Can Competition Eliminate Public and Private Differences?

A Key to Understanding Privatisation By Damilola Olajide**

Economists generally view competitive behaviour of firms operating in an industry as desirable. Competitive behaviour leads to socially desirable outcomes. When producers compete, they will choose socially acceptable levels of production and will undertake profitable investments that increase asset value. As a result, products are of high quality and prices are set at the opportunity cost of producing the good or service. In this way, competition ensures that resources are allocated to their best uses. In the absence of any externalities, competition promotes technical and economic (allocative and productive) efficiency. When competition is absent however, the exact opposite may be the case, leading to inefficient allocation of resources. Producers will set prices above the marginal cost leading to monopoly prices, and may employ inefficient production techniques. When a firm does not face competitive pressures of rivals and possible entrants into the product market, there is little incentive to indulge investments that improve technology and innovation. The importance of competition raises an issue of whether ownership does matter after all. Does ownership change (privatisation) matter if gains in efficiency can result from increase in market competition? A school of thought argues that it is competition which affects firm behaviour rather than ownership. This argument ignores a key issue, which is whether competition alone is sufficient to eliminate differences in behaviour of public and private firms. That is, whether the government can perfectly remove public and private differences. This contribution paper presents two lines of counterarguments to show why competition may not be sufficient for achieving efficient market outcomes. The limits of competition mark a point of departure from previous propositions and provide way to understanding why privatisation matters. Firstly, if competition alone is sufficient, then the government should be able to effect changes in public firms that improve economic efficiency and improve asset value without necessarily changing ownership. In this case, privatisation would not matter. Secondly, if competition alone is sufficient,
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then ownership should have no effect on behaviour (performance), even when firms operate in a competitive market. Empirical evidence supports the counterarguments in the sense that both ownership and competition matter for firm behaviour. Empirical evidence supporting ownership effects on performance under perfect competitive market assumption is overwhelming. An understanding of the key differences between public and private firms and the mechanisms through which the government can perfectly remove such differences are necessary for an understanding of privatisation or why ownership matters for firm behaviour and what explains behavioural differences between public and private firms. Public and private firms differ in some respects. Three major differences can be identified. These are objectives, monitoring, and managerial incentives. Firstly, it is sometimes argued that behaviour differs between public and private firms because they do not face the same objectives. This argument is less convincing. Truly, the range of objectives facing public firms is higher relative to those facing private firms. Private owners are motivated by profits. Production at lower costs can achieve this. However, there is no reason why the public firm cannot also be made to seek profit maximisation and to produce at lower costs. For example, a corporatised firm seeks profit maximisation, even though it is under public ownership. Also, operations of public firms are affected by political intervention. Politicians tend to manipulate operations of public firms in order to achieve political ends. Political intervention may take several forms including maintaining excess employment, transfer of wealth in favour of political supporters. Public firms also provide a platform for corruption and nepotism. Political intervention is distortionary to efficient operation and affects the extent to which profitable outcomes are enhanced in public firms. Thus, a public firm becomes relatively less profitable and less efficient than comparable firm in the private sector. It cannot be discountenanced however, that both private and public firms are subject to political intervention. The nature and extent of intervention may differ however. The second source of differences between public and private firms is the disparity in the ability to monitor managers. Ownership is concentrated in private firms, whereas ownership is highly diffused in public firms. Ownership shareholding of a private firm can be traded on the capital
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market. Private owners have incentive to monitor the performance of their managers through the capital market. Even where shareholders of the private firm are diverse, the capital market also aligns the interests of shareholders and managers. This sort of monitoring is less obvious for public firms. Even when ownership shareholdings in a public firm are traded on the capital market, ownership shareholding is highly dispersed with no identifiable shareholder that has sufficient voting rights to effectively control or to block decisions in the firm. The result is that there is little incentive to monitor public managers. Also, public managers tend to free-ride on any monitoring efforts of the government. An implication of the disparity in monitoring is that operational efficiency will be lower in public firms relative to private firms, even if both firms operate in a competitive market. Differential incentive is the most influential source of performance differences between public and private firms. Ownership matters for firm behaviour because managers of public and private firms do not face the same incentives. The public sector managers, who carry out the day-to-day operations in the firms, lack sufficient incentives comparable to private sector managers. The key incentive differences between ownership forms are the claimant on managerial activities that increase asset value and rewards for efforts that minimise costs. Under private ownership, activities that increase asset value and minimise costs are rewarded directly, whereas such activities are not rewarded under public ownership. Private owners benefit directly from increase in value of assets of the firm, whereas public sector managers have no claims on the asset of the firm. Also, private owners are liable for costs of operating the firm, public servants are not. Therefore, whereas private owners have incentive to undertake activities that increase asset value and minimise costs, public servants have little incentive to do the same. Perhaps the differential incentive view underlies a popular saying in the Yoruba tribe in Nigeria that A kii se ise oba laagun, which literally translates, One needs not sweat in undertaking government works. Thus, if the government can remove any incentive differences associated with ownership, public servants will behave exactly in the same way as private owners, and privatisation might not matter. Governments often seek to achieve this through mechanisms such as incentive contracts and regulation. For example, the government can provide incentive regimes such
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as performance and employment contracts in attempt to make public managers behave exactly in the same way as their private counterparts. Also, if profitable activities of a private firm will generate social costs such as pollution, regulation may be required. Regulatory contracts can stipulate activities to undertake and/or to avoid. How perfectly can the government do these? The argument borders on measures of asset value and costs. If measures of asset value and costs are perfect, desirable outcomes as noted in the above can be achieved. Public ownership is accompanied by appropriate incentive schemes and private ownership is accompanied by regulation. However, the point is that incentive contracts and regulations are far from perfect. This is largely due to differences in the level of information (information asymmetries) available to parties to such contracts, and regulations and associated monitoring are costly under private ownership than under public ownership. Empirical evidence supports these. This is why ownership change (privatisation) can be considered as an incentive mechanism and/or a regulatory tool for changing firm behaviour. In conclusion, if firms of different ownership forms face similar objectives and both are monitored at the capital market but face differential incentives, whether they also achieve the objectives similarly will depend critically on the incentives that motivate the managers who will carry out day-to-day operations towards achieving the objectives. Since incentives facing managers vary according to ownership forms, motivations vary, hence managerial activities towards achieving objectives will also vary. This is why public and private firms cannot always be expected to behave similarly. Ownership influences incentives and changes firm behaviour. Thus, the extent to which competition alone can achieve efficient market outcomes to the extent that public and private firms will behave exactly in the same way depends on whether it can perfectly eliminate public and private differences. This contribution suggests that it cannot do so. An empirical issue to be addressed is whether privatisation itself provides an optimal ownership form in the sense that private profitable activities align social welfare.
Damilola, a Research Associate Economics Department, Monash University, Clayton Melbourne Victoria 3800 Australia, is a Fellow of the Institute of Public Policy Analysis in Lagos, Nigeria.
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All references for this contribution have been duly acknowledged elsewhere.