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Privatisation and regulation

50 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.

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The test

1Privatisation is best defined as:

  1. A the transfer of assets from the public sector to the private sector
  2. B the removal of legal barriers to entry and of rules on how firms in a market may operate
  3. C the setting of maximum prices by a regulator
  4. D the sale of one private company to another

2A natural monopoly exists when:

  1. A the government grants one firm a legal right to supply a market and bans all other firms from entering
  2. B a firm has a market share above 25%
  3. C a firm owns a natural resource
  4. D one firm can supply the whole market at lower average cost than two or more

3If a regulator forces a natural monopoly to set price equal to marginal cost, the firm will:

  1. A produce at the minimum of average cost
  2. B earn exactly normal profit
  3. C make a loss, because average cost is above marginal cost
  4. D make abnormal profit, because marginal cost is below the price consumers are willing to pay

4A regulator sets a price cap of RPI − X with X = 2%. If RPI inflation is 5%, the firm may raise its prices by:

  1. A 7%
  2. B 3%
  3. C 5%
  4. D 2%

5An advantage of an RPI − X price cap over rate-of-return regulation is that it:

  1. A guarantees the firm a profit whatever its costs turn out to be
  2. B ensures the firm invests in new capacity
  3. C removes the need for the regulator to collect any information about the firm's costs
  4. D gives the firm an incentive to cut costs, since it keeps savings beyond X

6Regulatory capture occurs when:

  1. A a regulator comes to act in the interests of the firms it regulates
  2. B a firm takes over its main competitor without the regulator's approval
  3. C the government imposes a windfall tax on a regulated firm
  4. D a regulator takes a firm into public ownership because it has failed

7Which one of the following is an argument for privatising a state-owned firm?

  1. A private ownership removes the need for regulation
  2. B the discipline of shareholders and the threat of takeover push managers to cut costs
  3. C private firms always set price equal to marginal cost
  4. D the government gains a permanent source of annual revenue

8Which one of the following is an argument against privatising a natural monopoly such as a water network?

  1. A private firms cannot borrow to invest
  2. B shareholders are forbidden from receiving dividends
  3. C a private monopoly may raise prices and cut investment unless tightly regulated
  4. D privatised firms are always less productively efficient than nationalised ones

9Splitting a natural monopoly into two competing networks would most likely:

  1. A double the quantity supplied
  2. B remove the need for regulation
  3. C raise average costs, because fixed costs would be duplicated
  4. D lower prices, because competition between two firms always lowers costs and profit margins

10Deregulation differs from privatisation in that deregulation:

  1. A always creates a monopoly
  2. B transfers ownership from the state to private shareholders through a sale of shares on the stock market
  3. C only applies to nationalised industries
  4. D removes legal barriers to entry and operating rules, without changing ownership

11A regulated water company is allowed to charge £300 per household this year. Next year's cap is RPI + 2% and RPI inflation is 4%. The most it can charge next year is:

  1. A £318
  2. B £312
  3. C £306
  4. D £324

12Nationalisation of an industry is most likely to improve welfare when:

  1. A the industry is highly competitive with many small firms and low barriers to entry
  2. B the industry is a natural monopoly with large positive externalities
  3. C the firm is already productively efficient and well regulated
  4. D the government wants to raise money from the sale of assets

13Britain's railways were privatised between 1994 and 1997: the track went to Railtrack (later Network Rail, which returned to public ownership in 2002) and passenger services were franchised to private operators. Several franchises later failed or were taken back into public hands, among them East Coast in 2009 and 2018 and Northern in 2020. Under the Passenger Railway Services (Public Ownership) Act 2024 the remaining contracts are being brought into public ownership as they expire, starting with South Western Railway in 2025, to be run by Great British Railways. Supporters say this will cut the cost of franchise profits and fragmentation; critics point out that fares and subsidies rose under both systems. Table 1 shows illustrative figures for a regional rail operator.

Table 1: Illustrative annual figures for a regional rail operator
Passenger journeys (million)20304050
Average cost per journey (£)12.009.007.506.80
Marginal cost per journey (£)4.003.503.203.00
Average fare passengers would pay (£)11.009.007.005.00

(a)Using Table 1, identify the output at which the operator breaks even and calculate its loss per journey if it is required to set the fare equal to marginal cost at 50 million journeys. [2]

(b)Using Table 1, explain why a regional rail service has the features of a natural monopoly. [4]

(c)With the aid of a diagram, explain the problem a regulator faces in setting prices for a natural monopoly, and how it might be resolved. [6]

(d)Explain two reasons why bringing passenger services into public ownership might not lead to lower fares. [6]

14Discuss the view that privatisation always leads to greater efficiency. [20]

Answers

Show the answers

AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.

