Privatisation – 25 marker model answer for AQA Economics

Privatisation can be a difficult topic for some students, yet it often appears in the exams.

To help students revise privatisation, here is a practice question on privatisation.

Below, there is also an essay plan and model answer on privatisation.

Question

Evaluate the view that privatisation of the water industry has been beneficial. (25 marks)

Essay plan

Plan:

• Intro:
  • Define privatisation. State argument.
• A1:
  • Privatisation benefit: lower costs / higher productivity.
  • Leads to lower prices, so consumer surplus rises.
  • Dynamic efficiency and reinvestment of profits leads to costs falling further over time.
• Evaluation point 1:
  • Firms may not reduce costs over time – lack of investment, using profits for dividends instead of investment.
• A2:
  • Privatisation issue: does not take into account externalities, such as from sewage disposal.
• E2:
  • Privatised firms may face fines.
• Conclusion:
  • Privatisation is unlikely to be beneficial overall.
  • Evidence and regulatory capture.

Model answer

I have split the model answer paragraphs with subheadings for easier reading. In the exam, you do not need to use these subheadings.

Introduction

Privatisation is when a government owned company is sold off to the private sector. An example is the privatisation of the water industry under the Thatcher government in the 1980s. I will argue that for water companies, privatisation is likely to prove ineffective.

Analysis paragraph 1

Privatisation is likely to lower costs. Private water firms such as Thames Water  have an incentive to maximise profits in order to pay shareholders higher dividends, and to avoid the company making a loss and shutting down. A nationalised firm, by contrast, does not have to make a profit, as the government may subsidise any losses, shielding the firm from competition. As a result, the privatised water firm may pursue innovation to increase productivity, reducing average cost. An example is the decrease in water leakages by one-third since the 1990s. This results in the water company’s ATC shifting down to ATC1 and MC shifting down to MC1. This cost reduction increases supernormal profits from 0 to (p2-c)q2, making the firm dynamically efficient. The firm can then use its supernormal profits to invest in further innovation, reducing costs over time. Yearly investment in water and wastewater sectors in the UK has nearly doubled following water privatisation in 1989. The firm may pass on the cost reduction to consumers in the form of lower prices, with the price falling from p1 to p2. This increases consumer surplus, making consumers better off.

Evaluation paragraph 1

However, privatisation may not lead to a reduction in costs in the long term. Water companies have been accused of underinvestment in the UK’s water infrastructure. Only 0.05% of water pipes are replaced per year in the UK, below the European average.  Because investment today increases costs and reduces short-term profits, private firms may cut back on investment to maximise short-term profits, increasing dividends in the short-term for shareholders. As a result, the lack of investment means costs of production do not fall over time. So costs may remain elevated under privatisation, so prices remain high and consumer surplus does not rise. Under nationalisation, the firm may seek to maximise long-term consumer welfare instead, leading to greater investment and falling costs over time.

Analysis paragraph 2

One issue with privatisation is that private firms may not account for externalities when deciding their level of production. Water and sewage companies may release sewage into the water, causing illnesses for people swimming in the water, a negative production externality.  Specifically, the free market produces where MPB = MPC, only taking into account private costs and benefits. This leads to the free market producing  at quantity q. This is the outcome under privatisation, assuming private firms maximise profits and do not consider external costs. Companies such as Thames Water and Yorkshire Water have been criticised and fined for excessive sewage release. In comparison, the socially optimal outcome is where MSC = MSB, which takes into account all costs and benefits. This occurs at quantity q1. A nationalised firm may have the objective to maximise social welfare. As a result of the negative production externality, the free market quantity exceeds the socially optimal quantity, leading to overproduction of sewage by (q-q1). This leads to a welfare loss in the free market of area ABE due to privatisation.

Evaluation paragraph 2

However, privatisation may not lead to a welfare loss if firms are regulated. Firms may face fines for polluting the water with sewage, such as the £122m fine for Thames Water. This functions as a Pigouvian tax, making the polluter pay for the negative externality. As a result, the firm internalises the externality, shifting MPC upwards and closing the gap between MSC and MPC. As a result, the extent of overproduction is reduced and the welfare loss from privatisation is smaller. 

