Distinction between Public Enterprises and Private

Enterprises
A state owned enterprise, as the name suggests is one that is owned and managed
by the state whereas a private enterprise is one that owned and managed by
private individuals.

1. public enterprise is set up by the government whereas the private

enterprise is set up by private people.

2. Public enterprises are formed with social interest whereas private

enterprises are formed with personal interest.

3. public enterprises are set up through an act of parliament, but private

enterprises are set up through the registrar of companies.

4. Public enterprises are owned and controlled solely by the state, but private
enterprises are owned and controlled by private individuals.

5. The aim of the public enterprises is to provide essential services to the

people. However, the private enterprises are set up with the sole aim of
making profit for their owners.

6. Public enterprises are guided by social objectives like development of

backward region, creation of employment etc. whereas in private
enterprises social objectives are not important.

7. Public enterprises have reduced efficiency because there is red tapism and
bureaucratic control due to which decision making is not fast whereas in
private enterprises its efficiency is high because decision making is fast.

1
8. When public enterprises incur losses, these losses are borne by the
government, but the losses incurred by private enterprises are borne by the
private individuals.

9. When state enterprises make profit, the profit is paid into consolidated fund;
on the other hand when private enterprises make profit, the profit is shared
by the owners of the company.

10.The employees of the public enterprises have the security of the job along
with that they are given the benefits of allowances, perquisites, and
retirement like gratuity, pension, superannuation fund, etc. which are absent
in the case of the private enterprises.

11. In the private enterprises working environment is quite competitive which is

missing in the public enterprises because they are not established to meet
commercial objectives.

12. In general Public enterprises uses Seniority for promoting employees,

however, merit cum seniority is also taken as a base for promoting
employees. Unlike Private enterprises, where performance is everything, and
so merit is considered as a parameter to promote them

2
3
Advantages and Disadvantages
Of State Owned Enterprises
What is a state owned enterprise? A state owned enterprise is an organization
that is owned and controlled by the government. A state owned enterprise is
the exact opposite of a private enterprise which is owned by private individuals.

What are the advantages of state owned enterprises?

 They provide very essential services to the people at cheaper and

affordable rates. For example electricity and water are some of the
essential services that state owned enterprises produce for the people.
If such services are left solely in the hands of private enterprises, then
consumers would end up paying a great deal of money for it since the
private enterprises have a sole aim of making profit.

 Since state owned enterprises do not have a sole aim of making profit,
the services that they provide end up being cheaper than services
provided by private enterprises.

 They protect the consumers from being exploited by private

enterprises by offering them a cheaper and better alternative.

 Another advantage that a nation derives from state owned enterprises

is the fact that they create jobs for the people.

 State owned enterprises help the government to control certain

strategic sectors of the economy. There are certain industries which if
not monitored and controlled properly could pose serious risks to the
public. A good example is the atomic energy industry. It is imperative
that the state owns and controls such industries in order to make sure
operations do not pose any risk to the public.

4
What are the disadvantages of state owned enterprises?

 There can be high levels of corruption in state owned enterprises. This

is especially common in many third world countries where
management is very poor.

 State owned enterprises are sometimes plagued by too much political

interference and control.

 Negative work attitude by workers is another problem associated with

state owned enterprises. Many workers regard state owned enterprises
as something which does not belong to them so they handle it with
negative work attitudes such as laziness and dishonesty. Since it is not
their business they do not care what happens to it. This negative work
attitude that is heavily seen in state owned enterprises is one of the
major reasons many of these enterprises don’t do well.

 Bribery and corruption is more rampant in state owned enterprises

than the private enterprises. Studies have shown that majority of
workers in state owned enterprises are corrupt. The level of corruption
in state owned enterprises is even worse in underdeveloped regions
across the globe. Workers in state owned enterprises tend to take
bribes before they do jobs that they are being paid to do. Most
managers of these enterprises embezzle monies and others
misappropriate them, leading to the slow growth of most state owned
enterprises.

5
Importance

Planned development: Its main aim is to promote economic and social development in the weaker
section. It helps to run all the works of development in an efficient manner. It follows government plans
and policies. It generally focuses on private sector. It also earns profit. It provides planned development
by setting up industries too.

