State-Owned Enterprises: Theory and Practice, GCSE Coursework Example

Introduction

The developing world has seen two great waves of privatization. First, in the 1980s after Margaret Thatcher and Ronald Reagan (re) built the idea of robust private markets, numerous countries privatized state-owned assets and enterprises after the fall of communist governments in the late 1980s and early 1990s.  Second, in the mid-to-late 1990s, both China and Russia underwent a second big wave of privatization: For China, the privatization was undertaken slowly and methodically to help boost economic growth; In Russia, the privatizations were done quickly and resulted in prize state resource assets falling into the hands of a few oligarchs.  Whether the privatization of state-owned enterprises was beneficial to the country’s economy dependent both on the economic circumstances of the times, and how the privatization was carried out. Overall, the privatization of state-owned enterprises can potentially lead to gains and efficiency and benefits for the both the state and the consumer. As will be seen in the two case studies of China and Russia, however, there the difference between privatization in theory and privatization in practice.

Theory

One of the main issues animating the debate over whether to privatize state-owned enterprises is the potential gains of efficiency to economic growth.  Indeed, in order to understand the potential benefits of privatizing a state-owned enterprise, it is first necessary to analyse how state-owned enterprises are formed through monopolies.  There are two kinds of monopolies relevant to this analysis: 1) natural monopoly; 2) administrative monopoly.  A natural monopoly is dependent on the industry where it is formed.  A natural monopoly is formed in an industry that requires substantial capital expenditure and economies of scale (Sloman, 2006). They are typically found in the industries of water supply, electricity, gas, and other public utilities.  As is the case with any monopoly, if they are not properly regulated, there is the possibility of charging higher prices (rents) than needed due to pricing power. However, the privatization of natural monopolies will not necessarily lead to greater efficiencies: This is because, at least in theory, the lower prices charged are a function of economies of scale; thus, with proper regulation, the costs of capital and return can be directly monitored and controlled by the government.

Administrative monopolies, on the other, hand are typically established by government fiat.  When speaking of state-owned enterprises that are monopolies, they are usually administrative in nature rather than being natural.  For example, many of the state-owned enterprises that are monopolies in developing countries include transportation (e.g., taxi, train, airlines), logistics, production, and even some types of service firms.  It is important to distinguish the rationale behind an administrative monopoly versus a natural monopoly: While there is a cursory economic case that can be made for (some) natural monopolies, the deciding factor for administrative monopolies is government determination (Michie, J., and Lobao, L., 2011).  That is, the government gives these firms some type of legal or administrative standing as the only producer of the good.

The microeconomics of monopolies versus perfect competition serves as a fitting foundation to discuss free market economies versus socially planned economies.  While many socialist countries, with the exception of North Korea and the USSR under Stalin, have a mixed economy, they predominantly feature a centrally planned economy. The main features of a centrally planned economy include: government control over price setting, production, and industry regulation.

Perfect competition, in contrast, features the “free market” as the main driver of economic activity. Indeed, although few countries are able to fully implement an economy based on perfect competition, the governing principles are substantively different.  In general, the government does not play a major role in deciding which firm(s) compete or at what price in a free market: That decision is left to the market, by which is meant the free interplay of supply and demand forces.

That is not to say, however, that the government does not play any role in a free market economy. Even under Adam Smith’s “laissez-faire” economic system, the government essentially plays the role of a “referee”, setting the rules for competition such as contract law, providing public goods, and ensuring fair competition.  .

There are many advantages and disadvantages to each system of economic governance.  For the socialist planned economy, the government is given substantial power to set economic policy down to the industry composition, product selection, and price setting functions. The main disadvantage also stems from the main advantage: the government does have power to set policy over a wide range of items; however, it is difficult (impossible) to have information about everything, resulting in a loss of efficiency and economic growth over the long-term.  The free-market economy, on the other hand, is more efficient (at least in theory) as it devolves allocation functions to the market.  This tends to lead to more efficient (from a resource perspective) result.   The examples of Russia and China provide different experiences regarding how the privatization of state-owned enterprises led to different results.

