Competition: the missing link in Australia’s privatisation program.

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Stephen P. King.
Economics Program
RSSS
The Australian National University

During the last decade, privatisation has revolutionised government activity

throughout the world. This revolution has seen telecommunication compa-
nies, airlines, public utilities, banks, oil companies, car manufacturers and
numerous other government business enterprises (GBEs) in a wide variety of
countries move to the private sector. While Britain, under the Thatcher gov-
ernment, was the undoubted leader in this revolution, privatisation policies
have been implemented by governments around the world, including coun-
tries such as France and New Zealand where active government involvement
in industry had previously been the norm. Privatisation programs have not
been limited to developed Western economies but have played a crucial role
in transforming the economic fortunes of, among others, Mexico, Chile, and
Argentina. Some of the most vehement (and successful) advocates of pri-
vatisation have been the former communist countries of Eastern Europe,
such as the Czech republic, and privatisation is part of China’s economic
agenda.
The privatisation revolution extends beyond government asset sales to other
modes of introducing private involvement into the public sector. In Aus-
tralia, privatisation has included the extensive use of contracting out to
improve the delivery of services that were previously produced in-house by
government. Contracting out has been embraced most widely at the State
and local government levels, and encompasses a vast range of services from
refuse collection and office cleaning to maintenance, warehousing and welfare
services.2
1
From Agenda v10, summer 1994-95.
2
See Domberger 1994.

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Despite the political rhetoric, progress in Australia on privatisation has been
slow. The sales of the Commonwealth bank, GIO Australia, and Qantas,
have been the exception rather than the norm and in some cases, for ex-
ample Qantas, are still awaiting completion. There has been considerable
reluctance by the Federal government to complete the deregulation process
in telecommunications by following the lead of nations such as New Zealand
and the UK and selling Telecom Australia. Despite moves towards a national
electricity grid, the extent to which electricity generation will be moved to
private hands is unclear. After a decade of rhetoric and debate, Australia
has relatively little to show from the privatisation revolution.

Why Privatise?
There are two main reasons why privatisation is an essential ingredient in re-
forming sectors currently dominated by GBEs. First, privatisation is a way
of improving the incentives that face the owners, managers and workers in
an enterprise to ensure efficient, cost-minimising production. Secondly, pri-
vatisation places the enterprise at arms length from government and makes
it both more costly for the government to interfere in the operations of the
company and makes any interference more transparent.
A privatised firm usually faces the removal of the (either explicit or im-
plicit) government support that exists for a GBE. A government enterprise
is immune from the day-to-day judgment of the financial markets and is free
from the ultimate forms of private sector corporate discipline — takeovers
and bankruptcy. These pressures mean that private sector owners have
strong incentives to ensure that their companies operate efficiently, produc-
ing a product range that satisfies the desires of consumers at the minimum
possible cost. Unlike a government owned monopolist who faces few neg-
ative consequences if their products inadequately address the needs of the
public, a private firm which does not pay close attention to its consumers
opens the door for an innovative competitor to steal both market share and
profits. Even those who are highly critical of privatisation tend to concede
that private firms out perform their public counterparts when it comes to
innovation and response to changing market conditions (for example, see

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Quiggin 1994:16).
While there is a gulf between the desires of owners and the actions of man-
agers in both the public and private sector, this gap is likely to be smaller
in the private sector. Private sector owners have three related benefits in
comparison to their public sector counterparts when setting the incentives
for their managers and workers. First, private sector owners often have ac-
cess to better information by which to judge and reward their managers
particularly if the owner is able to compare their firm’s performance to that
of close rivals. While there have been attempts to mimic these sources of in-
formation in the public sector, through yardstick competition, requirements
on “dividend payments” and corporatisation, the information generated by
artificial attempts to replicate aspects of the private sector will inevitably
be second-best relative to a comparison between private firms competing
in the same market at the same time. Second, it is not only owners but
also managers who face market discipline. A manager who performs poorly
in their current position may find it extremely difficult to move to another
company at a later date. While similar penalties for under performance
exist in the public sector, the traditional rules of public sector firing, pro-
motion and transfer have tended to dampen these penalties. In the extreme
there is no public sector equivalent to the loss of reputation to a manager
associated with bankruptcy. Third, it is easier to set correct incentives for
a manager if the aim of the firm is as simple and clear-cut as profit maximi-
sation. In contrast, the bottom line for a public sector manager will alter
with government policy and will change as political incentives change.
Privatisation has the additional advantage that it sets the firm at arms
length from government interference. While a GBE is always at the beck
and call of its political masters who may intervene in ways which satisfy po-
litical necessities at the cost of economic and social efficiencies, it is harder
for a politician or government to interfere directly in the operations of a
private firm. While such interference can and does happen, either overtly
through political interference in a regulatory regime, or covertly through po-
litical pressures applied to the firm, privatisation makes it harder for govern-

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ments to unduly intervene in the functioning of the firm. Willig (1993:155)
argues that it is this “insulation” from “arbitrary political and self-serving
influences” which is the key gain from privatisation.

