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Regions in Changing Economic Environment
Gennadi Kazakevitch and Sharn Enzinger

ChapterThree

3. Microeconomic reform and/or large company's policy impact upon regions

3.1. Case study 1. Deregulation and privatisation of the electricity supply industry in the State of Victoria

As a result of the microeconomic reform of the electricity generation industry in Victoria, the state as a whole has started to enjoy some of the promised benefits of this measure. Meanwhile, the main power supplying area of the state - the La Trobe Valley Region - has been negatively affected. A few thousand people have been retrenched and considerable migration of population has taken place from the region to other areas of Victoria and interstate. This case is discussed as an example of the impact of microeconomic deregulation on a region. This case is then used to examine the theoretical issues and consequences involved when an industry, which forms a significant part of the local economy, is reformed.

3.1.1. Background

The geography, economy and population of the region of La Trobe Valley

The La Trobe region is located 150 km to the east of Melbourne in the State of Victoria. It is administered by the Shire [In the Australian political system, shire is a local government in non-metropolitan areas, comparable with county in USA] of La Trobe. The region is rich in natural resources, characterised by fertile agricultural land, extensive natural forests and plantations, and the brown coal fields. Electricity produced in the region supplies 90% of Victoria’s needs and has deposits of brown coal sufficient for about 300 years at current rates of utilisation. Other base sectors include agriculture (predominantly dairy and meat), forestry and pulp and paper.

The Shire of La Trobe has a population of almost 73,000. The population dramatically increased from the 1960s to the mid 1980s in response to major energy and construction developments. The population has decreased gradually since the mid 1980s, mainly because the major construction projects have been completed and the industry base, which was predominantly capital intensive, has entered the phase of steady operations. Based on recent trends, the population is not expected to grow in the future.

The La Trobe Valley has been characterised by a relatively youthful population. In the past there was a high proportion of the population in the 20-39 year age group, associated with young families and relatively high birth rates. This group of young families is mobile, increasing in numbers when job opportunities are available, and shifting away from the region in periods of decline. The recent trend indicates that the region’s population is aging.

Structure and performance of the electricity supply industry (ESI) prior to microeconomic reform.

Originally, the Victorian ESI was established and recognised as a public natural monopoly known as the State Electricity Commission of Victoria (SECV) . A number of reasons lead to public ownership of the ESI. Arguably, the most prevalent is the fact that the private sector was neither capable nor willing to finance the capital projects needed to successfully establish the industry. The costs associated with establishing the industry were beyond the scope of any private entity. Further, public ownership of the SECV was driven by the fact that the government saw the ESI as a mechanism through which it could pursue social and development objectives. The government could ensure that the unemployment rate in the La Trobe region was relatively low by employing thousands of people to work in the ESI. Another reason for public ownership was that having participated in two world wars, the government was not prepared to sell off an industry of vital importance; particularly if potential buyers had foreign interests.

During the early to mid 1980’s the SECV was grossly overstaffed. Arguably, the greatest contributor to the large SECV workforce was the strong union base, which existed in all facets of the industry. With relatively few exceptions, those who were employed in the industry belonged to a union. It was the diversity of jobs and subsequently the number of unions, which forced the industry to often indulge in inefficient work practices. Numerous cases are cited where union involvement resulted in a single job being performed by many employees. Hence, the underlying need for reform was not embedded in the fact that technological practices of the SECV needed improvement but, in the fact that restructuring was essential to rid it of its oversized workforce.

The concept of the industry restructuring

One the goals of a microeconomic reform of government owned public utilities is to either make statutory bodies more commercial in nature and thus more accountable, or to privatise them altogether. In any case the objectives include:

  1. Efficiency improvements;
  2. Better price signals;
  3. Improved investment decisions;
  4. Lower prices and lower state debt; and
  5. Independent regulation to ensure protection of consumer interests.

Neither Australia as a whole nor the state of Victoria were pioneering in the privatisation of the ESI. The precedent for electricity privatisation, in the years preceding the reform in Victoria, had been established by a number of countries including Chile, Argentina, New Zealand and the United Kingdom.

There were four stages in which the reform process took place (Figure 3.1).

The first stage of reform involved transforming the natural monopoly from a public property with statutory functions into a commercial company.

The nature of the ESI (as well as of other natural capital intensive monopolies) does not permit flexible changes in the physical amount of capital employed by the industry, either in terms of time or continuity of changes. Thus, in the short run, rationalisation of the industry did not affect the amount of physical capital. At the same time, a considerable rationalisation of job structure and reduction of employment was undertaken. The quantity of production appears to be relatively stable and not affected by the reform (Figure 3.2). On the other hand, it can be concluded from theory that any attempt to deregulate prices at that early stage, when the industry still had a monopolistic structure, would inevitably lead to price increases. Hence the government preserved price controls until later stages of the reform. The only result stemming from the reform at the first stage, was increased internal efficiency caused by the decrease in employment. This enabled the Government to remove subsidies from the sector, previously running at a loss, and possibly make a profit. See Figure 3.3.

