THE POLITICAL ECONOMY OF PUBLIC UTILITIES A Study of the Indian Power Sector

1
THE POLITICAL ECONOMY OF
PUBLIC UTILITIES
A Study of the Indian Power Sector
K. P. Kannan and N. Vijayamohanan Pillai
Working Paper No. 316
June 2001

---

2
This paper is part of a larger study on the power sector in India,
with special reference to Kerala, titled Plight of the Power Sector
in India: Inefficiency, Reform and Political Economy.
This is the third working paper arising out of this research project.
The details of the earlier working papers are as follows:
i)
Working Paper No. 308, Plight of the Power Sector in India:
SEBs and their Saga of Inefficiency (November, 2000); and
ii)
Working Paper No.312, Electricity Demand Analysis and
Forecasting - The Tradition is Questioned! (February,
2001).

---

3
THE POLITICAL ECONOMY OF PUBLIC UTILITIES
A Study of the Indian Power Sector
K. P. Kannan
N. Vijayamohanan Pillai
Centre for Development Studies
Thiruvananthapuram
June 2001
This paper is the outcome of a just-concluded larger study on the power
sector in India with particular reference to Kerala. We are thankful to
K. N. Raj for his support and to M. N. V. Nair, K. K. Subrahmanian,
Achin Chakraborty and K. Ravi Raman for comments. An earlier version
of this paper was presented by K. P. Kannan at a workshop on ‘An Asian
Dilemma: Modernising the Electricity Sector in China and India in the
Context of Rapid Economic Growth and the Concern for Climate
Change’, held in The Hague (the Netherlands) on May 17, 2001 by the
Institute of Environmental Studies, Free University, Amsterdam. The

---

4
ABSTRACT
In this paper, we attempt at an analysis of the political economy of
the Indian power sector with special reference to Kerala in the light of a
generic model of the political economy of public utilities we develop in
the first part of the paper. The model seeks to explain the political
economy of the rent seeking drives in a non-Smithian imperfect regime
of self-interest maximisation, with a regulatory structure of the public
utility described in a framework of the principal-agent relationship. In
contrast to the usual neo-classical monolithic representation of principal
and agent, we characterise each entity in a Marxian-Kaleckian vein, as a
composite set of conflicting sectional interests. This helps us develop a
comprehensive perspective of the politico-economic implications of the
relationship among the public, government and utility.
Based on this generic model, we seek to analyse, in the second
part of the paper, the political economy of the power sector in India,
with emphasis on Kerala. We also attempt, wherever possible, to estimate
the costs of corruption involved in the administration of the power sector.
JEL Classification: E11, H10, H4, L94, N4, P16
Key Words: India, political economy, rent seeking, principal-agent,
public utility, power sector

---

5
[The Jury acquitted Clodius of the charge of
violating the rites of Bona Dea,
wherein Cicero had given evidence against the alibi
Clodius had set up.]
“The Jury” sneered Clodius, “did not give you credit on your oath.”
“Yes,” retorted Cicero, “25 out of the 56 did;
the remaining 31 refused credit, for they took the bribe in advance!”
- quoted in Thakur (1979:166).
Introduction
In most countries, intervention by governments in the economic
sphere finds its justification on mainly two fronts: (i) to correct market
failures in the provision of public goods and in the presence of
externalities and natural monopoly, and (ii) to ensure the translation of
the lofty ideal of a ‘welfare State’. Often a convergence of the two fronts
is sought to be achieved, as in India, in the establishment of a public
sector in a particular historical context. It is argued in a simple neo-
classical framework that if the benefits of productive efficiency outweighs
the costs of allocative inefficiency, then the society will have a welfare
gain from maintaining the natural monopoly organisation of a public
utility. Furthermore, if such monopoly power (price) can be brought
down to a competitive level, say by means of its nationalisation, then
there will be both an equity gain and an efficiency gain. This is the theory.
However, the practice could be very different from the theory, as is often
the case. For example, the vast scope for administering discretionary
powers by the political and bureaucratic control processes involves

---

6
substantial costs of rent-seeking activities in a non-Smithian cultural
regime of self-interest maximisation.1 In the non-Marxian (more
precisely neo-classical) representation of political process, the
relationships among the public, government and utility may be aptly
analysed in the light of a model of principal-agent problem. The problem
consists in the default and breach of trust, likely on account of the
conflicting objectives of self-interest maximisation of the concerned
parties and the uncertainty or information asymmetry involved in the
relationship. In contrast to the usual neo-classical monolithic
characterisation of the principal and the agent(s), a kind of Marxian
structuring of each of the entities (especially the principal, the ruling
class) in terms of composite sets of sectional rent seeking interests in the
functional domains (of agriculture, industry, trade, and labour) may yield
more insights into the relationships. These different sub-sets in the
principal set vie with each other in appropriating the benefits of the utility,
through their representatives in political power. The very same agents of
diverse interests, on the other hand, strive to stand as a cohesive group
to ensure the long run end of both the continuity of their own regime and
the survival of the system, while catering to the short-term contingencies
of clashing sub-class interests. The long-term common agenda of
capitalist survival in turn requires pacifying class strains, the general
cause of crises. And this could be ensured in general by way of a
captivating welfare State slogan, sought to be materialised in terms of
State intervention and nationalisation. Such drives often went to the extent
of equating nationalisation with socialism; and the political process was
projected to be managed by ‘representative governments’. Such
‘intermediate regimes’ (to use the Kaleckian term) were in fact an
instrument for securing the class interests of capitalist empowerment,
by ensuring both economic development and social security equations,
true to the professed welfare State slogans.