Corporatisation.
If the arguments for privatisation are so clear, then why has both the
progress on privatisation and the payoff from existing reform been so slow?
One reason for Australia’s slow progress is that the above arguments do not
apply equally to all GBEs. In particular, there may be little if any advan-
tage in privatising a GBE in an industry that is characterised by natural
monopoly technology and has high barriers to entry and exit so that pri-
vatisation will merely lead to the exchange of a government monopolist for
a regulated private sector monopolist. As the industry commission notes
(1992:115) “it can be argued that private ownership would be preferred to
public ownership even under monopoly conditions. However, in reality there
are clear trade-offs between the efficiency of private ownership and regula-
tion to curb expected monopoly behaviour”. A regulated private sector
monopolist is unlikely to face the pressures and incentives that exist in com-
petitive markets, and will have the additional problems that arise through
political manipulation of the regulatory regime. In particular, the regulated
firm may face the significant risk of ex post expropriation, not through na-
tionalisation, but through the government setting a regulatory regime that
does not allow the firm to earn a reasonable return on its investments.
As an alternative to privatisation both state and federal governments have
attempted to gain the best of both the private and public sector by reforming
GBEs without changing ownership. Such reform, called “corporatisation”
involves a deliberate attempt by governments to set in place an incentive
regime that is similar to that imposed on a private firm including setting
cost-minimisation and efficient pricing as goals for the GBE’s managers. Few
GBEs, particularly in Victoria and New South Wales, have not been influ-
enced to some degree by corporatisation policies. The State Owned Enter-
prise Act 1992 in Victoria, for example, establishes an umbrella framework
of reform for that state’s government business sector including corporati-

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sation. These reforms have shown some success. For example the industry
commission (1993:25) reports that, since its corporatisation “Pacific Power’s
overall productivity” has risen “by over 30% from 1987-88 to 1991-92”.
There are, however, good reasons why corporatisation will often be an inad-
equate response to public sector inefficiencies in the short-run and is doomed
to failure over the longer run. The pressures for efficiency that exist in the
private sector arise, not simply from private ownership or the business prac-
tices that are associated with this ownership, but the competition which
exists in that sector. Any attempt to duplicate the results of this competi-
tive pressure without actually introducing competition, will lead to a series
of static measures which, while better than nothing, will often be inadequate
at attaining more than a cosmetic improvement in performance. For exam-
ple, requiring a GBE to remit a certain dividend to the government each year
may simply deprive the GBE of funds that it could have better employed
for internal investment. Similarly, setting targets based on short-term per-
formance may simply lead to an inefficient trade-off to current returns at
the expense of long term development. Corporatisation does not remove the
GBE from the shackles of political interference and the reforms are likely to
be watered down over time as it suits the GBE’s political masters. Evidence
from the UK suggests that corporatisation, by itself, is an inadequate policy
response to public sector inefficiency (see Hartley, et. al., 1991).

Competition — the missing ingredient.

The key missing ingredient in reform through corporatisation is competi-
tion. In fact it can be argued that any attempt to reform GBEs, including
privatisation, is likely to be of marginal benefit unless it is associated with a
market regime that allows for competition. This is not a new argument. For
example it was forcefully argued by Kay and Thompson (1986) in the con-
text of the British privatisation program. However, it is an argument that
appears to have been overlooked in the Australian debate. If the government
privatises a GBE without first considering the market in which that enter-
prise is going to operate and the possibilities for competition within that
market then the gain from privatisation may be small or negative. Further,

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it can be argued that there are substantial gains to be reaped from introduc-
ing competition into a sector previously dominated by a government owned
monopolist even if the relevant GBE remains in government hands. While it
can be argued that these gains will be muted compared to those which can
be reaped through full privatisation (see for example Industry Commission,
1991:15) the improved performance of Telecom Australia in both the lead
up to Optus’s entry and in the period since that entry, indicates that a little
bit of competition can have a significant effect on the performance of GBEs.

