Public Sector Enterprises (PSEs): Top 4 Pricing Policies

The following points highlight the top four pricing policies of public sector enterprises. The policies are: 1. Pricing of Public Utility Services 2. Marginal Cost Pricing Rule 3. No-Profit No-Loss Policy 4. Profit-Price Policy.

Pricing 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 because they are indivisible.

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 a bridge (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. J.F. Due has mentioned the following four rules where public services should be provided free and their costs covered from general taxation.

Firstly, in the case of such services where little waste will occur if they are provided free. Second, where charging a price will restrict the use of the service.

Third, where the cost of collecting taxes is high.

Fourth, where the pattern of distribution of tax burden on services 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, therefore, advocates the compulsory cost of service principle whereby the government should charge a price for the service provided to the people. This is essential because municipal services such as sewage, sweeping street, streets lighting, etc. are underpriced.

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 sort of government subsidy to the users of such services.

However, 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 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 service 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.

The general principle for pricing such public services is to recover costs without distorting the allocation of resources. This is done by making selling price equal to short-run marginal costs while keeping productive capacity constant. But water and power systems periodically require large investments. In such cases, average costs fall as production is increased and the actual price charged is below the average cost.

Charging that price would lead to a loss to the PSE. In such a situation, the public price has to be revised to cover the cost of providing the service. This is usually done by increasing-block tariff or multipart tariff and time-of-use rate structures.

Under an increasing-block or multi-part tariff the consumption of water or power is priced at a low initial rate up to a specified volume of water or power use (block) and at a higher rate per block thereafter. The number of blocks may vary from 3 to 10.

For instance, power charges for domestic light for the first 100 units may be Re. 1 per unit, Rs 2 for the next block of 200 units and Rs.4 for the block of next 400 units and above.

Under the time-use rate structure, consumers pay a premium during periods of high demand. It increases the overall utilisation capacity of the service and also profits of the PSE supplying the service. But its main advantage is that this rate structure encourages consumers to shift demand to lean (off-peak) periods. For instance, time-of-use rates vary by time of day for telephones.

The STD charges in India were 1/4 from 11 p.m. to 6 a.m. 1/3 from 8.30 p.m. to 11 p.m. and 6 a.m. to 7 a.m. and 1/2 from 7 a.m. to 8 a.m. and 7 p.m. to 8.30 p.m., and full charges from 8 a.m. to 7 p.m. till recently. Time-of-use rates vary by season in the case of water supply to agriculture, in the case of LDCs and natural gas for heating purposes in developed countries.

Pricing Policy # 2. Marginal Cost Pricing Rule:

One of the aims of PSEs 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 because 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 earn profits and if it is operating under increasing returns, the PSE will incur losses. Thus the application of the marginal cost pricing rule to PSEs 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 slope 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 because 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 equals the average cost.

To secure optimum resource allocation, the output of the enterprise should be increased. This is only possible if the marginal cost pricing principle is followed.

This is illustrated in Fig. 1 which shows the case of diminishing returns or increasing costs. If the PSE has a monopoly, it will sell OM output at MP Price. This 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. The figure shows 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. On the other hand, if the average cost pricing rule q is followed, AC = AR at point R. The price is further reduced QR which leads to excess demand for the product as well as in the resources of the enterprise.

There is mal-allocation of resources. Thus the marginal cost-price combination at point К 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 shown in Fig. 2 where the MC curve lies below the AC curve throughout its length. If the enterprise follows the 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 it incurs a loss of KL per unit of OS output. However, OS is the optimum output of the enterprise under marginal cost pricing.

The marginal cost price-output combination is also better than the price-output combination under the average cost pricing rule. In the former, the price SK<QR and output OS>OQ. But under the law of decreasing costs, the enterprise adopting the marginal cost pricing rule incurs KL loss per unit of output because the AC curve is above the AR (price) curve.

But this does not follow that the enterprise should not follow the marginal cost pricing rule which gives the optimum resource allocation at OS output.

