation
where i=1,2 ,..., n,
n = profit, pi = price of the ith product, qi = quantity of ith product, C(q,) = cost equation, Cp,q, = revenue equation.
to be maximized
is
R. Funkhouser and P. W. MacAvoy, Comparative
The company’s (Pi
pricing -
rule to achieve maximum
acl~dh
=
-
prices
355
profit is
11%
where e, =price elasticity of the ith product. In order to compare the behavior of actual companies using balance sheet and income statement accounting, this pricing rule leads to an observable net cash flow as a percentage of sales of (PiYi
-
Wli)lPi4i
=
-
llei
+
(9ilPi)(dW%ih
where mi= average variable cost of production, with no provision made for interest and depreciation. From the right-hand side of eq. (3) we can see that this margin will be greater than or equal to zero since all terms are positive. Even for the imperfectly competitive private firm there should be a positive margin of prices over unit production costs.’
2.2. The utility maximizing
public enterprise
A central concern of the public enterprise pricing literature has been the establishment of necessary conditions for achievement of a Pareto optimal allocation of resources. In this request early notions of the efficacy of marginal cost pricing have been superceded by models incorporating secondbest considerations and redistributional goals. But many of the newer models have been developed in a normative context and their operational usefulness is limited. One of the more important recent models with operationality is that of Baumol and Bradford’ who assume the public enterprise is operating to add to consumers’ benefits (over what would be forthcoming from paying private prices). With existing data the implications of this model can be tested against the experience of public enterprises to determine whether or not they are achieving such public goals. In the Baumol-Bradford public firm the social utility CJ=U(q,,r) of producing n products in simple firms using one resource, r, is maximized subject to two constraints:3 (1) do not use more than the initial resource endowment, R:
‘Except of course for the case of the firm operating under perfect competition with constant marginal costs. ‘W.J. Baumol and D. Bradford, Optimal departures from marginal cost pricing, American Economic Review, 60, June 1970. 3This is a simplification of Baumol and Bradford, provided by W.J. Baumol in a letter to P.W. MacAvoy of 28 February 1973.
356
R. Funkhouser
(2) earn M dollars
The pricing
rule under
and I’. W. MacAl;oy,
Comparatiae
prices
in profit:
these conditions
is
(pi - ~C/~qi)/pi = - ~/( 1 + ~)ej. Or, in terms of cash flow as a percentage
(4) of sales,
(PiYi - miqi)lPiqi = - j-/t1 + 2-)ei + (qi/Pi)(Zmi/c7qi).
(5)
This margin is the same as that of the private company if ei is the same and if i-/(1 +A)= 1, which would occur only when A= m. Otherwise the public firm’s margin is less than the private firm’s margin, since A< x implies A/(1 + 2) < 1. When A =O, the public firm’s price-cost margin equals zero because the public firm is maximizing consumer welfare. In summary, profit margins for the private firm and Baumol-Bradford public firm are, respectively (PiYi - miPi)lPiYi = - 1/ei + (qilPi)tamilFqi)
(6)
(PiYi - Vli)lPiqi
(7)
and = - ELl(1+ i)ei + (qilPi)(amilaqi).
The predictions of differences implied by these models are: profit margins will be higher for the private firm than for the public firm with the size of the difference dependent on the severity of the profit constraint; prices will be higher in the private firm given that costs of production are assumed to be the same in each comparable company. 3. Data on pricing in Indonesia Nationalization of Dutch companies in Indonesia upon the gaining of political independence resulted in central government ministries becoming the controllers of corporations in transportation, agriculture, manufacturing, finance and distribution. Private companies, both domestic and foreign, continued to operate in these sectors, especially in agriculture, manufacturing, finance and distribution. In some cases, private and public companies sold in the same markets; in others, they sold the same products but in different parts of Indonesia. Throughout the 1960s and early 1970s production conditions, public policies on import licensing and local taxes, and demand conditions were roughly the same for public and private operations on Java, Sumatra and Bali.
