Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction (1)
One of the major events in economic history of the XX
century is the major privatization wave starting in the UK
under Margaret Thatcher, followed by the mass
privatization in Russian and other transition economies.
The New State Capitalism (2)
Insights from Economic Theory
One could expect that this had been prepared by a lot of
theoretical and empirical research on the advantages and
disadvantages of state ownership vis-a-vis private
ownership and privatization.
Carsten Sprenger
Higher School of Economics Moscow
Februrary 2017 / CES Lectures, Munich
Carsten Sprenger
But economic theory in the early 1980’s had little to say
about these issues.
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction (2)
Overview
1
The first major and rigorous empirical study on the relative
performance of state-owned and private companies is
perhaps the paper by Boardman and Vining from 1989
(see Lecture 3).
In this lecture, we present a short overview and a selection
of the relevant theories.
Carsten Sprenger
Lecture 2
Economic Theory on State Ownership and Privatization
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
2
The proper scope of government (Hart, Shleifer and
Vishny, 1997)
3
A dynamic model of privatization (Che, 2009)
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
General equilibrium theory
Economic Theory on State Ownership and
Privatization
(This section follows broadly Roland, 2008, Chapter 1.)
General equilibrium theory – the core of economic theory,
as developed from Walras to Arrow and Debreu, stresses
the role of prices and competitive markets.
In a competitive market, where producers set their supply
in order to maximize profits and consumers determine their
demand as to maximize their utility, the outcome, the
competitive equilibrium is efficient (in the Pareto sense).
But there is no role of the ownership of firms. If one could
instruct a state-owned firm to maximize profits it would
behave in the same way as a privately owned firm.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Traditional industrial organization (1)
Models of imperfect competition are partial equilibrium
models in the sense that they omit some markets from the
model.
In the extreme case, monopoly, prices are higher and
quantities produced lower than in the competitive market,
leading to welfare losses.
Economists, therefore, concentrated on competition policy
and antitrust laws to keep market competitive.
"Natural monopolies" are markets where economies of
scale are so large that there is no place for more than one
firm.
Carsten Sprenger
Lecture 2
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Traditional industrial organization (2)
Many market economists (Simons, Pigou, Schumpeter,
Lewis, Meade, Allais) advocated public ownership of
utilities (water, electricity), such that the government could
impose pricing and production policies that deviate from
monopolistic profit maximization and increase social
welfare.
Henry Simons (1934, p. 51) writes in "A Positive Program
for Laissez Faire": "The state should face the necessity of
actually taking over, owning, and managing directly, both
the railroads and the utilities, and all other industries in
which it is impossible to maintain effectively competitive
conditions." (cited from Shleifer, 1998)
These views reflected partly the failures of regulation
during the Great Depression.
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Traditional industrial organization (3)
However, it does not follow from the "natural monopoly"
argument that these sectors should be nationalized: Why
can a government not regulate private monopolies and
issue appropriate incentive contracts in order to achieve
socially desirable outcomes? (Laffont and Tirole, 1993)
If the government can specify in a contract what it wants
and enforces it there would be no difference between state
or private ownership.
Example: Postal services in remote areas. Solution:
Private companies can compete for government
concessions that force delivery in those areas, or,
alternatively, market entry can be kept free but private
postal services are regulated.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Contract and incentive theory (2)
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Contract and incentive theory (1)
Contract theory has developed with the introduction of
informational asymmetries in economic theory (e.g.,
Akerlof, Spence, Stiglitz).
Contract-theoretic analysis of state vs private ownership
emphasizes therefore informational asymmetries between
the government and private agents. These can come in
several forms:
Government might lack incentives to monitor managers and
SOEs might be more opaque to to outsiders (e.g., stock
market participants), which again makes the monitoring of
managers more difficult
The government may also have superior information on an
SOE’s costs and profits because ownership gives privileged
access to the accounts of the firm.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Contract and incentive theory (3)
It might be one of the advantages of the new SOEs and
PSOEs compared to the "old" state enterprises under
100% state ownership that they are not insulated from
stock markets that convey information about the quality of
managerial actions that can be used for compensation and
hiring decisions in the managerial labor market.
