Answer

THE EXTENT TO WHICH PRIVATIZATION ELIMINATES AGENCY COSTS OF STATE-OWNED COMPANIES

Table of Contents

Introduction. 3

Premises. 3

Arguments. 4

How Privatization Eliminates Agency Costs of State-owned Companies. 4

Circumstances under which State-owned Companies should Not Be Privatized. 5

Evidence: Privatization and Agency Cost Elimination. 6

Conclusion. 7

Reference List 8

Introduction

            Agency theory outlines the relationship between the agents (company executives) and the principals (shareholders) in a business enterprise. The significance of this concept is that it provides a framework for solving agency relationship related problems that arise in business setup due to unaligned interests. The most common agency relationship in finance exists between shareholders and company managers. This essay discusses agency relationships and problems associated with them. The first part of the essay evaluates the extent to which privatization eliminates agency costs of state-owned companies while the second outlines when state-owned companies should not be privately owned.

Premises

            Agency costs comprise of internal costs arising from the actions of the agents (management) on behalf of the principal (shareholders). These costs occur due to the conflict of interest between management and shareholders. In business organizations, shareholders hire management to run the business on their behalf in a manner that increases the company’s share value. The management, on the other hand, would wish to expand the business to increase their personal wealth and power, which may not be in the best interest of the principals thus creating an agency cost to the owners of the company.

            To eliminate the costs associated conflict of interests in an agency relationship, there must be incentives to encourage the agents to be efficient and innovative to achieve tremendous vitality in the business.  Based on the Principal-Agent theory, the incentive to the agents is based on the performance of the firm which is represented by the firm’s profit, II (Hart 1995). Since a company’s profits are determined by the agent’s efforts (e), Incentives (I) are, therefore, geared towards the achieved profits: I= I (II).

            State ownership may prevent the agents from increasing the value of the business due to government imperfections. Imperfections in the government may fail to recognize the main objectives of state-owned companies. State ownership goes hand in hand with politics; therefore, the imperfect governance may maximize political goals at the expense of the company goals.

            Privatization efforts have increased in the past two decades throughout the world whereby businesses in the sectors such as telecommunications, energy and financial services which were held by the governments are currently owned privately in many economies (Shleifer 1998). This implies that there is a desirable feature of privatization concerning agency relationships in the business sector.

            There is a direct relationship between agency costs and the level of competition and regulations a business entity is subjected to. When the level of competition and regulations reduces, the agency costs are likely to increase because the agents will tend to be less productive and inefficient leading to agency problems.

Arguments

How Privatization Eliminates Agency Costs of State-owned Companies

            Privatization eliminates agency cost in state-owned companies by increasing the incentive to innovate and invest in such companies. Government ownership to the production units limits the amounts of innovation and investment associated with such companies (Shleifer 1998). When a private citizen invents a convenient way of producing goods and services, but the government owns the production facilities, the individual must first seek the agreement of the government to implement the innovation at the production sites. In the deal, the profits from the new form of production will be shared with the government who is the owner of the company. This reduces the bargaining power of the investor, thus discourages invention and investment. Privatizations offer individuals with the company-ownership as a bargaining chip; thus they can invest and innovate new ways of production to increase the share value of the company.

            Secondly, privatization eliminates agency cost in state-owned companies by increasing competition and efficiency of the enterprises. To remove the agency costs, the interest of the principals and those of agents must be aligned. This means that the agents must be compensated to oversee the achievement of the goals set by the principals. However, compensation is considered a factor of profits and is determined by the efforts of the management. Therefore, it depends on the performance of the business. Privatization enables company executives to operate efficiently to outperform other companies producing the same goods and services since the compensation is no longer determined by the profits alone but also by the business competitiveness in the sector.

            Again, privatization reduces agency cost by lowering the cost of production and improving the quality of goods and services (Shleifer 1998). Since private ownership drives the principals to innovate and invest, private firms are more likely to make superior products at lower production costs than state-owned organizations. Since private companies produce at lower costs, the profit margins and sales volume are higher because the products have superior quality than those provided by the government. With high sales and profit margins, private company executives are more likely to increase the company share value than state managers. Besides, state managers receive low incentives due to low-cost efficiency and poor product quality thus, their interest and those of the state are likely to be different.

            Privatization also eliminates patronage and the use of state assets for personal benefits (Shleifer 1998). Since the appointment of agents in state-owned companies is political, state managers are likely to transfer wealth to the constituents to gather political support for themselves of other political leaders. Patronage increases the agency cost because it allows unqualified managers who are incapable of meeting the goals of the principals of growing the share value of the company to lead State Corporation. The use of state-owned company assets to acquire political mileage does not only lead to a conflict of interest with the government but also the consumers of the company who are subjected to unequal distribution of services. In contrast, privatization eliminates patronage since the appointment of managers is based on a competitive process where only the best qualifies candidates are chosen and appointed to manage the company on behalf of the shareholders. It also reduces unauthorized use of company resources for private use thus reducing non-production expenses incurred by the companies.