Various solutions have been offered to this problem. Hoteling suggests that the government should give subsidies to such decreasing cost PSEs to cover the loss by levying lump-sum taxes. Lump-sum taxes do not violate the marginal conditions for consum­ers of firms.

They will, therefore, leave economic behaviour unchanged. If lump-sum taxes, such as poll tax, cannot be levied, the two- part tariff is the other device to cover the loss. According to this, the price which is charged to a consumer consists of two parts.

The first part is the price which is set equal to marginal cost. The second part is a lump-sum tax per period paid by all users. For example, an amusement park may charge an entrance fee and then separate charges for individual attractions such as merry-go-rounds, children’s train, swings, etc., as is done in the Appu Ghar in New Delhi.

The fixed fee (entrance fee) is used to cover installation and maintenance costs and variable charges are imposed to pay for the operating costs of specific items of amusement.

Limitations:

Whichever method is adopted to cover the loss of a PSE attributable to marginal cost pricing, there are associated difficulties.

1. Conceptual and Practical Difficulties:

The calculation of marginal cost in the case of ‘lumpy’ or indivisible factors is difficult to estimate accurately. All factors are variable in the long run. But ‘lumpy’ factors are fixed and their marginal cost is very high. For example, in the case of a flyover it is very high.

But so far as its use is concerned, the marginal cost of using the flyover by an additional vehicle is very negligible. This makes the calculation of marginal cost a difficult work.

2. Administrative Difficulty:

Henderson rejects the marginal cost pricing principle for its administrative non-viability.

He writes:

“The marginal cost principle is disqualified from being the sole or even the main principle of pricing on the score of administrative difficulty. It fails to supply a principle which is clear and unambiguous.”

3. Managerial Difficulty:

When a PSE incurs a loss, it may not be due to MC pricing but the result of general X-inefficiency. It is difficult to separate the two different causes by the loss in practice.

4. Inequitable:

The MC pricing is inequitable. When the loss of an enterprise is covered by general taxation, it is a subsidy which the users of a service or good get from the government. But this subsidy is at the expense of the non-users of the service who are taxed by the government. Thus MC pricing is inequitable.

5. Diversion of Resources:

When the government covers the losses of PSEs by giving subsidies through taxation, it diverts the country’s resources from other more productive uses. This may hamper economic development.

6. Second Best Problem:

Another problem about MC pricing for PSEs is of the ‘second best’. When all prices in all industries are equal to marginal cost, it is called the first best optimum. This is possible if every PSE follows MC pricing rule. But it is possible that some PSEs have a monopoly so that price is higher than MC and it may be impossible to force the price down to the MC level. In this case, the first best position cannot be attained.

What then is the second best position, that is, the next best position actually achievable? There is no theoretical answer to this question because it is not possible to identify the precise nature of the second best solution.

7. Adverse Effects of Taxation:

The levying of additional taxes by the government for subsidization of PSEs leads to adverse effects on the people and the economy. People have to pay more in the form of additional taxes and their ability to save and work is adversely affected.

8. Problems in Two-Part Tariff:

The imposition of two-part tariff in the MC pricing rule involves certain special difficulties in the case of some types of public services.

(a) Economic Loss:

For some public utilities such as national parks, public zoos, amusement parks, etc., the total fixed costs of operations are high. For such services, the principle of MC pricing may lead to an economic loss because the revenues may not be high enough to recover investments in fixed assets.

(b) Congestion Costs:

The overuse of services like an amusement park, zoo, museum or library in the form of overcrowding reduces the satisfaction of the people who visit them. This kind of pollution involves congestion costs which are difficult to estimate.

9. Restrictive Conditions:

According to Prof. Graaf, the MC pricing rule cannot lead to an optimum position unless certain restrictive conditions are fulfilled. They are technological neutrality, no externalities, perfect divisibility of factors, and all PSEs to follow the A/C-price equality rule. But the fulfilment of such a large number of conditions is not possible.

Hence there cannot be optimal allocation of resources. He, therefore, concludes that the only price a public enterprise of nationalized industry can be expected to set is what we may call a just price, a price which is set with regard for its effect on the distribution of wealth as well as its effect on the allocation of resources.