AnswerWhy
1APrivatisation moves ownership from the state to private shareholders; deregulation (removing barriers) is a separate policy often carried out at the same time.
2DVery high fixed costs and falling average cost over the whole range of market demand (a water network, the national grid) make duplication wasteful.
3CWith average cost still falling, MC lies below AC, so a price of MC does not cover average cost; the firm would need a subsidy.
4BThe cap allows a rise equal to inflation less the efficiency factor: 5% − 2% = 3%.
5DUnder a price cap, cost savings raise profit until the next review, so the firm has a reason to find them; rate-of-return regulation rewards spending.
6AClose contact, reliance on the firm's information and the prospect of jobs in the industry can lead regulators to side with the regulated.
7BProfit motive and capital-market pressure are the efficiency case; a sale raises a one-off sum, not a permanent income, and natural monopolies still need regulating.
8CWith no competition, the profit motive works against consumers unless the regulator can hold prices down and enforce investment.
9CTwo sets of pipes or tracks cost nearly twice as much to serve the same customers; the falling average cost that defines a natural monopoly is lost.
10DDeregulation opens a market to competition (bus services outside London in 1986, airlines in the 1990s); ownership may stay the same.
11AThe cap allows a 6% rise: £300 × 1.06 = £318. A positive K factor of this kind is used when heavy investment is needed.
12BPublic ownership can price for social benefit and coordinate a network; in a competitive market it adds little and risks political interference.

13 (a) Using Table 1, identify the output at which the operator breaks even and calculate its loss per journey if it is required to set the fare equal to marginal cost at 50 million journeys. [2: AO2 2]

  • AO2 (1) Break-even at 30 million journeys, where the average fare of £9.00 equals average cost
  • AO2 (1) At 50 million journeys a fare of £3.00 against average cost of £6.80 gives a loss of £3.80 per journey (£190 million in total)

13 (b) Using Table 1, explain why a regional rail service has the features of a natural monopoly. [4: AO1 2, AO2 2]

  • AO1 (1) A natural monopoly is an industry where average cost keeps falling as output rises across the whole market, so one firm can serve it more cheaply than two
  • AO1 (1) The cause is very high fixed costs (track, signalling, stations, rolling stock) relative to the low marginal cost of carrying one more passenger
  • AO2 (1) In Table 1 average cost falls from £12.00 to £6.80 as journeys rise from 20 to 50 million, while marginal cost stays between £3.00 and £4.00, always below average cost
  • AO2 (1) Two operators each carrying 20 million passengers would have an average cost of £12.00 against £7.50 for one carrying 40 million: duplication raises costs, which is why operators were given exclusive franchises rather than competing on the same route

13 (c) With the aid of a diagram, explain the problem a regulator faces in setting prices for a natural monopoly, and how it might be resolved. [6: AO1 2, AO2 1, AO3 3]

OutputPrice, costLRACMCD = ARMRPmPacPmcQmQacQmcPm: unregulated monopolyPac: break-even, P = ACPmc: P = MC, loss (hatched)
  • AO1 (2) Diagram: a demand curve cutting a long-run average cost curve that is still falling, with marginal cost below it; the unregulated profit-maximising price where MC = MR; the allocatively efficient price where P = MC, showing a loss because P is below AC; the break-even price where P = AC
  • AO3 (1) Left alone the monopoly sets a high price and restricts output, with abnormal profit and a deadweight loss; the regulator wants price nearer marginal cost
  • AO3 (1) But at P = MC the firm makes a loss on every unit because average cost is above marginal cost, so it would exit or need a subsidy; at P = AC it breaks even but output is below the efficient level
  • AO3 (1) Solutions: average-cost pricing with an RPI − X cap to force costs down over time; marginal-cost pricing plus a subsidy from taxation (justified by the positive externalities of rail); or public ownership that accepts the loss as the price of a social service
  • AO2 (1) Application: in Table 1 a £3.00 fare would need a subsidy of £3.80 a journey; the railway received several billion pounds a year of public support under both private and public operation, which is this subsidy in practice

Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct diagram with the loss at marginal-cost pricing explained; 5 to 6 for the trade-off between efficiency and break-even explained and a solution applied to rail.

