OECD Economic Studies, No.

25, /995/11

D E R E G U L A T I O N AND P R I V A T I S A T I O N
IN T H E SERVICE SECTOR

lens H0j, Toshiyasu Kato and Dirk Pilat

TABLE OF CONTENTS

Introduction ....................................................... 38
The role of deregulation and privatisation . . . . . . . . . . . . . . . , . . . . . .. .. . . . . . . 39
The impact of regulations and regulatory reforms: some sectoral evidence . . . . . 42
Distribution ..................................................... 42
Construction .................................................... 48
Road transport .................................................. 51
Telecommunications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5I
Airlines ........................................................ 57
Other network-related services: energy, postal services and railways . . . . . . . . 62
Economy-wide considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Effects on overall performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Extent and changes in service sector regulation . . . . . . . . . . . . . . . . . . . . . . . . . 67
Bibliography ....................................................... 72

The authors are grateful for helpful comments and suggestions by Sveinbjorn Blondal, Andrew Burns,
Kenneth Button, Jorgen Elmeskov, Michael P. Feiner, Robert Ford, Andrew Gurney, Peter Jarrett,
]on Nicolaisen, Michael Oborne, Joaquim Oliveira-Martins, Bernard Phillips, Stefano Scarpetta, Sally van Siclen
and D i m i t r i Ypsilanti. They are indebted t o Laurence Le Fouler, Martine Levasseur,
Brenda Livsey-Coates, Christophe Madaschi, Sandra Rayrnond-Guilbot and josiane Gutierrez for their
assistance.
37/
 INTRODUCTION

Since the early 1980s, structural reform programmes have been implemented in
all OECD countries. Although varying in scale and scope, a common aim of these
reforms was to improve overall economic efficiency and flexibility, hence enhancing
the adaptability of firms and markets in the face of major economic shocks. Thus,
reforms were at least partly based on the assessment that previous regulatory
regimes adversely affected the ability of economies to adapt (OECD, 1994).Given its
large and growing share of OECD output and employment, the service sector has
increasingly become the focus for structural reform programmes.
While trade is crucial in shaping competition for manufactured goods, many
services are not exposed to a high degree of external competition. Therefore,
deregulation and privatisation are the key to shaping competition for services and
the main elements of structural reform. Even if services are exposed to international
competition, domestic producers often tend to have strategic advantages over
foreign competitors, such as closeness to the market or a dominant market posi-
tion. In addition, since services are often produced on the same place as they are
consumed, international competition in services depends in many cases on the
establishment of outlets in each specific market. In itself, this may create an entry
barrier, to the extent that there are constraints on foreign direct investment.
The character of competition differs between service sectors. They tend to be
either highly fragmented or concentrated into natural monopolies or oligopolistic
markets (Oliveira-Martins, 1994; EC, 1993). Examples of fragmented service sectors
are retailing, restaurants, road transport and professional and personal services.
These sectors are typically characterised by atomistic or monopolistic competition,
althaugh the nature of competition can be affected by government regulations, or
rules imposed by professional organisations and associations. Public utilities, com-
munication and railways are generally characterised by oligopolistic (segmented)
market structures, due to high s u n k costs - resulting from the need to invest in
infrastructure - economies of scale or network externalities. In some' cases, a
"natural" monopoly may exist, partly arising from network externalities, and
governments have in the past often created public monopolies to avoid abuse of
market power, limit inefficient entry' or ensure universal access to networks.
This paper discusses some of the available evidence on the impact of regula-
E tory reforms and privatisation in enhancing competition in the service sector.2
 Deregulation and privatisation in the service sedor

Because aggregated (or macro) measures of performance in the service sector tend
to be somewhat unreliable, inter alia because of well-known measurement pro-
blems, the focus here is on micro-based data. The first section discusses some of
the broad trends in regulation and deregulation. The second section first discusses
the impact of regulations in fragmented sectors, focusing on distribution, construc-
tion and road transport. In these sectors, regulatory reform of entry barriers should
in principal ensure sufficient competition, so competition policy is only seldom
required to prevent anti-competitive conduct. The second part of this section dis-
cusses the impact of regulation and public ownership in segmented sectors, prima-
rily focusing on the experience of telecommunications and airlines. In these sectors,
regulatory reform generally needs to be accompanied by competition policy, to
ensure that incumbents do not abuse their market power and that competition is
actually enhanced following deregulation. The final section discusses changes in
the overall regulatory stance and some evidence on the effects of reform efforts on
overall performance.

THE ROLE OF DEREGUJATION AND PRIVATISATION

The traditional rationale for government regulations is, to a considerable
extent, related to market failures. For example, the market conduct of firms may be
regulated if there are significant externalities, such as those deriving from
investment in infrastructure or networks. In addition, governments may wish to
control some industries to stabilise economy-wide developments in prices and
employment. For instance, part of the regulation of the financial sector typically is
intended to stabilise the macroeconomic environment in general and capital mar-
kets in particular. Finally, in many markets a high degree of information asymmetry
may arise, for instance because of a high information content of a product or
service. To ensure well-functioning markets, governments may therefore impose
standards and other requirements on the provision of product information by
suppliers.
The trend of regulatory policy in OECD countries has shifted towards deregula-
tion over the past two decades, with an increasing emphasis on promoting competi-
tion. A number of developments have contributed to this shift in policy. First, it has
been widely recognised that traditional regulatory instruments can result in serious
efficiency losses. Such losses result either from regulations that restrict entry
-which reduce output below competitive levels and can contribute to high cost and
price levels, even in fragmented sectors such as distribution or professional ser-
vices - or from regulations concerning conduct (e.g. fixing of prices, quantities or
services) - which act to limit innovation and entry if prices are set at a tow level, or
boost rents to excessive levels if prices are set too high. Second, changing techno-
logy has motivated policy makers to re-evaluate traditional policy instruments, in
particular with regards to the regulation of natural monopolies. In telecommunica- 39/
OECD Economic Studies. No. 25. 1995l11

tion services, for example, changing technology is increasingly allowing entrants to

challenge monopolised incumbents by bringing down entry costs, while also crea-
ting both a demand for and supply of new information services, thus expanding the
potential benefits from regulatory reform. Third, the globalisation of OECD econo-
mies is forcing economies to adapt and adjust to changing circumstances. Fourth,
the opening-up of capital markets and free trade areas such as the European single
market have eroded many of the barriers to foreign direct investment, which has
increased the degree of international competition in many service industries.
There has also been a shift over the past decades in the evaluation of public
ownership in network services. Public ownership is currently often considered to
reduce incentives for efficient resource allocation, both in terms of improvements in
internal efficiency (cost-minimisation)and allocative efficiency (pricing according to
marginal cost) (see, among others, Pera, 1989).In general, privatisation can help to
improve internal efficiency stimulated by the profit-seeking behaviour of private
agents. The potential gains in allocative efficiency following privatisation depend
critically on the incentive structure, i.e. the regulatory framework and the degree of
Competition facing the firm. In addition, competition policy may be required to
prevent privatised firms from abuse of their strong, often monopolistic, position as
incumbents. Empirical studies suggest that in competitive environments, publicly-
owned firms tend to have a narrower market focus, although in sectors with an
element of natural monopoly it is not always obvious that private companies
perform better (OECD, 1994; 1995). However, in general, the principal barrier to
competition in many services is not the existence of a high degree of public
ownership in itself (OECD, 1994), but the regulations which governments have
imposed on entry and conduct in such sectors.
For most network services, such as telecommunications or energy supply,
privatisation by itself is insufficient to obtain a competitive market. If a newly
privatised company retains its monopoly position, privatisation will result in a
transfer of market rents from public to private hands. However, the adverse effects
of monopolisation can be mitigated through regulation (Box 1 ). Market structures
can also be influenced to enhance greater competition. For many network services,
the delivery of the final product to the consumer typically involves a set of distinct
economic activities, for example the generation, transmission and distribution of
electricity. Separation of activities, either by ownership or by management, makes it
possible to implement competition in some activities, while others, primarily the
basic network or infrastructure services, retain strong monopoly elements. If
ownership or management are not separated, but competition is introduced by
other means, it is important to allow new entrants interconnection with existing
networks on fair and equal terms. The following section analyses the impact of
L!KL regulation and deregulation in a little more detail, on a sectoral basis.
 Deregulation and privatisation in the service sector