Shapiro and Willig (1990) and Schmidt (1996) focus on the
second informational asymmetry in SOEs – between the
government and outsiders.
However, market inefficiencies and illiquidity (Holmström
and Tirole, 1991) make this argument somewhat weaker.
In Shapiro and Willig, the regulator (who regulates the
privatized or controls the state-owned firm) might have a
private agenda. Privatization acts then as a constraint on a
malevolent bureaucracy.
The threats of bankruptcy and takeover can also help to
sharpen incentives for managers.
Carsten Sprenger
Lecture 2
In particular, state ownership allows the government to
have more precise information about the firm’s cost than
what it would have under private ownership with regulation.
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Contract and incentive theory (4)
Schmidt (1996) assumes a benevolent regulator who,
however, cannot commit intertemporally to incentive
schemes.
The manager of a monopolistic firm makes a private
investment in cost reduction before production takes place.
He derives some private benefit from a higher production
level.
It would be optimal if the government could commit ex ante
to a subsidy scheme that punishes the manager if costs
turn out to be high by cutting back production or even
closing down the firm.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Contract and incentive theory (6)
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Contract and incentive theory (5)
In an SOE, such commitment is not credible. Given that
the government knows the cost structure, it would always
choose a production level that is ex post efficient, thus
forgiving high costs and paying more subsidies than
announced ex ante. This will lead to lower incentives for
managers to reduce costs.
In a private firm, the government is uninformed about the
costs of the firm. The optimal subsidy scheme distorts
production below the socially efficient level if costs are
high.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Contract and incentive theory (7)
Other types of commitment problems of the government:
The ratchet effect
Thus, under privatization allocative efficiency is clearly
lower than under nationalization.
In contrast, productive efficiency may be enhanced. The
manager faces a harder budget constraint because he
rationally foresees that subsidies will be cut back if costs
turn out to be high. Thus he has a stronger incentive to
invest in cost reduction in order to avoid the low production
level or the possibility of liquidation.
Carsten Sprenger
Lecture 2
Examples: organizations that spend all their budget at the
end of the year to avoid future budget cuts, workers who
shirk to avoid higher workloads etc.
Relevant for public sector managers who do not have
outside options in the private sector
Soft budget constraints
Belief that an SOE will always be bailed out in case of
financial distress.
Coined by Kornai (1980) to describe inefficiencies of
socialist firms, Dewatripont and Maskin (1995) see it as a
general dynamic incentive problem where a funding source
(government or bank) cannot commit not to bail out a firm
ex post.
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Incomplete contracts and ownership (1)
We concluded from the traditional industrial organization
literature that governments could write contracts or
introduce regulation that would correct prices and
quantities in sectors with "natural" monopolies.
But what if such contracts cannot be written because some
contingencies cannot be specified ex ante?
In these situations, control over productive assets
becomes important since it determines the bargaining
power of the parties in such situations.
This is the approach of the incomplete contracts theory.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Incomplete contracts and ownership (3)
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Incomplete contracts and ownership (2)
Governments have often multiple and fuzzy objectives that
may also change over time:
prevent monopoly pricing
control quality
reduce negative externalities
provide investment and employment in recessions.
Residual control rights in a firm enable the government to
make desirable adjustments in unforeseen contingencies.
However, managers’ incentives for cost cutting can be
curbed.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
General equilibrium theory
Traditional industrial organization
Contract and incentive theory
Incomplete contracts and ownership
Incomplete contracts and ownership (4)
Here are two of the main results of the paper:
Shleifer and Vishny, 1994 concentrate on the difference of
control rights of the governments in public and privatized
firms.
When bribes are allowed (under full corruption), the
allocation of resources is independent of either the
allocation of control or cash flow rights (Proposition 1).
Politicians derive political benefits from providing jobs to
the unemployed and must persuade managers to hire
excess labor by paying a transfer.
