Privatization and Regulation: Political Motivations in Europe

1. Università degli Studi Bergamo Highways: costs and regulation in Europe Privatization and regulation, according to politicians’ benefitsbyGiorgio RagazziUniversità di BergamoMassimo Di DomenicoIEFE-Università Bocconi

2. The promotion of privatisation processes for state-owned enterprises (SOE) has been supported by the idea that it enhances efficiency and competitiveness of an economy. Empirically, however, the success of privatisation programs is mixed; it is difficult to identify the determinants of success or failure. One possible key explanation of these different performances may be found in political economy explanations. Governments might pursue goals other than the enhancement of efficiency. Because of their private agenda and the influence of lobbying groups, politicians might choose privatisation even when this is not in the best interest of the economy. Politicians’ rent seeking and political motivations can be important drivers of the decision to privatise SOEs.

3. Political motivations may condition the choice of the method of privatisation. Some empirical analysis of privatisation processes show that privatisation is a bi-partisan decision. Both left- and right-wing governments have put privatisation programmes on their agendas. However, because of different priorities they have opted for different ways of implementing these programmes. Together with ideological political motivations, it is important to analyse the rent seeking activity by politicians and it is in this field that our paper would like to introduce some contributions. Our analysis will investigate privatisation and regulation from the point of view of the politicians’ interests, without taking into account the welfare effect of such a discretional behaviour and considering firms operating in a competitive market and in natural monopolies .

4. Privatisation of SOE in competitive markets To start with, let us consider a SOE in a competitive market. The firm’s budget is: pQ=cQ+sQ+G1 where p is the market price for output Q, c is the profit maximizing firm’s unitary cost, sQ is the additional cost due to political influence over the firm’s managers activity, G1 is the yearly firm’s profit (loss) flowing to the Government. The additional cost sQ may reflect inefficiencies due to poor control by politicians, but also the pursuit of social goals in the form of overmanning, extra salaries, social investments etc. to increase political support.

5. The politicians’ utility function can be written as follows: Ut=Us(sQ)+Ug(G1) where Us is the politician’s utility from control of the SOE (an increasing function of the cost sQ). Hereafter we refer to this utility as the “political rent” for politicians. Ug represents the utility politicians derive from the profit flow (loss) generated by the firm and accruing to the state budget. Indeed firm’s profits help to reduce the fiscal burden of citizens or/and allow to increase public expenditures. We refer to Ug as ”financial rent” for the politicians. Politicians, then, face a trade-off between increasing the political rent or the financial rent. Politicians, for example, could be in favour of increasing the number of the firm’s employees in order to receive greater political support from unions. However, this could be detrimental to the firm’s profit (G1), thus reducing the politicians financial rent.

6. If the SOE is privatized, politicians loose their influence on the firm, i.e. they loose the political rent. Therefore, a necessary condition for privatisation to be implemented by politicians is: where P is the total price collected by the Government by selling the firm and rp is the politicians discount rate for future profits G1. After privatisation, extra costs due to political influence will be removed. The firm’s new shareholders profits will be G2=G1+sQ. Therefore, a necessary condition for politicians to sell the firm and for private investors to acquire it must be: where r is the market discount rate(interests rate plus risk premium).

7. The likelihood that a SOE will be privatised increases if: politicians are “shortsighted”, i.e. discount the present value of future cash flows from the SEO at a higher discount rate than the market. Likely to happen if probability of being re-elected is low. public deficit is a critical issue: Ug is more important for politicians than the political rent Us; extra costs (sQ) due to political influence are high, and so it is high the potential for increasing efficiency by private shareholders. the present value of political rent is low , because of moral/judicial pressures and/or low probability to be re-elected. Given the maximum divestiture price P* politicians could pursue two avenues: sell the firm at the maximum price, in order to raise funds for social expenditures or to decrease taxes; sell the firm’ shares at a price lower than P* to the general public, in order to obtain political support from shareowners. Pricing is therefore affected by ideological issues.

8. Privatisation of a monopoy Let us consider a SOE in a natural monopoly (e.g. highway) regulated by politicians. Tariffs are a political issue. Political support could be increased in two ways, and again politicians face a trade-off. Increasing tariffs improves the public budget (G1). However, increasing tariffs reduces consumers’ surplus and thus also votes and support. The politicians utility function is then: Ut=Us(sQ)+Ug(G1(p))+Up(S(p)) where the utility terms Up represents the political costs (votes lost) when tariffs are increased and S(p) is the consumer’s surplus.

9. Let us consider a state-owned natural monopoly, without an independent regulation authority. Sale of natural monopolies to the private sector does not improve their efficiency (highways are a case in point). Costs are mostly depreciation and financial charges; technological innovation is limited; there are very limited possibilities for over employment (as a consequence of political influence). The main reason for privatization is politicians’ desire to raise cash, to reduce public debt, even if this means relinquishing the political rent.

10. Natural monopoly and tariffs determination before and after privatisation Let us now consider the political cost of tariff increases (the utility Up). A privatisation process weakens the link between tariff increases and citizens’ discontent directed at politicians. In this situation politicians may privatise for two reasons: to ease restructuring of a loss-making firm, or to derive a new type of political rent from the relationship with the privatised firm. An example of the first case is the privatisation process of the water sector in England under the Thatcher Government (low tariffs before privatisation because of strong political opposition - tariff increase after privatisation without sensible decrease of political support for the government). In the second case the Ministry in charge of regulating the firm may be interested in augmenting tariffs in order to obtain favours from the privatised firm (e.g. election campaign contributions, favours etc). This would constitute a new source of rent, possibly more than compensating the loss of political rent form control.

11. Politicians and privatised firms may justify tariff increases with the need to cover costs. Since citizens cannot check the tariff setting process, there’s a problem of asymmetric information. Hence privatisation makes it possible to increase tariffs without undermining the support for politicians and provides a new source of political rent for them. In this case the politicians’ utility function is: Ut=Up(S(p))+Ur((p)) where  is the firm profit. When the company was a SOE, politicians benefited from higher tariffs only in so far as these increased budget revenues; the value of this benefit for politicians is likely to be much lower than the benefit they may derive from allowing the private firm to increase its profit. The private firm is in a strong position to lobby, influence public opinion, provide direct benefits to politicians. Therefore, one may expect tariffs to be higher after privatisation. Tariffs represent an important variable and should be properly regulated: low tariffs discourage new investments; high tariffs, instead, are wasteful for consumers.

12. Important conclusion can be drawn: political influence and discretion is detrimental for social welfare; when the firm is government-owned, politicians face a trade off between increasing the consumer surplus or increasing resources for public finance purposes; after privatising SOEs, politicians face a trade off between consumer surplus and firm profits. They must deal with two interest groups: consumers, very numerous, but unable to organise themselves; the firm, with large resources for lobbying. the second situation is more detrimental for social welfare than the first; hence it needs to be more thoroughly investigated.