Box 1 . Frameworks to regulate monopolised markets

“Light hand” regulation is based on the assumption that a newly privatised

enterprise’s market is contestable, with potential hit-and-run entry forcing the
incumbent to operate as if being in a competitive market. However, high sunk costs
and an incumbent’s reaction to entry imply that monopolistic markets can seldom
be described as contestable (Vickers and Yarrow, 1988).Newly privatised companies
often enjoy a dominant or monopoly position. Surrogate competition can be imple-
mented through other regulatory frameworks.
Competition for monopoly, franchising,arises when firms bid for the operation
of a service over a given period (Demsetz, 1968; Baron, 1989).The system demands
little regulatory control and removes the information asymmetry problem for the
regulator as bidders reveal the franchise’s true value. However, the system faces a
number of problems, such as possible collusion between bidders, strategic advan-
tages for the incumbent, asymmetric information between bidders, sunk cost (or
asset hand-over) considerations and the difficulty of constructing contracts in the
face of changing markets and technology. Franchising is, for instance, used in the
licensing of television channels in the United Kingdom.
Yard-stick competition is used when the cost performance of several local
monopolies determines the allowed price increase for a particular local monopoly.
A firm is only allowed to increase prices in line with the cost-development in the
industry’s yard-stick. Hence, the firm cannot pass on increases in its own costs, and
can only maximise profit by minimising costs,which in itself puts downwards cost
pressure on the yard-stick. The system provides pressure towards cost minimisation
and price movements towards the competitive level. Yard-stick competition can
only be introduced in markets where local monopolies face similar demand and
supply conditions, such as water companies, thereby limiting its use. Yard-stick
competition faces a problem of asymmetric information, may lead to collusive
behaviour, and provides no incentive to encourage new entrants.
RPI-X regulation is a framework that allows prices to increase by the retail price
index (RPI) minus a given percentage (X), that reflects projected efficiency gains
(Armstrong et al., 1994).RPI-X rules increase internal efficiency, since the regulated
firms may keep realised gains above X, while part of the efficiency gain is passed on
to the customers through X, thereby improving allocative efficiency. Allowance is
often made for passthrough of unforeseen costs outside the firm’s control. The rule
is simple and imposes an arms-length relationship between the regulator and
enterprises, thus minimising regulatory capture. The rule is widely used in the UK,
extending to almost 50 firms and has been applied to ATT since 1989. However, the
rule requires regulatory commitment, whereas a problem may also arise in setting
the initial price and the value of X.

(continued on next page)

OECD Economic Studies, No. 25, 1995l11

(contin ued)

Rate of return regulation allows prices to increase by a certain amount to

secure a given rate of return (Stewart-Smith, 1995) When the enterprise demands a
review of prices (tariffs),its operating costs and capital requirements are examined
to determine a fair rate of return. Together with assumptions concerning demand
conditions the overall revenue requirement is calculated, and the appropriated
tariffs are derived. The method is cumbersome and complicated, with a large risk of
regulatory capture. In addition, there is no incentive for cost minimisation and the
introduction of new technologies, since the rule calculates the rate of return for a
given capital stock.

THE IMPACT OF REGULATIONS AND REGULATORY REFORMS:

SOME SECTORAL EVIDENCE
Distribution
The distribution sector accounts for between 8 and 18 per cent of CDP across
the OECD area and for between 10 and 20 per cent of total employment (Table 1 ) .
The large size of the sector and its role in channelling goods from producers to
consumers, makes its performance quite important from an overall perspective on
the economy. There are, however, substantial differences in the relative size of the
distribution sectors across the OECD. It is particularly small in Germany, Ireland
and the Nordic countries, and largest in Australia and the United States.
A substantial number of regulations affect the competitive situation of the
distribution sector. Zoning laws limit the establishment of new outlets to certain
areas. Such legislation is generally intended to protect the environment and contri-
bute to urban planning. Such laws can, however, contribute to high land cost for
retail outlets and may thus contribute to high price levels. They may also work as an
entry barrier for new shops and thus limit competition. Zoning laws exist in all
OECD Member countries, although there is considerable differentiation in how
restrictive they are (Table 1 ) . 3
Shop-opening hours are also legally restricted in various countries. Such res-
trictions were originally intended to provide shopkeepers with a common pause
day, while at the same time creating a level playing field for competition. However,
in addition to limiting consumer choice, these restrictions particularly protect
small, owner-operated shops, for whom it is more difficult to expand opening times.
Larger stores have more employees and can use part-time work and flexible
W working-time arrangements (provided these are legally permitted) to fill staffing
 Table 1. Performance and regulation in the distribution sector
-~ ~~~~~

Annual Annual Average Regulations

Annual average average average Share Of Distribution Retail outlets size of retail
growth of real distr'bution share in total per 10 000 outlets Maximum
productivity employment
output in output in
distribution growth I n growth I n total cDp employment inhabitants (in persons opening hours,
employed) 'pening Zoning laws
1979-94 distribution distribution 1993l I990 hours 8am-24pm
1993
1979-94 I 1979-94 I990 I990

United States 23 08 15 I5 7 20 5 79 96 UNR PAR I12

lapan 34 22 I 1 12 5 I8 4 132 42 PAR REC n.a.
Germany 27 08 18 78 II 3 85 44 REG R EG 60.5
France 19 18 01 12 2 13 8 97 38 PAR PAR n.a.
Italy 19 20 -0 0 15 3 193 171 4 24 R EG R EG 66
United Kingdom 19 19 -0 0 I2 8 17 I 81 65 PAR PAR 67
Canada 24 10 14 I0 0 I6 4 n a. na na PAR n.a.
Australia 30 13 17 I7 9 20 8 90 67 na PAR n.a.
Austria 21 13 08 12 8 I4 4 69 48 R EG R EC n.a.
Belgium 19 19 -0 0 I5 4 I5 9 141 20 PAR REC 73
Denmark 19 17 01 10 7 10 8 I00 39 R EG R EC 63.5
Finland 19 26 -0 7 84 12 5 77 41 R EC R EC 80
Greece 15 06 09 96 15 5 I84 18 UNR R EG 112
Iceland 21 08 13 89 II 9 67 47 na PAR n a.
Ireland 39 37 02 79 143 90 42 UNR PAR 112
Netherlands 18 08 10 12 7 I6 2 92 53 PAR REC 55
New Zealand 20 15 05 1685 12 4 95 46 UNR PAR 112
Norway 27 23 05 97 13 9 94 32 PAR PAR 80
Portugal 26 19 07 14 I 13 2 I92 20 UNR PAR 112
Spain 23 26 -0 2 I4 2 I6 7 I 34 28 UNR PAR I12
Sweden I2 17 -0 4 83 II 9 94 39 UNR PAR I12
Switzerland 12 12 05 I4 7 13 9 83 68 REG REC n.a.

I CDP per person employed

2 Or latest available year
3 UNR = Unregulated PAR = Partially regulated REC = regulated
4 In s o m e countries local governments can allow opening hours t o deviate from legal requirements and maximum opening hours may differ
5 Including restaurants and hotels
Source ISDB and OECD National Accounts Outlet density and average size from EC ( 1993a) and national sources Real expenditure on goods from OECD Purchasiiig Power Parities a n d Real
Expenditure 1990 Vol 1 EKS results Paris 1992 Regulations from EC (19931 McKinsey (19941 OECD EconomicSurveysand national sources Maximum opening hours from Kremers
et a / 1994

k
OECD Economic Studies, No. 25, 1995111

requirements (McKinsey, 1994) The general trend towards more flexible working-
time arrangements by consumers, employers and employees, as well as the rise in
part-time work, have put such restrictions under increasing pressure. Regulations
on shop-opening hours differ substantially across the OECD (Table 1 ) . In a few
countries, including the United States, Ireland, New Zealand and Sweden, no legal
restrictions exist, although in some cases local governments may apply certain
restrictions. In others, including Italy and Germany, and, until recent legislative
changes, Denmark and the Netherlands, opening hours are more restrictive.
In a few countries, notably Belgium, France, Italy and Japan (EC, 1993; EC 1994;
McKinsey, 1994), existing retailers can - despite reforms in this area - block the
establishment of new shops under legislation aimed at large stores. This effectively
creates an entry barrier, in particular if incumbent firms are consulted with regards
to the implementation of such laws. In particular in Italy and japan, but also in
Belgium, such laws appear to have effectively slowed down the move towards larger
stores and protected small, owner-operated shops. This type of legislation may
reduce the efficiency of the distribution system, which is closely linked to the size of
establishments. In larger stores, sales per employee tend to be 50-80 per cent
higher than in the smallest size class (OECD, 1992). There has been a general
tendency in the OECD area to move towards a larger average establishment size,
and consequently a lower density of retail outlets (Figure 1 ), but in some countries
zoning laws or restrictions on large stores appear to have limited such changes.

