The 1980s and 1990s saw an upsurge in organisational reform in the world economies. This included the disposal of state property to the private sector and methods of delivering public services (such as education and health) using private suppliers and providers. We shall first explore the different approaches to privatisation, and then discuss the ways of regulating privatised utilities and delivering public services.

Different types of organisation are characterised by different structures of property rights (rights to the residual and control rights). In public corporation/enterprise, there are no privately exchangeable rights to the profits, and the directors are appointed by the government. In public limited company, shareholders receive profits in the form of dividends and may take part in a collective process to appoint the directors. Government bureau/ agency receives government grants, rather than deriving its revenues from sales.

The approach taken by many Western European governments was of ‘public interest’ in controlling public enterprises. ‘Public interest’ meant that public enterprises in areas of natural monopoly should not attempt to maximise profit, but should produce an output and sell at a price that was ‘socially efficient’, taking account of external and environmental externalities. This approach came to be associated with the correction of ‘market failure’. There were different ways in managing public enterprises:

• the marginal cost pricing rule: output is produced where marginal social benefit equals marginal social cost. Though this can result in financial losses when marginal costs are below average costs, so requiring taxes or charges to sustain the public enterprise.
• the investment rule: ‘social’ discount rate used to calculate net present value.

Marginal cost pricing and investment rules , with their focus on economic efficiency, sit uneasily with social objectives. The tension between efficient pricing and redistributional (or social) objectives remains unresolved.

Critics of the public interest approach argue that the public interest view ignores agency costs (i.e., any losses resulting from less than perfect commitment of the agent to the interests of its principal). This criticism shifts towards the ‘property rights’ analysis that forms part of the new institutional economics. In this framework, managerial incentives, monitoring arrangements and agency costs are important. Managers in public enterprises are poorly motivated and act for short-term political gains. In response to this, changes are made to their incentives and constraints, and financial targets are introduced. In effect, by devising the appropriate contract, the individual’s behaviour is structured to minimise agency costs. However, for many public goods and services, contractual changes can create additional problems. For example, social elements of the public enterprise can be ignored if financial results become the only criterion of success. Furthermore, where the output is a complex service (such as health), managers will focus on meeting a specific target (e.g., waiting time to attend to patients) while ignoring other important components (such as staff training, research and development, quality of after-care) of the output that are too costly to measure.

Another response to the agency costs is proposals for privatisation; three reasons are given for this:

• exchangeability of residual rights: improves incentive and control mechanisms, so reducing the transaction and agency costs and improving managers’ monitoring;
• threat of takeover: acts as a powerful incentive for better managerial performance;
• managers’ labour market: enables managers to be mobile and changeable, so talented managerial skills can be purchased, facilitating better monitoring and incentives.

The organisational forms (such as public limited company, public enterprise and public bureau/ agency) will vary in their abilities to monitor performance, because they exist in different institutional settings (in terms of managerial labour market, competition in the product market, capital market constraints, bankruptcy constraint, and balance of power between owners-managers).

Once a natural monopoly is privatised, a regulator has the responsibility for establishing the framework of rules and incentives that seek to prevent the privatised monopolist from exercise market power against the public interest. The regulatory duties include the promotion of competition and efficiency, the protection of consumers, and proper financial corporate practices.

Some regulatory problems arise when the market is ‘contestable’ (there are low entry and exit costs - i.e., small sunk costs). Here, a regulator of a natural monopoly faces a dilemma with respect to new entry. On the one hand, the force of potential competition and the threat of entry help to keep costs and prices under control. Against this, there is a possibility that entry could be destabilising (‘hit-and-run’ entry strategy). However, this problem is not widespread, as many privatised utilities (such as power and telephone) have substantial sunk costs to deter such kind of entry.

Given the regulatory problems associated with ‘natural monopoly’, it is important to recognise that only one part of the activities of public utilities as traditionally conceived is naturally monopolistic. For example, electricity transmission and distribution are naturally monopolistic, though the generation of electricity is not subject to large-scale economies. In addition, while cost economies are important in distributing electricity to domestic users, this is not always the case for industrial users. However, there may be substantial contractual problems of linking generation and distribution. A key feature of utilities’ regulation has been to isolate the component of natural monopoly in each case and encourage competition in other areas such as the generation of electricity and distribution of electricity to industrial users. Indeed, some industries (e.g., UK electricity) are disintegrated before they are privatised, though some (e.g., UK gas) are broken up or de-emerged after they have privatised.

As well as entry and new competition, mergers and takeovers require regulatory intervention.

One of the dangers of regulation is that the regulator becomes captured by the industry being regulated. The regulator is dependent upon detailed information, which is controlled by the regulated firms.

One method of regulating a natural monopolist is to impose a price ceiling on a natural monopolist (in the US, profits are capped). The main advantage of such price regulation is that it does not affect decisions about production techniques. However there are some problems:

• regulator requires some criterion by which to base regulated price, and it does not possess the firms’ detailed knowledge of cost and revenue conditions. The firms overestimate their future costs so as to have a higher price ceiling.
• to prevent the monopolist responding to price control by reducing quality, the regulator is drawn into the detailed specification and policing of standards.

In the UK, price capping (or ceiling) is set using the formula ‘RPI minus X’. This formula allows a utility firm to increase prices by the % increase in the retail prices index less a number of % chosen by the regulator as a value for X. The value of X is set for a number of year into the future. The system is inevitably rough and ready.

Franchising makes a distinction between competition in the market and competition for the market. When a service (such as rail, school, prison and security, hospital services) is franchised, a principal (the franchiser) invites competitive bids from firms to provide the service for a specified period. The winning firm in such an auction is the franchisee. The principal-agent relation between principal and franchisee leads to a somewhat different regulatory structure.

Problems that may arise from franchising:

• defining and policing quality: where services are varied and complex and where quality is difficult to define and measure, the problem of writing a suitable contract will be serious. Principals will find it hard to know whether the bidders can really achieve what they are claiming (moral hazards and adverse selection problems).
• contract duration: as contract duration lengthens, the franchisee will want some protection against extreme changes in cost and demand conditions. At the same time, franchiser might want the freedom to insist on the provision of some newly developing some services over time.
• asset valuation and ‘hold-up’: a franchisee, who has not managed to retain a franchise, may not be able to use the capital assets in other businesses nor sell them on the open market, and fears ‘hold-up’ as it receives less for their assets than their proper value. Franchisee is therefore less likely to undertake significant physical and human investment, and jeopardise dynamic efficiency

Most studies suggest that public enterprises are relatively less inefficient. Yet the studies are complicated by the political history of the privatisation, and the changing environmental conditions, so that it is difficult to make a straightforward comparison.