R. Funkhouser
und P. W. MucAvoy,
Compurcrtiue
prices
351
Data were collected from the records of more than 100 public companies on the islands. These data for 1971 were compiled for public companies from reports made by them to the Minister of Finance acting as public stockholder. They provided income information for calculating profit margins on sales for 64 companies, average production costs for 56 companies, and measures of labor productivity for 49 companies. The company-wide information and some of the individual statistics on particular operators were checked against information from state banks making loans to these companies, and inconsistencies were removed by establishing through interview which were the correct estimates. Comparable private company data were very difficult to obtain. Most private corporations in Indonesia have been privately owned and reports on performance not publicly distributed. Moreover, bank or public debt holders in many companies were inaccessible, since they were sources in Hong Kong or Singapore. But requests made by Harvard Advisory Group members directly to companies for cooperation on this research project eventually produced data on more than 50 privately-held companies operating in the same industries as the government or public enterprises. The financial information was checked against the tax records of these companies and against independent estimates of a private investment banking group also collecting company data for investment purposes4 Differences were dealt with in subsequent interviews until samples of size 30 to 40 observations remained.5 Recent performance statistics for private and public companies are shown in tables 1 to 3. ‘Profit margins’ in table 1 indicate company sales revenues minus direct expenses divided by sales revenues, as representative of (piqi --w~~q~)/~.+q~ in eqs. (4) and (5). Average, high and low profit margins are shown for public and private companies in 11 industries. The coverage includes firms in most sectors of the economy and in most ministries. Both highly competitive conditions (in agriculture) and monopoly conditions (in cement and fertilizer) are represented although domestic monopolies were subject to competition from abroad. A first examination of table 1 shows
4The banking group collected data from companies in 1972 via interview, for the purpose of determining whether it was feasible to establish an international private investment bank in Jakarta. Companies cooperated with the group by providing detailed current financial and investment planning information. Those cooperating most fully presumably did so in anticipation of loans or investments from the bank after it was set up, so that then information if biased would have indicated recent performance supporting ‘good’ prospects for further investment. 5Tax records for a number of companies showed sales and profit margins lower than reported to the investment banking group. When the differences could be reconciled as terminological differences (as in ‘costs’ for purposes of taxation) or could be eliminated by the corporate manager by showing that one estimate was more ‘accurate’ than another, then the observation was included in the sample. The sample sizes are 35 (profit margins on sales), 40 (unit costs) and 30 (productivity).
communications communications agriculture agriculture agriculture industry industry trade linance finance public works
Supervising ministry
‘Profit margin: sales minus direct expenses for insurance and trading.
Shipping Airlines Rubber Palm oil Sugar Cement Fertilizer Trading Banking Insurance Construction contractors emgineers architects
Industry
as a percentage
Table
1
5 2 *
4 4 3
7 10 25
15 19 31 65 54 42 21 58 49 89
High
(7”)
49 43 _
3 9 17
31 48 43
3 -32 50 4 2 14
(u,,)
23 34 39
35 69 42
_
32 43
16
15 21 36
51 29
10
25 43
-3
Low
of value-added
Average
as a percentage
_ 54 85 67
30 27
49
40 _
High
Profit margin (private)
0
Low
minus direct expenses
5 6 18
6 64 16 46 33 37 27 24 13 68
Average
Profit margin (public)
firms.
Value added
firms firms tirms
firms
of sales revenues.
‘
6 no 5 1 no no no 5 5 4
Private
3 2 10 6 I 3 1 11 6 4
Public
of
in public and private
Number firms
Pricing
in the early 1970s approximately
av.cost/ton cargo DC/ton km sold DC/kg DC/kg DC/ton DC/ton DC/value-added DC/net revenue DC/value-added DC/sales
Shipping Airlines Rubber Palm oil Cement Fertilizer Trading Banking Insurance Construction contractors engineers architects
‘Rp=rupiah,
Measure
Industry
Table 2
5 2 2
4 3 3 415 to the dollar.