Figure I . Outlet density in food retailing for selected OECD economies

Numbers of outlets per I 000 inhabitants

12 12

Source: OECD Secretariat.

 Deremlation and brivatisation in the service sector

Substantial differences remain in the OECD area regarding the average size of
retail establishments (Table 1 ). Establishments are particularly large in Australia
and the United States, and relatively small in Italy, Belgium, Greece, Portugal and
Spain. Some estimated equations for the average size of establishments across the
OECD area are shown in Table 2.4 As incomes rise, there is a strong tendency for
establishment sizes to increase (OECD, 1992). Moreover, a higher average size of
outlets is associated with lower average price levels, consistent with the notion that
larger outlets increase the overall efficiency of the distribution system. Two dum-
mies for regulatory regimes, one reflecting zoning laws*and the other large-scale
restrictions, are included in the equation. Both dummies have the expected sign
and the coefficient on the dummy for large-scale restrictions is significant, indica-
ting that these restrictions may slow down growth in the average size of esta-
blishments. It is evident, however, that many other variables influence the average
size of retail outlets, and economic factors tend to explain most of the variation
across countries (OECD, 1995b).
Further evidence to this effect is provided in Table 3 that updates the results
from an earlier OECD study (OECD, 1992).5The table shows an estimated equation
for the density of food retail outlets, covering France, Germany, Italy, Japan, the
Netherlands, Sweden, the United Kingdom and the United States. Three dummies
are included to represent regulatory restrictions on large-scale outlets. Among the
countries covered, only France (Loi Royer - 1974), Italy (Commercial Law - 1971)
and Japan (Large Scale Store Law - 1973), have specific restrictions on large-scale
outlets (OECD, 1992; McKinsey, 1994),even though these have been eased somew-
hat over the past decade. The dummies for Japan, Italy and France are highly
significant and would, if rendered inoperative, lead to a substantial fall in the
predicted number of food retail outlets, in particular in Japan and Italy. This result
suggests that the removal of entry-restricting regulations on large establishments
could lead to substantial efficiency gains in the distribution sector. Potential gains
include reduced consumer prices (Table 2 ) and increased output of distribution
services.
Furthermore, in regulated distribution systems, it is likely that product variety
has been constrained. In addition, consumers have been confronted with additional
costs, as their ability to purchase goods where and when they wanted to has been
constrained. In addition, these rules have prevented structural change in the retai-
ling industry and the sector has moved relatively slow to high value-added and high
productivity formats in countries with strict regulations (McKinsey, 1992; Baily,
1993). .
A lack of competition in the distribution sector can also arise from vertical
restraints. Producers can impose restrictions on distributors, both with regards to
the prices being charged (e.g.resale price maintenance) or to the non-price aspect
of the distribution process (e.g. exclusive dealing or territorial restraints). 3
/s
Table 2 . Equations modelling the average size of retail outlets, 1990
( A b s o l u t e values of t-statistics in p a r e n t h e s e s )
Dependent variable: average employment size of retail outlets

Standard
Real income Large scale Zoning laws* Price level
R2 error of the F-statistic
level Restrictions* of goods regression

Equation 1 00517 -1 991 0 549 I 268 24 35

( I 6 122) ( 2 812)
Equation 2 0 0543 -1 776 -0 633 0 577 I259 12 98
(13 762) (2 437) ( I 130)
Equation 3 0 0787 -2 194 - 00217 0 678 I 099 I9 99
(7 723) ( 3 548) ( 2 757)
Equation 4 0 0786 -2 063 -0 350 -0 0204 0 686 I115 13 12
( 7 604) ( 3 148) (0 687) ( 2 497)
* These variables are dummies taking a value of zero for mild restrictions under zoning laws and no specihc restrictions on large scale stores, and one for restrictive
zoning laws and large-scale restrictions, respectively
Sources Equations cover the 22 countries shown in Table I , excluding Canada. but including Luxembourg
 Dereeulation and brivatisation in the service sector

Table 3. Equations modelling the density of food retail outlets

Food retail outlet density
Independent variable

Constant 3.5963* * 4.6264**

(4.753) (9.2 15)
Urban concentration 0.8181** 0.9271 * *
(5.181) (8.260)
Car density -1.876* * -1.266* *
(3.178) (3.522)
Relative price of land -.0269* * -.O 17 1 * *
(2.671 ) (2.752)
Female labour force participation rate -2.764* * -1.550**
(4.022) (3.633)
Population density 1.6695* * 1.3423**
(8.398) (10.803)
Personal consumption -.4199 -3.2595* *
(0.283) (3.568)
Japan dummy .. 0.6918**
.. (9.289)
Italy dummy .. 1.0462' *
.. (16.053).
France dummy .. 0.4392**
.. (5.772)
Summary statistics
R2 0.7197 0.90 12
Standard error of the regression 0.4 185 0.2505
F-sta t i st i c 80.44 187.49
Number of observations 195 I95
Absolute levels of t-statistics are i n parentheses
** Indicates significance at the 1 per cent level
* Indicates significance at the 5 per cent level
Source OECD calculations

Governments can counter such behaviour by competition policy. Price restraints are
generally prohibited in all OECD countries (OECD, 1994a),whereas non-price res-
traints are sometimes tolerated (OECD, 1992).However, recent research has conclu-
ded that - in some cases - vertical restraints may have efficiency-enhancing effects
and help to improve resource allocation.6 In addition, vertical restraints are unlikely
to affect overall competition if the vertically restrained combination faces vigorous
competition, even if this is from outside a narrowly defined market (OECD, 1994a).
Competition policy is therefore confronted with a range of possible outcomes,
suggesting that a complete prohibition of vertical restraints may be inefficient.
Reflecting these views, a number of countries, including Germany and the United
States, have recently softened their legislative stance against vertical restraints. 47 I
OECD Economic Studies, No. 25, /995//1

Deregulation of the distribution sector has been implemented in many OECD

countries. An evaluation of the liberalisation of shop-opening hours in Swedish
food retailing suggests that output and employment increased and that prices fell
somewhat (Civildepartmentet, 1991 ). Regulations on large-scale stores were eased
in Japan in 1992 and 1994, and the evidence suggests that competition has increa-
sed and that price levels have fallen somewhat (OECD, 1993; 1995b). Deregulation
in the United Kingdom also appears to have had broadly positive effects (OECD,
1994b). Studies for France (Cette et al., 1992) and the Netherlands (Kremers et al.,
1994) suggest that a (further) liberalisation of shop-opening hours would positively
affect output and employment and contribute to lower price levels.

Construction
The construction industry consists of a large number of small companies,
although in non-residential construction and civil engineering, larger companies
play a significant role and some market power is likely to exist, at least at the local
level. The industry is in most countries affected by a large number of regulations
regarding land use, building standards, planning permits, building inspections and
rent (EC, 1994; McKinsey, 1994). In addition, labour, health and safety regulations
play a significant role. To some extent, such regulations and standards are neces-
sary as they serve to protect workers and consumers and simply create a level
playing field for suppliers. Excessive or unnecessarily complicated standards may,
however, contribute to high price levels for residential construction (OECD, 19944
and may restrict consumer choice. They may also contribute to discrimination
against foreign contractors or serve as a barrier to trade in construction materials
and service^.^
Some performance measures for construction are provided in Table 4.8 Except
for Japan, Canada and Sweden, output growth in the construction sector has been
very limited, and employment in most countries has actually fallen. Productivity
growth over the period 1979-92 was relatively strong in Japan, France, the Nether-
lands and Sweden. Productivity growth in the United States was by far the lowest in
the OECD area, but the productivity level of the US construction industry is among
the highest in the OECD, suggesting that some of the productivity growth in OECD
economies may have been due to a catch-up effect.
The price (i.e.cost) levels of construction expenditure deserve particular atten-
tion in assessing perf~rmance.~ Price levels are partly related to labour costs and
partly to the price and availability of land. An equation that links the price level of
construction expenditure to hourly labour cost and to population density is shown
in Table 5. The latter variable serves as a proxy for land availability and land prices.
The lack of comparable cross-country policy variables, and the inherent complexity
L?.-.! and heterogeneity of regulations, did not allow for a numerical assessment of the
 Table 4. Performance measures for construction
Real
Annual average Share of Price level of construction Comparative
Productivity Share of construction in construction productivity
growth of real growth lob creation expenditure
output construction in total expenditure, per capita, level in 1990
1979-92 ' 1979-922 1970-19903 total CDP, 1992 employment,
I992
1990
(OECD= loo)
1990
(OECD = 100)
(USA = 10014