Balanced development: Development works are done in planned and balanced way. It also provides
decentralization of industries. It tries to develop all regions in harmonious ways. Balanced development
is the main aim of public enterprise.

Accelerating the rate of economic growth: In developing countries, increasing the rate of economic
growth always gets the first priority. It tries to remove deficiency of economy. It provides infrastructural
facilities for economic development. It provides employment opportunities. Government invests the
money. Amount of capital, technical empowerment and other facilities can be easily arranged by the
government.

Public utilities: Public enterprises provide the utility of transportation, water supply, irrigation,
electricity, communication, education, health facilities and so on to the general public.

Supply essential goods and services: public enterprise provides goods and services to the public at
reasonable price. The government helps in manufacture and distribution of goods. These types of
services are not done for earning profit.

Provide job opportunities: They help to create the employment opportunities in the society and work as
the model employer. They help in uplifting the living standard of the people.

Reducing economic inequality: It removes economic inequality. It helps to develop different regions of
the country. Therefore, it maintains living standard of the public.

6
Establishment of social welfare: They help in planned development and balanced development of the
country. They also try in accelerating the rate of economic growth. They are also established for supply
essential goods and services. They help in providing job opportunities to many people. They further help
in reducing economic inequality. Thus, they establish social welfare.

What is a Cost Benefit Analysis

 It is a tool used to more objectively assess:

o the value of a solution or action
o the comparison between alternative solutions or courses of action
 For our purposes, it does not include detailed financial analysis
When to conduct a Cost Benefit Analysis

 To determine feasibility of a solution or course of action

 To compare alternative solutions or courses of action
 When you are justifying a course of action
 When you are requesting additional resources for something
How to do a Cost Benefit Analysis

1. Determine the Costs

2. Calculate the Benefits
3. Compare Alternatives
4. Report and Plan Action
Determine the Costs

 You should first check to see if any analysis has already been done on your
project or idea. Perhaps there has already been some detailed costing work done. If
not, you will need to collect the cost numbers.
 List out costs of your solution or course of action:
o Initial or capital costs
o Ongoing costs – what are the costs in the coming months or years?
o Labor costs – how much time will your idea take from people?
o Contractor costs – Are there external labor costs?

7
 o Supply or input costs
o Non-monetary costs – what is the impact on safety, morale, reputation and
other less tangible things. You may not be able to assess a number to these
things, but you should at least list them for consideration.
Calculate Benefits

The next step in the Cost Benefit Analysis is to estimate the benefits on all the same
dimensions as you did for costs:

 Dollar value of benefits:

o Time (labor) saved
o Supply (input) savings
o Energy savings
 Non-monetary benefits:
o Safety, environmental
o Reputational
o Morale, turnover
o Quality
You should consider the immediate, yearly, and ongoing benefits in your Cost Benefit
Analysis.

Compare Alternatives

You now need to compare the costs and benefits from each of your alternatives. If you
only have one alternative, you are still comparing your option with the status quo.

 Subtract costs from benefits for each alternative

 First compare against doing nothing
 Compare each alternative with each other
 Take non-monetary into consideration
Below is a comparison table for a simple Cost Benefit Analysis. In the last 4 rows, a
dollar figure may be difficult to quantify, so you can put a description of the cost or
benefit in each of these areas:

Status Quo Option 1 Option 2

8
Initial Costs
Ongoing
Costs
Time Savings
Supply
Savings
Energy
Savings
Safety
Environmental
Reputational
Morale
Report and Plan Action for your Cost Benefit Analysis

 Make a recommendation based on your Cost Benefit Analysis

 Put together a brief plan of action for your recommendation.
 Don’t forget about other influencing conditions. Sometimes, you may have a
compelling argument that still needs to be deferred for other reasons, such as:
o Cash flow
o Availability of resources
o Competing priorities
3 Things to Remember About How to do a Cost Benefit Analysis:

1. Non-monetary conditions may have a considerable influence. Safety

considerations, for example, may trump all other criteria in determining action
2. The time-value of money must not be underestimated. Many people forget that
capital has a cost, and if your idea ties up dollars there is a direct cost to this.
3. If it gets complicated, more detailed financial analysis may be more appropriate.
You may need to seek out a finance individual in your organization to assist with
your analysis.
What is 'Internal Rate of Return - IRR'
Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the
profitability of potential investments. Internal rate of return is a discount rate that makes
the net present value (NPV) of all cash flows from a particular project equal to zero. IRR
calculations rely on the same formula as NPV does.

