Tuesday, 4 December 2012

Economics of nationalisation versus privatisation.

MC= Marginal cost
MR= Marginal revenue
MRC= Marginal revenue for a firm under competition
AC= Average cost
AR= Average revenue
ARC= Average revenue for a firm under competition

The profit maximisation diagram is used by economists to explain how firms determine the level of output that leads to the highest level of profit for the firm, specifically the point where total revenue exceeds total costs by the highest amount and hence profits are maximised. This is where the yellow and blue lines cross. Not the gap shown by the black lines in between the average cost and average revenue indicates the profit per unit.

However, if we were to assume that the firm instead opted to produce at the “Highest non loss-making point” (HNLP), which is where the green and orange lines cross and hence the firm makes zero profit as costs equal revenue, then the societal benefit of the firm would be greater. This is because, as we can see, it produces a higher level of output with a lower unit price. Therefore in this diagram the social optimum level of production and the incentivised level of production differ. It is also impossible to incentivise the firm to produce at this level other than subsidising the firm to such an extent that this level of output becomes the most profitable. This tactic is unattractive as it simply everyone, including those who do not wish to consume the product, paying via taxation for the product to be sold at a lower store price and to drastically increase the firms profits.

A different option would be to simply nationalise the firm, turning it from a private enterprise to a state run firm. Since the profit maximisation incentive would be replaced by an “electorate pleasing” incentive. While the electorate may at first like the idea of a large state enterprise turning a profit to pay for public services, they would quickly realise that they would themselves just be paying for the public services through higher prices, a somewhat more regressive manner than income taxation. Furthermore a lower level of output, which is necessary to generate profits, would mean lower demand for inputs. This translates directly into a higher level of unemployment. Because of this, the “electorate pleasing” incentive results in the HNLP.

The diagram shown, however, assumes a monopoly, and while it can be stated with some confidence that in a choice between government monopoly and a private monopoly, the former is preferable, often in reality the choice is not so simple. The choice is often between private competition and government monopoly.
In order to model both monopoly and competition within the same diagram we must use the formula: (ARcn =ARmn*F). This means: The average revenue for a single firm producing quantity “n” in a competitive environment is equal to the average revenue for a monopoly producing a quantity of “n” multiplied by the number of firms. This is because whether 5 firms each produce 20 of a product or a single firms produces 100, the quantity is still the same and hence the effect on price is still the same.

With this formula we can create a new graph incorporating competition. The following example assumes there are 4 firms. It assumes this because that is the number of firms that results in a level of output at the lowest point on the marginal cost curve, any level of output above this, in the long run, will lead to new firms entering the market and any level below will lead to firms buying others.
As we can see, the firms in a competitive produce at a lower price and although they produce a lower quantity, this quantity multiplied by 4 would clearly exceed the level produced by a private monopoly. From this diagram then we can state that private competition is preferable to private monopoly. However if we compare it to the HNLP we can see it produces a lower price, though cannot say simply from looking at the diagram say that it produces a higher level of output, in order to properly compare private competition against state monopoly in this context we must look at the figures behind the graph.

State monopoly

As the table demonstrates, in this incidence the competitive market produces a higher total output at a lower price, for this industry then it can be said that, with measures to ensure competition, society is best served by the sector being in private hands. It is also possible however for the state monopoly to produce more at a lower price. When either the state or the private sector can produce superior results in both price and output, then the choice is obvious. However when there is no absolute superior option then a trade off must occur. The government must decide if they prioritise the price level or the level of output, and to what degree they prioritise it. For example a government may have to decide whether a 5% increase in the level of output is worth a 4% increase in the price level.

Since the optimal form of organising the industry is determined by their relative equilibrium outputs and price levels, but this data is sometimes difficult to accurately measure, we must look at what determines the cost and revenue curves, namely the intricacies of supply and demand respectively.

The main determinates of the cost curve are the “Economies” and “Diseconomies” of scale. These refer to the benefits and problems gained by a firm gaining size, respectively.

An example of an economy of scale is the division of labour. If a firm produces more, it will have to hire more staff, this means they can divide the number of tasks between more people. Where a person may have done three tasks five times a day, now they can do one task all day. Because the person is focused on this single task they become better at performing it and gain experience faster. Also having each employee doing less tasks makes training faster, as well as filling temporary vacancies easier.

An example of a diseconomy of scale would be communication channels. With some companies communication between employees is vital, and the best way to do this is one-on-one communication channels. However as the number of employees increases the number of communication channels this requires increases quickly.

Communication Channels

Economies and diseconomies of scale determine the optimum size of a firm, with higher diseconomies and lower economies of scale making the optimum size smaller. The smaller the optimum size of a firm, the more likely that it suits private competition rather than state monopoly.

The determinants of the shape of the revenue curve are the variety, volatility and intangibility of demand.

A monopoly attempting to meet a wide variety of demand will suffer, as can be seen by poor quality of cars in the Soviet Union. Since the automotive industry has a large variety of demand, attempts by a monopoly to meet all these demands will struggle, leading to a “one size fits all” while a large number of firms can each engage in specialisation, some making “luxury sports cars”, while others can provide “cheap utilitarian transport for the masses”, to quote Giorgetto Giugiaro.

Another determinant of the revenue curve is the “intangibility of demand” for certain products. Before a movie is released to the general public, a film company can assess it and come up with a number of demonstrably true figures; length, budget, a list of the actors, production time, CGI expenditure. However, none of these are real indicators of the films quality as a product, nor the demand for it, the audience does not judge a film based on these figures, but rather their enjoyment from the film. Their enjoyment from the film is derived not from these figures, but from a set of characteristics that are based partly on these. A film can be too long or too short, it can be too low budget to allow for decent suspension of disbelief or it can have so much in terms of special effects that the audience is reminded they are watching a movie. This type of demand is difficult for a monopoly to produce for, since it can not set easy targets for its products. Other products however have a less intangible demand, for example televisions. When people are considering buying a television they have certain characteristics in mind; size, features, clearness of sound and picture, inputs, power consumption. These are all measurable and demonstrable. Another good example of tangible demand comes in the form of refined materials and components. Since the aesthetics of a good are often dealt with by the manufacturer, the materials and components bought by the manufacturer are free to focus on tangible characteristics such as size, weight, strength etc. It is because of this that while car manufacture may be best left to private firms, the production of steel and aluminium for the cars may be better suited to a state monopoly.

Another factor that determines the optimum method of organising an industry is the size of the barriers to entry. Barriers to entry refer to the start up costs of a business, such as acquiring the land, buildings and machinery to produce the goods. The lower these are, the easier it is for firms to enter the market and hence the optimum firm size is reached quicker if there are too few firms. The less barriers to entry there are, the more desirable a private enterprise approach is.

To summarise, the traits which indicate a superiority for the private enterprise approach or the state monopoly approach are as follows.

Economies of scale
Diseconomies of scale
Variety of demand
Intangibility of demand
Barriers to entry

From this list we can work out a variety of sectors that are best served by private or state control

Better off nationalised
Better off private
Utilities; power, water etc
Public transport
Natural resources
Corner shops