Conclusion:

To overcome some of the difficulties of MC pricing, the principle of peak-load pricing is suggested. According to this, the price of a product or service overtime is adjusted according to the product’s (or service’s) intensity of use, such as in the case of telephone services.

Pricing Policy # 3. No-Profit No-Loss Policy:

Economists like Lewis, Coase, Durbin, Henderson, and little advocate no-profit no-loss policy or the principle of break-even for PSEs. Their contention is that PSEs are meant to serve public interest and not to make profits.

According to Lewis, the price policy of PSEs should be such that they should make neither a loss nor a profit after meeting all capital charges. He further states that what the economists principle supports is not the MC pricing but a system of charging what the traffic will bear’ so that consumers contribute to fixed costs according to their capacity to pay.

Lewis supports this policy on the ground that it prevents over-expansion and under-expansion of PSEs and avoids inflationary and deflationary tendencies. Other economists opine that PSEs should pay their way taking one year with another. They should fix such a price for their products or services so as to break-even over a period of years, making neither losses nor profits.

The no-profit no-loss policy means that the prices of PSE products or services should cover total costs. Total costs include all types 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-part or multipart policy.

The full cost or average cost pricing policy is advocated on the following grounds. 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 concessional rates. Full-cost prices lead to neither 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 illustrated in Fig. 1 where the AC curve cuts the AR curve at point R which determines OQ output and QR price. This price enables the enterprise to break­even 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. This case is illustrated in Fig 2 where the AC curve cuts the AR curve at point R under the AC pricing rule and provides OQ services at QR price.

Limitations:

No doubt the AC pricing principle leads to no-profit no-loss in PSEs, yet it has certain limitations.

1. This pricing policy may lead to mal-allocation of resources when consumers do not buy additional units at the marginal cost.

2. If the demand (AR) curve lies below the AC curve throughout its length, the AC pricing will not give any output. The total costs will not be covered at all.

3. Difficulty also arises in distributing appropriate depreciation over a period of time.

Two-Part or Multipart Tariff:

In order to overcome the above limitations of the AC pricing principle, Lewis, Coase, and Henderson advocate two-part or multipart tariff policy. They divide costs into overhead costs and direct costs. Large infrastructural enterprises like telecommunications, power and water systems have large overhead costs and small direct costs.

In their case, average costs fall as production is increased and the price is below the average costs leading to financial loss.

To avoid such a loss, PSEs should follow two-part or multipart tariff pricing formula. For instance, the price of the service or product is revised to cover the cost of providing the service plus a mark-up leading to multipart tariff. Another way is to charge a fixed annual rent from, say, the users of electricity and a further charge for the actual units consumed every month.

Its Defects:

The system of charging two-part or multipart tariff has certain defects.

1. It is difficult to distribute overhead costs between different products and consumers. In other words, how much is to be covered in the price of the product and service to the consumers.

2. The two-part or multipart tariff policy is applicable only where consumers buy continuously from one PSE and the PSE, in turn, can sell at the average cost price to them.

3. This policy is discriminatory which is unfair and unjust. For instance, charges for electric supply to industrial users are high and for agricultural purposes are low.

Conclusion:

Despite these limitations, both two-part or multipart tariff pricing and AC pricing policies aim at covering total costs. But in both cases resources are not optimally allocated. It is only under MC pricing principle that a PSE is able to allocate resources optimally.

Pricing Policy # 4. Profit-Price Policy:

In developing countries like India where PSEs are required to play a dominant role in economic development, PSEs follow the profit-price policy. The profit-price policy was first put forward in India by Dr. V.K.R.V. Rao in June, 1959. In a Note to the AICC Seminar on Planning held at Ooty, he categorically rejected the theory of no-profit no-loss for PSEs and argued for the adoption of profit-price policy.