United States -0.6 -1.2 16 4.0 5.1 79 101 I00

Japan 2.4 1.8 20 9.7 9.3 130 142 80
Germany 0.7 1.1 -10 6.0 6.7 1 I8 101 76
France 1.1 2.4 -1 I 5.5 7.2 94 I13 80
Italy- 0. I 0.2 -1 1 5.6 7.4 I00 85 83
United Kingdom 0.5 1.7 3 6.2 5.8 1 I7 60 62
Canada 1.7 I .3 20 6.9 5.6 77 172 140
Australia 0.9 0.1 12 6.8 7.0 82 121 103
Belgium 0.3 I .7 -10 5.8 7.0 I00 87 90
Denmark -2.0 -0.2 -16 5.2 6.3 128 87 66
Finland 0.5 I .5 1 6.1 7.3 I24 I59 94
Netherlands 0.4 2.3 -1 5 5.7 7.2 1 I8 77 70
Norway -0.2 0.2 6 4.2 6.9 98 105 69
Sweden I .6 2.2 -1 3 7.3 6.3 152 87 75
I United States 1979-91, Norway 1979-90 and Italy 1979-93
2 CDP per person employed, United States and United Kingdom 1979-91, Norway 1979-90 and Italy 1979-93
3 Number of lobs created in construction. per I 000 persons of working-age Adlusted for labour force growth, 1970-90
4 CDP per person, adlusted to a common currency with relative price level from OECD (1993a)
Sources ISDB, Comparative price level for construction expenditure and real expenditure per capita from OECD, Purchasing Power P a m e s and Real Expenditure 1990,
Vol 1 EKS results, Paris 1992
OECD Economic Studies, No. 25, /995/11

Table 5. Equation modelling the price level of construction expenditure, 1990

(Absolute values of t-statistics in parentheses)
Dependent variable is construction price level

Population Standard
Hourly
Constant labour costs density R2 error of the F-statistic
(in logs) regression

Equation 1 39 37 2 877 4922 0 541 16 00 1 1 17

( 2 71 1 ) ( 4 110) ( 2 094)

Note Equation covers all OECD countries, except Mexico for which no construction price level was available, and Turkey
and Iceland, for which no hourly labour costs were available Hourly labour costs refer to production workers i n
manufacturing, as no hourly labour costs were available for construction
Source Hourly labour costs from BLS ( 1 994), Population density from OECD, Main Economic Indicators

effects of these regulations. However, the results of the standard regression indicate
that price levels in some countries, including Denmark, Finland, Japan, Sweden,
Switzerland and the United Kingdom, are higher than suggested by the equation.
These countries also tend to have a relatively low level of productivity indicating a
substantial potential for catch-up.
While the complexity of regulation makes their effects difficult to quantify,
regulatory barriers or other types of anti-competitive conduct have been identified
in several of the countries where price levels are higher than suggested by the
regression equation, suggesting that there is a link between regulations and perfor-
mance across OECD economies. In Sweden, regulations are in place that can
potentially impede competition at all stages of the building process (OECD, 1992a),
including regulations applying to foreign contractors, rents and housing support
measures. In Japan, government regulations facilitate exclusionary practices, such
as bid-rigging, although restrictions on land development also play an important
role here (OECD, 1992b). In Switzerland, cartelisation and segmentation of local
markets in building materials and construction, and uncompetitive tendering arran-
gements for public works, appear to have contributed to high price levels (OECD,
1992~;OECD, 1994~).In Finland, there is a considerable degree of horizontal
concentration, with four enterprises accounting for about 35 per cent of turnover
(OECD, 1991 ), whereas technical standards appear to discriminate against imports
of building materials. In addition, construction companies and building material
producers are often vertically integrated. The allocation of land for construction also
involves some restrictive practices. Similar restrictive practices have been identified
for Denmark (OECD, 19936).
 Deregulation and brivatisation in the service sector

Road transport
Road freight and passenger transport used to be among the most heavily
regulated sectors in the OECD area (OECD, 1990). Over the past three decades
OECD economies have progressively abandoned many regulations that restricted
the number of licenses and therefore entry to the industry, while freight rates were
also deregulated. In contrast with road freight, only a few countries (notably the
United Kingdom and New Zealand) have introduced reforms in the road passenger
transport sector, which remains subject to extensive regulation in most OECD
countries.
The effects of deregulation in road transport have generally been positive, in
particular with regards to freight services (Table 6). Following deregulation, freight
rates generally declined, services expanded and the efficiency of freight service
providers increased substantially. The experience with the deregulation of intercity
and local bus services is more limited. In the United States, the deregulation of
long-distance services led to a sharp restructuring of the market, with fares falling
but some services being cut. An important factor in the restructuring of the industry
was the sharp competition from private automobiles and the deregulated airline
industry (see below). In the United Kingdom, the experience is less positive as the
dominant position of the national carrier, in particular with regards to inner city
terminal facilities, forced new entrants out of the market which subsequently led to
an increase in prices.

Telecommunications
The market structure in telecommunications differs somewhat for each of the
various market segments (Table 7). Voice telephony remains dominated by large,
often public, monopolies, whereas the markets for data transmission and mobile
communications are slowly becoming more competitive. In general, only the mar-
kets for equipment and value-added services are fully competitive. In Europe
governments are still heavily involved except in the United Kingdom, while Austra-
lia, New Zealand and japan have a somewhat lower degree of public ownership.
There is no public ownership in Canada and the United States.
Historically, the industry was characterised by high sunk costs, and most
governments regarded the market as being a natural monopoly, justifying public
ownership or strict regulation. In addition, a large public role has often been
justified by the need for universal access to telecommunication services. Technolo-
gical progress is currently enabling new entrants to provide new services, challen-
ging incumbents, for instance by allowing high-speed links, voice mail or call-back
services. Such new services are effectively removing national-based monopolies
on international calls and are enhancing the degree of competition in the sector.
The rapid pace of technological progress is also resulting in a lowering of entry 3
 Table 6. Gains from deregulation in road transport

Effects
Periods and
type of Notes3
Rates and Service
d ereguI a t i on I Entry
fares quality2

Australia Freight: UP DOWN UP - (F) Concentration of ownership has increased (two largest firms
1950s and control 60% of the road freight market).4
1960s (e, p)
- (F, P) lntermodal competition between road and railroad transport
has increased.
Passenger: UP DOWN UP - ( P ) Trial period of deregulation of intra-state bus services in New
1986-87 (e, p ) South Wales (Sydney-Canberra and Sydney-North Coast).

Canada Freight UP DOWN UP - Deregulation of both inter-and intra-provincial road transport;

profits in the industry have generally fallen.

France Freight: UP DOWN - The number of transport authorisations doubled between 1974 and
1979-89 (e, p) 1987. Price levels fell by 6.4% for short-zone traffic, and by 3.4%
for long-zone traffic following the I986 deregulation.

New Zealand Freight : UP UP - lntermodal competition with railroads has increased, and
1983 (e, p, s ) employment has expanded.