The following is the formula for calculating NPV:

9
Where:

Ct = net cash inflow during the period t

Co= total initial investment costs

r = discount rate, and

t = number of time periods

To calculate IRR using the formula, one would set NPV equal to zero and solve for the
discount rate r, which is here the IRR. Because of the nature of the formula, however,
IRR cannot be calculated analytically, and must instead be calculated either through
trial-and-error or using software programmed to calculate IRR.

What pricing policy should a Public Enterprise (PE) adopt? It is a

complex problem and is not possible to lays down, general principle of
pricing that should be followed by all the PEs. The complexity of
pricing problem arises because of the fact that some PEs are industrial
and commercial undertakings; some PEs are promotional and
developmental; and some PEs provide basic and essential
infrastructure facilities.

Also, competitive environment—domestic and international—has got

to be taken into account in the case of goods produced by some PEs.
There is also to be considered the need for financial resources for
investment purposes in a developing country like India. From all these
considerations; it should follow that there cannot be just a single,
principle of guiding of pricing that can be prescribed for or that should
be followed by all PEs.

The following points highlight the top four pricing policies of

public sector enterprises. The policies are: 1. Pricing of

10
Public Utility Services 2. Marginal Cost Pricing Rule 3. No-
Profit No-Loss Policy 4. Profit-Price Policy.
Pricing Policy # 1. Pricing of Public Utility Services:
There are a number of principles which govern the pricing of public
utility services. There are public utilities like education, sewage, roads,
etc. which may be supplied free to the public and their costs should be
covered through general taxation. Dalton calls it the general taxation
principle. Such services are pure public goods whose benefits cannot
be priced because they are indivisible.

It is not possible to identify the individual beneficiaries and charge

them for the services. In some cases, the beneficiaries may be
identified but they cannot be charged for their use. For instance, the
users of a bridge (flyover) over the railway line can be identified, but it
may be inconvenient to the taxing authority to collect the road tax and
for the road users to pay the tax due for the time involved.

The best course is to finance the flyover out of general taxation. J.F.
Due has mentioned the following four rules where public services
should be provided free and their costs covered from general taxation.

Firstly, in the case of such services where little waste will occur if they
are provided free. Second, where charging a price will restrict the use
of the service.

Third, where the cost of collecting taxes is high.

Fourth, where the pattern of distribution of tax burden on services is

inequitable.

These rules are applicable to a few essential public services like

education, sewage, roads, etc. But in the case of services other than
those included under “pure public goods,” free services might lead to
wastage of resources.

Dalton, therefore, advocates the compulsory cost of service principle

whereby the government should charge a price for the service

11
provided to the people. This is essential because municipal services
such as sewage, sweeping street, streets lighting, etc. are underpriced.

Every family of a locality may be asked to pay for them. But since they
are public utilities, they may be charged nominally and the gap
between revenues and costs remains. This is met from general
taxation. This is sort of government subsidy to the users of such
services.

However, Dalton favours the voluntary price principle for public

utilities. According to this principle, the consumers of a public service
are required to pay the price fixed by the PSE. The PSE may have a
monopoly in a particular service, such as water or power supply and it
may fix a price for it.

But the service being a public utility, it may set a price lower than its
cost of production so that the welfare of the community is not
adversely affected.

The general principle for pricing such public services is to recover

costs without distorting the allocation of resources. This is done by
making selling price equal to short-run marginal costs while keeping
productive capacity constant. But water and power systems
periodically require large investments. In such cases, average costs fall
as production is increased and the actual price charged is below the
average cost.

Charging that price would lead to a loss to the PSE. In such a situation,
the public price has to be revised to cover the cost of providing the
service. This is usually done by increasing-block tariff or multipart
tariff and time-of-use rate structures.

