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public ownership, public regulation or public subsidy?
European
Economic
Review 31 (1987) 343-345.
Public Enterprises,
North-Holland
Privatization
and Nationalization
INTRODUCTION Public ownership, public regulation or public subsidy? John A. KAY* London Business School, London NW1 4SA, UK
As little as five years ago, the content of a session in this subject would have been wholly different. The European tradition of analysis of public enterprise derived from Hotelling (1938) and Boiteux (1956). The problem it described was that of welfare maximisation in a framework characterised by market failure and constraints. The most common market failures were natural monopoly or externality; constraints were on revenue, or on the behaviour of other agents (which led to problems of the second best). A general feature of this analysis was that it appeared sufficient to derive appropriate conditions for optimisation in the face of any specific characterisation of the public enterprise problem. The issue of how the information derived to implement these rules could be obtained was rarely considered, and it was implicitly assumed that if welfare maximising behaviour could be described, public sector managers would naturally wish to implement them. Little’s critique (1952) had questioned these issues, but although widely read it did not inhibit the growth of the Hotelling tradition. The change in the direction of the subject is partly the outcome of development of the underlying theory. The economic theory of property rights [Furubotn and Pejovich (1972)] directs attention to the central role of personal objectives and constraints in determining managerial behaviour. In the context of government policy for nationalised industries, this was paralleled by a realisation that merely prescribing the rules which public sector managers ought to follow was insufficient to determine their behaviour. Management might be more concerned to provide growth, or maximise output, or to enjoy a quiet life. Several other research areas have contributed to a better understanding of the problems of regulating public industry or of devising alternative institutional arrangements. The merits of competitive market organisation are seen as efficiency in the use of information and effectiveness in the exploitation of *Professor Kay is Professor of Industrial Strategy, London Business School. 00142921/87/$3.50
0
Policy,
1987, Elsevier Science Publishers
and
Director
of the Centre
B.V. (North-Holland)
for Business
344
J.A. Kay, Introduction
incentives. The suppression of competitive markets - through nationalisation or regulation - may be expected to yield problems on both counts, They are, moreover, self-reinforcing problems. As the principal/agent literature [e.g., Crew and Kleindorfer (1979)] makes clear, if the principal - in this case the government - holds the same information as his agent, he does not need to worry about incentives, because he can simply prescribe and monitor appropriate behaviour. If principal and agent have similar objectives, then asymmetry of information raises no great difficulty. It is apparent that public industries have encountered both groups of problems. These difficulties are reinforced by the fact that government itself is an imperfect agent for the implementation of welfare maximising policies. The object of the privatisation debate is, then, to construct a regulatory framework which minimises the costs of differences in information and objectives between the principal (government) and the managers of nationalised industries (agents). Privatisation is particularly concerned with the role of ownership and management in this regulatory framework. One issue which requires elucidation is when this involves public ownership, rather than intervention in management through regulation or specific financial involvement, through taxes and subsidies. But although the terms ownership and management are widely used, they are rarely precisely defined. Developing suggestions of Hart and Grossman (1985), I define ownership of an asset or activity, as holding the residual financial claim on its value; management as controlling those elements which are not the subject of an explicit contract. I own my house, even though the bank has provided the bulk of the finance, because I have the equity stake in it. I manage my house, even though previous owners specified covenants and the local authority restricts my freedom to use it, because all aspects which are not the subject of such explicit agreement or contract are determined by me rather than by the previous owner or the local authority. There are clear efficiency advantages in the association of ownership with management, because it relieves incentive problems which arise if there is a separation between the ability to take decisions which have financial consequences - problems which are familiar, for example, in the arrangement of cost plus contracts in government procurement. At the same time, however, there are also efficiency gains if management is located at the place which holds fullest information about the effects of the activity. If management is defined as the ability to specify implicit contract terms, it can be seen that the need for management arises partly because imperfections and asymmetries in information preclude complete contract specifications, partly because complex contracts are costly to make, to administer and to monitor. It would follow that privatisation is least appropriate where the implied contract between the public and private sector is a particularly complex one or where the asymmetry in information between the two parties is very great.