At the second stage, the single monopoly was vertically disintegrated into three new state-owned companies. The first of these companies was in charge of all power generation. It was responsible for power generation and supply to the high voltage transmission network ("the grid"). The second was in charge of high voltage transmission. It was responsible for receiving the energy from the generators and supplying it to the distributor. The third was responsible for the retail distribution of energy. At the same time, non-core activities of the industry were to be outsourced. Consequent to the implementation of this stage of the reform, the non-core services, which were previously self-provided, were then purchased from contractors.

During the third stage of the reform, the generation and distribution enterprises were disintegrated into commercially operating but still state-owned businesses, including several competing power generation plants and a number of regional distribution and retail monopolies. The balance sheet, cost and revenue structures for each of these new enterprises were in line with similar organisations operating in the commercial sector. Meanwhile, high voltage transmission remained a regulated natural monopoly. The generation units competed with one another for shares in the total amount of electricity suppled both to the grid and to large consumers. At the same time, large consumers had the choice of either buying energy directly from a generation unit or relying upon the more stable grid price.

The core industry was eventually disaggregated into five Business Units, including three generating units, which independently trade in the electricity supply market. The disaggregation was based upon the physical structure of the power stations and their adjoining mines.

The distribution and retail arm of the previous industry structure has been broken up into five distribution businesses, each of which services a geographic area in the State of Victoria.

The new industry structure also included the Victorian Power Exchange (VPX). The role of the VPX is to monitor and control the wholesale electricity market and to ensure that the supply system is secure. Power Net Victoria (PNV) is another body established under the new regime. PNV is a transmission company, which owns, maintains and manages the high voltage grid.

The final stage of ESI restructuring was the privatisation of the newly established Business Units.

Recent tendencies in the regional economy as a result of the reform

There are two points of interest with regard to the impact of the ESI reform upon the La Trobe Valley region. Firstly, a large percentage of those people who opted to leave the reformed industry resided in the affected region. Secondly, many of those who took the "Voluntary Departure Packages" (VDP’s) did so with the belief that they would be able to find alternative employment in the region easily. With hindsight such a belief appears illogical, but we must recall that during the late 1980’s through 1991, Australia was experiencing an economic boom where the level of unemployment was relatively low. Consequently many VDP recipients left the ESI without foreseeing the financial hardships that lay ahead.

The reform impacted upon many facets of the regional economy. The most evident impact was the increase in the region’s unemployment rate. The ESI has reduced its employee numbers by over 75% since 1989 through the introduction of the VDP. In addition, the rationalisation of the region’s Local Governments and of the Australian Paper Manufacturers (APM) have also contributed to the number of regional unemployed.

Initially the economy may have experienced an increase in demand. Depending upon the number of years an employee was with the ESI, the VDP could equal anything from half-a-year to several years wages. The VDP recipients were often in a position where they could afford to pay off their mortgage or purchase luxury items. For instance, according to the focus group studies (Kazakevitch, Stone and Foster, 1997), a large number of VDP recipients bought luxury motor vehicles. In the long run, however, VDP recipients who remain in the region and are unable to find alternative employment, will be forced to reduce their consumption. The effective demand levels of households will decline across the region. The direct reduction in consumer demand was one of the first round effects of the reform. Second round effects followed as local businesses experienced a decline in sales and, in extreme cases, were forced to close down.

Meanwhile, those former SECV employees who were employed by private contractors, delivering outsourced services to the ESI, softened the economic impacts. However, local contractors employed by the ESI found themselves under threat when the generating units were sold to private organisations who's objective was cost minimisation. When purchasing mobile services, such as equipment maintenance, the owners of the generating units were less likely to employ local contractors if employees in other regions offered the same service at a reduced rate.

The demographic aspects of the restructuring are very important to the region. The most common employee category who accepted a VDP were males aged between 25-35 years. Men who fall into this category are in the prime of their working life and are likely to find alternative employment. Due to the reduction in employment opportunities in La Trobe region, many of these men migrated with their families to other regions. The cycle of first and second round effects of the reform became clearer at this point as the reduction in the labour force reduced demand, which in turn reduced the number of employment opportunities. Another prominent VDP employee category was men who had worked in the ESI for 31 years or more. Men in this group had almost finished their working life and were more likely to retire either within or outside the La Trobe region, living off their VDP.