Competition is the necessary ingredient to achieve both allocative and pro-

ductive efficiency in the market place. In its absence a firm, either privately
or publicly owned, will have little incentive to set prices at an efficient level.
Both the private and the public monopolist will also face severe organisa-
tional constraints on their ability to ensure cost-efficient production. In the
absence of a competitive benchmark, provided by existing or potential com-
petitors, neither public nor private sector owners may be able to ensure that
their management is acting efficiently.
In the Australian reform process, however, competition has been relegated
to a minor position. This is clear, for example, from the emphasis on cos-
metic reforms such as corporatisation. Such internal reform of GBEs has
little or nothing to do with competition. Even in those sectors where gov-
ernments have claimed to introduce competition through deregulation, that
competition has often been subject to government “management”. For ex-
ample, in telecommunications, the government has restricted competition in
the pre 1997 period to a single chosen competitor. While the government
claimed that such managed entry would ensure “effective, broadly-based vi-
able competition” (see Maddock 1992), the real effect has been to limit price
competition and product innovation. Similarly, while the deregulation of do-
mestic air services in Australia has led to periodic price wars, particularly
when the incumbent duopolists have been faced by a new competitor, the
Federal government recently signaled is intention to prevent true competi-
tion in this market by reneging on its agreement to allow Air New Zealand

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to fly domestic passengers in Australia from November 1, 1994.
While the reluctance of governments, particularly at the Federal level, to
introduce competition into their privatisation programs is distressing, it is
also predictable. The forces which have moved governments towards privati-
sation have had little to do with the arguments of economists or advocates
of the free-market, but have more to do with political expediency. This is
amply illustrated by ANL. The proposed privatisation of the national ship-
ping line is not the result of well argued economics but is the result of an
agreement between the Federal Government and striking maritime workers.
Rather than encouraging competition, the aim of the agreement is to en-
sure ANL’s future through generous tax concessions and the continuation of
restrictions on shipping in Australia.
Privatisation has also become an acceptable way for governments to raise
revenue. The most recent example of this is the proposed sale/long-term-
lease of the Commonwealth Airports Corporation — a policy which the Fed-
eral government has justified on the grounds of providing funds for a variety
of short-term labour market programs. However, given a public accounting
regime where the returns from asset sales enter as current revenue, the sale
of Australia’s airports is only one of the more obvious attempts by a gov-
ernment to use privatisation as a way to lower the budget deficit without
curbing its expenditure. The former labor government of Victoria appears
to have used similar tactics to avoid explicitly issuing government debt when
it raised revenue by selling government buildings and other assets on “lease-
back” arrangements. Despite protestations to the contrary, the sale of the
Loy Yang B power station may also be best explained by the need of the for-
mer labor government to raise funds rather than the desire for a yard-stick
competitor.
If efficient privatisation was simply a desirable side-effect of political dealing
and government accounting, then there may be little room for complaint.
For example many of the privatisations to date, such as the Commonwealth
bank and GIO Australia, have occurred in industries that were already sub-
ject to reasonably high levels of competition. In such situations the gov-

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ernment is able to raise revenue while freeing the GBE from the shackles
of government ownership. However, as privatisation proceeds, if the main
aim is to either raise government revenue or placate vested interests, then
competition becomes an anathema to the process. It does not require so-
phisticated analysis to realise that a monopoly is usually worth considerably
more than a large firm subject to the rigors of competition. The conflict
between revenue raising and economic efficiency can lead to a privatisation
program which attempts to simply transfer public sector monopolies to pri-
vate hands. Revenue raising objectives may distort the privatisation process
away from alternatives such as contracting-out and short term leases towards
asset sales, even where the former are more likely to enhance economic effi-
ciency. For example, if the federal government is dissatisfied with the current
performance of its airport management then there is a good case to contract
out this management to the private sector. It is, however, far from obvious
that selling the airports to the private sector is the optimal privatisation
strategy.3 In most cities their are relatively few substitution possibilities
for passengers so that the private ownership of local airports will in general
either require government intervention through a regulatory regime or lead
to monopoly pricing. Sale of the airports will lead to substantial revenue,
with this revenue increasing the more the government commits not to apply
restrictions on airport pricing. It is, however, unlikely to provide a signif-
icant impetus to economic efficiency when compared to other privatisation
possibilities.

Where to from here?

