Maximizing revenue v. economic efficiency
An important conflict between the objectives set out in Question 9.1 is that between efficiency in all its forms and revenue raising. Clearly any company will be more valuable on the market if it is protected from competition than if it is not. As was seen in Module 3, however, monopoly is likely to result in output restrictions and higher prices to consumers which is economically not efficient. British Gas was privatized with very little restructuring of the industry. Breaking it into smaller companies with perhaps a monopoly common carrier operating the main pipeline network would have been more radical and would have pleased more economists, but the price of the shares would have been greatly affected. It was not until 1993 that the Monopolies and Mergers Commission recommended the establishment of transportation and storage as a separate unit of British Gas and the divestment of BG's trading activities no later than 31 March 1997 (MMC 1993).
If the company is very large as well as being highly protected from competition, it is possible that share prices could suffer. Shareholders might expect most of the potential profits to accrue not in dividends but in the form of benefits to the management interest. Low levels of technical efficiency and high management remuneration would not be in the shareholder's interest, but the importance of these factors will depend upon the control mechanisms discussed in Module 8.
Technical and productive v. economic efficiency
Where a company being privatized is a natural monopoly, the regulatory structure must be specified clearly before potential shareholders can assess the value of the assets. The regulatory system may not only influence the value of shares but may reduce the incentive to be technically efficient. Certain types of regulation may affect the choice of inputs and hence influence productive efficiency as was discussed in Module 3. The take-over threat and the operation of the managerial labour market may also be less effective under heavy compared with light regulation (see Module 8). Thus the regulatory structure accompanying privatisation will represent a compromise between these different efficiency objectives.
Encouraging small and employee shareholders v. maximizing revenue
Making a share issue attractive to small shareholders will usually entail sacrificing revenue. In a fixed price offer (the usual method employed in the UK for share offers) the shares are priced to trade at a premium after the issue and this will attract small investors looking for a relatively risk-free capital gain and low transactions costs. Where the payment for shares is in instalments, there is further encouragement to people to buy privatisation issues. Suppose a share has an issue price of 200 pence to be paid in four instalments of 50 pence. If the partly paid share trades at 70 pence this is a premium of about 10 per cent on the issue price, whereas it represents a capital gain of 40 per cent to someone selling immediately. However, presumably the government's objective is not simply to encourage small investors to act as ‘stags’ in the case of new issues. To encourage small investors to hold their shares a number of other devices have been used, including loyalty bonus shares. Such devices would be expected to reduce the value of the overall issue.
For employees, encouragement has been offered by a certain number of free shares or shares at a proportion of the price (the government matching each purchase with one or two free shares depending on the issue). In these cases, restrictions were imposed on the ability of employees to sell their shares quickly. Employees were also given priority in allocations when the issue was oversubscribed. Special arrangements for employees featured in many of the privatisation issues including Amersham International, British Airways, British Gas and British Telecom.
Productive efficiency v. other objectives
In some instances the objectives of encouraging efficiency has taken precedence over all others. Particularly where monopoly is not a problem and the firms concerned face difficult conditions, the management buy-out (MBO) or direct sale has been preferred to either tender or fixed price offers. Most of the warshipyards, for example, were sold by means of management buy-outs. These give management the greatest incentive to organize the resources of the firm as efficiently as possible. MBOs are not incompatible with maximizing the value of the assets at sale, but clearly the encouragement of small shareholders is not an issue in these more risky areas.
The contractual relationship between generator and distributor of electricity has, in the past, been considered so complex that the industry is widely assumed to be a natural candidate for vertical integration. The main characteristics of electricity supply of relevance to the transacting problem are as follows:
Electricity generation is highly capital intensive and the assets cannot, at low cost, be transferred to alternative uses.
Electricity distribution is usually considered a classic case of natural monopoly.
Electricity cannot be stored cheaply so that production and consumption have to be coordinated very accurately.