A brief analysis of the above VDP groups indicates that the demographic structure of the La Trobe region underwent significant change as a result of the ESI restructuring. Younger men in the 25-35 age group left the region while older members of the community retired, often remaining within region. To the extent that the young leave, and the older recipients remain in the region, more demands are made on the resources utilised by the older generation such as health care and community services.

The Australian Bureau of Statistics conducted a survey across all Victorian regions from October 1990 to October 1993, and found the La Trobe region to have the highest proportion of those employed who had been retrenched or had accepted voluntary departure packages.

The decline in the La Trobe Valley’s economic activity over the period from 1987 to 1995 was most evident by the steep rise in the number of recipients of pensions and benefits, as illustrated in Table 3.1 (below), and compared with Victoria in Figure 3.4. The rise in the number of residents receiving aged pensions supports the trend toward an ageing population. In 1995, the proportion of the population receiving aged pensions was close to that of Victoria whereas in the late 1980s, the proportion was much less. The number receiving unemployment benefits increased by over 160% from 1987. This declined slightly in 1994 and 1995 as labour market policies showed some success and the Australia-wide recession eased. The continual upward trend in the number of low income families receiving the Family Allowance Supplement suggests that while some have found employment, it could be low-paid and/or part time.

Table 3. 1: Residents of La Trobe Shire receiving Pensions and Benefits, 1987-1995
Pensions and Benefits
Aged Single Parent Unemployed
1987 4960 1110 2 014
1988 5122 1145 1872
1989 5161 1454 1678
1990 5308 1462 1909
1991 5548 1575 3237
1992 5945 1663 4045
1993 6289 1685 5346
1994 6566 1756 4980
1995 6484 1822 4819
Source: Department of Social Security (1988-1994, 1995)

Housing prices in the La Trobe Valley have remained at a low level over the period since 1987.

Overseas migration into the La Trobe Valley (a considerable component of the population growth in Australia) has tended to be at a lower level than for Victoria and Australia, as most of the overseas population settled in the area during the boom period of the 1950s and 1960s.

The changing structure of the La Trobe Valley workforce is illustrated in Figure 3.5 . The major heavy industry sectors of Mining, Electricity, Gas and Water, Engineering, Forestry, Wood Products, Pulp and Paper and Manufacturing have declined in employment while the service industries - Public Administration and Defence, Community Services and Recreation, Personal and Other Services - show increases in employment since 1986.

3.1.2. An empirical analysis of economic and social impact of industry restructuring upon the region

An expenditure flow model. The estimation of the economic impact of the industrial restructuring should be based on a comparison between the expenditure flow generated by the industry into the regional economy both prior to and post reform. The context of the data, which can be used for such an impact analysis, and the methodology of calculation of the first round effect, are represented by the following block charts.

Figure 3.6 (with a reference to Figure 3.8) is a flow model of industry expenditure before the reform. Prior to reform, the ESI was represented by just one company - the publicly owned monopoly located in the region. The flow of expenditure from this company was used to determine the amount of injection into the regional economy by the industry prior to reform. Figure 3.6 demonstrates the flow of expenditure in three directions. Payments to employees and expenditure in the regional economy represent injections into the regional economy. The third flow of expenditure is on goods and services outside the region.

Figure 3.7 represents a flow model of expenditure into the region by the industry following microeconomic reform. A new sector of the industry included in the flow model comprises the contractors who provide services to core companies. The contractors provide those services that were outsourced from the core operations during the reform process.

The flow of expenditure injected by newly established companies into the region is diverted either to employees or contractors, or diverted to general expenditure. Expenditure outside the region by the companies represents a leakage. The contractors’ expenditure into the local economy includes salaries and wages and general expenditure. A portion of their expenditure also represents a leakage to other regions. In turn, the employees from the industry can either spend their income on goods and services produced in the regional economy or outside the region.

Figure 3.9 represents the ESI related flows of households incomes prior to and post restructuring.

Numerical data illustrate the impact of the reform on the region. The data is based on primary and secondary sources of information. Overall the results indicate that the regional economy has experienced negative economic repercussions due to the reform in the ESI.

As a result of the reforms the industry "successfully" reduced its employee numbers. Figure 3.10 illustrates the significant reduction in the ESI employee numbers between the base years - 1989/1990 prior to the beginning of the reform, and 1994/1995 post reform. The number of employees with the ESI decreased from 8,481 to 3,661. As most of these employees reside in the region this has impacted negatively upon the regional economy.