Under an increasing-block or multi-part tariff the consumption of

water or power is priced at a low initial rate up to a specified volume of
water or power use (block) and at a higher rate per block thereafter.
The number of blocks may vary from 3 to 10.

12
For instance, power charges for domestic light for the first 100 units
may be Re. 1 per unit, Rs 2 for the next block of 200 units and Rs.4 for
the block of next 400 units and above.

Under the time-use rate structure, consumers pay a premium during

periods of high demand. It increases the overall utilisation capacity of
the service and also profits of the PSE supplying the service. But its
main advantage is that this rate structure encourages consumers to
shift demand to lean (off-peak) periods. For instance, time-of-use
rates vary by time of day for telephones.

The STD charges in India were 1/4 from 11 p.m. to 6 a.m. 1/3 from
8.30 p.m. to 11 p.m. and 6 a.m. to 7 a.m. and 1/2 from 7 a.m. to 8 a.m.
and 7 p.m. to 8.30 p.m., and full charges from 8 a.m. to 7 p.m. till
recently. Time-of-use rates vary by season in the case of water supply
to agriculture, in the case of LDCs and natural gas for heating
purposes in developed countries.

Pricing Policy # 2. Marginal Cost Pricing Rule:

One of the aims of PSEs is to be economically efficient or to maximise
social welfare. If a PSE has a monopoly in the production of a good or
service, it will not be economically efficient because it produces where
MC=MR. However, for more efficient resource allocation, it is
essential to find out whether the PSE is operating under decreasing or
increasing returns.

If price equals MC under decreasing returns, the PSE will earn profits
and if it is operating under increasing returns, the PSE will incur
losses. Thus the application of the marginal cost pricing rule to PSEs
has implications for the financial position of the enterprise.

A PSE is usually in a monopolistic or semi monopolistic position so

that its AR and MR curves slope downward. In such a situation, price
(AR) is always higher than the marginal cost: AR (P) > MC= MR.

In case the price is higher or lower than the average cost (AC), the
output will not be of the optimum size because the enterprise will be
13
earning either supernormal profits or incurring losses. Again, the
output will not be of the optimum size even if the price of the product
equals the average cost.

To secure optimum resource allocation, the output of the enterprise

should be increased. This is only possible if the marginal cost pricing
principle is followed.

This is illustrated in Fig. 1 which shows the case of diminishing returns

or increasing costs. If the PSE has a monopoly, it will sell OM output
at MP Price. This price is higher than its marginal cost (ME) by EP
when MC=MR at point E.

Enforcement of the marginal cost pricing rule makes MC=AR (price)

at point K. Thus increased output MS is sold at the lower price SK. The
figure shows that at MP Price, the enterprise earns AP profit per unit
of output.

This output is less than that under marginal cost pricing rule, OM<OS.
Thus resources are not optimally allocated under monopoly. On the
other hand, if the average cost pricing rule q is followed, AC = AR at
point R. The price is further reduced QR which leads to excess demand
for the product as well as in the resources of the enterprise.

There is mal-allocation of resources. Thus the marginal cost-price

combination at point К leads to optimal resource allocation even

14
though the enterprise incurs a loss of LK per unit of output. To meet
this loss, the government should compensate the enterprise from taxes
levied on consumers of the product.

If the enterprise is operating under increasing returns or decreasing

costs, the marginal cost pricing principle will also lead to losses. This
is shown in Fig. 2 where the MC curve lies below the AC curve
throughout its length. If the enterprise follows the MC=MR rule, OM
output is produced and sold at MP Price.

It earns AP profit per unit of output. But the marginal cost pricing rule
sets SK price and OS output combination at point K where MC=AR
(Price). But it incurs a loss of KL per unit of OS output. However, OS is
the optimum output of the enterprise under marginal cost pricing.

The marginal cost price-output combination is also better than the

price-output combination under the average cost pricing rule. In the
former, the price SK<QR and output OS>OQ. But under the law of
decreasing costs, the enterprise adopting the marginal cost pricing
rule incurs KL loss per unit of output because the AC curve is above
the AR (price) curve.