13 (d) Explain two reasons why bringing passenger services into public ownership might not lead to lower fares. [6: AO1 2, AO2 2, AO3 2]

  • AO1+AO2+AO3 (3) Operator profit is a small share of costs: franchise margins were typically a few per cent of revenue, while track, staff, energy and rolling stock make up most of the cost of a journey, so removing shareholders' dividends frees little money for fare cuts, and the Treasury may keep any saving to reduce subsidy
  • AO1+AO2+AO3 (3) Loss of the efficiency pressures that private ownership brings: without the threat of losing a contract or the profit motive, costs may rise through X-inefficiency, and public bodies may give in to pay demands or political pressure, so costs and therefore fares or subsidies rise (Network Rail and the publicly run operators have not shown lower unit costs)
  • AO1+AO2+AO3 (3) Or: fares are set by government policy whichever body runs the trains, and with public finances under pressure the government may choose to raise regulated fares to cut subsidy; investment needs (electrification, new trains) compete with fare cuts for the same money

Maximum 6: two reasons, each explained and applied to rail.

14 Discuss the view that privatisation always leads to greater efficiency. [20: AO1 6, AO3 6, AO4 8]

OutputPrice, costAR = DMRMC = ACPmPcQmQcabnormal profitwelfare loss

Knowledge and analysis (AO1 to AO3)

  • Define privatisation and distinguish it from deregulation and contracting out; define productive, allocative, X- and dynamic efficiency, since the view may hold for some and not others.
  • The case for: private owners seek profit, so managers must cut costs or face falling share prices and takeover; access to private capital allows investment the Treasury rationed; decisions are taken on commercial rather than political grounds. BT after 1984 cut waiting lists and real prices; British Airways and British Steel became profitable and more productive.
  • The case against: many privatised industries were natural monopolies (water, energy networks, rail track), so ownership changed but competition did not arrive; a private monopoly sets price above marginal cost (diagram: Pm, Qm, abnormal profit and deadweight loss), so allocative efficiency can fall unless regulation holds prices down.
  • Regulation is imperfect: RPI − X caps need information the regulator lacks, can be set too loosely (early water and energy profits) or too tightly (under-investment), and regulators risk capture; water companies paid large dividends while leaks and sewage spills rose, and Thames Water built up debts it could not service.
  • Rail shows mixed results: passenger numbers doubled after privatisation but subsidy and fares rose, fragmentation raised costs and several franchises collapsed; Railtrack failed in 2001 after under-investment in maintenance, and services are now returning to public ownership.
  • Where competition came with privatisation (telecoms, airlines, energy retail) efficiency gains were largest; where it did not, gains came mainly from regulation and job cuts.

Evaluation (AO4)

  • It depends on the market structure: privatisation into a competitive or contestable market tends to raise efficiency; privatising a natural monopoly swaps a public monopoly for a private one, and the result depends on the regulator.
  • It depends on which efficiency: productive efficiency usually improves (lower unit costs, fewer staff); allocative and dynamic efficiency depend on pricing rules and investment incentives, and the record is mixed.
  • It depends on the quality of regulation and on whether the gains are passed to consumers or kept as profit; the same firm can look efficient to shareholders and inefficient to customers.
  • Time horizon: early gains from shedding slack are one-off; long-run performance depends on investment, where private owners with short horizons may under-invest in long-lived assets.
  • 'Always' fails: there are enough counter-examples (rail, water) that the honest claim is 'usually, under the right conditions', and some sectors with large externalities may be run better in public hands.

Judgement

A supported judgement might conclude that privatisation often raises productive efficiency by exposing firms to profit pressure and private capital, but it does not always raise efficiency overall: the gains depend on competition or effective regulation, and where neither exists, as in several natural monopolies, the outcome has been higher prices, under-investment or both; the policy works best as part of a package with competition and regulation rather than as a change of ownership on its own.

Marking

Bands, out of 20 (AO1 knowledge 6, AO3 analysis 6, AO4 evaluation 8, as WJEC marks a 20-mark question). Top band (16 to 20): a range of points developed in full chains of reasoning, supported by an accurate diagram and real examples, with evaluation that weighs the arguments and reaches a judgement that depends on stated conditions. Middle band (9 to 15): some developed chains, a relevant diagram, evaluation present but one-sided or asserted. Bottom band (1 to 8): points listed or described, little use of theory or examples, judgement missing or unsupported.

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