The politician and the manager extract subsidies from the
Treasury (until the political cost of the last dollar extracted
equals a dollar), employ extra labor until the marginal
political benefit is equal to the wage. Having resources
allocated efficiently, they use bribes to divide the surplus.
Control rights and cash flow rights can be separated
(transferring the first from the state to private individuals
would be corporatization, transferring the latter would be
privatization).
Carsten Sprenger
Lecture 2
When bribes are not allowed, excess employment is lower
under management control than under politician control
(Proposition 7).
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Introduction (1)
The model is about the choice between providing a public
good or service by the government (in-house) or by
contracting out to a private provider.
The proper scope of government (Hart,
Shleifer, and Vishny, 1997)
In the first case, the government hires public employees
and gives them employment contracts specifying what they
need to do.
In the second case, the government signs a contract with a
private supplier who in turn hires employees to do the job.
If the government can write a complete (comprehensive)
contract with either employees or a contractor, the same
outcome can be achieved, even in the presence of moral
hazard or adverse selection.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Carsten Sprenger
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Introduction (2)
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Introduction (3)
There is no competition in the model.
Therefore, the authors consider a situation of incomplete
contracts.
This is realistic since often the quality of the required
service cannot be fully specified for all possible
contingencies. Some examples:
Schools
Health care
Prisons
Privatization is often advocated because it brings more
competition. But the authors want to hold these two issues
separate.
Several government agencies could compete for providing
a service, or, on the contrary, a privatized firms could be a
monopolist.
The crucial difference between private and public
ownership is the allocation of residual control rights.
However, the authors discuss cases where competition
may strengthen the case for privatization.
Carsten Sprenger
Lecture 2
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Introduction (4)
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Introduction (5)
Crucial idea: The provider of a service (government
employee or private contractor) can invest time and
resources to either improve its quality or reduce its cost.
Cost reduction has an adverse effect on quality.
Neither innovation is contractible ex ante.
A government employee needs approval from the
government to implement either improvement.
A private contractor does not need approval for cost
reduction (he owns the physical assets), but will
renegotiate quality improvements to get a higher price for
the service.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The model assumptions (1)
The effects of ex post competition between contractors is
discussed, as well as the effects of corruption and
patronage.
Finally, examples including the ones mentioned above are
discussed in the light of the model.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The model assumptions (2)
A benevolent government wants to offer a public good that
consumers cannot buy directly in the marketplace.
Private vs public provision are distinguished by the residual
rights over the non-human assets used to provide the
service, called the facility F (e.g., the prison).
Residual rights matter because they determine who has
authority to approve changes in procedures or innovations
that are not written in the contract.
The facility is run by a single manager M. Government is
represented by a single bureaucrat G (who perfectly
represents the interests of society).
Carsten Sprenger
The model derives results about the relative efficiency of
in-house production vs government contracting.
Lecture 2
The contract is a long-term contract: if F is private it needs
to support relation-specific investments (e.g., building the
prison).
The contract describes the "basic" good (before quality
improvements or cost cuts) and denotes its price P0 .
If F is private (M owns F ) then P0 is the contract price.
If F is public (G owns F ) then P0 is the wage that M
receives as an employee.
The contract cannot specify all possible contingencies that
call for some modification of the basic good, e.g. quality
improvements (increased security) or cost reductions
(hiring cheaper or fewer guards).
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The model assumptions (3)
B = B0 − b(e) + β(i)
C = C0 − c(e)
where e and i denote effort devoted to the cost innovation
and quality innovation, respectively, c(e) ≥ 0 is the cost
reduction from the cost innovation; b(e) ≥ 0 is the
reduction in quality corresponding to the cost innovation;
and β(i) ≥ 0 is the quality increase net of costs from the
quality innovation.
Standard assumptions about convexity (b(e)), concavity
(c(e), β(i)), and monotonicity.
Also, c 0 − b0 ≥ 0 (important!) and β 0 > 0.
