Until the 1970s it was conventional to regard public enterprises as extensions of the government. Once policy objectives had been established by ministers, the directors of the enterprises could, it was assumed, be relied upon to conduct their operations in accordance with these objectives. The bulk of economic analysis in these years therefore concerned the normative task of discovering rules of conduct for the public enterprises which might permit the achievement of various plausible government objectives. These policy objectives were not easy to deduce from acts of parliament or government statements. Usually nationalisation Acts defined the responsibilities of boards of directors in very vague terms.
The Coal Nationalisation Act 1944 established the Coal Board in the UK and defined its task as that of ‘securing the efficient development of the coal mining industry … making supplies of coal available, of such qualities and sizes, in such quantities and at such prices, as may seem to them best calculated to further the public interest in all respects …’
The ‘ public interest’ was interpreted in economic writing of the time as the correction of ‘market failure’ and the pursuit of an ‘efficient’ allocation of resources. It was argued that enterprises were taken into public ownership in order to correct the inefficiencies that would otherwise arise. Sources of possible market failure were wide ranging and included the following:
The exploitation of natural monopoly.
The inability of markets to spread risks as efficiently as the state (thus rationalising public ownership of high-technology – and high-risk – firms).
The failure of normal commercial enterprises to consider external effects and the wider social consequences of their decisions. Public enterprise, it was argued, would be able to take account of all social costs and benefits in its decision-making.
To cope with market failure economists developed a set of rules for the conduct of public enterprise which it was thought would produce a better allocation of resources.
If the marginal social benefits derived from an activity exceed the marginal social costs then, according to conventional analysis, there are efficiency gains available and the activity should be undertaken. Assuming that the price of a good or service can be taken as a measure of marginal social benefit, efficiency then requires that this price be set equal to the marginal social costs of production. The practical application of this principle raises many difficulties and requires that marginal social costs are well defined and easy to calculate. Nevertheless, the rule appeared to have such a sound basis in welfare economic theory that it came to play an important role in the formulation of policy towards public enterprises in the UK. The principles of marginal cost pricing were extended to cope with industries such as electricity and the railways which face great variation in demand, both seasonal and by time of day, and which cannot store their product. If demand varies over time, the marginal cost pricing rule will imply price varying over time as peak consumers impose greater social costs on the system than do off-peak consumers. Thus, marginal cost principles justify low priced ‘night-time’ electricity, higher rail fares at peak periods, and telephone charges that vary by time of day.
Projects were to be undertaken if they produced a positive ‘net present value’. A well-conducted private company might well adopt this criterion, but in the public sector it was argued that adjustments could be made to reflect market failures. In particular the rate of discount used in project appraisal could reflect ‘social’ rather than merely ‘private’ valuations. In practice this amounted to using a lower rate of discount in the public sector to reflect its greater risk-spreading properties, or to encourage investment in the interests of generations yet unborn, or to correct for ‘under-investment’ caused by income taxation. ‘ Shadow pricing’, i.e. the use of valuations in project appraisal which differ from market prices, was also recommended if external benefits were associated with the output of a project, or if market prices of inputs gave an inaccurate impression of social costs.
Where economies of scale are significant (as in natural monopoly industries) the application of the marginal cost pricing rule results in the enterprise making losses. In Figure 8.1, for example, marginal cost pricing would result in an output q*, a price p*, and a financial deficit given by the shaded area. A two-part tariff in which the consumer pays a lump sum per period of time independent of the quantity purchased and in addition a price per unit equal to marginal cost would enable the enterprise to break even – if such a scheme could be implemented. Financing the deficit would be no problem if the government had means of revenue raising which would not result in efficiency costs. In reality, however, it was recognised that no such ‘costless’ source of revenue exists. This led to the development of ‘second best’ solutions in which pricing rules were developed for public enterprises on the assumption that they were constrained to meet certain financial targets. For a single product enterprise this involved a price sufficiently in excess of marginal cost to meet the target.
Figure 8.1 Marginal cost pricing implies a financial loss with declining average cost
The analysis reviewed briefly in the preceding paragraphs was at its most influential in the late 1960s and official recognition was apparent in the White Paper of 1967 Nationalised Industries (Cmnd. 3437). On the basic principles of pricing, for example, it was accepted that ‘prices need to be reasonably related to costs at the margin and to be designed to promote the efficient use of resources within industry’ (p. 9). Investment projects were to be appraised using discounted cash flow techniques, and the ‘test rate of discount’ to be applied was to be 8 per cent which ‘represents the minimum rate of return to be expected on a marginal low-risk project undertaken for commercial reasons’ (p. 5). The use of cost–benefit appraisal to take externalities into account was explicitly recognised. ‘Many investments also produce social costs and benefits which can in principle be valued in financial terms and which, when taken into account, will provide a good economic justification for them’ (p. 6). Peak-load pricing was recommended. ‘Provided off-peak charges do not fall below the levels needed to cover the variable costs incurred, differentiation can be increased with advantage until the balance between peak and off-peak is economically most efficient’ (p. 9). Financial targets, it was stated, ‘should reflect sound investment and pricing policy and not vice versa’ (p. 13) and, if this involved deficits, two-part tariffs could be used ‘to improve financial results without distorting the allocation of resources’ (p. 9).