---

7
The apparent fall of socialism and its emulations elsewhere has,
however, opened up an impressive interpretation of the viability of
economics: that there is no alternative to the capitalist mode of general
welfare. Thus has started the new notion of liberalisation-based world
welfare to sweep across the countries, replacing nationalisation by private
sectorisation as a now seemingly viable stratagem in a historical necessity
of capitalist survival. In the new dispensation of the on-going realignment
of sub-class interests in India as elsewhere, the industrial and trade
interests have risen to assert themselves. And in the political economy,
corruption has scaled new heights in the implementation of privatisation
drives, in addition to the old transactions in awarding concessions and
contracts.
In what follows, we discuss these aspects in the context of the
development of the Indian power sector. While the provocation for this
paper arose out of our just concluded study of the power sector in Kerala,
the discussion of its political economy here is firmly set in the national
context. Though the reference to Kerala experience is largely illustrative,
there is a significant dimension to it. In the development literature, Kerala
is now well known for its remarkable achievements in human
development despite low income, reflecting the continuing inability of
the state to translate the social development into commensurate economic
development. What the discussion in this paper points out is that the
political economy of government intervention in Kerala in the economic
sector (as opposed to such social sectors as school education and health
care) is not very different from that in most other parts of India.
The following discussion is divided into three parts. In the first
part, we present a generic analysis of the political economy of public
utilities in a new synthetic methodological framework. The present stage
in the development of history is interpreted in a Marxian perspective as

---

8
characterised by a series of seemingly feasible capitalist survival
strategies. The class character of the State, on the other hand, is found
more or less to obey the Kaleckian proposition of the ‘intermediate
regime’, but largely dictated by the currently viable alignment of the
sub-class interests in the common capitalist class. And in the
superstructure of political economy of regulation, a neo-classical
theorisation of rent seeking drives in an imperfectly co-ordinated domain
of self-interest maximisation within a principal-agent relationship
framework is adopted to obtain more insights. Such a synthetic analysis
appears to provide a comprehensive and consistent explanation of the
issues under study.
Leaning on this generic background, the second part discusses the
plausible implications in the political economy of the Indian power sector,
with special reference to Kerala. An attempt has also been made to
estimate, wherever possible, the costs of corruption involved in the
administration of this public utility in terms of the purely avoidable but
allowed cost escalation. Finally, the third part gives our concluding
remarks.
I
A Generic Analysis
The economic theory of public choice runs in the justification
of market failure in the provision of public goods and in the presence of
externalities and natural monopoly. Where market fails in the absence
of preferences revelation, the political process steps in to obtain such
revelation; ballot voting replaces rupee voting. Consumers as voters find
it in their interest to vote such that the political outcome approximates
their own preferences and choices. Such voting on collective tax and
expenditure decisions reveals their choices in the determination of

---

9
provisions of goods and services that price system cannot supply. Tax
functions as a price here.
The natural monopoly problem
Our concern centres on the market failure (and the subsequent
political intervention) from the existence of natural monopoly.
Traditionally, public utilities (such as gas, electricity, telephone, water,
cable TV and waste treatment facilities) are defined in terms of the
technical features giving rise to natural monopoly position. A natural
monopoly used to be interpreted as a single product, decreasing cost
industry.2 However, most utilities are multi-product: electric utilities
distribute high and low voltage power as well as peak and off-peak power,
telephone industries provide local as well as long-distance call facilities,
etc. In this context, a natural monopoly is defined under the cost
conditions when ‘the cost of a sum of any m output vectors is less than
the sum of the costs of producing them separately’ (Baumol 1977: 809).3
If this condition is satisfied, then the least cost method of producing the
whole vectors of output is with a single firm. Hence the natural monopoly
position.
Electric utility is unique in that its product is non-storable and
must be generated and supplied the moment it is demanded. This technical
characteristic in turn makes the industry essentially a vertically integrated
monopoly with the co-ordination of all the three basic functional
processes of generation (production), transmission (transportation to
markets) and distribution (supply to final users) for reaping the full
advantages of an integrated network system. This in turn gives rise to
economies of scale and the resultant natural monopoly status.
The natural monopoly justification (in terms of productive
efficiency) has however the danger of violating allocative efficiency

---

10
criterion, as prices are set above marginal cost (MC). Ensuring allocative
efficiency requires competition in the market that drives price down to
MC. But too many firms flooding the market leads to productive
inefficiency. This in turn opens up the fundamental problem of public
utility economics, as to the choice of an appropriate institutional
arrangement of governance structure that can manage to make use of
these economies, but without the excesses of monopoly power, creating
dead weight loss. The practical solutions to this problem were originally
addressed in terms of two kinds of government intervention: (i) outright
nationalisation (state monopoly) as in most of the developing countries,
France and the UK till the end of the eighties; and (ii) regulation of the
private monopoly as in most of the USA, where the former is considered
an anathema.
The significance of nationalisation appears obviously
overwhelming, once we recognise the scale economies associated with
a public utility and accept the consequent natural monopoly position of
it. This is easy to show, following Williamson (1968), in terms of a simple
neo-classical analysis of a trade off between market power and scale
economies. In Fig. 1, a natural monopoly, enjoying scale economies, is
shown to be able to supply at a lower average cost ACm than a
competitive, or more realistically, an oligopoly, utility at an average cost
of ACc. If, under such conditions, the cost savings, given by the rectangle
PcBDE, exceed the dead weight loss in consumer surplus due to the
monopoly price (Pm), given by the triangle ABC, there will be a welfare
gain from accepting the monopoly organisation of the utility. If, by
nationalising the public utility, the monopoly power can be eliminated
and the price reduced to the competitive (or oligopolistic) level of Pc,
then there would be both an equity gain and an efficiency gain, in addition
to profit. Nationalisation still involves possibilities of further price
reductions and increased gains. As we will see below, the significance

---