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The model assumptions (4)
The such "modified" good yields a benefit B to society and
costs the manager C to produce. C is borne directly by M.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The model assumptions (5)
M’s overall costs (need to add ex ante effort cost; no
discounting):
C + e − i = C0 − c(e) + e − i
Cost and quality innovations do not represent a breach of
contract (the contract is sufficiently incomplete).
i, e, b and c are observable to both M and G but not
verifiable to outsiders and can thus not be part of an
enforceable contract. That implies also that G’s benefits
and M’s costs are not transferable to third parties.
G and M are at least partially locked into their relationship.
There is no other facilty F that can provide the service, and
there is no other use for F (the prison).
M and G are risk-neutral and have no wealth constraints.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Default payoffs (1)
The time line is summarized in the following figure.
Renegotiation of the contract at date 1 once M and G learn
about potential quality improvements and cost reductions.
It is assumed that M and G divide the gains from
renegotiation according to Nash bargaining, i.e., the split
the surplus 50:50. (Why?)
Any innovation has to be approved by the owner of the
facility.
If M owns F he can implement cost reductions without G’s
agreement. But he will seek G’s consent on quality
improvements since no payment will be forthcoming for
uncontracted-for quality improvements.
IF G owns F , M cannot reap the full fruit of his innovations.
Only a fraction of the benefits require M’s participation, and
the reminder can be realized without M because some
aspects of his ideas have become public knowledge.
Carsten Sprenger
Lecture 2
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Default payoffs (2)
If F is private, the cost innovation is implemented but the
quality innovation is not. Thus, G gets B0 − P0 − b(e) and
M gets P0 − C0 + c(e) − e − i
If F is public, both innovations are implemented. G replaces
M and gets only a share (1 − λ) of the gains. Thus, G’s
default payoff is B0 − P0 + (1 − λ)[c(e) − b(e) + β(i)], and
M gets P0 − C0 − e − i.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
UG = B0 − P0 + 21 β(i) − b(e)
= P0 − C0 + 12 β(i) + c(e) − e − i
M chooses e and i to maximize UM , leading to the unique
solution (eM , iM ) given by the FOCs
1 0
2 β (iM )
=1
There are two deviations from the first-best:
1
2
M ignores the deterioration of quality resulting from cost reduction.
M needs G’s approval on quality improvement, so he gets only half of the
benefits, reducing his incentive to improve quality.
Carsten Sprenger
max{c(e) − b(e) + β(i) − e − i}
e,i
with a unique solution (e∗ , i ∗ ) characterized by the first-order
conditions
c 0 (e∗ ) − b0 (e∗ ) = 1 and β 0 (i ∗ ) = 1
Marginal social benefits equal marginal costs of effort.
Carsten Sprenger
M owns F . Gains from quality innovation are split 50:50. The
parties’ payoffs are
and
Consider a benchmark where e and i are contractible and total
net surplus from G and M’s trading relationship is maximized:
Lecture 2
Equilibrium under Private Ownership
c 0 (eM ) = 1
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
First-best
Under public ownership, G can realize a fraction
0 ≤ (1 − λ) ≤ 1 of the net social gains from innovation
c(e) − b(e) + β(i).
Thus, λ measures the incentives of government
employees. In the case of λ = 1, the public employee is
irreplaceable.
To summarize, the default payoffs (in the absence of
renegotiation) are as follows.
UM
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Equilibrium under Public Ownership (1)
G owns F . Renegotiation is over the fraction λ of the gains from
both innovations. The parties split 50:50. Their payoffs are
UG = B0 − P0 + 1 − λ2 [c(e) − b(e) + β(i)]
UM
= P0 − C0 + λ2 [c(e) − b(e) + β(i)] − e − i
M chooses e and i to maximize UM , leading to the unique
solution (eG , iG ) given by the FOCs
λ 0
2 [c (eG )
− b0 (eG )] = 1
and
λ 0
2 β (iG )
=1
In contrast to the private ownership case, because the publicly
employed M needs to negotiate the cost reduction with G, he
takes account of quality reductions resulting from cost-cutting
innovations.