Norway Freight: UP - New licences issued in 1987 exceeded those in 1986 by 41%.
1987 (e, p, s )

Sweden Freight : UP - (F) Progressive deregulation since 1964, resulting in a large influx
1964 (e) of new entrants.
Passenger: - ( P ) Introduction of a new tendering system for scheduled bus
late 1980s services has lowered procurement costs.
 Table 6. Gains from deregulation in road transport (cont’d)

Periods and Effects

type of Notes3
Rates and Service
deregulation I
fares quality2

United Freight: UP UP - (F) The stability of markets - prices, turnover rate, safety - was
Kingdom 1968 (e, P. s ) maintained after deregulation.
Passenger: UP DOWN UP - ( P inter-city) National Express continued to dominate the markets for
in ter-city (and UP inter-city bus services, yet some 15 firms survived by specialising in
1980-85 later) one or two routes offering high quality services Entry into commuter
(e, P* s ) service markets to London increased steadily, creating inter-modal
competition with trains and subways.
local UP DOWN in UP - ( P local) The National Bus Company was split into 72 companies and
some privatised completely in 1988. Private companies have introduced
areas minibus services (10-15% of the total stock of vehicles in use in
(UP in 1989).
others)
United States Freight: UP DOWN UP - (F) The number of carriers and intermediaries doubled between 1979
1980 (erP, s ) and 1985, but most new entrants were small firms with less than
$ I million annual revenue, and as a result, overall concentration
increased slightly.
Passenger: UP DOWN - (P) Entry into the chartered bus service market increased significantly.
i nter-ci ty in some
1982 (e, P, s ) routes
I . Types OF deregulation: e = entry; p = prices; s = services.
2. Service quality mainly includes routes serviced, safety levels and improvement of Facilities and equipment.
3 . ( F ) notes regarding freight transport. (P) notes with regard to passenger transport.
4. Data From Sleuwaegen. L. (1993) “Road Haulage”, in European Community, European Economy: Market Services and European Integration. No. 3 , Brussels
Source: OECD ( l990), Competition Policy and the Deregulation of Road Transport. Paris.
OECD Economic Studies, No. 25, /995/11

Table 7. Ownership status and level of facilities competition in I994

Degree of comDetition
Data comms
Ownership Network competition and leased lines Mobile communication

EUROPE Local Trunk International X.25 Leased lines Analog Digital Paging

Austria
Belgium
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
.*.., r r r

Swiaerland
Turkey
United Kingdom

NORTH AMERICA
Canada PRI C C C C

United States C C C C C C
Local and
inter-exchange carriers PRI
Long distance and
international
exchange carriers PRI

PACIFIC
Australia C C
Japan C C
N e w Zealand C C

Ownership: PUB = public; MIX = mixed; PRI = private.

Key: C = Competition, D = Duopoly, PC = Partial Competition, RD = Regional Duopoly, M = Monopoly, 9x = Competition
expected to be introduced this year.
Intercontinental Canada-US traffic, which constitutes 70 per cent of international traffic originating in Canada, is handled by
Stentor regional telcos, Unite1 and resellers on a competitive basis.
Intercontinental (non-Canada-US) traffic is carried by Teleglobe; international resale since I99 I .
Source: OECD (I 995), Communication Outlook, Paris.

costs for new entrants, leading governments to reconsider their regulatory frame-
work. As a result, there has been a marked trend towards a liberalisation of telecom-
Lk!-! munication services over the past decade. A few countries (New Zealand and the
 Deregulation and privatisation in the service sector

United Kingdom) have also completely privatised their public telecommunication

operators (PTOs), whereas several others (including Japan, Denmark and the
Netherlands) have partially privatised their PTOs.
The effects of privatisation and regulatory reform have been considerable
across the OECD area, in respect to both prices and connections {OECD, 1995~).
There has been a general move towards more efficient pricing with a move from
usage towards fixed charges, reflecting the high fixed and low marginal cost of
providing telecommunication services. Furthermore, the cross-subsidisation of local
calls at the expense of long-distance calls has diminished. Over the period
1990- 1994, in countries with competitive telecommunication industries, the price of
local calls increased by 14.9 per cent, whereas that of long distance calls dropped by
between 18 and 35 per cent (depending on the distance)." In contrast, in non-
competitive countries, the price of local calk increased by 20 per cent and the price
of long distance calls fell only with between 12 and 16 per cent (OECD, 1995~). From
1990 to 1994, total business charges decreased by 8.6 per cent in countries with
competitive telecommunication industries, while in non-competitive countries the
fall was only 3.1 per cent. The difference is even bigger for total residential charges,
where private consumers in competitive countries enjoyed a 3.1 per cent fall compa-
red with a 8.7 per cent increase in non-competitive countries (Figure 2).
In general, the improvement in technology and the rationalisation of activities
(partly by increased out-sourcing) has substantially increased productivity in PTOs.
However, new products and services have developed outside the traditional domain
of the PTOs, and the overall demand effect of product innovation and reduced price
levels has been to increase output in the telecommunications industry substantially
(OECD, 1995~)'while keeping employment roughly constant. Case studies have
been made for japan and Finland. Since the 1985 privatisation of Japan's Nippon
Telegraph and Telephone (NTT), as many jobs were created by new entrants in the
industry as were lost by NTT. The gradual liberalisation of the Finnish telecommuni-
cations market since the mid- 1 %OS, also resulted in substantial employment
growth, with more jobs being created outside the traditional PTO than were lost by
the PTO over the same period (Ministry of Transport and Communications, 1995).
Privatisation is generally insufficient to ensure competition as can be observed
from the UK experience. The privatisation of British Telecom (BT) in 1984 did not
initially lead to significant changes in performance, as the monopoly was simply
replaced by a duopoly (BT and Mercury). Competition only increased in 1991, when
entry restrictions were eased and more than eighty operators applied for licenses
- of which 45 were granted - to compete in different segments of the market.
Currently, BT still has about 90 per cent of the telecommunications market, mainly
due to its dominance of the basic network. In general, privatisations should be
accompanied by an effective competition policy that allows for new entry and
ensures a level playing field in terms of competition, technical standards, and equal -,=%!-
OECD Economic Studies, No. 25, 1995/11

Figure 2. The impact of competition on telecommunications charges

Index I990 = 100

Business users Residential users

Fixed charges
I35 I35
/*-
I30 *--------_c# I30
I25 '4'' I25
'
& '
. Non-competitive
I 20 A/
,/ I20
Non-competitive #/'-

I15 --.Hoe ,/' I15

/
0 H F#o.*-- /
I10 I 10
,/'/ /
0 Competitive
I OS
105
# -
100 / 0
' Competitive
I00
95 95
I990 91 92 93 94 1990 91 92 93 94

Usage charges
I10 I10

I05 h I05
Competitive
1 00

95

90
85
,
I990
Non-competitive

91 92 93
\
94 1990 91 92 93 94
95

90

85

Total charges
I10 I10

I 05 ,/
---------------
f
OH.#
&&-

I05
/
Non-competitive 0'- Non-competitive
J 0

I
loo I00
------ 7
Competitive
1
95 95
Competitive

90 90
I990 91 92 93 94 1990 91 92 93 94

Source: OECD (I 995),Communicotions Outlook, Paris.

t.J.!L
 Deregulation and privatisation in the service sector

and fair access between different operators' networks. Indeed, the challenge for
regulators in the coming years will be to adjust the regulatory framework to comply
with the rapid changes in technology, the introduction of new products, and new
structures, so the continued development and expansion of the telecommunication
industry are not hampered.

Airlines
The structure and regulation of the air transport market generally differs between
domestic and international services. In the majority of OECD economies, public
monopolies dominate domestic flights. The principal exceptions are the US and Cana-
dian domestic markets, which are highly competitive. Recent EU-legislation has crea-
ted a framework that should help, in principle, to make the internal EU market more
competitive. Australia, Canada, Japan and New Zealand have recently taken steps to
further increase competition in their domestic markets. In general, international ser-
vices are regulated through bilateral agreements. For example, each European Union
country has 60 to 70 bilateral agreements with third countries (Good et al., 1993). Even
so, on very high volume routes, such as transatlantic flights, customers can choose
between various alternatives, thereby stimulating competition.
Economies of scale are relatively limited in the industry, the main exception
being off-flight activities, such as aircraft maintenance.I2 On the other hand, there
are substantial economies of scope and revenue related to the ability of an airline
to connect flights.13This happens typically through hub-and-spoke operations (pre-
dominant in the United States),through code-sharing and the operation of compu-
ter reservation systems (CRS) between airlines. In addition, customer loyalty is
enhanced through frequent flyer programmes. Furthermore, reputation and expe-
rience can function as entry barriers due to a consumer preference for security and
safety. These scale effects explain the high concentration in the industry, although
this is less true in Europe than in the United States. Technological progress affects
the industry in a very balanced manner as a result of the limited number of
suppliers to the industry.
There has been a steady improvement in aircraft design, CRS and infra-
structure, and correspondingly a substantial trend increase in productivity. The
improvement in productivity, combined with regulatory reform, has lowered real
prices throughout the OECD area.I4 The US deregulation process began in 1978,
while the rest of the OECD, with the exception of the United Kingdom, only began
implementing deregulation in the late 1980s. From 1980 to 1993, both the absolute
and the relative differences in prices between the United States and the rest of the
OECD have widened (Table 8). The average nominal price (measured in US dollars)
for one revenue passenger kilometre (RPK) in the United States has increased
by only 1.3 cents compared with an increase of 2.1 cents in the price of European 57/
 Table 8. Average airline prices, costs and variance
1980 I985 1990 I993

