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Pricing of Public Undertakings

 Pricing of Public Undertakings

Introduction

            A good deal of controversies persists over the subject of pricing policy of public undertakings. The policy is based on the type of services provided by public sector undertakings. In context, we can divide the pricing policies into four categories. First, Services rendered by public sectors in the case of public utilities, Second, no-profit, no loss policy, Third marginal cost pricing and Fourth Profit Price policy.

1. Pricing of Public Utility Services

            There are a number of principles which govern the pricing of public utility services. There are public utilities like education, sewage, roads etc. which may be supplied free to the public and their costs should be covered through general taxation. Dalton calls it the general taxation principle. Such services are pure public goods whose benefits cannot be priced for the reason that they are invisible. It is not possible to identify the individual beneficiaries and charge them for the services.

            In some cases, the beneficiaries may be identified but they cannot be charged for their use. For instance, the users of flyover over the railway line can be identified, but it may be inconvenient to the taxing authority to collect the road tax and for the road users to pay the tax due for the time involved. The best course is to finance the flyover out of general taxation. JF Due has mentioned the following four rules where public services should be provided free and their costs covered from general taxation.

  1. In the case of such services where little waste will occur if they are provided free.
  1. Where charging a price will restrict the use of the service.
  1. Where the cost of collecting taxes is high.
  1. Where the pattern of distribution of tax burden on service is inequitable.

These rules are applicable to a few essential public services like education, sewage, roads etc. But in the case of services other than those included under “pure public goods,” free services might lead to wastage of resources.

Dalton hence, advocates the compulsory cost of service principle whereby the government should charge a price for the service provided to the people. This is essential for the reason that municipal services such as sewage, sweeping street, street lighting etc are under priced. Every family of a locality may be asked to pay for them. But since they are public utilities, they may be charged nominally and the gap between revenues and costs remains. This is met from general taxation. This is a sort of government subsidy to the users of such services.

            Nonetheless, Dalton favours the voluntary price principle for public utilities. According to this principle the consumers of a public service are required to pay the price fixed by the Public Sector Enterprises (PSE). The PSE may have a monopoly in a particular service, such as water or power supply and it may fix a price for it. But the services being a public utility, it may set a price lower than its cost of production so that the welfare of the community is not adversely affected.

2. No Profit, No Loss Policy

            The no-profit, no loss means that the price of PSE products or services should cover total costs. Total costs include all type of expenses incurred by a PSE in producing a product. They are short period and long period fixed and variable costs of production, current and replacement costs, depreciation charges, interest on capital employed and advertisement, selling and distribution expenses. These costs may be covered by making the price equal to the average total costs of production or by following two parts or multipart policy.

            The full cost or average cost pricing policy is advocated on the following reasons. Full cost prices of a PSE are based on its average total costs of production which can be easily estimated from an enterprise’s accounting records. It is better to fix full cost price for merit goods, such as highways, public transport, public education, public libraries, museums, recreation parks etc. For all such services, people should be charged a price instead of providing them free or at concession rates. Full cost prices lead to profits which compensate for losses, so that there is neither loss nor profit.

                                   

Further full cost prices cover average total costs of production and also yield a fair return on the PSE’s capital investment. Full cost pricing under diminishing returns is presented in the diagram above, where the AC curve cuts the AR curve at point R which determines OQ output and QR price. This enables the enterprise to break even by covering its average total costs of production. It earns normal profit.

            If the PSE has a monopoly in supplying public utility service, it may have increasing economies of scale over a wide range of output, showing increasing returns or diminishing costs. In the diagram, where AC curve cuts the AR curve at a point R under the AC pricing rule and provides OQ services at QR price.

3. Marginal Cost Pricing Rule

            One of the prime objectives of Public Sector Enterprise is to be economically efficient or to maximise social welfare. If a PSE has a monopoly in the production of a good or service, it will not be economically efficient for the reason that it produces where MC = MR. however, for more efficient resource allocation, it is essential to find out whether the PSE is operating under decreasing or increasing returns. If price equals MC under decreasing returns the PSE will incur losses.

            Thus the application of the marginal cost pricing rule to PSE has implications for the financial position of the enterprise. A PSE is usually in a monopolistic or semi monopolistic position so that its AR and MR curves incline downward. In such a situation, price AR is always higher than the marginal cost AR (P) > MC = MR.

            In case the price is higher or lower than the average cost AC, the output will not be of the optimum size for the reason that the enterprise will be earning either supernormal profits or incurring losses. Again the output will not be of the optimum size even if the price of the product of the enterprise should be increased. This is only feasible if the marginal cost pricing principle is followed.

                       
                                                     

            This is represented in the diagram 2, which represents the case of diminishing returns or increasing costs. If the PSE has a monopoly, it will sell OM output at MP price. Thus price is higher than its marginal cost ME by EP when MC = MR at point E. Enforcement of the marginal cost pricing rule makes MC = AR (price) at point K. thus increased output MS is sold at the lower price SK represents that at MP price, the enterprise earns AP profit per unit of output. This output is less than that under marginal cost pricing rule, OM<OS.

            Thus resources are not optimally allocated under monopoly. Conversely, if the average cost pricing rule is followed, AC = AR at point R. the price is further reduced to QR which leads to excess demand for the product as well as the resources of the enterprise. There is misallocation of resources. Thus the marginal cost price combination at point K leads to optimal resource allocation even though the enterprise incurs a loss of LK per unit of output.

            To meet this loss, the government should compensate the enterprise from taxes levied on consumers of the product. If the enterprise is operating under increasing returns or decreasing costs, the marginal cost pricing principle will also lead to losses. This is represented in the diagram 2 where MC curve lies below the AC curve throughout its length. If the enterprise follows MC = MR rule, OM output is produced and sold at MP price.

It earns AP profit per unit of output. But the marginal cost pricing rule sets SK price and OS output combination at point K where MC = AR (price). But is incurs a loss of KL per unit of OS output. Nevertheless, OS is the optimum output of the enterprise under marginal cost pricing.

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