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Equilibrium under Public Ownership (2)
But there are new distortions:
1
2
For both quality and cost innovation, the public manager
needs the approval of G and hence surrenders half the
gains from trade, which reduces his incentives to innovate.
If λ < 1, the public manager can be replaced, and hence
has even weaker incentives to innovate.
These results can now be used to analyze what would be
the optimal ownership structure from the viewpoint of
society.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Optimal ownership structure (2)
Equilibrium levels of e under different ownership structures
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Optimal ownership structure (1)
Public ownership is preferable if total surplus (UG + UM ) under
public ownership, denoted by SG is larger than total surplus
under private ownership, SM .
⇔ SG > SM
⇔ c(eG ) − b(eG ) + β(iG ) − eG − iG
> c(eM ) − b(eM ) + β(iM ) − eM − iM
Renegotiation is under symmetric information. Therefore, all
outcomes are ex-post efficient. The only difference is in the
choice of ex ante investments e and i. This is illustrated in the
following two figures.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Optimal ownership structure (3)
Equilibrium levels of i under different ownership structures
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Optimal ownership structure (4)
Proposition 1: eM > e∗ , iM < i ∗ .
Proposition 2: eG < e∗ and iG ≤ i ∗ (with iG < iM unless
λ = 1).
Proposition 3 offers conditions under which private
ownership is superior. Replace the function b(e) by θb(e),
where θ > 0, and replace the function c(e) by φc(e),
where φ > 0. Then,
For sufficiently small θ (i.e., quality deterioration from cost
innovation is small), private ownership is superior to public
ownership.
For sufficiently small θ and φ and λ < 1 (i.e., cost reduction
is ineffective, only quality innovation matters), private
ownership is superior to public ownership.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The role of competition (1)
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Optimal ownership structure (5)
Proposition 4 offers conditions under which public
ownership is superior. Let b(e) ≡ c(e) − σd(e), where
σ > 0 and replace β(i) by τ β(i), where τ > 0. Then,
For sufficiently small σ and λ sufficiently close to 1, (i.e.,
social gains from cost reduction converge to zero and
incentives for quality innovation are similar under both
regimes), public ownership is superior to private ownership.
For sufficiently small σ and τ (i.e., social gains from cost
reduction converge to zero and gains from quality
innovation are small), public ownership is superior to
private ownership.
Proposition 5: Costs (C0 − c(e)) are always lower under
private ownership. Quality (B0 − b(e) + β(i)) may be higher
or lower under private ownership.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The role of competition (2)
The model omits ex post competition between suppliers of
the good. Suppose that
consumers buy the good directly from the contractor
(without government intervention),
consumers can assess the quality on their own (a good
assumption with most goods, a plausible assumption for
education, and probably the wrong assumption for health),
suppliers are competitive.
Then the private contractor would face socially optimal
incentives (he receives c(e) − b(e) + β(i) since any quality
shortfall resulting from cost reduction would lead to a lower
price.
Carsten Sprenger
Lecture 2
The public manager would still have to negotiate any
innovation with the government and reap only part of the
benefits.
Thus, trivially, if there is no need for the government,
private provision is more efficient. More interesting cases
involve some need for government financing or other social
objectives
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Corruption and patronage (1)
Relax the assumption that the bureaucrat (G) act on behalf
of society and allow for him to be self-interested.
Case 1: Corruption – the politician uses control rights to
extract money from the contractor.
Suppose a politician can decide on privatization before
date 0 (before any relation-specific investments). Later
contracting decisions concerning F pass to a lower level
(honest) bureaucrat.
The politician can then sell the company to M at an
artificially low price and extract a bribe from M.
If the politician keeps F public, M fears replacement, so
before date 0 (when relation-specific investments are
made) his future payoff is zero, and so is the politician’s
bribe.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The example of prisons (1)
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
Corruption and patronage (2)
Thus, under corruption, the politician privatizes even if it is
socially inefficient.
Case 2: Patronage – the politician caters to special interest
groups to win elections.
For example, he hires more public sector employees or
pays them wages above market levels.