Average prices Average prices Variance Average prices Average prices Variance
Variance and costs Variance and costs
and costs and costs "

Prices (US cents per RPK) I

United States 7.74 1.4 8.1 1 2.6 8.39 3.2 9.08 1.6
OECD- Eu rope
- Flag carriers 12.02 10.9 10.73 9.9 15.37 22.3 14.96 37.4
- Charter 2 12.17 102.2 9.98 144. I 6.40 20.8
Other OECD3 9.05 4.6 9.94 5.2 13.13 17.9 14.55 38.4
Costs (US cents per ATK)4
United States 36.99 72.70 40.68 53.89 46.50 45.94 45.72 44.90
OECD-Eu rope
- Flag carriers 59. I6 2 76.09 53.55 243.19 83.82 702.03 84.01 992.06
- Charter 2 .. .. 59.5 1 829.2 1 46.89 121.42 46.66 194.03
Japan 39.992 .. 45.98 281.43 74.66 1 494.00 82.42 1 231.15
Other OECD6 49.00 118.90 42.33 209.09 45.07 21.34 39.6 I 20.40

I RPK - revenue passenger kilometre

2 Data for charter flights start in 1988
3 Australia, Canada, Japan and New Zealand
4 ATK - available tonne kilometre
5 Data cover only one company
6 Australia, Canada and New Zealand
Source OECD calculations based on data provided by the Institute of Air Transport, Paris
 Deregulation and privatisation in the service sector

fag-carriers and 5.5 cents in the rest of the OECD. Moreover, the strong competi-
tive pressure in the United States has ensured that prices are quite similar between
the different carriers (i.e.a low variance). In Europe and the rest of the OECD the
competitive pressure is much more uneven and prices vary much more among the
different carriers (i.e.a high variance). While Japan continues to face difficulties in
reaching price levels comparable with best practise, the deregulation process in
Australia, Canada and New Zealand has successfully led to competitive price levels.
The higher prices in Europe have not led to higher profits. In fact, only the
European charter business has consistently shown positive profit rates, albeit low
compared with other industries. This points to substantial costs differences. Indeed,
Table 8 confirms that the observed price differences and their development over
time are closely related to the development in costs. Of particular interest is the
increase in the European cost variance, which indicates that although a number of
European operators face increased competition, a number of other European air-
lines face substantial difficulties in undertaking the necessary restructuring and
modernisation to remain cost efficient. A maior determinant in the industry’s unit
cost is stage length, which is due to a number of factors. For instance, fuel
consumption is greatest until the aircraft has reached cruising altitude and longer
stage length minimises unproductive turnaround time on the ground. However, cost
differences cannot be attributed to differences in stage length alone, as the U S
airlines have lower unit costs than European airlines for all stage lengths (Figure 3 ) .
Recent studies suggest an almost 20 (McKinsey, 1992) to 40 per cent (European
Commission, 1994) difference in productivity between the United States and
Europe.
As in other segmented sectors, privatisation may not be a sufficient condition to
increase competition in airline services, and provisions for allowing access to new
entrants are of particular importance. Enhanced competition in air transport requires
a market-based allocation of landing and take-off slots and the abolishment of the
international system of bilateral agreements. In addition, an effective competition
policy15 must address a number of other issues (see Box 2) to prevent incumbents
from exploiting their dominant position. For instance, incumbents may have substan-
tial advantages through the operation of hub-and-spoke systems, frequent flyer pro-
grammes, computer reservation systems, code sharing or outright predatory behavi-
our, which can all be used to exclude or raise the cost of entry.
European airlines are unlikely in the present situation to become as efficient as
American airlines, due to a range of external factors and the structure of the
European market. The external factors include higher fly-over cost, partly reflecting
inefficient air-control systems. The inefficient European system also results in
delays and air congestion. Furthermore, European airport charges vary between
2.0 and 11.5 US cents per available tonne kilometres (ATK) compared with around
1.0 US cent per ATK in the United States. This is mainly the result of a lack of -?.?.I
OECD Economic Studies, No. 25, 1995/11

Figure 3. Operating costs per ATK

and average stage length, I993
Average cost per ATK (US cent) Average cost per ATK (US cent)

I60 I60

I20 \ I20

80 80

40

”.
0 0
0 500 I 000 I 500 2 000 2 500 3 000 3 500 4 000
Average stage length (km)

Note: The lines refer to cost curves reflecting unit cost for a given stage length.
ATK Available Tonnes Kilometres.
Source: OECD calculations based on data provided by the Institute of Air Transport, Paris.

competition between ground handling providers (OECD, 19954. European airlines

also have 15 per cent more expensive fuel costs than US airlines, due to their
smaller size and hence their weaker bargaining position (European Commission,
1994a). These external factors can change through reforms and investment pro-
grammes, but only over a fairly long time horizon.
The structural features of the European market, however, will hardly change.
Higher European population density, together with the existence of strong inter-
modal competition from high-speed trains and road transport, makes it unlikely
that the European market will reach the same relative size as that in the United
States. Moreover, the North-South charter market is already very competitive.
Hence, growth in Europe, through increased competition, is likely to be found
mostly in the East-West business market, which is typically not very price sensitive
and thus expands only modestly in response to lower prices. In addition, a large
segment of non-business travel in the United States is to visit friends and relatives,
a service which in Europe is typically served by other means of transportation. The
expected benefits of deregulation in terms of consumer surplus are substantial, but
l..!%are
?-unlikely to reach US levels (McGowan et al., 1989).
 Deregulation and privatisation in the service sector

Box 2. Sources of market power in the air transport industry

Airport slots are allocated by scheduling committees including representatives
for the incumbent airlines and are based on the “grandfather principle”, which gives
incumbents preferential treatment. An additional problem is the lack of peak pricing
(with the notable exception of Heathrow and Gatwick airports in the United King-
dom). One possible solution is to set up an auction system (as it is currently done
in four American airports: La Guardia and Kennedy airports in New York,
Washington’s National and O’Hare in Chicago) to determine the economic value of
different slots (McGowan et al., 1989). Even in the event of a suitable auction
system, there remains a potential co-ordination problem. Each airport can only sell
one landing or take-off slot, but any flight needs a matching pair. For hub-and-
spoke operators this is not a problem as they always have slots at their hub and
hence only need one additional slot. New entrants without a hub-and-spoke are put
at a disadvantage with an auction system only in landing rights. Thus, the design of
an auction system becomes non-trivial if potential obstacles to new entry are to be
avoided. Nevertheless, the introduction of a slot allocation system based on eco-
nomic incentives would be a considerable improvement compared with the present
system.
Predatory behaviour, by which an airline accepts a short-run loss against
expected higher profits in the future, can either be implemented by cutting prices
below marginal costs, by expanding output or by changing the timing of services.
Predatory timing implies either scheduling departures around the entrants (to take
over customers), or by scheduling departures away from the entrants to remove
connection possibilities. Particularly for small entrants this may be a problem a s
the quality of their service depends on the ability to connect to other networks.
From an empirical point of view, it is difficult to distinguish predatory behaviour
from the effects of normal competition. Indeed, in the presence of legal sanctions,
predatory behaviour only takes place when the possibility of detection and punish-
ment is low (Dodgson, et al. 1991).
The hub-and-spoke system co-ordinates the incoming and outgoing flights to
a central airport to facilitate interconnection between flights. This implies that
during the day the hub will experience several waves of planes coming in and
leaving 60-90 minutes later. The advantage of the system is that it increases the
density of the route network and hence offers customers a wider choice, enhancing
the revenue-scale economies for the airline operating the system. On the other
hand, hub-and-spoke systems may increase the market power of the incumbent, as
inter-connection takes place within the same airline and excludes competitors
(McGowan, 1989). In addition, the hubs are spatially differentiated so vertical inte-
gration allows the airlines to create and exploit local monopolies around the hub.
In particular, this is true with predatory scheduling, where a hub-and-spoke network
allows the “owner” to engage in predatory scheduling without running the risk of
becoming the target of predatory scheduling itself.