But this does not follow that the enterprise should not follow the
marginal cost pricing rule which gives the optimum resource
allocation at OS output.

15
Various solutions have been offered to this problem. Hoteling suggests
that the government should give subsidies to such decreasing cost
PSEs to cover the loss by levying lump-sum taxes. Lump-sum taxes do
not violate the marginal conditions for consumers of firms.

They will, therefore, leave economic behaviour unchanged. If lump-

sum taxes, such as poll tax, cannot be levied, the two- part tariff is the
other device to cover the loss. According to this, the price which is
charged to a consumer consists of two parts.

The first part is the price which is set equal to marginal cost. The
second part is a lump-sum tax per period paid by all users. For
example, an amusement park may charge an entrance fee and then
separate charges for individual attractions such as merry-go-rounds,
children’s train, swings, etc., as is done in the Appu Ghar in New
Delhi.

The fixed fee (entrance fee) is used to cover installation and

maintenance costs and variable charges are imposed to pay for the
operating costs of specific items of amusement.

Limitations:
Whichever method is adopted to cover the loss of a PSE attributable to
marginal cost pricing, there are associated difficulties.

1. Conceptual and Practical Difficulties:

The calculation of marginal cost in the case of ‘lumpy’ or indivisible
factors is difficult to estimate accurately. All factors are variable in the
long run. But ‘lumpy’ factors are fixed and their marginal cost is very
high. For example, in the case of a flyover it is very high.

But so far as its use is concerned, the marginal cost of using the flyover
by an additional vehicle is very negligible. This makes the calculation
of marginal cost a difficult work.

2. Administrative Difficulty:

16
Henderson rejects the marginal cost pricing principle for its
administrative non-viability.

He writes:
“The marginal cost principle is disqualified from being the sole or even
the main principle of pricing on the score of administrative difficulty.
It fails to supply a principle which is clear and unambiguous.”

3. Managerial Difficulty:
When a PSE incurs a loss, it may not be due to MC pricing but the
result of general X-inefficiency. It is difficult to separate the two
different causes by the loss in practice.

4. Inequitable:
The MC pricing is inequitable. When the loss of an enterprise is
covered by general taxation, it is a subsidy which the users of a service
or good get from the government. But this subsidy is at the expense of
the non-users of the service who are taxed by the government. Thus
MC pricing is inequitable.

5. Diversion of Resources:
When the government covers the losses of PSEs by giving subsidies
through taxation, it diverts the country’s resources from other more
productive uses. This may hamper economic development.

6. Second Best Problem:

Another problem about MC pricing for PSEs is of the ‘second best’.
When all prices in all industries are equal to marginal cost, it is called
the first best optimum. This is possible if every PSE follows MC pricing
rule. But it is possible that some PSEs have a monopoly so that price is
higher than MC and it may be impossible to force the price down to
the MC level. In this case, the first best position cannot be attained.

What then is the second best position, that is, the next best position
actually achievable? There is no theoretical answer to this question
because it is not possible to identify the precise nature of the second
best solution.
17
7. Adverse Effects of Taxation:
The levying of additional taxes by the government for subsidization of
PSEs leads to adverse effects on the people and the economy. People
have to pay more in the form of additional taxes and their ability to
save and work is adversely affected.

8. Problems in Two-Part Tariff:

The imposition of two-part tariff in the MC pricing rule involves
certain special difficulties in the case of some types of public services.

(a) Economic Loss:

For some public utilities such as national parks, public zoos,
amusement parks, etc., the total fixed costs of operations are high. For
such services, the principle of MC pricing may lead to an economic
loss because the revenues may not be high enough to recover
investments in fixed assets.

(b) Congestion Costs:

The overuse of services like an amusement park, zoo, museum or
library in the form of overcrowding reduces the satisfaction of the
people who visit them. This kind of pollution involves congestion costs
which are difficult to estimate.

9. Restrictive Conditions:
According to Prof. Graaf, the MC pricing rule cannot lead to an
optimum position unless certain restrictive conditions are fulfilled.
They are technological neutrality, no externalities, perfect divisibility
of factors, and all PSEs to follow the A/C-price equality rule. But the
fulfilment of such a large number of conditions is not possible.