Many employees were paid a substantial sum for resigning voluntarily from the SECV and then continued to receive weekly income payments from their new employer. For those who gained employment back in the industry, the question of how they spent their package becomes an issue. For many, the package acts as a large bonus or as security for the future. If the VDP recipients who gained re-employment continued to spend the same amount of money as when they were employed with the ESI, the immediate impact of the reform would be lessened.

Overall, expenditure in the region by industry employees declined substantially, offsetting the increase in expenditure by the industry. This conclusion is seemingly logical as the reduction in employment within the industry in turn reduced the expenditure injected into the region by employees on the whole. Figure 3.11

The aggregate results of the study are represented in Table 3.2 (below).

The Input-output approach is used to estimate the regional employment multiplier effect of the direct decrease in employment caused by the ESI restructuring. For this purpose, the structure of household expenditure within the region, which was obtained from an employee survey, was applied to the absolute value of the decrease in payments to the core industry's and contractor’s employees spent in the region. As a result, the sector structure of the absolute decrease in demand within the region was calculated.

Table 3.2: The impact of the ESI on the Regional Economy before and after the Microeconomic Reform
1989/1990
‘000
1994/1995
‘000
Change Change
(% to 1989/90)
Employment
Number of Employees in the ESI Core Industry 8,481 2,004 -6,477 -76.37
Number of Employees/Self-employed in Contracted Firms 1,657 1,657
Total Impact on the Region 8,481 3,661 -4,820 -56.83
Expenditure within the Region ($ '000)
Non-salary/wages Expenditure by the ESI Core Industry 78,909 44,956 -33,953 -43.03
Non-salary/wages Expenditure by Contracted Firms 38,673 38,673
Subtotal Expenditure Effect 78,909 83,629 4,720 5.98
Expenditure Injection in the Region by Business Unit Employees 124,051 29,569 -94,482
Expenditure Injection in the Region by Contractors’ Employees 24,448 24,448
Subtotal Expenditure Effect 124,051 54,017 -70,034 -56.46
Employment Multiplier Effect -367
Total Expenditure Effect 202,960 137,646 -65,314 -32.18
Total Employment Effect -329

The impact of the change in regional demand upon the change in total employment was then calculated using the conventional methodology of income and employment multiplier analysis. (See, for example, Hewings, 1985).

The national input-output table of 1989/90 was used for a rough estimate of the regional employment multiplier effect of the direct decrease in employment caused by the ESI restructuring. The national input-output table of 1989/90 was used for a rough estimate of the regional employment multiplier effect of the direct decrease in employment caused by the ESI restructuring. For this purpose, the structure of household expenditure within the region, which was obtained as a result of the employee survey, was applied to the absolute value of the decrease in payments to the core industry's and contractor’s employees spent in the region. As a result, the sectoral structure () of the absolute decrease in demand within the region was calculated.

Labour productivity coefficients () were calculated based on the national data and a standard assumption made that employment in a sector j is a linear function of the gross output of the same sector () and that zero employment corresponds to zero output:

The impact of the change in regional demand upon the change in total employment was then calculated as:

where is the Leontief inverse matrix

Figure 3.12

3.2 An approach to theoretical analysis

3.2.1. The initial stage of the reform: the commercialisation of natural monopoly

To theoretically evaluate the possible impact of reform upon the region using the model from section 2, consider how the reform, in terms of production functions, affects the production possibilities and factor efficiency of the reformed industry.

Let us assume that an official or private monopolist supplies a homogenous commodity or service and that managerial incentives to engage in cost reduction activities are not sufficient. This scenario is common in utility sectors if they have a monopolistic structure. For this reason, regardless of whether they are publicly or privately owned, monopolies attract the attention of reformers. This is a conventional assumption in the theories of deregulation and privatisation, as suggested in Vickers and Yarrow (1988), Bös and Peters (1986) and Bös (1986).

Following microeconomic reform, it is expected that managerial incentives are improved so that the unchanged amounts of conventional factors used in production can produce more output, or the unchanged level of output is achievable by reduced factors.

In terms of production functions, it is convenient to represent microeconomic reforms by introducing an additional "reform factor" (R), which partially substitutes one or more conventional factors. In some models this factor is considered to be a normal factor of production which not only affects the level of output, but also involves a cost (Vickers and Yarrow (1988), pp 35-39).

The greater the anticipated benefits of the reform process, the greater the cost incurred during the process. However, in this model, the microeconomic reform of an industry is represented as the exogenous change of the factor R with no internal costs. This corresponds to the British and Australian experience of microeconomic reforms of public utilities when the actual costs of reforms were met by the government, not industry.