J.A. Kay, Introduction
345
This is why, for example, taxation is an inappropriate subject for privatisation. The cheapest methods of collecting taxes - in terms of costs per unit of revenue obtained - are ruled out on grounds of equity, and this is why privatised tax collection (tax farming) enjoyed a poor reputation when it was attempted. A contract with a privatised revenue service would need to define the admissible methods of collection and administration in some detail - in such particular detail that in practice the contract specification would be equivalent to the management of the activity concerned. Similar problems are posed by the privatisation of justice, and discussed by Blankart. There are many ways of administering justice, most of them unacceptable. For example, tossing a coin is an inexpensive method of settling legal disputes, but one which meets few other objectives. A contract with a privatised judiciary would therefore have to specify the means of providing justice in such detail that the reality of privatisation would be very slight. The position would be changed somewhat if competitive judicial systems would select the system most appropriate to their needs - and this somewhat fanciful development has some reality in the way in which parties to international contracts typically define the jurisdiction which will be relevant in the case of dispute. Scope for privatisation principally exists, then, in cases where the product specification is simple and the technology well known, so that the difficulties of prescribing contracts and of differences in the information available to regulator and regulated are relatively small. It is, in practice, in those areas that governments have been most anxious to pursue privatisation. The problems to be faced there are those of the extent of privatisation and the design of regulatory contracts. Those are the subject of the remaining papers of this session. References Boiteux, M., 1956, Sur la question des monopoles public astrients a I’equilibre budgetaire, Econometrica, Jan., 24, 2740. Crew, M.A. and P.R. Kleindorfer, 1979, Public utility economics (Macmillan, New York). Furubotn, E.G. and S. Pejovich, 1972, Property rights and economic theory: A survey of recent literature, Journal of Economic Literature, Dec. Hart, 0. and S. Grossman, 1985, The costs and benefits of ownership, CEPR Investment Conference, Sept. Hotelling, H., 1938, The general welfare in relation to problems of taxation and of railway and utility rates, Econometrica. Little, I.M.D., 1952, A critique of welfare economics (Oxford).
Economic
Review 31 (1987) 343-345.
Public Enterprises,
North-Holland
Privatization
and Nationalization
INTRODUCTION Public ownership, public regulation or public subsidy? John A. KAY* London Business School, London NW1 4SA, UK
As little as five years ago, the content of a session in this subject would have been wholly different. The European tradition of analysis of public enterprise derived from Hotelling (1938) and Boiteux (1956). The problem it described was that of welfare maximisation in a framework characterised by market failure and constraints. The most common market failures were natural monopoly or externality; constraints were on revenue, or on the behaviour of other agents (which led to problems of the second best). A general feature of this analysis was that it appeared sufficient to derive appropriate conditions for optimisation in the face of any specific characterisation of the public enterprise problem. The issue of how the information derived to implement these rules could be obtained was rarely considered, and it was implicitly assumed that if welfare maximising behaviour could be described, public sector managers would naturally wish to implement them. Little’s critique (1952) had questioned these issues, but although widely read it did not inhibit the growth of the Hotelling tradition. The change in the direction of the subject is partly the outcome of development of the underlying theory. The economic theory of property rights [Furubotn and Pejovich (1972)] directs attention to the central role of personal objectives and constraints in determining managerial behaviour. In the context of government policy for nationalised industries, this was paralleled by a realisation that merely prescribing the rules which public sector managers ought to follow was insufficient to determine their behaviour. Management might be more concerned to provide growth, or maximise output, or to enjoy a quiet life. Several other research areas have contributed to a better understanding of the problems of regulating public industry or of devising alternative institutional arrangements. The merits of competitive market organisation are seen as efficiency in the use of information and effectiveness in the exploitation of *Professor Kay is Professor of Industrial Strategy, London Business School. 00142921/87/$3.50
0
Policy,
1987, Elsevier Science Publishers
and
Director
of the Centre
B.V. (North-Holland)
for Business
344
J.A. Kay, Introduction