Such a policy would make the state utilise its own resources rather than taxing its citizens. According to him, PSEs must be carried on a profit making basis not only in the sense that the public enterprises must yield an economic price but also get for the community sufficient resources for financing a part of investment and maintenance expenditure of the government. This involves a profit-price policy in regard to PSEs.

The theory of no-profit no-loss in PSEs is particularly inconsistent with a socialist economy and if followed in a mixed economy like India, it will hamper its development. In support of his view, Prof. Rao quoted the example of the erstwhile USSR. In the USSR, PSEs made a double contribution to development finance: reinvestment of profits for their own expansion and contribution to the state budget.

Arguments for a Profit-Price Policy:

The following arguments are advanced in favour of a profit-price policy:

1. When the state makes large investments in establishing PSEs, it expects a return in the form of profits in order to augment its resources for the development of the economy.

2. The main aim of every private enterprise is to earn profits. It is, therefore, essential that PSEs should also earn profits and should not be dependent on the state for financial help and subsidy.

3. When PSEs operate side by side with private enterprises and compete with them in such areas as oil, steel, consumer goods, shipping, airways, etc., they should earn profits like private enterprises.

4. Even in the case of those PSEs where the state has a monopoly, it is not desirable to have a no-profit no-loss policy or charge a low price to consumers of the product or service. For there is no guarantee that the users of the product or service will save more on this count. Therefore, the best course is to charge a price which gives a minimum of profit to the PSE which will ultimately go to the state for capital formation.

5. The running of PSEs on profit-price policy will contribute to the general revenues of the state. As pointed out by the Indian Planning Commission “When taxation has its limits, public exchequer should benefit by the surplus of public enterprises. When private sector pays a portion of its profits for general revenues, there is no reason why the public sector should be exempted from this.”

6. When they are operated on profit-price policy, the PSEs earn sufficient profits which can be ploughed back for reinvestment and partly for utilisation by the state in other projects. This reduces the need for borrowing from external sources and debt servicing and even dispenses with deficit financing.

7. Further, surpluses accruing from profit making enterprises provide adequate funds for improvement, modernisation and expansion of the plants in PSEs.

What Profit-Price Policy should be followed?

So far as the actual profit-price policy to be followed by a PSE is concerned, Dr. V.K.R.V. Rao observed: “By and large, as far as the individual firm is concerned the price policy that the manager should follow should not be different from the policy that the private entrepreneur follows. That, however, does not mean that that will be the final price. The final price for a public enterprise should be determined not by the manager or by the board of directors or whoever is the decision making authority but by the government, an authority which takes into account not merely costs and receipts of other enterprises. As far as the manager is concerned, his objective should be the same as the objective of the private manager which is the maximisation of industrial profit.”

Thus PSEs should aim at a reasonable rate of profit.

However, it is difficult to have a particular rate of profit for all PSEs. Further, all PSEs cannot earn profits simultaneously for the following reasons:

First, those PSEs which have not broken-even cannot earn profits because their overhead costs will be high.

Second, in the case of heavy industries, the gestation period is long. Therefore, it takes them a very long period to break-even and start earning profits. At the most, such PSEs pay their way and not run in losses.

Third, in the case of public utilities, public welfare and not profitability is the principal objective. They try to equate MC with price. They lay stress on output rather on the rate of return on investment.

Criticism:

1. Certain economists do not favour profit-price policy in the case of all PSEs. Some advocate a no-profit no-loss policy for public utilities or the marginal cost pricing rule. Others accept the profit-price policy with certain reservations.

2. In cases, where the product of a PSE is used as an input for production in the private sector, a profit- price policy will adversely affect the development of the private industry.

3. If the prices of products of PSEs are rigged up to provide a surplus, the pertinent question arises why consumers of those products should be made to pay a special tax through the back door for the benefit of the state.

4. In those PSEs where the government has a monopoly or semi-monopoly, there is a great temptation on their part to deliberately create huge surpluses by charging the users of their products very high prices. Such a profit-price policy is, therefore, harmful to the society because high prices can lead to a high-cost economy.

The remedy is not to eliminate profit-price policy but to regulate this policy in the interest of consumers and the economy.