(continued on next page)

OECD Economic Studies. No. 25. /995/11

(contin ued)

Frequent flyer programmes allow the members to collect points to obtain

discounts on future ticket purchases. In addition, members receive preferential
treatment with respect to ticketing, check-in procedures, lounge facilities, and often
have business facilities at their disposal. The programmes encourage members to
gain as many frequent flyer points as possible, thus enhancing brand loyalty,
ensuring that customers only use one airline, and expanding the value of the hub-
and-spoke system. This allows the airlines to impose switching costs on the cus-
tomers, whereby the system functions as a barrier to new entry. The switching costs
also segment the market between the incumbents, and contributes to the creation
of a number of local monopolies.
Computer Reservation Systems may present serious asymmetric problems.
The systems provide information on possible travel routes and on transactions of
sales and reservation. Owners of such systems may promote their products ahead of
competitors, through the ordering of the computer listing or through the marketing
commissions offered to the travel agents. Indeed, most customers base their deci-
sion on the first couple of computer screens presented. Codes of conduct have been
established to prevent abuses. CRS systems can also be used to optimise the
designation of seats into different ticket categories, thus optimising the revenue of
each single flight. Moreover, the systems opened the possibility of code sharing,
whereby friendly airlines’ products can be promoted alongside with the proprietors.
This increases the range and scope of services offered, thus increasing the value of
their networks and the scale advantages enjoyed.

Other networkerelated services: energy, postal services a n d railways

In electricity supply, there is a general realisation that although the transmis-
sion and distribution of electricity are natural monopolies (IEA, 1994), the genera-
tion of electricity is not, and that a decentralised network of suppliers can contri-
bute to the supply of electricity to the grid. In some cases, competition can be
strengthened by allowing end-use consumers to choose their own power supplier.
For instance, the 1989 electricity law in the Netherlands allows consumers (with the
exception of municipalities) to choose where to purchase their electricity - inclu-
ding from foreign producers (IEA, 1994).Similar reforms were introduced in Norway,
where the 1991 Energy Act has opened up the electricity grid to all producers and
consumers in the country, and broken up local monopolies for electricity genera-
tion. In addition, electric power companies are now required to separate their
financial accounts for power generation and for grid-related activities, thus avoiding
b&?- cross-subsidisation (OECD, 1995e). A regulatory framework is required to ensure
 Deregulation and privatisation in the service sector

access of private producers to the grid and to help in settling disputes with regards
to transmission access and pricing. Most countries are still in the process of making
a transition to more competitive markets, but preliminary evidence suggests that
competitive markets for electricity can, if properly regulated, work efficiently (IEA,
1 994a).
In postal services, less regulatory change has occurred, although many coun-
tries have moved to separate the functions of postal and telecommunication ser-
vices, often as a step in the direction of partial privatisation of the latter (OECD,
1992d).Across the OECD, competition has generally been enhanced in basic parcel
and courier services by abolishing price and entry regulations. Public monopolies,
protected by entry and price regulations, remain dominant in basic letter services,
however, although some countries are currently allowing private companies to
deliver letters above a certain weight limit. ‘Within the European Union, little
progress has so far been made in liberalising this sector.
In railways, change has also been slow. A few countries, including Japan and
the United States (Conrail),have privatised railway companies over the past decade,
and privatisation of British Rail is currently in progress. A few countries, including
Sweden and Germany, have separated the provision of transport services from grid-
related activities, and Mexico and the United Kingdom are in the process of doing
so. In addition, some railway companies have been allowed to differentiate prices
for customer services, helping them to improve efficiency. For European railways,
there are substantial differences in efficiency, and part of these differences appear
to be related to the differing degrees of autonomy under which railway companies
operate (Pestieau, 1993; OECD 19954.

ECONOMY-WIDE CONSIDERATIONS
Effects on overall performance
The sectoral evidence presented above suggests that regulatory reform in ser-
vices, if properly designed and implemented, can help to increase the degree of
competition in the service sector and can contribute to improved performance. A
summary of this sectoral evidence is provided in Table 9. The table suggests broadly
positive experiences with regulatory reforms and also points to regulations on entry
as the dominant barrier to competition in most of the service sectors.
The economy-wide effects of increased Competition are likely to exceed the
sum of these sectoral effects (Pera, 1989),however. First, enhanced competition in
one sector may free resources for use in other sectors of the economy and thus
improve overall resource allocation (the “static” effect). Second, as suggested for
instance by the results of regulatory reforms in distribution and telecommunica-
tions, a more competitive environment arising from deregulation may enhance
the overall capacity for product innovation and growth (the “dynamic” effect), by 4
 Deregulation and privatisation in the service sector

expanding the range of goods and services provided. Third, regulatory reform may
contribute to improved flexibility of the economic system and thus help to reduce
price and wage rigidities. Higher productivity or lower prices in one sector are also
important as they lower the costs of inputs from that sector for users and can thus
contribute to enhanced performance in other sectors of the economy. Deregulation
in one sector can also put pressure on other sectors that remain regulated.I6 For
instance, the deregulation of road haulage lowered price levels in that sector and
improved the competitive position of this sector with regards to other freight
carriers, in particular railways.
Evidence on the economy-wide effects of deregulation and privatisation is
limited, and the analysis is complicated by the fact that most countries have opted
for a gradual and sector-specific approach to regulatory reform. This implies that its
effects on performance are difficult to disentangle from economic performance in
general and cyclical phenomena in particular. In countries where extensive regula-
tory reform has been undertaken (the United States, New Zealand and the United
Kingdom - see Figure 4 below), some evidence is available on the overall effects.
For some other countries (Germany, Australia and the Netherlands) modelling
studies provide a rough indication of the overall effects of reforms.
- Regulatory reforms in the United States, covering airlines, railways, trucking,
telecommunications, cable television, brokerage and natural gas, are estima-
ted to have increased social welfare by at least $36 to 46 billion (in
1990 prices) annually (or 0.65-0.85 percentage points of GDP), primarily due
to deregulation of the transport industry (Winston, 1993). Furthermore, the
gains from deregulation were often transferred to consumers, and were not
at the expense of workers or producers, who generally also benefitted from
the deregulation process.
- The long process of structural reforms in New Zealand - including extensive
trade liberalisation and macroeconomic policy reforms - initially led to a
difficult and slow adjustment to the new situation, but currently shows signs
of improvement, in particular with regards to tradeable sectors of the eco-
nomy (OECD, 1994; 1994d). Business strategies are much more internatio-
nally oriented and the trade package has diversified in both products and
destination (OECD, 1994d).More significantly, there was a marked and signi-
ficant rebound of productivity growth in the 1980s (Englander and Gurney,
1994).
- The UK structural reform packages over the past 15 years appear to have
contributed to a marked improvement in international competitiveness and
have helped to improve productivity and growth performance (Haskell, 1991 ;
Crafts, 1993; OECD, 1994).Recently, Parker and Martin (1995)concluded that
the UK experience with privatisation, and in particular the run-up to privati-
sation, could be associated with marked improvements in performance. This 4
OECD Economic Studies, No. 25, /995/11

Figure 4, Change in regulatory regimes, 1975-90

I
Summary measure of regulations, selected services sectors

Ownership Entry regulations

Degree of regulation2 Degree of regulation2

2.0 A
Be1
. L.U

I.8 Jap +Ni

I.8

I.6 I .6
I.4 I 1 IV I I.4
Aut
1 Ger I

.
-
I.2

I.o
A
I- *Be1 ' +c?n
v
rn
I .2

I .o

0.8
1
+Ger
I
bswi I
I la II
II
0.8
Ir
0.6
i +Can Aus
L 0.6
L' I
0.4 p 0.4

0.2 0.2
0 0

Price regulations Total

Degree of regulation2 Degree of regulation2
2.0 2.0
Den
ire
I.8

I.6

I.4

I.2

I.o

0.8
0.6
0.4

0.2
0.4 _____;tt 0.2

0 0

I. Based on regulations in road transport, airlines, telecommunications, postal services and utilities.
Due to the lack of information, indicators for Belgium include only telecommunications, postal services and utilities.
2. Degree of regulation varies from 0 unregulated or private ownership, t o 2 highly regulated or public ownership.
Source: OECD calculations, based on OECD, Regulatory reform, privatisation and competition policy, 1992.
 Deregulation and privatisation in the service sector

appeared related to a reduction in overstaffing and inefficiency in the run-up

to, and following privatisation. However, the fact that several companies
were able to improve performance before privatisation suggests that privati-
sation is not the only factor affecting performance.
- Much research has focused on the benefits of deregulation in the context of
the European internal market (Pera, 1989; EC, 1993; Hoeller and Louppe,
1994). Studies from the European Commission analysed the gains from
dismantling technical trade barriers and customs formalities, enhanced eco-
nomies of scale and lower profit margins resulting from increased competi-
tion and found these to be quite sizable, from 3 to 7 percentage points of
GDP. The real effects of integration are still difficult to evaluate, however,
although a simple macroeconomic evaluation suggests an EU-wide gain of
1 % percentage points of GDP so far (Hoeller and Louppe, 1994).
- The Australian “Hilmer” reform package, that was proposed in 1993 (Hilmer
et al., 1993), consists of an extension of competition legislation to most
sectors of the economy and also aims at regulatory reforms in the utility
sector, road transport and ports. The total reform package is projected to
increase Australia’s level of GDP by about A$ 23 billion, or about 5.5 percen-
tage points (Industry Commission, 1995),provide benefits to each consumer
of about A$ 1500 and create about 30 000 new jobs. The benefits of the
reforms are expected to be widely distributed across sectors.
- Other studies, for Germany and the Netherlands (Lipschitz et al., 1989;
Van Sinderen et al., 1994; Van Bergeijk and Haffner, 1995), also suggest
substantial benefits from deregulation, with GDP and employment rising and
inflation falling following regulatory reforms.