The modified production function of the industry experiencing the reform (let it be the industry producing product X in region 1) is

(3.1)

Generally, regional models differ from national models in their assumptions concerning unemployment. In standard non-spatial general equilibrium models, the economy is assumed to be closed with regard to labour. The labour force only moves from one sector to another. In contrast, Keynesian equilibrium allows for unemployment. In inter-regional models, however, labour is able to move from one region to another.

In the differential form:

, (3.2)

The analytical solution of this model with respect to the relative change in the exogenous "reform factor" is rather complicated to interpret in the general case, when all parameters are different from zero. Considering the signs of the parameters of elasticities, the relative change in R affects the welfare of both regions in opposite directions. Roughly, the reduction of costs in sector X, of region 1 reduces the price for X and, therefore increases welfare because of the increasing affordability of the product, but decreases demand for factors. Subsequently, income falls, which leads to the decrease in welfare.

The introduction of additional assumptions more realistically reflects the peculiarities of the reforms of large monopolies, comparable to that considered in Case Study 1.

The nature of utility monopolies, which are normally large and capital intensive, does not allow small changes in the physical amount of capital employed by the industry. That is why it is easer to consider the short run-effect of the reform, which excludes changes in capital.

Also assume that either the utility produced by the reformed industry is inelastic, or that during initial stages of the reforms price is regulated by the government (this corresponds to the initial stage of the ESI restructuring in Victoria). Then the quantity of the output remains stable, compared to the considerable decrease in labour - the only factor affected by restructuring. Meanwhile, during the initial stage of the reform internal efficiency is improved. However, the structure of the industry remains close to a natural monopoly. Hence, at this stage of the reform the only likely consequence of the increase in internal efficiency is the decrease in employment. This type of reform is reflected inFigure 3.13A. The only result of the reform is an increase in profit caused by savings on costs.

Further developments of the reform, if the price is deregulated and the structure of the industry remains monopolistic, are reflected in the Figure 3.13B. The price would increase and quantity demanded would decrease. Profitability is expected to increase. (This is an amazing analogy to the consequences of reforms in the state owned sector in the East European economies, in which the majority of manufacturing industries have monopolistic structures).

In this model it is realistic to assume that the labour retrenched from the reformed industry is not able to find stable employment in the region. Therefore, in the ideal case, people move to the other region.

However, as shown in the Case Study 1, there is evidence that a considerable number of those retrenched, at least in the short run, chose not to migrate. The underlying reasons for people not migrating are normally considered in the regional science literature (Armstrong and Taylor, 1993) as follows:

  • The retrenched workers are specialists in their field, and there is no comparable employment elsewhere;
  • High cost of migration is not affordable, especially for low income workers;
  • The depressed real estate market in the region that experiences the downsize of employment created a situation where those willing to migrate are not able to sell their home, and/or are not able to obtain sufficient finance to buy a home elsewhere;
  • The age of worker is a factor of their mobility; the less working life left, the less likely they are to migrate;
  • Cultural reasons: people are attached to their community and to their extended family;
  • Cultural reasons: people are attached to their community and to their extended family;
  • People are concerned with children changing schools;
  • Their marital and family status;
  • Their spouse’s employment opportunities elsewhere, etc.

The assumptions discussed above allow for the reduction in the number of variables and equations in the system (2.8)-(2.14) and (3.2).

The output of industry X remains unchanged. Therefore, in the short run the demand for labour in this industry decreases with the increase of the "reform factor":

(3.3)

In the short run, the production function of industry Y determines only the demand for labour:

(3.4)

The supply function (2.11) of this industry and the function (2.14) for changes in income remain the same as in the general model.

The demand for product Y now does not depend upon changes in the price for product X :

(3.5)

The solution of the system (2.11), (2.14), (3.3)-(3.5), gives the following relationship between the "reform factor" and the demand for the product of industry Y in the whole economy (the only one affecting public utility):

, (3.6)

 

and the demand for the same product in the region affected by the reform:

 

. (3.7)

 

The determination of the direction of changes in the demand for Y and, therefore, in the public utility of the whole economy is not straight forward, as the sign of the expression (3.6) depends upon the relationship between positive and negative components. However, it is clear that even the negative direction of changes in those regions of the State which are not affected by the reform, are determined only by the change in demand in the region affected by the reform. Therefore, the smaller the population residing in the area affected by the reform as a fraction of the population of the State, the lower the overall effect.

The signs of the parameters of expression (3.7) determine the expected negative relationship between the change in the "reform factor" and consumer demand in the region affected by the microeconomic reform.

and are all positive. Thus the first bracket in (3.7) is positive. and . Thus , the second bracket is possible and the whole expression (3.7) is negative at any positive change in the reform factor R.

Therefore, the effective regional demand in the region affected by industry restructuring decreases.

