Thursday, 29 November 2012

Just for fun: the theory of privatisation

Having been working on a survey of the theory of the firm I noted that an often neglected topic in the literature is that of state owned firms and their privatisation. Thus I added a short section on the literature on privatisation.

There is a surprising overlap between the theory of the firm and the theory of privatisation. Hart (2003: C69) makes this clear when he writes,
"Let me begin by discussing the very close parallel between the theory of the firm and the theory of privatisation. In the vertical integration literature one considers two firms, A and B. A might be a car manufacturer and B might supply car-body parts. Suppose that there is some reason for A and B to have a long-term relationship (e.g., A or B must make a relationship-specific investment). Then there are two principal ways in which this relationship can be conducted. A and B can have an arms-length contract, but remain as independent firms; or A and B can merge and carry out the transaction within a single firm. The analogous question in the privatisation literature is the following. Suppose A represents the government and B represents a firm supplying the government or society with some service. B could be an electricity company (supplying consumers) or a prison (incarcerating criminals). Then again, there are two principal ways in which this relationship can be conducted. A and B can have a contract, with B remaining as a private firm, or the government can buy (nationalise) B".
"[ ... ] the issues of vertical integration and privatisation have much more in common than not. Both are concerned with whether it is better to regulate a relationship via an arms-length contract or via a transfer of ownership". Hart (2003: C70)

The incomplete contracting framework discussed in the previous subsection gives an approach which can be utilised to study the difference between public and private ownership. In fact incomplete contracts are a necessary condition to explain the differences between the two forms of ownership. In a world of complete or comprehensive contracts there is no difference between private and state owned firms. In both cases the government can write a contract with the firm that will anticipate all future contingencies - it will detail the managers' compensation, the pricing policy of the firm, how changes in technology will the change the firm's products etc - and thus the outcome under both forms of ownership will be the same.

This intuition has been formalised into a series of Neutrality Theorems. These theorems establish the conditions under which private or public ownership of productive assets is irrelevant for the final allocation of resources. Consider first the `fundamental privatisation theorem' due to Sappington and Stiglitz (1987). Assume the government's aim is to simultaneously achieve three objectives: (i) economic efficiency; (ii) equity; (iii) rent extraction. What Sappington and Stiglitz show is that the government can design an auction scheme that will result in these three objectives being achieved and where both public and private production give the same outcome. The government has a `social' valuation of the level of output. This valuation embodies the government's concerns with regard to equity issue such as the consumption levels of the good among different classes of citizens. It is assumed that the costs of production are such that production by a single firm is optimal but there are at least two risk-neutral firms, who have symmetric beliefs about the least-cost production technology, willing to bid to be the supplier. The government auctions off right to the supplier of the good with the understanding that the supplier receives a payment which equals the social evaluation. The most efficient firm will win the contract with the highest bid, which will equal the firm's (expected) profits, and will set the production level most preferred by the government. Rent extraction is achieved since the wining bit equals the firm's profits and economic efficiency is achieved since the most efficient firm is selected as the producer and the firm produces the government's preferred (social welfare maximising) level of output.

A simple example of this mechanism is given by Bos (1991: 20). Let the payment received by the firm equal the government's social valuation which equals the sum of consumer surplus plus revenue. (This is the total area under the demand curve for a given quantity.) This induces a profit maximising firm to maximise the sum of consumer and producer surplus. This implies technological and allocative efficiency. Since the highest offer in the competitive auction is identical to the expected profit of the firm, the expected monopoly profit goes to the government.

Shapiro and Willig (1990) obtain a similar result for a setting in which a public-spirited social planner or framer decides on the nationalisation/privaitisation outcome and sets up the governance structure for the enterprise chosen. The framer's decision is driven by the informational differences between private and public ownership. The important pieces of information are: (i) information about external social benefits generated by the firm; (ii) information concerning the difference between the ``public interest" and the private agenda of the regulator; (iii) information about the firm's profit level (cost and demand information).

First consider the case where the firm is state owned. Here the firm is run by a public official that Shapiro and Willig refer to as a Minister. By virtue of his role in managing the enterprise, the minister receives the private information about the profitability of the enterprise. By virtue of his position in the public sector, the minister also observes information that bears on the external social benefits generated by the enterprise's operations. Given this information the minister makes decision as to the level of investment in the firm and the level of output for firm. The overall social welfare function that the framer seeks to maximise is the sum of external benefits plus enterprise profits where there is a magnification factor added to the profit term which equals the unit cost of raising public funds, including any distortions caused by the taxes required to finance public sector operations. The minister's objective function is that of the framer plus a term related to the private agenda of the minister where there is a weighting parameter attached to private agenda term which measures how easily the minister can extract these benefits. This parameter can be interpreted as being a proxy for how well the political system works. The better the system the greater the limits on what the minister can extract.

If the firm is a private company then it is managed by a professional manager and is overseen by a regulator. The manager observes the profitability of the firm while the regulator learns the nature of the externality variable and the private agenda variable. The regulator designs a regulatory scheme that offers the expectation of a competitive rate of return on the private firm's sunk capital. The firm then maximises profit subject to the regulatory scheme while the regulator has the same objective function as the minister under state ownership. The framer's objective is to maximise the sum of the external benefits plus profits net of the cost of rasing any public funds needed to make the transfers to the private company required under the regulatory scheme.

The important difference between the two ownership forms is who receives the information about cost and demand conditions. The manager is the informed party under private ownership while under public ownership the minister is informed. This means that an informational barrier is created between the firm and the government by privatisation. The advantage of this barrier is that it reduces the discretion the minister has to interfere with the working of the firm. The disadvantage is that it makes it more difficult for the regulator to motivate the firm to purse social welfare objectives.