incentives. The suppression of competitive markets - through nationalisation or regulation - may be expected to yield problems on both counts, They are, moreover, self-reinforcing problems. As the principal/agent literature [e.g., Crew and Kleindorfer (1979)] makes clear, if the principal - in this case the government - holds the same information as his agent, he does not need to worry about incentives, because he can simply prescribe and monitor appropriate behaviour. If principal and agent have similar objectives, then asymmetry of information raises no great difficulty. It is apparent that public industries have encountered both groups of problems. These difficulties are reinforced by the fact that government itself is an imperfect agent for the implementation of welfare maximising policies. The object of the privatisation debate is, then, to construct a regulatory framework which minimises the costs of differences in information and objectives between the principal (government) and the managers of nationalised industries (agents). Privatisation is particularly concerned with the role of ownership and management in this regulatory framework. One issue which requires elucidation is when this involves public ownership, rather than intervention in management through regulation or specific financial involvement, through taxes and subsidies. But although the terms ownership and management are widely used, they are rarely precisely defined. Developing suggestions of Hart and Grossman (1985), I define ownership of an asset or activity, as holding the residual financial claim on its value; management as controlling those elements which are not the subject of an explicit contract. I own my house, even though the bank has provided the bulk of the finance, because I have the equity stake in it. I manage my house, even though previous owners specified covenants and the local authority restricts my freedom to use it, because all aspects which are not the subject of such explicit agreement or contract are determined by me rather than by the previous owner or the local authority. There are clear efficiency advantages in the association of ownership with management, because it relieves incentive problems which arise if there is a separation between the ability to take decisions which have financial consequences - problems which are familiar, for example, in the arrangement of cost plus contracts in government procurement. At the same time, however, there are also efficiency gains if management is located at the place which holds fullest information about the effects of the activity. If management is defined as the ability to specify implicit contract terms, it can be seen that the need for management arises partly because imperfections and asymmetries in information preclude complete contract specifications, partly because complex contracts are costly to make, to administer and to monitor. It would follow that privatisation is least appropriate where the implied contract between the public and private sector is a particularly complex one or where the asymmetry in information between the two parties is very great.
J.A. Kay, Introduction
345
This is why, for example, taxation is an inappropriate subject for privatisation. The cheapest methods of collecting taxes - in terms of costs per unit of revenue obtained - are ruled out on grounds of equity, and this is why privatised tax collection (tax farming) enjoyed a poor reputation when it was attempted. A contract with a privatised revenue service would need to define the admissible methods of collection and administration in some detail - in such particular detail that in practice the contract specification would be equivalent to the management of the activity concerned. Similar problems are posed by the privatisation of justice, and discussed by Blankart. There are many ways of administering justice, most of them unacceptable. For example, tossing a coin is an inexpensive method of settling legal disputes, but one which meets few other objectives. A contract with a privatised judiciary would therefore have to specify the means of providing justice in such detail that the reality of privatisation would be very slight. The position would be changed somewhat if competitive judicial systems would select the system most appropriate to their needs - and this somewhat fanciful development has some reality in the way in which parties to international contracts typically define the jurisdiction which will be relevant in the case of dispute. Scope for privatisation principally exists, then, in cases where the product specification is simple and the technology well known, so that the difficulties of prescribing contracts and of differences in the information available to regulator and regulated are relatively small. It is, in practice, in those areas that governments have been most anxious to pursue privatisation. The problems to be faced there are those of the extent of privatisation and the design of regulatory contracts. Those are the subject of the remaining papers of this session. References Boiteux, M., 1956, Sur la question des monopoles public astrients a I’equilibre budgetaire, Econometrica, Jan., 24, 2740. Crew, M.A. and P.R. Kleindorfer, 1979, Public utility economics (Macmillan, New York). Furubotn, E.G. and S. Pejovich, 1972, Property rights and economic theory: A survey of recent literature, Journal of Economic Literature, Dec. Hart, 0. and S. Grossman, 1985, The costs and benefits of ownership, CEPR Investment Conference, Sept. Hotelling, H., 1938, The general welfare in relation to problems of taxation and of railway and utility rates, Econometrica. Little, I.M.D., 1952, A critique of welfare economics (Oxford).