3.2.2. Horizontal disintegration and privatisation

In the latest stages of the reform, horizontal disintegration, and especially privatisation, catalyse enormous discussions among politicians, academics and the broader community about who will gain and who will lose as a result of privatisation. Those opposing privatisation appeal to the public who are accustomed to more or less stable prices and concessions provided by the government to pensioners and the unemployed. Those defending reforms claim that the state monopoly caused excess costs and that as a result of privatisation and the initiation of competition, an increase in efficiency and a decrease in costs and prices should occur.

In the view of the above considerations (equations (3.6) and (3.7), from the public interest perspective (in terms of public utility in the State as a whole and in the reforming region), even though horizontal disintegration and privatisation would not cause a further decrease in the number of jobs, only a decrease in costs and in the price for electricity would make the reforms acceptable to the broader community. The question is whether there are grounds for lower price expectations considering that the scheme of reforms has been implemented.

Deregulation should cause greater efficiency and lower costs. However, the cost minimisation goal is achieved at the earlier stages of reform, when the number of jobs in the reformed industry is reduced to a minimum.

Even though the industry is privatised, production costs cannot decrease below a certain "technologically predetermined" level. Therefore, competition does not result in pressure on the input market. The "technological" level of costs is structurally predetermined in the very expensive construction costs of the industry infrastructure. Meanwhile, basic technologies and levels of efficiency may vary in each of the production units, mainly because of their different vintage. Each was built during a different period of time and embodied corresponding contemporary (of that time) engineering solutions.

We assume that the government owned utility or independent private providers just break even. Thus, before disintegration, the cut in the wholesale price is set to cover aggregate costs of all generation plants. This kind of cross-subsidisation is not possible when all plants begin to function independently.

However, the fact that the wholesale market is still a state monopoly (as is demonstrated in Case Study 1) creates only two opportunities. Either the wholesale authority differentiates prices through individual contracts with each of the suppliers, or the price would be established, as a result of bidding, at a level satisfying all supplies. The first option would dramatically restrict the degrees of freedom for competition. The second option would establish one of the known forms of oligopolistic competition. Therefore, depending upon different factors, the price would appear at a level either higher or lower than before disaggregation, considering that the "technological" level of efficiency was achieved during the earlier stages of the reform.

Generally, due to difficulty of formal analysis and uncertainty, the price formation as a result of disintegration, is demonstrated here as the result of a numerical simulation. Consider one of the options of oligopolistic markets.

The following assumptions are being made:

  • There are n production units which, after horizontal disintegration, are starting to operate independently;
  • Each unit is characterised by increasing cost functions

; (3.8)

  • Demand for the output of the industry (q) is variable, however, it is fluctuating within the range that requires facilities of all the production units; though, generally, they operate below their capacity:

; (3.9)

  • The cost function of the wholesale monopoly is determined only by the contract price/s of the generators;
  • The wholesale price is established at a level not lower than the cost

(3.10)

  • The wholesale monopoly breaks even but does not function according to the profit maximisation criteria;
  • The retail market is, to some extent, elastic and is characterised by a conventional decreasing function:

; (3.11)

The wholesale monopoly is aware of the conditions of the retail market and translate those conditions to the producers, through contracts, by determining price and quantity schedules.

Prior to the reform, when the industry functioned as a state authority, it was supposed to break even at a (periodically reconsidered) regulated price P*. Otherwise, the industry might be subsidised. Thus, the average cost of the industry is determined as one of possible combinations of the average costs of the generators (Figure 3.14A):

(3.12)

As a result of the first stage of the reform, vertical disintegration and commercialisation of the state authority, the choice of production schedule was restricted by the condition of, at least, breaking even (Figure 3.14B):

, (3.13)

Therefore, the most inefficient production schedules, at each given price, are eliminated.

The disintegration of production units into a few independent businesses, even though not private, creates a market with oligopolistic characteristics. The consequences of this stage of the reform for price formation depend upon the market conduct of newly established firms and their interaction with the wholesale monopoly.

Considering the "official past" of the newly established oligopolistic market, it would be realistic to assume collusion as one of the possible kinds of market conduct. According to the well known concept of collusive market (Kogiku, 1971), the participants avoid rivalry and tend to maximise the total industry profit:

(3.14)

Combining (3.14) with (3.11) and (3.12) gives the following expression for the objective function:

 

(3.15)

The maximisation conditions for the function (3.15) are:

(3.16)

i=1,..n

Equations (3.16) mean, that the optimal solution corresponds to the market shares of the generation businesses at the point where their marginal costs ( ) are equal to each other and to the marginal revenue of the industry ( ).