Russia and China

Russia’s privatization of state-owned enterprises proceeded quickly and without adequate supervision to accrue the benefits of efficiency.  It is important to note two distinct features that characterized Russia’s privatization of state-owned enterprises: 1) The resource-based nature of the economy; 2) The lack of structure that privatization occurred under (Sachs, 1992). Russia, similar to Australia and Canada, is a resource-rich country.  In addition to valuable oil and natural gas deposits, the country also has rich mineral deposits in nickel, copper, and iron.  It is no accident, therefore, that the USSR had created a number of monopolies around the resource sector: Indeed, as a socialist country there was a strong case for not only an administrative monopoly but also as a natural monopoly- many of the deposits required substantial capital expenditures and economies of scale to extract from the ground (Burawoy, 2006).

The resource rich nature of Russia’s economy played into the political upheaval that led to the privatization of state-owned enterprises.  Indeed, after the USSR disbanded in 1990, there was a round of “spontaneous privatization” in the words of IMF economist Simon Johnson.   This means that there was no deliberate government agenda to proceed with a gradual privatization of state-owned enterprises; rather, after the fall of a central political authority that previously served as the legal and economic regulator of the enterprises, enterprises simply found themselves to be “private.”  As a result, there was no sustained process for the tendering and selling of these firms; in many cases, local oligarchs stepped into the political and economic vacuum to purchase these state assets at a substantial discount.  Due to the lack of regulation and supervision, not only did the transfer not meet many best practices for the privatization, the actual pricing and potential benefits of privatization were not realized.  This is because: many of the formerly state-owned enterprises were purchased and turned into private monopolies, which still charged rents and higher prices without accruing the benefits of privatization.

China, on the other hand, conducted privatizations in a more deliberate fashion that helped the country reap economic dividends.  Under Mao Zedong in the 1950s and 1960s, all enterprises were nationalized. After Deng Xiaoping assumed power in 1979, however, he started a long-term privatization drive that differed from Russian efforts in two main areas: 1) China’s privatization focused on enterprises that had administrative monopolies, rather than explicitly natural monopolies; 2) China’s privatization drive was conducted in an environment of political stability.

Beginning in the 1980s, Deng started to privatize local and rural monopolies that were primarily administrative in nature.  In contrast to Russia, the enterprises were primarily in the industry of manufacturing; the privatization process was carried out slowly and at first only minority stakes were sold, primarily to local private entrepreneurs.  In addition, the local government (in China the county government) carried out the privatization rather than the central government in many other cases, or in the case of Russia- local businessmen and a collection of local officials without authority.  (Naughton, 1994). In total there were 12,334 enterprises privatized during the 1980s and early 1990s (Naughton, 1994); some of these enterprises were integrated into private conglomerates, some of the enterprises were infused with private capital and became independent private enterprises. At the end, however, the privatization helped China move towards a mixed economy as the weakest monopolies were already privatized, contributing to a more efficient allocation of resources in the economy.

Overall, while theory posits that privatization of state-owned enterprises should lead to a more efficient allocation of capital andlabor that is not always true. Indeed, economic theory indicates that a free-market economy is more efficient that a socialist-planned one; this is because markets decided allocation rather than the state. In the real world, however, seldom does one see an economy that is purely free market or purely state planned; mixed economies are the norm. This real world constraint may explain the dissonant outcomes between the Russian and Chinese experience of state-owned enterprise privatization.

Indeed, as one sees in the Russian example, the “spontaneous” privatization of state-owned enterprises did not reap the promised gain of more efficient operation and lower prices, largely because there was no functioning political or regulatory system.  China, on the other hand, was able to carry out a systematic privatization effort that focused on weak, local state-owned enterprises.  While China is still currently ruled by “socialists” (at least in name), the mixed economy is a testament to the successful privatization drive the country undertook in the 1980s.

References

Burawoy, M. (1996), ‘The State and Economic Involution: Russia through a China Lens,’ World Development,’ Vol.24, No. 6

Michie, J., and Lobao, L. (2011), ‘Ownership, Control and Economic Outcomes,’ Cambridge Journal of Regions, Economy and Society, Vol. 5, Issue 3.

Naughton, B. (1994), ‘Chinese Institutional Innovation and Privatisation from Below,’ The American Economic Review, Vol.84, No. 2.

Sachs, J. (1992), ‘Privatisation in Russia: Some Lessons from Eastern Europe,’ The American Economic Review, Vol. 82, No. 2.

Sloman, J. (2006), ‘Economics,’ Pearson – Chapter 11.