If spending public resources to transfer wealth to such
interest groups is easier with in-house provision than with
contracting, then politicians would have a bias toward too
little privatization.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The example of prisons (2)
Private prisons have grown in the United States, but, as of
1996, were housing only about 3 percent of the total prison
population.
Private prisons are about 10 percent cheaper per prisoner,
partly because they do not pay the public union wage
premium, and partly because they hire lower quality
workers.
Quality is with no doubt an important issue here:
order (security of prisoners, escapes, staff conduct,
violence)
amenities (food, health care)
rehabilitation (vocational training, education for prisoners)
Objections to prison privatization typically focus on these
quality issues.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
Many details can be written into contracts (personnel
policies, staff training, physical conditions and safety
codes, inmate rights, services, inmate work programs,
visiting, etc.
But many quality issues are left out (quality of personnel,
quality of personnel training, ...)
There is some evidence of more violence in private
prisons, but also of direct contract violations that have not
been followed up by public authorities.
In terms of the model, there are significant opportunities of
cost reduction at the expense of quality that do not violate
contracts (c(e) and b(e) are comparable).
With limited opportunities for quality innovation (β(i) small),
we are close to Proposition 4.
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
The model assumptions
The first-best and equilibria under the two ownership regimes
Optimal ownership structure
Discussion
The example of prisons (3)
A Dynamic Model of Privatization: Che, 2009
Could competition between prisons for inmates strengthen
the case for privatization?
If convicts could choose, this might contractors induce to
attract customers by allowing gangs, drugs and perhaps
even easy escapes.
More plausible: judges choose. They might choose higher
quality prisons, but might also choose lower quality to get a
stiffer penalty for their convicts.
In any case, contractors would cater to the preferences of
judges, which need not coincide with social welfare.
Overall, the case for prison privatization does not seem to
be very strong!
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Most papers, including Schmidt, 1996 and Hart, Shleifer
and Vishny, 1997, have focused on privatization of firms
that have substantial market power or provide public
services, rather than competitive firms, a major target of
privatization in transition economies.
Che, 2009 offers a dynamic model of privatization, the
evolution in the protection of property rights and
post-privatization performance.
The (exogenous) evolution of the institutional environment
creates a need for privatization.
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
A Dynamic Model of Privatization (2)
If now a firm could adopt the optimal ownership structure
without transaction costs, we should not observe any
changes in post-privatization performance.
An additional friction is introduced – financial constraints of
the buyers.
The model is designed to reflect the Chinese experience.
The buyers were typically the managers of the firms, with
long-lasting working relationships with the government.
This helped to alleviate informational asymmetries.
Carsten Sprenger
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Lecture 2
A Dynamic Model of Privatization (3)
Economic reforms in China started in the late 1970’s, but
there was no privatization for 15 years.
Growth was driven by local government-owned companies
and partly by the new private sector.
It thus seems that growth can be achieved by organizations
that are robust to weak institutions but they are only
imperfect substitutes for better property rights protection.
In the 1990s there was a shift towards better protection of
private property (amendment of the constitution in 1999).
Carsten Sprenger
Lecture 2
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
Introduction
Economic Theory on State Ownership and Privatization
The proper scope of government
A Dynamic Model of Privatization
A Dynamic Model of Privatization (4)
The model derives results on timing of privatization: It can
be suboptimally early or late due to the financial
constraints. This affects pricing of firms and
post-privatization performance.
Improved protection of private property rights has two
opposing effects from the viewpoint of the government:
1
2
It reduces the abilty of the government to extract rents from
the firm.
But it also encourages higher effort from the manager (who
feels less threat of expropriation) and hence fives rise to
more rent being available for the government to extract.
Conclusion
It seems that not yet all the tradeoffs between government
ownership and private ownership are well understood.
The trend towards partial state ownership, possibly
combined with stock market listing, as well as recent
nationalizations are hard to explain with current theory.
The next lecture will show (selectively) the state of
empirical research on these issues.
This tradeoff may explain the conflicting attitudes of
governments towards privatization.
Carsten Sprenger
Lecture 2
Carsten Sprenger
Lecture 2