6 none 1 4 5 1 5 5 4
Private Rpa USS RP RP RP RI,
96 98 86
12 700 0.16 114 56 6546 20601 97 132 51
High
Cost (public)
costs in public and private
3 2 10 6 3 1 11 6 4
Public
EYirzber Of
Unit production
96 94 81
6967 0.12 91 39 6148 20601 76 87 32
Average
enterprises
93 89 75
3600 0.08 69 27 5474 20601 42 51 11
Low 9500 _ 69 40 6363 18896 90 49 71 85 79 64
RP RP RP RP RP
%
High
Cost (private)
77 66 60
69 33 4600 18896 65 31 58
4195 _
Average
69 52 54
69 28 2697 18890 46 15 33
1020
Low
contractors engineers architects
Construction
Insurance
dwt/EE ton/km/avil/EE
Shipping Airlines Rubber Palm oil Cement Fertilizer Trading
kg/FE kg/EE tons/capac/EE tons/capac/EE value-added/EE (Rp thousands) value-added/EE (Rp millions) sales/EE (Rp millions)
Measure
Industry
Productivity
1
3 2 10 3 3
Pubiic
Number firms
5 4 3
4
11
Table 3
of
5 2 2
4
5 none 1 3 5 1 2
Private
in public and private
9.940 9.3 1.3
6.1
38 60516 1312 6204 416 63 1056
High
7.0 3.4 0.8
3.4
24 44 164 890 4901 251 63 672
Average
Productivity (public)
enterprises.
4.570 0.7 0.4
0.5
14 21811 528 3144 171 63 417
Low
10.7 7.3 3.2
1.4 4.0 1.8
1.0
2275 13045 1545 273 153
2215 16817 1717 273 1061 1.3
25
Average 36
High
Productivity (private)
3.1 0.6 0.5
0.4
2215 1711 1380 273 444
13 _
Low
P K‘ Z
2 2 ? i? $’
Z b S Y
;
?J * f Z 9 5 a 6
R. Funkhouser and P. W. MacAvoy, Comparative prices
361
higher average profit margins for private companies in most industries where there are data for both. Tables 2 and 3 provide summary indicators of public and private company costs and productivity. With less data available in these areas, the sample is smaller for comparing public and private companies in the same industries. There is only one observation of a private company in fertilizer, which was obtained by using data from companies in this industry in adjoining Southeast Asian countries. Local private company data in cement were also supplemented in this way. A first examination would seem to indicate higher costs and lower productivity on average in public companies than in private companies in the same circumstances. 4. Comparing prices of public and private firms More systematic examination should establish whether, in keeping with Baumol-Bradford theory, profit margins in Indonesian public enterprises were systematically lower than those of comparable private enterprises. If comparisons are limited to firms strictly operating under the same market conditions, the sample size becomes too small to permit any conclusions. However, some comparisons are possible within four subsamples as follows: (1) all public and private firms; (2) all public and private lirms from those industries in which there are both types of companies; (3) public and private firms of comparable size only; and (4) public and private firms ‘paired’ on the basis of comparable levels of sales of the same products. The first sample is put together on the assumption that demand and cost conditions are much the same not only across firms but also across industries. Given the variety of firms and industries we cannot state that this is indeed the case, but many of the products are broadly defined and (except in agriculture) are all sold in domestic markets of about the same degree of imperfection in competition, so that the companies may face about the same demand elasticity conditions. For this sample the firms are viewed simplistically as one-product firms acting independently of each other such that the cross elasticities of products of all firms are zero and demand elasticities for their products approximately equal to minus one. In an economy centering on tropical agriculture, there are no recognizable economies of scale or special conditions for purchase of input factors, so that dmi/dqi is approximately the same for firms across processing and trading industries. To the extent that this holds, profit margins can be compared across industries simply by averaging those of all private firms and those of all public firms and analyzing the differences.6 6For the Baumol-Bradford conditions, all companies set profit margins on sales so that (piqi - miqi)/piqi= pi = I/( 1+ I)ei + (q,/p,)(dmJdq,).The public firms are assumed to have the same values of I, ei and (ami/dqi). The private firms are assumed to have the same values of ei and dm,/dq, as the public firms, but with I.=co. The comparison for the public and private firms should show the profit constraint for the public firms by a lower average pti
362
K. Funki~user
and P. W. MrrcA~~q.