Hence there cannot be optimal allocation of resources. He, therefore,

concludes that the only price a public enterprise of nationalized
industry can be expected to set is what we may call a just price, a price
which is set with regard for its effect on the distribution of wealth as
well as its effect on the allocation of resources.

Conclusion:
18
To overcome some of the difficulties of MC pricing, the principle of
peak-load pricing is suggested. According to this, the price of a
product or service overtime is adjusted according to the product’s (or
service’s) intensity of use, such as in the case of telephone services.

Pricing Policy # 3. No-Profit No-Loss Policy:

Economists like Lewis, Coase, Durbin, Henderson, and little advocate
no-profit no-loss policy or the principle of break-even for PSEs. Their
contention is that PSEs are meant to serve public interest and not to
make profits.

According to Lewis, the price policy of PSEs should be such that they
should make neither a loss nor a profit after meeting all capital
charges. He further states that what the economists principle supports
is not the MC pricing but a system of charging what the traffic will
bear’ so that consumers contribute to fixed costs according to their
capacity to pay.

Lewis supports this policy on the ground that it prevents over-

expansion and under-expansion of PSEs and avoids inflationary and
deflationary tendencies. Other economists opine that PSEs should pay
their way taking one year with another. They should fix such a price
for their products or services so as to break-even over a period of
years, making neither losses nor profits.

The no-profit no-loss policy means that the prices of PSE products or
services should cover total costs. Total costs include all types of
expenses incurred by a PSE in producing a product. They are short-
period and long-period fixed and variable costs of production, current
and replacement costs, depreciation charges, interest on capital
employed, and advertisement, selling and distribution expenses.

These costs may be covered by making the price equal to the average
total costs of production or by following two-part or multipart policy.

The full cost or average cost pricing policy is advocated on the

following grounds. Full-cost prices of a PSE are based on its average
19
total costs of production which can be easily estimated from an
enterprise’s accounting records. It is better to fix full-cost price for
merit goods, such as highways, public transport, public education,
public libraries, museums, recreation parks, etc.

For all such services, people should be charged a price instead of

providing them free or at concessional rates. Full-cost prices lead to
neither profits which compensate for losses so that there is neither
loss nor profit.

Further, full-cost prices cover average total costs of production and

also yield a fair return on the PSE’s capital investment. Full-cost
pricing under diminishing returns is illustrated in Fig. 1 where the AC
curve cuts the AR curve at point R which determines OQ output and
QR price. This price enables the enterprise to breakeven by covering
its average total costs of production. It earns normal profit.

If the PSE has a monopoly in supplying public utility service, it may

have increasing economies of scale over a wide range of output,
showing increasing returns or diminishing costs. This case is
illustrated in Fig 2 where the AC curve cuts the AR curve at point R
under the AC pricing rule and provides OQ services at QR price.

Limitations:
No doubt the AC pricing principle leads to no-profit no-loss in PSEs,
yet it has certain limitations.

1. This pricing policy may lead to mal-allocation of resources when

consumers do not buy additional units at the marginal cost.

2. If the demand (AR) curve lies below the AC curve throughout its
length, the AC pricing will not give any output. The total costs will not
be covered at all.

3. Difficulty also arises in distributing appropriate depreciation over a

period of time.

20
Two-Part or Multipart Tariff:
In order to overcome the above limitations of the AC pricing principle,
Lewis, Coase, and Henderson advocate two-part or multipart tariff
policy. They divide costs into overhead costs and direct costs. Large
infrastructural enterprises like telecommunications, power and water
systems have large overhead costs and small direct costs.

In their case, average costs fall as production is increased and the price
is below the average costs leading to financial loss.

To avoid such a loss, PSEs should follow two-part or multipart tariff

pricing formula. For instance, the price of the service or product is
revised to cover the cost of providing the service plus a mark-up
leading to multipart tariff. Another way is to charge a fixed annual rent
from, say, the users of electricity and a further charge for the actual
units consumed every month.