The answer to the question of whether the equilibrium price would be higher or lower than the price before deregulation depends on several factors including:

  • The parameters of the demand function;
  • The level of price and production quotas before deregulation; and
  • The cost functions of independent generators after deregulation.

The following numerical example illustrates possible consequences of horizontal disintegration and deregulation of price in the short run.

It is assumed that excess capacity still exists and the optimisation of factors has occurred during the previous stages of the reform. The level of production before the disintegration q* corresponds to the point on the demand curve at a regulated price p*. In addition, it is assumed (for purposes of more convenient diagrammatic representation), that there are two firms with different fixed but similar variable costs. The later assumption implies similarity of the industry’s marginal cost. This also means, that for the cost functions used in the example, the firms would be allowed equal quotas at any level of the industry’s output.

As a result of deregulation, in the sense of the condition (3.15), the profit maximising industry’s output, appears at a lower level and price at a higher level than before deregulation.

The diagram reflects a particular case, where the price before deregulation appears to be below the average cost of the oligopolistic competitive industry. As it can be seen on the diagram, the consequence of the deregulation might be similar, if the regulated price was above the industry’s average cost curve, but still between firms’ average cost curves.

The above example shows that, generally, expectations of a decrease in prices and increase in the welfare at a given cost structure are groundless. Those expectations would be reasonable only if, as the result of privatisation and emerging competition, in the long run investments in equipment cause improvement in the "technological" level of efficiency and, therefore, decrease in the costs of independent commercial firms. This is currently confirmed with the experience of the privatised production units in the La Trobe region of Victoria.

3.3. Conclusions

  • Microeconomic restructuring imposed on an industry predominantly located in a particular region, inevitably causes shrinking of the regional economy.
  • The theoretical conclusions correspond to the results of the case study conducted on the electricity industry restructuring in the Australian State of Victoria. Overall, the results of the case study indicate that the regional economy of La Trobe Valley experienced negative economic repercussions due to the micro-economic reform.
  • The impact of such a reform on effective demand of the rest of the national or state economy is not that obvious. However, the smaller the regional economy, the less significant the impact on the national or state economy as a whole.
  • In the case considered in this chapter, when as a result of restructuring a natural monopoly is transformed into an oligopolistic market structure, a decrease in retail price is not an automatic consequence of increased efficiency. Apart from immediate fiscal implications, positive consequences should be expected in the longer run.

Appendix

The diagrams in Figures 3.14 and 3.15 were plotted using the following numerical example.

P=D(q)=22 - 2.2q

Q

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

17.30

23.20

29.70

36.80

44.50

52.80

61.70

71.20

81.30

6.30

12.20

18.70

25.80

33.50

41.80

50.70

60.20

70.30

18.80

17.70

24.20

31.30

39.00

47.30

56.20

65.70

75.80

17.30

11.60

9.90

9.20

8.90

8.80

8.81

8.90

9.03

6.30

6.10

6.23

6.45

6.70

6.97

7.24

7.53

7.81

11.80

8.85

8.07

7.83

7.80

7.88

8.03

8.21

8.42

5.90

6.50

7.10

7.70

8.30

8.90

9.50

10.10

P=D(q)

19.80

17.60

15.40

13.20

11.00

8.80

6.60

4.40

2.20

P*

7.50

7.50

7.50

7.50

7.50

7.50

7.50

7.50

7.50

3.4. Bibliography

3.4.1. References

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Vickers, J. and Yarrow, G. (1988) Privatisation: An Economic Analysis, The MIT Press,.

3.4.2. For further reading

Industry Restructuring, Deregulation and Privatisation

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Hartley, Peter., & Trengove, Chris. (1984). "The Marginal Costs of Electricity Supply in Victoria", The Economic Record, December.

Haskel, J. (1994). "The Winners And Losers From UK Privatisation", Department of Economics, Queen Mary and Westfield College, University of London, Paper No. 308, March.

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Industry Commission. (1991). "Energy Generation and Distribution", Australian Government Publishing Service, Canberra, 17 May.

Jenkinson, Tim., & Mayer, Colin. (1988). "The Privatisation Process in France and the U.K.", European Economic Review, v. 32, pp. 482-490.

Leontief, Wassily., Morgan, Alison., Polenske, Karen., Simpson, David., & Tower, Edward. (1965). "The Economic Impact - Industrial and Regional - of an Arms Cut", The Review of Economics and Statistics, No. 3, August.

McCarthy, Mary R. and Thomas G. McCarthy. (1989) "Irish Migration: The Search For The Efficiency And Equity Basis Of A European Regional Policy", The Economic and Social Review, v21(1), pp. 71-84.

