Monday, 31 January 2011

Private v. public ownership (updated)

Bernard Hickey, who wishes to lecture all of us on things economic, writes:
I wonder too, why can't Treasury and the government appoint boards that apply the same rigour as NZX listed companies? Other non-listed entities can do it.
If I interpret this question correctly (and, of course, I may not) then it seems odd that New Zealand's great economic guru has to ask it. The reasons for different outcomes, no matter who is on the board, under public and private ownership have been well known for the last 20 years. Since the early 1990s there has been a well known literature which explains the difference between private and public firms utilising an incomplete contracts framework. Within a complete contracts model - eg a principal-agent type model - the performance of private and public firm will be the same. This is because complete or comprehensive contracts cover all relevant state of the world and ownership is irrelevant in such a situation.

In an world of incomplete contract not all sates of the world are covered and this gives us a role for ownership - the owner is whoever gets to determine what happens in the situations not covered by the contract. Hart, Shleifer and Vishny ("The Proper Scope of Government: Theory and an Application to Prisons", Quarterly Journal of Economics, 112(4): 1127-61, November 1997) argue that the case for government provision of goods or services is generally stronger when non-contractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant and when corruption in government procurement is a severe problem. It has been argued that the case for government production is strong in such services as the conduct of foreign policy, police and armed forces. The case can also be made reasonably persuasively for the case of prisons. The case for private sector provision is stronger when quality reducing cost reduction can be controlled through contract or competition, when quality innovations are important and when patronage and powerful unions are a severe problem inside the government.

Its not clear that the government's interventions have been in areas where the Hart, Shleifer and Vishny arguments would suggest the government should be involved. Rail or banking, for example, are not a areas where cost reduction come at the expense of quality, where innovation is unimportant or where there are any problem with government procurement. So why have the government owning KiwiRail or Kiwibank? Also government involvement in Air New Zealand is hard to justify on these grounds. As noted above, the case for private sector provision is stronger when quality reducing cost reduction can be controlled through competition, and the airline industry is very competitive, when quality innovations are important, and we want a high quality and innovative airline industry, and when patronage and powerful unions are a severe problem inside the government, which are things we wish to avoid with an airline. Here private provision makes sense.

The Hart, Shleifer and Vishny argument applies to contracting out as well as outright privatisation. A question that arises therefore is, Why would private ownership ever be more efficient than public? As to why private provision is superior, there are two results that need to be explained. Oliver Williamson's idea of selective intervention and the 'Fundamental Theorem of Privatization' by Sappington and Stiglitz. (Sappington, David E. M. and Stiglitz, Joseph E. (1987). 'Privatization, Information and Incentives'. Journal of Policy Analysis and Management, 6(4): 567-82.) These tell us that there should be no differences in efficiency between a privatised and a nationalised firm. Thus any explanation of the relative efficiency between the two must explain why these ideas cannot be applied.

The first notion, of selective intervention, argues that the government can reach the same level of productive efficiency as the private sector by mimicking the private owner. Is this what Hickey is getting at with this question? If the government organises the firm in exactly the same way as a private owner would, if it gives the same incentive schemes to managers and workers, and if it deviates from such a policy only if there is the possibility of doing something strictly better than a private owner, then a nationalised firm should produce at least as efficiently as a privatised one. Think about what the SOE model was all about.

The second idea is concerned with allocative efficiency and says that a public firm will choose a socially more efficient production level because the government cases about social welfare and internalizes externalities, whereas a private owners just maximizes private profits. However, this argument implicitly assumes that the government cannot regulate the firm. Sappington and Stiglitz suggest a privatisation and regulation procedure that perfectly overcomes the problem of different objective functions. The government could auction a contract that entitles the private owner to receive a payment for the firm's output that exactly equals its social valuation. Thus, the owner fully internalizes social welfare and chooses a socially efficient production level. Furthermore, if the bidding process is competitive, the government will extract all the rents form the contract through the auction ex ante even if it doesn't know the cost function of the firm.

