Tricky compromises

Problems with regulation and privatisation

Regulation is required to alleviate the damaging effects that market imperfections such as monopolies can have for social wellbeing and economic development. Regulation, however - be it by governments or independent agencies - faces two particular problems of its own: ‘hold-up’ and ‘information asymmetry’. What is at stake when countries try to regulate the market for development?

Hold-up

Utility networks such as water and electricity involve large investments such as networks of pipelines and wires. Once a network is created, the costs of building it are ‘sunk’.

When the investment is first negotiated the firm and the state must both agree a price - for example the fee the government will pay to the contractor for carrying-out a service. This price must be acceptable to both if the private investment is to go ahead. However, once the investment is undertaken and becomes ‘sunk’, there is considerable scope for ‘opportunism’ or ‘gaming’ from both sides.

The state regulator, for example could attempt to reduce the contract fee. In principle, the firm will still choose to go ahead provided that its labour and material costs are covered. Therefore, the regulator could attempt to negotiate the price down to this bare minimum. Equally, the firm might recognise that it is providing an essential facility, such as water. If the government has no alternative supplier, or cannot obtain one quickly, the firm might attempt to renegotiate the price of the contract upwards, above the original fee.

The result is a dual ‘hold-up’ problem. The firm can be held-up by a government that takes advantage of the firm’s vulnerability having invested heavily in a network. Equally, the government can be held-up by a firm that realises the government cannot afford the social and economic costs of closing an essential facility.

Information asymmetries

To regulate efficiently and effectively the regulator needs to have considerable information about the supplies (of materials and labour) and demands (from consumers) a firm has at its disposal. This knowledge is especially necessary to set prices and restrain excess profits. However, in practice the firm and the regulator can be expected to have very different levels of information. In general, the firm has this information and the regulator must tease it out.

Even with an efficient incentive system to reveal information, or alternatively draconian legal penalties for failure to co-operate, it is highly unlikely that the regulator will receive all of the information required to regulate optimally.

When public utilities such as telecommunications, electricity or water service are privatised, a tricky compromise has to be made between the former advantages of state ownership (when the state owns an enterprise it should know the costs and revenues from operating! Similarly, it would be unlikely to try to hold-up itself) and the lack of incentives under state ownership to keep down costs and remove waste.

David Parker and Colin Kirkpatrick
Centre on Regulation and Competition
IDPM
University of Manchester
M13 9GH
UK

David.Parker@cranfield.ac.uk

See also

Parker, Kirkpatrick & Zhang (2002) ‘Electricity Sector Reform in Developing Countries’ CRC Working Paper no. 31
http://idpm.man.ac.uk/crc/wpdl149/wp31.pdf (PDF)

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