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Newbery, David. (1993). "Restructuring and Privatising Electric Utilities in Eastern Europe", Department of Applied Economics, University of Cambridge, Discussion Paper, November.

Petrecolla, Alberto., Porto, Alberto., & Gerchunoff, Pablo. (1993). "Privatization in Argentina", The Quarterly Review of Economics and Finance, Vol. 33, Special Issue, pp. 67-93.

Rees, Ray. (1988)."Inefficiency, Public Enterprise and Privatisation", European Economic Review, v. 32, pp. 422-431.

Rodriguez, Flavia. (1992). "The Mexican Privatisation Programme: An Economic Analysis", Social and Economic Studies, 41:4.

Stevenson, Rodney E. (1983) "Institutional Objectives, Structural Constraints, And Deregulation In The Electric Utility Industry", Journal of Economic Issues, v17(2), pp. 443-452.

Stevenson, Rodney. (1983). "Institutional Objectives, Structural Barriers, and Deregulation in the Electric Utility Industry", Journal of Economic Issues, Vol. XVII, No. 2, June.

Tasman Institute Pty Ltd. (1991). "Project Victoria 1991 - A Restructuring Strategy for Electricity in Victoria", November.

Thompson, D.J. (1987). "Privatisation In The U.K. - Deregulation and the Advantage of Incumbency", European Economic Review, No. 31, pp. 368-374.

Trebing, Harry. (1986). "Apologetics of Deregulation in Energy and Telecommunications: An Institutionalist Assessment", Journal of Economic Issues, Vol. XX, No. 3, September.

Troughton, Peter (1994)., "Competition In Electricity Supply - Is It Really Good For Business", Victorian CPA Congress, October.Melbourne.

Walsh, Pat., & Wetzel, Kurt. (1993). "Preparing for Privatization: Corporate Strategy and Industrial Relations in New Zealand’s State-owned Enterprises", British Journal of Industrial Relations, v. 11(1), March.

Wendling, Robert., & Ballard, Kenneth. (1980). "Projecting the Regional Economic Impacts of Energy Development", Growth and Change, October.

Wright, Arthur. (1979). "Energy Policy and Deregulation - Two Hot Topics, or Does Smoke Necessarily Mean There’s Fire?", Growth and Change, January.

Yunker, James.(1975). "Economic performance of public and private enterprise: the case of U.S. electric utilities", Journal of Economics and Business, v28(1).

Regional Impact of Industry and Industry Restructuring

Ballis, Harry., & Munro, Lyle. (1992). "Opting Out: A Report on the Experiences of Recipients of Voluntary Departure Packages from the State Electricity Commission of Victoria in the La Trobe Valley", March.

Bezdek, Roger. (1875). "The 1980 Economic Impact - Regional and Occupational - of Compensated Shifts in Defense Spending", Journal of Regional Science, Vol. 15, No. 2.

Hampton, P.(1968). "Regional Economic Development in New Zealand", Journal of Regional Science, Vol. 8, No. 1.

Hobbs, Benjamin F. and Richard E. Schuler (1986) "Deregulating The Distribution Of Electricity: Price And Welfare Consequences Of Spatial Oligopoly With Uniform Delivered Prices", Journal of Regional Science, v26(2), pp. 235-266.

Hobbs, Benjamin, & Schuler, Richard. (1986). "Deregulating the Distribution of Electricity: Price and Welfare Consequences of Spatial Oligopoly with Uniform Delivered Prices", Journal of Regional Science, Vol. 26, No. 2.

Industry Commission, (1994) Impediments to Regional Industry Adjustment, Report No. 35. Volume I: Report; Volume 2: Appendices.

Isaacs, Herbert. & Caffrey, John. (1971)., Regional Impact of Oakland University, American Council on Education, Washington, D.C.

Leontief, Wassily., Morgan, Alison., Polenske, Karen., Simpson, David., & Tower, Edward. (1965). "The Economic Impact - Industrial and Regional - of an Arms Cut", The Review of Economics and Statistics, No. 3, August.

Mickens, Alvin. (1977) "Regional Defence Demand And Racial Response Differences In The Net Migration Of Workers", Quarterly Review of Economics and Business, v17(1), pp. 65-82.

Rimmer, S. M., (1994) Australian Labour Market & Microecomomic Reform, La Trobe University Press.

Temple-Smith, Richard. & Elvidge, Norm. (1992). "The Economic Impact of the University of Southern Queensland on the Toowoomba Economy", University of Southern Queensland.

Wendling, Robert., & Ballard, Kenneth. (1980). "Projecting the Regional Economic Impacts of Energy Development", Growth and Change, October.



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