Its Defects:
The system of charging two-part or multipart tariff has
certain defects.
1. It is difficult to distribute overhead costs between different products
and consumers. In other words, how much is to be covered in the price
of the product and service to the consumers.

2. The two-part or multipart tariff policy is applicable only where

consumers buy continuously from one PSE and the PSE, in turn, can
sell at the average cost price to them.

3. This policy is discriminatory which is unfair and unjust. For

instance, charges for electric supply to industrial users are high and
for agricultural purposes are low.

Conclusion:
Despite these limitations, both two-part or multipart tariff pricing and
AC pricing policies aim at covering total costs. But in both cases
resources are not optimally allocated. It is only under MC pricing
principle that a PSE is able to allocate resources optimally.
21
Pricing Policy # 4. Profit-Price Policy:
In developing countries like India where PSEs are required to play a
dominant role in economic development, PSEs follow the profit-price
policy. The profit-price policy was first put forward in India by Dr.
V.K.R.V. Rao in June, 1959. In a Note to the AICC Seminar on
Planning held at Ooty, he categorically rejected the theory of no-profit
no-loss for PSEs and argued for the adoption of profit-price policy.

Such a policy would make the state utilise its own resources rather
than taxing its citizens. According to him, PSEs must be carried on a
profit making basis not only in the sense that the public enterprises
must yield an economic price but also get for the community sufficient
resources for financing a part of investment and maintenance
expenditure of the government. This involves a profit-price policy in
regard to PSEs.

The theory of no-profit no-loss in PSEs is particularly inconsistent

with a socialist economy and if followed in a mixed economy like
India, it will hamper its development. In support of his view, Prof. Rao
quoted the example of the erstwhile USSR. In the USSR, PSEs made a
double contribution to development finance: reinvestment of profits
for their own expansion and contribution to the state budget.

Arguments for a Profit-Price Policy:

The following arguments are advanced in favour of a profit-
price policy:
1. When the state makes large investments in establishing PSEs, it
expects a return in the form of profits in order to augment its
resources for the development of the economy.

2. The main aim of every private enterprise is to earn profits. It is,

therefore, essential that PSEs should also earn profits and should not
be dependent on the state for financial help and subsidy.

3. When PSEs operate side by side with private enterprises and

compete with them in such areas as oil, steel, consumer goods,

22
shipping, airways, etc., they should earn profits like private
enterprises.

4. Even in the case of those PSEs where the state has a monopoly, it is
not desirable to have a no-profit no-loss policy or charge a low price to
consumers of the product or service. For there is no guarantee that the
users of the product or service will save more on this count. Therefore,
the best course is to charge a price which gives a minimum of profit to
the PSE which will ultimately go to the state for capital formation.

5. The running of PSEs on profit-price policy will contribute to the

general revenues of the state. As pointed out by the Indian Planning
Commission “When taxation has its limits, public exchequer
should benefit by the surplus of public enterprises. When
private sector pays a portion of its profits for general
revenues, there is no reason why the public sector should be
exempted from this.”
6. When they are operated on profit-price policy, the PSEs earn
sufficient profits which can be ploughed back for reinvestment and
partly for utilisation by the state in other projects. This reduces the
need for borrowing from external sources and debt servicing and even
dispenses with deficit financing.

7. Further, surpluses accruing from profit making enterprises provide

adequate funds for improvement, modernisation and expansion of the
plants in PSEs.

What Profit-Price Policy should be followed?

So far as the actual profit-price policy to be followed by a PSE is
concerned, Dr. V.K.R.V. Rao observed: “By and large, as far as the
individual firm is concerned the price policy that the manager should
follow should not be different from the policy that the private
entrepreneur follows. That, however, does not mean that that will be
the final price. The final price for a public enterprise should be
determined not by the manager or by the board of directors or
whoever is the decision making authority but by the government, an

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authority which takes into account not merely costs and receipts of
other enterprises. As far as the manager is concerned, his objective
should be the same as the objective of the private manager which is
the maximisation of industrial profit.”

Thus PSEs should aim at a reasonable rate of profit.

However, it is difficult to have a particular rate of profit for all PSEs.