Compuruticx
prices
The comparative performance of public and private companies in this first sample is shown in table 4. The average profit margin for 62 public companies was 26 “/: and for 37 private companies was 36%.7 The hypothesis that the difference of 10% is insignificant is rejected given that the standard deviation of the difference of means is 4.6 “/I. To the extent that the assumptions held as to cost and demand conditions, and thus this sample can be considered relevant, then public companies had a significantly lower average profit margin on sales than private companies. The lower margin for public firms could be due, however, to departures of actual demand and cost conditions from those assumed. By eliminating from the sample those public companies from industries in which there are no the costs and demand conditions of the comparable private companies, remainder would likely be more similar. This modification was made for sample two, and the reduced sample shows differences in profit margins even greater than in sample one, suggesting that the margins for public firms have been greater in those industries in which there are few private firms. By eliminating all observations for which public and private firms are not of comparable size, so that the cost conditions implied by the term (qi/pi)(&ni/i$,) are more comparable, a third sample has been constructed. Here the average profit margin of public companies is 1.5 percentage points lower than private companies, and the difference is statistically significant. Thus some of the higher profit margin companies in the public sector were ‘out of scale’ (and primarily larger) with respect to private companies. By pairing public and private companies in the same industry on the basis of comparable levels of sales, repeating an observation for either a public or a private company to complete all pairs, the fourth sample has been constructed. The 31 paired observations indicate that public companies have profit margins on average 14 percentage points lower than private companies, a difference that again is statistically significant. Although all four samples overlap, they together indicate that public companies have lower profit margins than private companies.* Were public-private differences in profit margins the same in different industries? This possibility has been investigated as follows. By subtracting the private company profit margin from that of the public company in the ‘The sample sizes depart from those shown in table 1 because of two changes. One public company half-owned by a foreign private company was reclassified as a private company. Two public insurance companies were ‘merged’ for purposes of comparison because the business of one of them consisted of servicing the other. sFurther assessment of this difference between public and private company profit margins can be gained by means of chi-square analysis. Using observations from sample two, in which data are included only for those industries where there are both public and private companies, a contingency table has been constructed by classifying the firms according to whether they had profit margins higher or lower than their industry average. The chi-square test performed on this basis gives the result x2 = 11.87 > ,x20.95 = 3.85, which indicates that the profit margins of public firms are significantly lower than those of private firms.
and
private
“Note: ex a_R 0is the standard
public
deviation
31
19
3. Public and private firms of comparable size only 25
4. Paired firms
36
49
in inpublic
2. Observations only dustries with both and private firms
37
62
in both private
1. All observations public and enterprise
of the differences
0.23
0.24
0.22
0.26
Public
Average margin
of means.
0.37
0.39
0.36
0.36
0.063
0.080
0.050
0.046
ox.-X,
between
Table 4 differences
Private
profit
costs and productivity
Private
Public
Sample number and description
Sample size
Profit margins,
0.888
0.929
1.015
1.016
Public
Average costs
0.895
0.925
0.877
0.818
Private
direct
public and private
0.076
0.098
0.075
0.086
OR.-Xp
enterprises,
0.796
0.851
1.002
0.949
Public
1.153
1.111
0.992
1.134
Private
0.224
0.236
0.189
0.159
“X.-X,
productivity average)
(7” of industry
Labor
1971.”
364
R. Funkhouser and P. W. MacAvoy, Comparative prices
same industry, assuming the same marginal cost functions for the two companies, the expression do - pP = l/( 1 + n)e, + (qG - qp)ami/lTqi is obtained where po and p,, are the government company and private company margins, respectively. Assuming ami/i3qi is a constant, it can be estimated as a parameter (b) in the regression equation ho - pP = a, + C aid, + b(q, -4,) with qG and qp being government and private firm sales, respectively. These regressions have been fitted for the sample of 31 paired public and private companies, where di is an industry dummy variable to capture the effect of variations in demand elasticities ei and profit constraints from industry to industry. Successive regression equations indicate that the coefftcient b is not significantly different from zero. The dummy variables for industry were signilicantly different from zero only for banking, insurance and construction. The regression equation pG -pp=
-6.23 -53.56 bank. +41.73 insur. - 15.35 constr. (5.15) (10.30) (15.01) (4.13)
R= = 0.625
shows these interindustry variations in margins, with standard errors given in brackets. The four ‘base’ industries show public company margins 6.2 percentage points lower (an insignificant difference), but public banking company margins were 53.5 percentage points lower, public insurance company margins 41.7 percentage points higher, and public construction company margins 15.4 percentage points lower than margins for private companies. Thus the answer to the question is that margin differences vary greatly across industries, and the average difference is mostly associated with finance and construction industry behavior. Are the observed differences in profit margins between public and private enterprises due to demand conditions (differences in e,), the cost conditions (the differences in &ni/dqi assumed away in the regression analysis), or to degrees of zeal shown by the public authority in keeping prices down to the consumer’? The answer would require information on e, and tTjm,/dq, by firm and industry that is not available at the present time. But some indicative cost information is available. Table 4 indicates attempts to compare unit operating costs between public and private firms in the same industries. Taking all public and private firms as the full sample (sample one) public company costs are above average and private company costs below average, as shown by the ratio of public company to industry average costs, m&i, exceeding 1.0 while the ratio of private company to industry average costs falls short of 1.0. When only pairs of public and private firms of the same size are included in the sample (samples three and four) the cost difference disappears. Both public and private companies have unit costs from 88 to