Extent and changes in service sector regulation

Most OECD economies remain much more regulated than the United States,
the United Kingdom and New Zealand. A rough overview of the strictness of regula-
tory policies in the OECD area can be derived by analysing indicators of regulation
and ownership. Such indicators are available for utility and postal services, road
transport, telecommunications and airlines and cover ownership, entry and conduct
(price and services) regulation^.^^ An overall indicator can be derived by weighing
the sectoral indicators by their weights in GDP.18 Figure 4 shows four different
aspects of overall regulation, for 1975 and 1990, with a high value implying a high
degree of regulation. The top left-hand panel shows the regulatory stance with
regards to ownership. There is a substantial differentiation in the degree of public
ownership, with, in particular, Denmark, Ireland and Norway having substantial
public ownership in these sectors and the G-7 countries having relatively little
public o ~ n e r s h i p .The
’ ~ most significant privatisation efforts over this period took 67/
OECD Economic Studies, No. 25, /995/11

place in the United Kingdom and New Zealand, while Finland and Japan also
privatised some services. In several countries, hardly any change in ownership
occurred.
Entry regulations were liberalised in several countries, in particular in New
Zealand and the United States. Price regulations were most strongly liberalised in
New Zealand and Finland. An overall indicator of regulation (covering the three
available aspects of regulation) is shown in the final panel of the graph. In 1975, the
overall regulatory stance of Denmark, Ireland and New Zealand was the most
restrictive in the OECD area, while Canada and Australia were the least regulated.
Since 1975, most OECD economies have deregulated their service sectors with, in
particular and as discussed above, New Zealand and the United Kingdom making
significant changes in their regulatory stance. Currently, the United States, United
Kingdom, Canada, Australia and New Zealand use much less regulation and gene-
rally have more private ownership, than the continental European economies, while
Japan occupies a “middle” ground.
The remaining differences in regulation across the OECD area imply that there
is scope for further deregulation in many countries and many sectors. The analysis
suggests that the benefits may be substantial. Policies that encourage entry and
strengthen competition have proven to be the critical element in achieving these
benefits.

68
 Deregulation and privatisation in the service sector

NOTES

1. Entry t o such sectors is often regulated if a monopoly situation is perceived t o be the

most efficient solution, due for instance to significant economies of scale or network
externalities, and if entry barriers would otherwise be too low.
2. This paper does not cover the role of competition in the provision of social and public
services, such as health o r education (the health sector was discussed extensively in
Oxley and MacFarlan, 1994). Nor does it cover the extensive deregulation of the
financial sector, which was recently discussed in OECD (I995~).
3. The restrictiveness of zoning laws is partly based on an assessment by the European
Commission (EC, I993), while for non-EC countries information from OECD Economic
Surveys, McKinsey ( I 994) and national sources was used.
4. Measured as the number of persons employed per outlet.
5. OECD (I992) discusses an earlier version of this table. The current table uses more
recent data and includes data for the Netherlands for the f i r s t time.
6. Vertical restraints imposed on distributors by manufacturers could enhance efficiency
under several circumstances. For instance, vertical price restraints may ensure new
distributors a reasonable profit margin, and encourage them t o invest in an expansion of
their retail network. This may encourage competition among distributors, and could
thus enhance dynamic efficiency. Vertical price restraints may also improve efficiency
when the demand for a manufactured product is highly dependent on the quality of
services provided by its distributors. In this case, vertical restraints prevent distributors
from free-riding on service costs made by other distributors. Even though prices are
higher, the increase in service should lead t o an overall increase in efficiency. See Katz
(I989), OECD (I992), and OECD (I994a) for elaborations of this issue.
7. The recent “Molitor” report (EC, 1995) suggests that a lack of harmonisation of
standards and technical specifications in the European Community area forms a signifi-
cant barrier t o the free circulation of construction products in the EC area.
8. Output and productivity growth in the construction industry is of a highly cyclical
character, implying that indicators of productivity growth depend partly, and somewhat
arbitrarily, on the chosen observation period. In addition, productivity measurement in
the construction industry is confronted with substantial measurement problems.
9. The relative price level in a given year is calculated as the purchasing power party
divided by the exchange rate. Indicators of construction price levels are derived from 69/
OECD Economic Studies, No. 25, 1995l11

OECD estimates of purchasing power parities for total final expenditure (OECD,
1993~).They are based on a market price, instead of a factor cost concept, which
implies that differences in the level or structure of taxation or subsidisation can
influence the estimated levels. Second, price levels are influenced by movements in
exchange rates. Thus, sharp disequilibrium movements in exchange rates can affect their
level.
10. The actual ability of new entrants to provide these services depends on the regulatory
framework, e.g. their ability to interconnect.
11. Defined as those countries where there is open competition in the provision of tele-
communication services. As of I994, these countries are Australia, Canada, Finland,
Japan, N e w Zealand, Sweden, the United Kingdom and the United States. See OECD
(I995c) for details.
12. As an example, Southwest Airlines, a very efficient domestic United States airline, only
uses Boeing 737 aircraft, thereby increasing its efficiency in both aircraft maintenance
and flight crew organisation.
13. Economies of revenue relate to the ability of airlines to exploit their network and
generate additional revenue from a given customer base arising, for instance, from
frequent flyer programmes.
14. Table 8 shows that nominal prices have risen somewhat. However, the price increase
has been much less than the general increase in price levels, suggesting that real price
levels have fallen substantially.
15. Another potentially crucial issue for competition is the evidence of airlines living by the
“golden rule”. This refers to airlines refraining from price competition on a given route
to avoid retaliatory behaviour from their competitors on jointly contested routes. Evans
et al., 1994, produce empirical evidence for the existence of “golden rule” behaviour in
the United States airline industry. They show that air fares are higher in city-pair markets
served by airlines with extensive inter-route contracts. Such behaviour is particularly
worrisome with the current development of market structures, towards a few large
airlines operating hub-and-spoke systems, which tends t o increase multi-market contacts.
Along the same lines of analysis, Joskow et al. (I994) find for the US domestic market
that prices substantially above the competitive level are not sufficient to induce entry,
indicating that network issues are important.
16. Enhanced competition in product markets may also increase the pressures to deregu-
late labour markets.
17. See OECD (I992d). Indicators of regulations are not systematically collected across
countries, but are available for a limited number of sectors and time periods, and for
17 out of 25 OECD countries. Data for France, Italy, Greece, Iceland, Luxembourg,
Mexico, the Netherlands and Portugal, are not available.
18. To derive an overall assessment o f regulation, values are assigned to represent the
strictness of regulation. Public, mixed and private ownership are assigned values 2, I and
0, respectively, whereas for entry, price and service regulations, regulated, partially
regulated and unregulated are also assigned values 2, I and 0, respectively. The indicators
can subsequently be aggregated at the industry level to derive an indicator of regulation
 Deregulation and privatisation in the service sector

a t that level, or they can be aggregated for all services (or types of regulation) combined
by weighting them by sectoral GDP weights.
19. Figure 4 excludes Portugal, Greece, Italy and France, which have the largest share (the
arithmetic average of shares in employment, gross fixed capital formation and value
added) of public enterprises in the non-agricultural business sector in OECD-Europe
(OECD, I994e).
OECD Economic Studies, No. 25, /995111

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