Conclusion

Overall, privatisation of water companies is unlikely to be beneficial and is more likely to harm social welfare. Evidence of sewage disposal from water companies in the UK suggests that water companies are likely to fail to consider the external harms from sewage disposal. Moreover, regulation has, so far, not proved sufficient. Fines could be used to make firms internalise the external costs, but fines may be too small to affect the firm’s pollution decisions. This is particularly because of the risk of regulatory capture. This is where senior regulators are promised well-paid executive roles in the private sector in exchange for watering down regulation. This means that privatisation, even in combination with regulation, may not be sufficient to prevent excess sewage disposal. The success of privatisation depends on the design of the regulation. The regulation could be extended to cover dividend payments and there are robust measures against regulatory capture. This could include paying regulators more in exchange for restrictions on which jobs they can take after leaving the regulator. In this case, regulation can ensure the private water companies’ incentives are more closely aligned with socially optimal outcomes, forcing firms to take into account the full external cost. 

Commentary on the answer

This answer features all the qualities of a top-level answer.

In particular, the answer on privatisation contains:

• Detailed chains of analysis on privatisation. This includes the effect of privatisation on costs and the knock-on effects of this. 
• Use of diagrams, including reference to key areas such as supernormal profit and welfare loss.
• Evaluation that explains weaknesses in the previous analysis point, developing the point with mini chains of reasoning.
• Use of real world examples on water from current affairs, such as fines, pollution and specific companies.
• A conclusion that answers the question and justifies the answer. The conclusion also explains what the answer to the question may depend on. 

As a result, this answer would likely score full marks or close to this.

Related questions

How do you write a 25 marker response on privatisation for AQA Paper 1?

If you are unsure where to start, consider which key points and particularly diagram(s) could be useful in your answer.

One diagram could be a negative externality of production diagram. This could show the fact that privatised firms may not take into account external costs, when deciding how much to produce.

Another diagram could be a fall in ATC and MC curves showing falling cost for privatised businesses, due to their incentive to cut costs to maximise profits. However, this is quite a challenging diagram. Another option, to show a similar point, could be to shift the supply curve to the right. 

These diagrams or points are the building blocks for an essay on privatisation. 

For the full model answer on privatisation in AQA Paper 1 style, see the model answer above.

How do you analyse the microeconomic effects of privatisation?

Key analysis points for privatisation could include:

• The possible cost reductions, due to the incentive to maximise profit.
• Privatised firms may not consider the external effects of their actions, leading to a welfare loss. 
• Short-termist behaviour by firms could lead to underinvestment. This could increase costs and bills over time, as infrastructure deteriorates and is not replaced.

You can see examples above of how to write up some of these points.

You can also read my notes here on privatisation and nationalisation.

How do you evaluate privatisation for microeconomics?

Possible evaluation points for privatisation include:

• Whether profits are reinvested or are paid out as dividends to shareholders.
• Whether regulation, including fines, can force firms to take into account external costs.
  • Related to the theme of regulation, the design of regulation and regulatory capture also matter.
• The business objectives of the privatised firm.
• The market structure of the privatised industry.

In the model answer above, you can find examples of some of these evaluation points, written up in exam style. 

For more evaluation points, see the link here.

How about an essay on the macroeconomic effects of privatisation?

If your essay is a Paper 2 macroeconomics essay on privatisation, you could discuss the effects of privatisation on AD, LRAS and SRAS instead. For instance:

• SRAS: cost reduction could shift SRAS right.
• LRAS: productivity growth could shift LRAS right.
• AD: higher investment by water companies could shift AD right. 
• There could be counterarguments, such as monopoly power reducing the incentive to minimise costs, or short-termism reducing investment.

You can find more about the macroeconomics of privatisation and other supply-side policies here.

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