Government Promises To Privatized Firms And The Public Interest

William J. Baumol

BUENOS AIRES: A danger haunts the market mechanism and threatens the benefits expected from privatization of inefficient state firms everywhere in the world. During the privatization process, promises are made to investors to induce them to bid for companies and to provide incentives for enhancement of efficiency. Soon after privatization, however, governments come under political pressure to renege on their promises once the benefits of privatization begin to be harvested. The danger is that these benefits may vanish. Experience in telephone privatization in Argentina and the United Kingdom offers useful lessons for privatization programs elsewhere, particularly in the transition countries.

By 1989 the long underfunded Argentine telephone company could no longer provide acceptable services. The government had little alternative to privatization. It could not fund the huge investments necessary to replace the aging network and installations. The new private purchasers laid out the necessary funds, having been promised the opportunity to earn substantial profits. Dramatic improvement in service followed. According to one study, before privatization unsatisfied demand for lines averaged about 45 percent of the number of lines already installed. Since then, installation of new lines rose from considerably less than 200,00 to some 700,000 lines per year. Before privatization unrepaired breakdowns were 5.3 percent of lines in service; only one year later, it had dropped to 0.9 percent. Delay in customer repair was 16.4 days in 1990 and 1.2 in 1995.

Huge investments were made by the private firms, induced by the opportunity to reap high profits, after taking the telephone industry over. Now, there is strong pressure on the government to retract its profit commitments in the belief that it is too late for the private firms to withdraw their investment outlays.

Similar scenarios occurred in many countries in which privatization occurred. The British telephone industry is illustrative. Prices charged by British Telecom, the privatized former state monopoly, are regulated under a widely used "price-up" regime. Price caps were designed to overcome a serious shortcoming of earlier forms of regulation which tried to prevent excessive monopolistic profits by imposing a ceiling on what firms were permitted to earn. The trouble was that, with no way to increase their profits under regulation, firms lost all incentive for innovation or, indeed, any other means to increase efficiency. Cost saving through efficiency improvement takes great effort and involves great risk. With no reward, managements saw no reason to make the required effort.

The new price-cap rules supposedly solve the problem by setting upper limits on price rather than profits so that a firm can increase profits by cutting costs. Price ceilings are automatically revised annually by a built-in inflation adjustment and a fixed annual reduction in price (called the "X-factor" deduction) that shares part of the firm's added profits with consumers in the form of lower prices. For a grace period of several years the telephone company is permitted to keep the remainder of its new profits as its reward for innovation, but after a prespecified period of time prices are ultimately adjusted to pass all future savings from past improvements to consumers. After this the firm can obtain new profits only by still more improvements in its efficiency.

Under a price cap, then, the higher the "X" factor deduction, the lower the profit that the company is permitted to keep. Ideally, the government selects an "X" deduction number that is considered fair to consumers but also leaves the firm a sufficiently strong profit incentive for it to struggle to reduce its costs and increase its profitable sales. The government should then announce its selected "X"-deduction number, say 2 percent per year, and not reduce prices for consumers more than this amount for some fixed period, say five years.

This was what was announced in a number of countries for their privatized industries, but what actually happened came as a surprise. Quality of service improved with unexpected speed and effectiveness (as happened in Argentina), greatly increasing demand for the products of privatized firms. At the same time costs fell dramatically. Predictably, this unexpectedly good performance brought unexpectedly high profits, and that led to strong political pressure for the government to break its implied word and increase its "X" deduction from the profits of the privatized firms.

That, for example, is just what happened in the U.K. At the time of the telephone company's privatization (1984) an "X" deduction of 3 percent per year, scheduled to last until 1989, was announced. However, in 1988 the "X" profit deduction was raised from 3 to 4.5 percent, supposedly for four years. Only three years later, in 1991, "X" was raised again, to 6.25 percent. Then, just one year later, the "X" deduction from profit was increased to 7.5 percent!

The trouble with all this is that investors who are potential buyers of government firms, and who are expected to sink much capital into them, are learning rapidly that government promises are not to be trusted. Because of this danger, they may be unwilling to pay much for government firms offered for sale in the future. They may not invest the amount of capital necessary to bring service quality up to world standards. Even the already-privatized firms may hold back their investments and so subject their companies to deterioration of plant, equipment and service quality.

The moral of all this is that governments must be careful and conservative in what they promise during privatization. But once a promise is made it should be kept. Otherwise, consumers will have to pay many times over for their temporary gains as private firms, stripped of the profit motive, prove themselves as capable of inefficiency as their nationalized predecessors.