Economic surplus

Economic surplus

A privatised monopoly is still a monopoly, and consumers pay the price

The economics of privatisation are pretty simple.

Moving a business from state-ownership to private-ownership improves the profit incentive. Private owners will focus on their return. That means lower costs, higher prices and increased profit. State-owned businesses can, at best, attempt to mimic private incentives through ‘corporatisation’. But even the best run state-owned business will have an eye on the government and can expect a ‘call’ if it crosses political objectives.

By themselves, both forms of ownership are imperfect.

State-owned businesses do not act in the general public interest. They respond to their own interests and the interests of the government that owns them. They usually pursue a variety of sometimes-contradictory objectives, some of which may be broadly beneficial to society. But some activities will be wasteful, or even harmful, to the country’s long-term interests.

In contrast, private businesses are more likely to focus on profit. This can be bad if the profit-maximising activities of the private business hurt society. It is good when those activities are aligned with society’s interests.

A simple example is pricing power. If a business is a private monopoly then it will use its market power to extract maximum profit from consumers. It will meet consumer preferences, but at a price. It will try to keep production costs down but will also want the sell the mix of products customers desire. Doing this means it can charge higher prices and maximise profits. A private monopoly is a servant who does what you want, so long as it can raid your bank account at the same time.

A public monopoly will focus less on profit. From the customers’ perspective, it will not do what you want – unless that aligns with the interests of its political masters. You may not pay as much, but paying less for something that doesn’t meet your needs doesn’t sound like a great deal.

So the trick with privatisation is to align private profit making incentives with the incentives of society. There are two ways to do this.

The first is through competition. In a competitive market, private profit maximising businesses try to steal each other’s customers. They do this both by better meeting customers’ needs and by undercutting their rivals’ prices. Each business acts to raise its own profits. But the overall effect is that profits are competed away. Customers gain, innovative businesses gain, and businesses that can’t meet customers’ needs go bankrupt. It is ruthless but it also aligns business interests with the interests of the public who are buying their goods and services.

So privatisation needs competition. As Kikeri and Nellis note, “[p]rivatization and pro-competition policies are in fact complements that are mutually reinforcing”.

But there is one problem with this solution. It means lower privatisation revenues for the government.

When a government business is sold to the private sector, the price the government receives reflects the future expected profits of the business with private owners. If the government privatises the business as a monopoly then the expected profits – and price received by the government – is high. In contrast, if the government sets up a competitive market for a newly privatised business then the future expected profits will be lower. And so is the price received by government.

So privatisation with competition can be a big win for Australia. Private ownership creates incentives to produce what we want, when we want it, at minimum cost. Competition keeps prices down.

But privatisation without competition is like a hidden tax. The government gets more today because we will all be paying more tomorrow.

Hence the comments this week by the ACCC chairman, Rod Sims, by Fred Hilmer and by former ACCC chairs, Graeme Samuel and Alan Fels (in the pay-walled AFR). If a state government privatises a monopoly port or airport, then it will get more money than if it establishes a competitive market. If it privatises those businesses with a first right of refusal to develop a competitor (such as Badgerys Creek airport or the Port of Hastings in Victoria) then the government will get even more money, because competition will never happen.

So the current debate on privatisation is only half the story. Privatisation without competition risks turning a public monopoly into a private monopoly. The owners may change but the public will get ripped off just the same.

What is the second option? If competition is not possible then the privatised business needs to be regulated so that it cannot exploit its market power.

In today’s Australian Financial Review, Graeme Samuel notes this alternative.

“He believed that most issues could be resolved through regulation and access regimes and that Australia had a reasonable record in that regard”.

Professor Samuel is correct. But regulation is always going to be a second best solution. Both government-owned and private monopolies can play games with regulators and the end result will always fall short of vigorous competition between private businesses. If competition is not possible, for example for monopoly electricity transmission lines, then privatisation and regulation is a compromise solution. But privatisation with competition is where society really wins.

The current round of privatisations is predictable and regular. Businesses move into and out of government ownership over time. Government ownership is only needed when there are strong conflicts between profit-incentives and public welfare. But if privatisation occurs without competition, then, as a nation, we only get a fraction of the benefit. The government will make more money but do not be fooled. It is just a future hidden tax as consumers pay for today’s increased government revenue through tomorrow’s higher prices.