These features combine to make transacting difficult. If there is a tendency for distribution to become monopolized, a potential generator of electricity will expect to have to sell his output to a single buyer. Once the capacity has been constructed and the resources ‘sunk’ however, the distributor might attempt to force down the price until it just covers variable costs. The distributor could do this knowing that the generator could not use his capital for any other purpose. This is sometimes called the problem of potential ‘hold-up’. Effectively the distributor could attempt to steal the capital of the generator.
Removing ‘hold-up’ potential requires either very reliable and very long-term contracts between generator and distributor, or some way of overcoming the natural monopoly of distribution. In the former case, the contract would somehow be made proof against opportunist re-negotiation on the part of a single buyer. In the latter case the generator would face many alternative buyers of electricity so that the capital assets are not dedicated to the supply of any particular one. Any attempt by a given distributor/buyer artificially to reduce the price could then be met with a decision by the generator to sell elsewhere at market rates.
The contractual solution is difficult precisely because it has to be of such a long duration and because supplies must be tailored so closely to variations in demand. The costs of devising a ‘hold-up’ proof contract covering such a long period of time have provided an explanation of the tendency of the industry to integrate vertically thereby eliminating the contractual problem and replacing market relationships by internal management control.
The competitive solution requires either that several distribution networks might exist (in the same way that cable TV systems have been overbuilt in the US), or that a way is found to use the network as a common carrier with competitive buyers and sellers. The New Electricity Trading Arrangements introduced in the UK, described in Section 9.2.2, are designed to achieve the latter objective.
Before contracting out, the total cost of the given level of output was 11 000. Capital costs were 1000 and total wages paid were 10 000. After contracting out, total costs fell to 10 000. Capital costs were 4000 and total wages were 6000. This represents a genuine increase in productive efficiency and a saving of 1000.
The situation is illustrated in Figure A1.5. Before contracting out, Process A is used. Along the line aa’, costs are constant at 11 000. At the prices of labour and capital prevailing in the market there is a clear advantage to moving to Process B. Along the line bb’, costs are constant at 10 000.
Although we can be confident that productive efficiency has improved, it is not possible to say, on the information provided, whether the efficiency gains have been derived entirely from adopting a more appropriate production process or whether technical efficiency has improved as well. For example, if we suspected that the original in-house production was technically inefficient and that the service could have been produced at lower cost even using Process A (say at A’ in the diagram) some of the efficiency gain from contracting out may derive from reducing this technical inefficiency. Without knowing precisely what is technically achievable, however, it is not possible to disentangle improvements due to adopting lower cost processes of production from improvements in operating any given process.
Studies have attempted to estimate what is technically achievable by using data about inputs and outputs from many different authorities or firms. Observations of the operations of the most efficient firms can then be used to estimate the best that can be achieved using any given process. If, on the basis of this type of information we knew that the contracted-out service was technically efficient but that the in-house service was inefficient and could have operated at A’, we could then argue that the total gain to contracting out was made up of 500 due to technical efficiency gains and 500 due to adopting a more efficient process of production.
Figure A1.5 Productive versus technical efficiency gains
In the second case, wages are assumed to fall to 75. This appears to reduce radically the costs of the service. Given that output is still unchanged, total costs are 4500 in wages and 4000 in capital costs making a total of 8500. Costs have fallen by 2500 compared with the original in-house position. Although this may be very welcome to community charge payers it is not clear that we can ascribe the cost savings to increase in productive efficiency. Let us suppose that, before the service was contracted out, workers were paid at a rate higher than was available elsewhere in similar employment. This premium has now been lost. The 60 people who continue to work for the contractor and the 40 whom we assume now work elsewhere at the competitive wage of 75 have experienced a fall in wages. Indeed the entire cost saving of 2500 derives from this source. Notice that there is no cost saving from the change in the process of production used. At the new wage rate of 75, the old method of production using 100 people and a capital cost of 1000 would be equally productively efficient. The cost savings in this case represent, therefore, a transfer from workers to taxpayers.