            Privatization reduces agency cost by eradicating rampant corruption in state-owned companies. Service provision by state agents is characterized by corruption in many developed and developing economies (Shleifer 1998). In some countries, police officers and health practitioners accept bribes from citizens to offer services. Managers in tax collection organizations also take bribes to minimize the amounts of taxes paid by taxpayers. This reduces the reputation of such government units among many stakeholders. By privatizing such government entities, the level of corruption would reduce since service offering is closely monitored through innovative ways to ensure that the objective of the stakeholders are met and the reputation and efficiency restored.

Circumstances under which State-owned Companies should Not Be Privatized

            When the reduction of the cost of production have damaging effects on the non-contractible quality of goods and service offerings (Shleifer 1998). One of the significant financial benefits of privatization is the reduction in the cost of production through innovation and high quality of goods and services. Therefore, when the cost reduction affects the quality of the company offerings, then privatization is neither desirable nor beneficial for a state-owned company. For instance, if privatizing a public school result in the exchange of experienced teachers with inexperienced ones in an attempt to reduce the cost, privatization should not be implemented.

            When the privatization of state-owned company is likely to create a reputation effect. A negative reputation affects the company’s future sales thus if privatization of a government-owned entity is capable of causing a reputation effect, the unit should not be privatized. Just like efficiency, investment, innovation and cost reduction, reputation is vital for a company’s future operations and must be preserved for better agency relationship in the company.

            When the need for innovation is relatively unimportant (Shleifer 1998). Generally, the government is not the best innovator of new means of production both in developed and developing countries. This makes the private sector the best option for innovation dependent companies. However, when a company is not innovation dependent, it can be held by the state.

            When there is a weak competition in the sector that the company operates, and the consumer choice is rendered ineffective (Shleifer 1998). When there is a weak competition in the private sector, companies tend to exploit consumers due to lack of variety of goods and services to choose from. A company in such an industry preferably should be owned by the state rather than private shareholders.

            When there is no agency problem in the company in question. According to Hart (1995), in the absence of any agency problem, agents in the company can be directed to minimize cost or increase the company’s share value, and they will be ready to follow the directives fully since they require no incentives to motivate them to execute their instructions. In this case, there is no reason for privatizing the company since there will be no conflicts to be resolved by the privatization.

Evidence: Privatization and Agency Cost Elimination

Figure 1. Most innovative companies by number of patents claimed.

Source: Adopted from Statista.com

            Figure 1 above presents the most innovative companies in the world as of 2017 by the number of patents granted. All these companies are state-owned. Therefore, they supports the view discussed above that company ownership, through privatization increases individual incentive to invest and innovate in new ways of production that lower the cost associated with the process while increasing the quality of company offerings.

            Similarly, a patent is an intangible asset or intellectual property that gives the holding company exclusive rights to produce a product while limiting other companies from making or selling a similar product. Patents are used by companies to gain a competitive advantage in the market by increasing their commercial and financial performance. In the figure above, all the ten companies possess over 2000 patents. This shows that the level of competition in the sectors in which they operate.

            According to the survey in the United States by Transparency International (2017), 21% of the people interviewed indicated that tax officials are the most corrupt in the country. The survey also indicates corruption in other government organizations such as the police departments. Such statistics is one of the many evidence of the rampant corruption in such institution that can be eliminated by privatization efforts.

            After the World Wars, most companies in various sectors were owned by the government and the corporate policies during the time were weak and were characterized by patronage. The use of company assets for political gains was the order of the day. This is still evident in the current state-owned companies. Many company assets are used to achieve political goals especially in developing countries particularly those in Africa where ministers and cabinet secretaries use public vehicles to campaign during electioneering periods. Such actions increase the institution’s expenses.  In contrast, patronage does not exist in privately owned companies due to the availability of strong corporate structure and policies.

            As indicated in the figure 1 above, many privately owned companies priorities innovation as a way of reducing the cost of production and remaining competitive in the sector of operation. By lowering the cost of production, agents in private companies increase the profitability of the company as well as the share value. The ability to reduce the cost of production is one of the contributing factors to the market dominance of private companies as shown in the table below.

Figure 2. Top Companies by Market Value.  

Conclusion

            In summary, agency theory tries to solve agency problems that arise in the relationship between the principals and agents in a company. Such issues may be as a result of a conflict of interest or disagreement between the members of the organization. Such agency problems must be solved to achieve the organizational goal of increasing share value and profitability. In my view, there are many agency issues in state-owned companies as opposed to private companies as earlier discussed; therefore, privatization of production units is superior to state ownership. However, in some sectors state ownership is preferable.