There are still considerable benefits that can be reaped from a well thought
out privatisation program in Australia. Progress has been slow in many ar-
eas including the reform of public utilities and the provision of government
services such as those in health and social welfare. While Victoria is leading
the way in the reform and privatisation of electricity generation, other gov-
ernments are lagging well behind. Reform and privatisation by themselves
are, however, insufficient to achieve long term economic gains. The key to
3
Leasing the airports for 50 year periods is effectively identical to selling them.

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reform is competition and if reform is carried out without consideration of
increasing competition where ever feasible then many of the benefits from
privatisation will be lost. Given the incentives that face governments at the
State and Federal level, it is likely that competition will often be ignored in
the race either to raise short term revenue or to satisfy political expediencies.

Where then does the reform process go from here? Without doubt the
brightest part of the privatisation revolution for Australia has been the rapid
increase in the use of contracting-out. The use of private sector provision
and competitive tendering has freed numerous services from monopoly in-
house government provision paving the way for both increased innovation
and substantial cost savings. While contracting out needs to be approached
carefully, and is not a panacea for every inefficiency in government produc-
tion, it has and will continue to provide some substantial gains.4 This said,
contracting out by its very nature ensures the long term involvement of the
government in the production process and, as such, can continue to be at the
mercy of government intervention. This intervention may involve explicit or
implicit bribery, with the latter involving paybacks for contracts through,
for example, campaign contributions or may simply involve interfering in the
tendering process to satisfy the whims of a particular political lobby. In the
extreme, contracting out procedures are often easily reversed over time with
the government resuming in-house production of services if this is viewed as
politically desirable.
The best hope for successful long term reform must rest with changing the
incentives of the government. We cannot expect a government to embark
upon an efficient privatisation program if it faces incentives that mitigate
against the introduction of competition. Efficient privatisation needs to be
preceded by an efficient system of government incentives. At a minimum,
the government must not face incentives to maximise either sales revenue
or political payoffs from privatisation but rather to maximise economic effi-
4
See King 1994 and the articles which follow for a review of the progress of contracting
out in Australia.

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ciency by allowing open competition where ever possible. If such a reform
in incentives does not occur, then it is likely that few of the potential gains
from reform will be achieved in the short term, and in the longer term
we are likely to see significant policy reversals as the gains that have been
achieved in the past decade are diluted or destroyed by changing political
requirements.
If the incentives for government are to be changed then the pressure for such
change must come from the electorate at large. It is the average consumer
who will be the main beneficiary of sensible privatisation with competition.
It is also the average consumers (and voters) who are the “forgotten people”
of the Australian reform process. To see this, one need look no further than
the arguments presented by the government to exclude Air New Zealand
from the domestic aviation market. The claims that the benefits will all
flow to the foreign carrier show that the government holds the benefits to
consumers — lower prices and improved service — at naught.
If the reform process, including privatisation, is to continue in Australia
with long term success, then the pressure for competitive reform must be
maintained. This will require strong opposition parties and a vigilant public.
Without these ingredients, we are likely to see a privatisation agenda run
increasingly for short term revenue and political gains. The outcome could
be disastrous, with monopoly power simply shifting from the public to the
private sector, inefficient rent seeking replacing bureacratic ineptitude, and
higher prices for business and consumers with no efficiency gain.

References.

Domberger S. (1994) “Public sector contracting: Does it work?” The Aus-

tralian Economic Review, 91-96.

Hartley K, Parker D and Martin S. (1991) “Organisational status, owner-

ship and productivity”, Fiscal Studies, v.12.

Industry Commission. (1991) Annual Report 1990-91, AGPS Fyshwick

ACT.

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Industry Commission. (1992) Annual Report 1991-92, AGPS Fyshwick
ACT.

Industry Commission. (1993) Government trading enterprises performance

indicators 1987-88 to 1991-92, Belconnen ACT.

Kay J. and Thompson D. (1986) “Privatisation: A policy in search of a

rationale”, The Economic Journal v96, 18-32.

King S. (1994) “Competitive tendering and contracting out: An introduc-

tion”, The Australian Economic Review 75-78.

Maddock R. (1992) “Microeconomic reform of telecommunications: The

long march from duopoly to duopoly”, in P. Forsyth (ed) Microeco-
nomic reform in Australia, Allen and Unwin, Sydney.

Quiggin J. (1994) “Does privatisation pay?” Discussion paper number 2,

The Australia Institute.

Willig R. (1994) “Public versus regulated private enterprise”, Proceedings

of the world bank conference on development economics 1993, 155-170.

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