A decade after the 1967 White Paper, the public interest model of public enterprises was increasingly subject to criticism. Studies of technical and allocative efficiency such as Pryke (1981) and NEDO (1976) argued that the performance of public enterprises in the UK, especially in the 1970s, was generally poor, relative to the manufacturing sector as a whole. Table 8.2 taken from Pryke (1981) shows output per head and total factor productivity trends in the years 1968–78. Although productivity growth was substantial in technologically progressive industries such as air transport and telecommunications, the slow-down in productivity growth in the years 1973–8 was very evident and forms the background to the NEDO report.
| Annual trend percentage | Total factor | |||
| changes in output per head (%) | productivity (%) | |||
| Organization | 1968–73 | 1973–8 | 1968–78 | 1968–78 |
| British Rail | 2.7 | −1.2 | 0.8 | – |
| British Steel | 2.5 | −2.7 | −0.2 | −2.5 |
| Post Office | −1.4 | −1.2 | −1.3 | – |
| British Telecom | 7.7 | 8.6 | 8.2 | 5.2 |
| British Coal | 0.0 | −1.4 | −0.7 | −1.4 |
| Electricity | 8.7 | 1.9 | 5.3 | 0.7 |
| British Gas | 10.8 | 6.2 | 8.5 | – |
| National Bus | 1.9 | −3.0 | −0.5 | −1.4 |
| British Airways | 7.7 | 5.7 | 6.4 | 5.5 |
| UK manufacturing | 4.4 | 1.0 | 2.7 | 1.7 |
Note: For a discussion of the distinction between output per head and total factor productivity see review question 8.3 at the end of this module.
Source: Pryke (1981)
The contrast between the NEDO report and the White Paper of 1967 could not be more marked. The NEDO report argued that ‘the principles underlying the 1967 White Paper are too simplistic’ and that an arm's length relationship between nationalised industries and government with the responsibilities of each clearly defined, while attractive in principle, would not work in practice. ‘The evidence demonstrates convincingly that in the real world things would not work out like that’ (p. 9). As for the detailed policy guidelines recommended in 1967, the NEDO report found that the marginal cost pricing principle ‘has been followed to a negligible extent in the four corporations which have been studied in detail’ (p. 31) while ‘only a limited proportion of investment in nationalised industries is subject to full investment appraisal using the test discount rate’ (p. 31). As for the use of cost–benefit analysis ‘there is little evidence of material progress in implementing this aspect of the White Paper’ (p. 32).
Instead of a preoccupation with optimal rules for pricing and investment, concern began to focus on ‘the realities of our political system’ (p. 9) which would inevitably lead politicians to intervene in decision-making processes, and on the structure of incentives faced by managers. It was noted that managers and politicians had different time-scales when it came to business decisions; that unions were often in a powerful bargaining situation; that ‘the threat of liquidation and other disciplines provided by external financial markets’ (p. 42) were absent; that where a corporation was a natural monopoly it was a matter of some importance to know whether low profits were a result of efficient pricing and investment strategies or whether they simply reflected poor cost control. Thus institutional considerations and the design of incentives for the various interested parties began to supersede the purely technical and almost entirely institution-free analysis of the 1960s. If the 1970s saw disillusionment with public enterprise in the UK, the 1980s witnessed a considerable change in performance as measured by simple trends in productivity. Table 8.3 shows the growth rate in output per person employed for those industries still in the public sector in 1990. Over the decade the growth rate in output per head averaged 4.4 per cent and exceeds that for the manufacturing sector as a whole. The government's White Paper on expenditure (HM Treasury 1990) could claim that ‘Since 1980 the nationalised industries have made significant progress in reducing overmanning and improving overall efficiency’ (p. 87 Ch. 21). Productivity at British Coal had increased by 75 per cent in the years since 1985. The general picture was confirmed in a study of the nationalised industries by Molyneux and Thompson (1987): ‘Our results indicate that in the most recent period, productivity growth has seen a marked upturn’ (p. 59).
Historical experience in the UK reveals a rather erratic pattern, with periods of substantial productivity improvements interspersed with other periods in which a relatively poor rate of productivity growth was achieved. This rather confusing picture can only be understood by looking in more detail at the problems of incentives and control which exist in all government-industry relations.
| Output per person employed, | |||
| annual percentage change | |||
| Nationalised | Manufacturing | Whole | |
| Year | industries | industries | economy |
| 1979–80 | 0.8 | 1.0 | 0.7 |
| 1980–1 | −1.8 | −5.3 | −2.1 |
| 1981–2 | 2.0 | 6.9 | 3.2 |
| 1982–3 | 2.0 | 6.3 | 3.2 |
| 1983–4 | 4.5 | 8.5 | 3.5 |
| 1984–5 | 5.5 | 4.9 | 1.1 |
| 1985–6 | 8.4 | 1.8 | 1.7 |
| 1986–7 | 8.6 | 4.8 | 3.4 |
| 1987–8 | 7.3 | 6.4 | 3.0 |
| 1988–9 | 6.4 | 5.6 | 2.2 |
| Average | |||
| 1979–80 to 1988–9 | 4.4 | 4.1 | 2.0 |
Notes:
Source: HM Treasury (1990) Chapter 21, Table 21.5.10.