R. Funkhouser and P. W. MacAvoy, Comparative prices
365
93 % of the industry average, because very large public companies with unit costs closer to the average of the industry costs (in fertilizer, cement, airlines and sugar) have been excluded from the samples, as have some very small public companies (in rubber and trading). Thus the public companies ‘out of scale’ with respect to their industries appear to have had higher costs as well as lower profit margins.g Of particular interest are costs in banking, insurance and construction. By subtracting private from public company unit costs, m, - m,=(X/d, -dC/dq,)-(qc -q&?m/dq, where again it is assumed that the slopes of the unit cost functions are the same for public and private firms. Regression for in, - mp = a0 + C aid, + b( qG -qp) should indicate higher marequations ginal costs in the public firms in industry i by a significant positive coefficient a, on the industry dummy variable di. Successive regressions indicate an insignificant value for b and insignificant values, as well, for coefficients for dummy variables for most industries. The coefficients for banking, insurance and construction have the highest levels of significance, as follows (with standard errors given in brackets): mo - mp = - 6.21+ 66.01 bank. - 28.29 insur. + 27.41 constr.. (8.33) (16.67) (24.30) (14.77) R2 = 0.444. Here it is shown that the costs of government banking and construction companies are significantly higher than for private companies in those industries,” and public company costs in the insurance industry are insignificantly lower than costs for private companies in that industry. There would appear from all of this to be a pattern for public versus private enterprise costs and profit margins. The various tests support the hypothesis of lower public profit margins and higher public unit output costs for industries where there are both public and private companies. These differences are further defined in the regression analysis indicating that public ‘The hypothesis that public enterprise costs are higher is supported by the results of a chisquare analysis. Taking industries in which both public and private firms operate (sample two), a contingency table was constructed by classifying the public and private firms according to whether they had higher or lower than industry average costs. A chi-square test performed on this data shows that unit output costs of public firms are significantly higher than those of private firms, the result being x2 = 26.07 > ,x20.95 = 3.85. “‘One question that arises for these industries is whether the high cost is accompanied by lower labor productivity, as would be expected if the public enterprise is redistributing income by overpaying and overhiring labor. The question cannot be answered conclusively due to a lack of productivity data for private firms in the banking industry. However, in each area of the construction industry (i.e. contractors, engineers, architects) average labor productivity in the public firms is exceeded by that in private firms, as seen in table 3. Labor productivity differences also appear for samples 3 and 4 in table 4, where it can be seen that private firm labor productivity exceeds the industry average while that of public tirms is significantly lower than the industry average.
366
R. Funkhouser and P. W. MacAvoy, Comparative
prices
companies in banking and construction had lower profit margins and higher costs than their private counterparts. (In insurance, where the public companies’ average profit margin was higher than the private companies’ average, public company unit costs were significantly lower.) Thus where there were public-private differences, public prices were not reduced closer to the industry-wide cost level, but rather public firm costs were increased to the industry-wide price levels. The rather startling conclusion that lower public company margins were due to higher costs should be discussed. With the exception of insurance, the highest cost firm in every industry was a public firm. The second highest cost firm in 8 of 11 industries was also a public firm. Moreover, of the three public firms in shipping, the highest cost firm had a negative profit margin. Out of ten public trading companies, the four highest cost firms had operating losses. The two highest cost firms in the banking sector were public banks, each with operating or variable costs that exceeded current revenues. The three highest cost firms in the engineering sector were public, one of which suffered operating losses. The public enterprises with the highest unit costs departed from average costs in their industries more widely than did the ‘higher cost’ private firms. A possible explanation for this is the lack of an internal government institution for public firms comparable to bankruptcy proceedings for private companies. Ailing enterprises on a downward spiral of sales and profitability continued to operate with negative profit margins without any ‘benchmark’ process leading to their reorganization and restoration to financial health. Thus the variations between Indonesian public and private company pricing go beyond those predicted from the theory of public versus private enterprise. There was a tendency for public enterprise profit margins to be lower, but the lower margins were dictated by higher costs rather than by lower prices under public control in a number of important industries.
