ECN 4152

1. ECN 4152 PRIVATIZATION

2. INTRODUCTION • Government generally favors market operations/forces, but often there is control of production of certain goods and services. This involves either: • State ownership • State regulation (of the way which private sector should operates)

3. INTRODUCTION • Government generally favors market operations/forces, but often there is control of production of certain goods and services. This involves either: • State ownership • State regulation (of the way which private sector should operates)

4. INTRODUCTION • Recent economic theory of developments has often question the benefits and usefulness of these types of intervention because of the poor performance of industries under state control. • In consequence to poor performance reason, for much of the 20th century there has been a trend for greater move to reduce state regulation and state ownership. Not only in UK, the USA, but also France, Japan and New Zealand, including Malaysia.

5. INTRODUCTION • In the less developed/advanced economies such as Chile, Mexico and Malaysia privatization has also taken place. • Developing countries are starting to transfer large enterprises (like banks, telecommunication companies and airlines) to private sector.

6. INTRODUCTION • According to World Bank Report. 1992, between 1980 and 1991, almost 7000 state –owned enterprises (including some 2000 in developing countries and 4500 in former East Germany) are transferred to the private sector. • Privatization continues; in 1993 France announced the plan for second wave of sales involving state firms including Renault, Air France and steel-maker Usinor Socilor.

7. INTRODUCTION • Privatization also forms a major element of transition to a market economy in Hungary, Poland, Russia and other former Eastern Bloc states.

8. State Control Firms: • There are several theoretical arguments for firms that are under State Control; • It stems from the operation of either an active or planning approach to industry policy. • It is because product is deemed to be (a) merit goods or (b) public goods 3. Natural Monopoly argument.

9. Privatization: What is privatization? • It is a term describing the process of switching ownership from the state to the private sector (narrow definition) • Privatization can also be described as the general removal of state control on economic activity.

10. Privatization: What is privatization? • This definition will encompass on; • firstly, change in ownership (denationalization), • secondly, to remove regulatory constraints and general attempts to expose more economic activities to the rigors of the market process.

11. Ownership Arguments What are some of the advantages of privatization? A. Proponents of privatization argue that (with no change in the competitive environment) the switch to private provision will enhance welfare by improving performance because the change of ownership increases the motivation of managers.

12. Ownership Arguments • There are 2 reasons here; • In the private sector it is more common for financial remuneration (the “Carrot”) to be linked to company performance ( for instance through share options schemes). • The “Stick” – in the form of increase pressure resulting from exposure to the capital market - is likely to be more effective in disciplining management.

13. Ownership Arguments B. Principal-agents problem (greater scope for managers in state-owned firms to pursue personal objectives that are not in the best interest of the firms) should be less pronounced in the private sector where the capital market is likely to be more effective in monitoring managers’ performance.

14. Ownership Arguments This could be due to; • The threat of takeover may focus minds more sharply on the task of efficient operations because of the likelihood of dismissal by new owners. • There may be also more pressure on private sector management from the need to satisfy shareholders, especially if these firms have large holdings and are well-informed (as, for instance, in the case of pensions funds).

15. Ownership Arguments C. The private sector ‘institutional rules’ differ from those of the state-owned firms. Much greater priority is accorded to the pursuit of profit, and there is less concern with political or social factors. • In state hands firms may find themselves subject to interference in its operations as the government seeks to achieve macroeconomic objectives. For instance, borrowing by state-owned firms in the UK and Italy has been restricted because of the need to control the public sector borrowing requirements.

16. Ownership Arguments • In the private sector such constraints – which may have prevented the implementation of viable investment projects - is removed, but may open up additional sources of finance (such as bank borrowing and issuing shares). • Moreover, in the private sector, the firm is freed from government intervention in its pricing or employment decisions (such as being directed to contain price increases on the grounds that this will help the government restraint inflation). Veljanovski (1989)indicated that ‘…One major attractions of privatization is that it takes politics out of the day-to-day operation of these industries…’.

17. Ownership Arguments • On the whole the benefits of a change in ownership therefore depend on the managers’ rapid acquisition of the skills required for effective management of a private sector firm, and the attitude of their managers as well.

18. Ownership Arguments • Assistance from firms operating in established market economies could be of considerable value. Example: Polkolor of Poland has been transformed swiftly into an internationally competitive producer through a joint venture with Thomson of France.

19. Ownership Arguments • If changes in management performance do occur as a result of change in ownership, by eliminating X-inefficiency will improve resource allocation by reducing costs, greater efficiency may also be displayed in more aggressive exploitation of market power.

20. Ownership Arguments Costs and Revenues • Before privatization: • AC and MC is 0F (because there is the directive to set price equal to MC) • Price is equal 0F. • After Privatization: • Price 0Pm and cost level is 0E • This is assumed that management is brought under the pressure of the share-owners: - Prices rise to monopoly levels while cost reduced. • Therefore, privatization results in • productive efficiency gain which is equal to cost reductions (area EFBG) • an allocative loss occurs (equal to area ABC) • From a static viewpoint, privatization enhances economic welfare only if the area EFBG is bigger than the areas ABC (immediate effect) MR D A Pm MC State C F B E MC Private G O Q Private Q State Quantity

21. Ownership Arguments • The static loss however, may be offset by beneficial changes over time. I.e. managers have more reason to foster new products and processes if any increase in profit will increase their income.

22. Ownership Arguments • Further, the higher rate of successful innovation will soon overcome the short-run allocative loss and advance the welfare of society.