At this point the argument tells us that efficiency should be the same for both private and state firms. Why then does the empirical evidence tell us otherwise? Well, both arguments are based on the implicit assumption that it is possible to write a comprehensive contract for the entire horizon of the firm - otherwise the involved commitment problems could not be overcome. To illustrate this point, consider again the auction suggested by Sappington and Stiglitz. For such an auction to work, the government must be able to commit at the stage of privatisation to actually pay the social valuation of output to the private owner in the (possibly distant) future. That is, it must be possible to specify unambiguously in a contract the social benefit of production for all possible state of world such that this agreement can be enforced by the courts. Otherwise, the private owner will rationally expect that once she has made a relationship specific investment the government will exploit the fact that investment costs are sunk and will expropriate her quasi-rents; therefore she will not invest efficiently. However, if comprehensive contracts are feasible, it is not surprising that there is no difference in efficiency, since it is well known that any organizational mode can be copied by any other organizational mode through a comprehensive contract. Therefore, if there is any difference, it must be due to the fact that only incomplete contracts are feasible at the stage of privatisation.

A simple example is the paper by Klaus Schmidt, "The Costs and Benefits of Privatization: An Incomplete Contracts Approach". (The Journal of Law, Economics & Organization, 12(1): 1-24, 1996.) The intuition is roughly as follows: Suppose the manager of the firm has to make a private investment in cost reduction before production takes place. For example, he may have to expend effort to restructure the firm and to organize production more efficiently. Assume also that the manager derives some private benefit from a higher production level, either because he is an "empire builder" or because he is afraid of the firm being liquidated, in which case he loses his job and his reputation may be damaged. To improve the manager's incentives, the government may want to commit ex ante to a subsidy scheme that punishes the manager if costs are high by cutting back production or even closing down the firm. However, under nationalization this commitment is not credible. If the government could observe the cost function - and it can in this case -, it would always choose a production level that is ex post efficient, thus forgiving high costs and paying more subsidies than announced ex ante. Anticipating this, the manager has little incentive to save costs because he faces a "soft budget constraint". Under privatization, however, the government is not informed about the costs of the firm whereas the private owner is. It is shown that the optimal subsidy scheme under incomplete information distorts production below the socially efficient level if costs are high. Furthermore, there is a positive probability that the firm will be liquidated, even though this is inefficient ex post. Thus, under privatization allocative efficiency is clearly lower than under nationalization. The more surprising result is that productive efficiency may be enhanced. The manager faces a harder budget constraint because he rationally foresees that subsidies will be cut back if costs turn out to be high. Thus he has a stronger incentive to invest in cost reduction to avoid the low production level or possible liquidation. To summarize, there is a trade-off between a less efficient production level (lower allocative efficiency) and better incentives for the manager to save costs (higher productive efficiency).

This article makes a very strong assumption about the role of government. The government is modelled as a benevolent, fully rational, and unitary decision maker. There are no conflicts of interest between politicians, ministries, and regulatory agencies; no rent-seeking lobbyists trying to get subsidies; and no self-interested politicians struggling for power, bribes or a larger share of the electoral vote. This assumption is clearly unrealistic. therefore the main result of the paper should be seen as an existence theorem: It shows that privatization can be can be strictly superior to nationalization even in the best of all words for government. Thus, even if it were possible to fix all the deficiencies of the political system a case for privatisation could still be made

I'm not sure if this answers Hickey's question but it does give us insights as to why the performance of public and private firms differ, which I assume is what he is worried about.

Update: Roger Kerr discusses problems with the discussion of privatisation by journalists here and here.


Horace the Grump said...

Yes, well Bernard is this country's most vociferous economics commentator mainly because he has incentives to do so... namely to drive traffic to his employers website (

The fact that Bernard is the pre-eminent economics commentator in NZ probably says more about the lack of commentary from real economists than it does about Bernard per se.

As is perfectly clear to anyone that reads his website or his columns or listens to him on the radio, Bernard's grasp of economics is pretty weak. On the dainty side of flimsy I would say.

But he has a big incentive (an income) to get out there and make commentary, whereas academics generally have incentives in other directions (PBRF funding and points come to mind).

So it may seem fair from your point of view to slag him off, but really is it entirely his fault he is the only commentator being listened to?

Something to consider perhaps in the cloistered halls at U of C

Paul Walker said...

"So it may seem fair from your point of view to slag him off, but really is it entirely his fault he is the only commentator being listened to?"

I think its fair "to slag him off" because he is talking rubbish that's the point here.

ttv said...

I don't think so for that Paul. Be more specific.