5. Rationalizing
pricing practices in light of the empirical findings
There could be any number of reasons why operating costs have been higher and profit margins lower in the public enterprises. If the public firms had different relative factor costs than private firms, they could be operating at similar output levels but at a different point on the transformation curve, with higher variable costs and lower profits. Alternatively, the public and private firms could be utilizing the same factor input ratio but with the public firm operating at a higher output level with higher unit costs (and charging a lower price) in order to supply greater amounts to consumers. For the public enterprises in question, higher costs and lower profits cannot be traced either to their operating with different factor input ratios or their desire to provide more output. Instead, it seems that all cost elements
R. Funkhouser and P,W. MacAvoy, Comparative prices
361
in the public firms are higher, and it is this phenomenon which requires explanation. In the Indonesian case the ministries that set the usual ‘public welfare’ goals for public enterprises did not have the control mechanisms to establish these goals for operations of management out in the field. With only schematic controls being exercised by the central administration, the local company was subject to pressures from other central government agencies, from local government and from its employees to pursue other goals. For instance, the local governments in some cases sought to raise local employment, or required the local purchase of materials from certain suppliers at higher prices. In one case an army brigade was garrisoned in the middle of a complex of government plantations to be ‘employed’ on a palm oil plantation. The nature of such locally established goals is such that the public enterprise is required to increase disbursements to the factors of production it employs, so that the goals are met by payments to factors - resulting in higher operating costs - rather than by increased dividend payments. These pressures can be rationalized with a simple model that takes account of the assumed goals of the ministry but that also imposes a ‘tax’ on operations to meet the requirements of local political organizations. The ministry wants to maximize the social utility function U = U(q,, r) subject to a budget constraint and a profit constraint, so that the Baumol-Bradford utility function and constraints (1) and (2) hold. But assume a cost function of the form C* = (1 + cC)C(qi),
(8)
in which alpha is a measure of the local ‘tax’ to meet other goals and C(Q) is the cost function of the comparable private firm, which we assume is the ‘truly efficient’ cost of producing. When there is local interference in the public enterprise and the costs of the public and private firm are the same, alpha is greater than zero. The pricing rule under those conditions is (Pi - (1 + a)X/dqi)/Pi
= -A/( 1 + A)ei
or, in terms of cash flow as a percentage
(PfJ-(l
(9)
of sales,
+a)m,/pi4,)= -E-/(1 +A)ei+(l
+@)(L/i/pi)(?mi/i~i),
(10)
Thus the pricing of the public firm differs from that of the private firm operating under the same market conditions. Profit margins in the public firm will be lower than in comparable private firms, because of the income constraint on public operations. But costs in the public firm will be higher by the factor (1 +u). With lower margins but higher observed costs (1 + cr)C(q),
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R. Funkhouser and P.W. MacAvoy, Comparative prices
prices in the public firm could approach the level of those in private firms, depending on the actual extent to which costs of public firms are higher. This simple model has two positive attributes. (1) Although derived from the general Baumol-Bradford approach, it has been changed to reflect empirical regularities in the one country to produce data. (2) It can be used to test the proposition that public enterprises operate at higher costs. If in further empirical studies profit margins of public companies tend to be lower while prices are not lower than in comparable private enterprises, then the alpha tax vitiates the economy-wide gains from public ownership. The ‘CI’tax on public operations need not be very large to eliminate any price reduction from public ownership; with I= -2 and A= 10, then TVneed be only 20 % to cancel out the price reducing proclivities of the public company. The question is whether the ‘tl’ tax prevails to the extent that the price-reducing targets of public corporations are not reached because of an equally strong tendency towards cost increases in those companies.