Further, all PSEs cannot earn profits simultaneously for the following
reasons:

First, those PSEs which have not broken-even cannot earn profits
because their overhead costs will be high.

Second, in the case of heavy industries, the gestation period is long.

Therefore, it takes them a very long period to break-even and start
earning profits. At the most, such PSEs pay their way and not run in
losses.

Third, in the case of public utilities, public welfare and not profitability
is the principal objective. They try to equate MC with price. They lay
stress on output rather on the rate of return on investment.

Criticism:
1. Certain economists do not favour profit-price policy in the case of all
PSEs. Some advocate a no-profit no-loss policy for public utilities or
the marginal cost pricing rule. Others accept the profit-price policy
with certain reservations.

2. In cases, where the product of a PSE is used as an input for

production in the private sector, a profit- price policy will adversely
affect the development of the private industry.

3. If the prices of products of PSEs are rigged up to provide a surplus,

the pertinent question arises why consumers of those products should
be made to pay a special tax through the back door for the benefit of
the state.

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4. In those PSEs where the government has a monopoly or semi-
monopoly, there is a great temptation on their part to deliberately
create huge surpluses by charging the users of their products very high
prices. Such a profit-price policy is, therefore, harmful to the society
because high prices can lead to a high-cost economy.

The remedy is not to eliminate profit-price policy but to regulate this

policy in the interest of consumers and the economy.

(a) Fixed Exchange Rate System:

Fixed exchange rate is the rate which is officially fixed by the
government or monetary authority and not determined by market
forces. Only a very small deviation from this fixed value is possible. In
this system, foreign central banks stand ready to buy and sell their
currencies at a fixed price. A typical kind of this system was used
under Gold Standard System in which each country committed itself
to convert freely its currency into gold at a fixed price.

In other words, value of each currency was defined in terms of gold

and, therefore, exchange rate was fixed according to the gold value of
currencies that have to be exchanged. This was called mint par value of
exchange. Later on Fixed Exchange Rate System prevailed in the world
under an agreement reached in July 1994.

The advantages and disadvantages of this system are as

under:
Merits:
(i) It ensures stability in exchange rate which encourages foreign
trade,

(ii) It contributes to the coordination of macro policies of countries in

an interdependent world economy,

(iii) Fixed exchange rate ensures that major economic disturbances in

the member countries do not occur,

(iv) It prevents capital outflow,

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(v) Fixed exchange rates are more conducive to expansion of world
trade because it prevents risk and uncertainty in transactions,

(vi) It prevents speculation in foreign exchange market.

Demerits:
(i) Fear of devaluation. In a situation of excess demand, central bank
uses its reserves to maintain foreign exchange rate. But when reserves
are exhausted and excess demand still persists, government is
compelled to devalue domestic currency. If speculators believe that
exchange rate cannot be held for long, they buy foreign exchange in
massive amount causing deficit in balance of payment. This may lead
to larger devaluation. This is the main flaw or demerit of fixed
exchange rate system,

(ii) Benefits of free markets are deprived;

(iii) There is always possibility of under-valuation or over-valuation.

(b) Flexible (Floating) Exchange Rate System:

The system of exchange rate in which rate of exchange is determined
by forces of demand and supply of foreign exchange market is called
Flexible Exchange Rate System. Here, value of currency is allowed to
fluctuate or adjust freely according to change in demand and supply of
foreign exchange.

There is no official intervention in foreign exchange market. Under

this system, the central bank, without intervention, allows the
exchange rate to adjust so as to equate the supply and demand for
foreign currency In India, it is flexible exchange rate which is being
determined. The foreign exchange market is busy at all times by
changes in the exchange rate. Advantages and disadvantages of this
system are listed below:

Merits:
(i) Deficit or surplus in BOP is automatically corrected,

26
(ii) There is no need for government to hold any foreign exchange
reserve,

(iii) It helps in optimum resource allocation,

(iv) It frees the government from problem of BOP

Demerits:
(i) It encourages speculation leading to fluctuations in foreign
exchange rate,

(ii) Wide fluctuation in exchange rate hampers foreign trade and

capital movement between countries,

(iii) It generates inflationary pressure when prices of imports go up

due to depreciation of currency.

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