When considering neutrality results first consider the operation of an enterprise in an environment in which there is no private information whatsoever. Suppose all information about the external benefits of the enterprise and all information about its profitability is contractible. In such circumstances, the regulator could put in place a set of taxes or subsidies, contingent on what will become commonly known realisations of the public costs and benefits of the enterprise's operations. These taxes and subsidies could be designed to induce the owners to operate the enterprise to serve precisely the regulator's objectives in every contingency.

Perhaps it is not surprising that one can obtain a neutrality result in the complete absence of noncontractible private information, for in such a case there is no truly active role for the managers of the enterprise. They need only carry out the detailed instructions left by the minister or the regulator, and the manager cannot claim that there will ever be any new information or extenuating circumstances that can justify departures from that mechanical mandate.

The more interesting neutrality results arise in situations where there is private information. First assume that the private information about the firm's profitability is known only after the investment is made but the private information concerning public impacts and private agenda is known to the regulator when he must commit himself to the regulatory mechanism, before the time of the investment decision. Under these conditions, the regulator can exert sufficient indirect control over the private firm to obtain the same outcome and payoff as under public ownership, so the framer is indifferent between public and private enterprise. The regulator's control is secured by paying the firm according a the schedule which takes into account the sum of external benefits generated plus the private agenda of the regulator plus the smallest possible payment that will induce the firm to invest. With this schedule, the regulator induces the same actions and achieves the same payoffs as does the minister under public enterprise. The mechanism operates by forcing the firm to internalise the objectives of the regulator.

The second distinct case occurs when private information concerning both costs and public impacts is revealed only after the investment commitment must be made. Only the prior probability distributions of the private information of the regulator and the profitability of the firm are known at the time the investment decision must be effected. After the investment has been made, but before the activity level must be chosen, the private information of the regulator will become know to him and the nature of the firm's profitability will be revealed to the manager of the enterprise. Again, the regulator's optimal payment scheme results in the same choices of activity levels and the same expected drain on the treasury that would be the result of public enterprise. The logic behind this result is a straightforward extension of the analysis of the first case. Here the regulator commits himself to the menu of payment schedules, with the understanding that he will choose a particular schedule from this menu after investment is made and his private information is revealed to him, but still before the activity level must be chosen by the firm. The firm is indifferent, ex ante, about which particular schedule will be chosen from the menu by the regulator, because each of them offers the same zero level of expected profits, that is just enough to induce the firm to make the investment. Once the regulator learns his private information, he will be motivated to select the payment schedule corresponding to that information because that schedule is optimal for his objective function. Given this payment schedule, the firm will be motivated to choose the same activity level as in the first case above, and here too that is the optimum from the perspective of either the regulator or the public minister.

In the third case of neutrality the private firm has private information about its costs before the investment decision must be made. It is assumed that there are no costs to raising public funds and thus any transfers from the treasury are not a matter for concern to the framer, the regulator or the public minister. Because the firm knows information about its profitability and the regulator is aware of that fact but does not know this information himself, the regulator, to assure that investment will be made, must commit to a payment schedule or to a menu of schedules that provides non-negative profit for all demand/cost cases. Here, because of the stipulation that public funds can be raised at zero cost, this requirement poses no problem for the regulator: he is perfectly willing to add enough funds to any payment schedule to assure its profitability in the light of his indifference to transfers from the treasury. Consequently, it is optimal for the regulator to offer the firm internalisation schedules, each with different levels of investment funds, such that these funds are sufficiently large to guarantee the firm non-negative profit even if its profitability level is the worst possible. In the end, the regulated firm chooses the same activity levels that the public enterprise would choose, but the drain on the treasury caused by regulation is greater than that caused by public enterprise. Since, in this case, however, that drain is not a matter of concern, the framer would find no difference between the performance of public and private forms of organisation.

The third neutrality result is that of Shleifer and Vishny (1994). Their starting point is the idea that politicians control SOEs in order to achieve political objectives, such as excess employment and/or high wages. In this model the politician derives benefits from this inefficient allocation of resources, as they create political support for him. If the firm is privatised then the politician must bargain with the manger of the firm to get the outcome he wants. Clearly the manager, who aims to maximise profits, and the politician, who wants political support, have conflicting objectives. The firm will not want to expand employment above the profit maximising level as the politician wishes to do. The politician must make a transfer, from the treasury, to the firm to induce the takeing on of the extra workers. This is a problem to the politician since the transfer is costly to him as taxes need to be raised to finance the subsidy.

The Shleifer and Vishny model allows for a complete separation of income rights and control rights. There is no clear-cut dichotomy between state-owned and private firms in the model as it allows for four corparate forms: (i) a SOE, the Treasury has income rights and the politician has control rights; (ii) a regulated firm, the private owners have income rights, but the politician has control rights and can interfere in the operating activity of the firm; (iii) a 'corporatised' firm, when the government has income rights, but the control rights are in the hand of the firm's management; (iv) a purely private firm, when the manager/owner has both income and control rights.

As the model has the two parties bargaining, disagreement points have to be identified. These point are were the politician and the manager control the firm. When the politician controls the firm he has control over the manager and is able to the firm down to zero profits. He can use the firm's cash flow to hire extra labour up to the point where the marginal benefits of the excess employment equals the marginal cost of raising public funds. Under control by the manager, the manager has power over the politician, and the firm produces at the efficient level (with zero excess labour) but does not receive any transfer from the Treasury.

As far as the manager and the politician are concerned, the efficient point is reached when the level of excess employment reaches the point where the marginal political benefits equals the wage, which is the marginal cost of labour. At this point the amount of excess labour employed is lower than that under politician control and the subsidy paid to the firm is higher than under private control.

The neutrality result that Shleifer and Vishny present is basically an application of the Coase Theorem to privatisation. As side payments are allowed - or more correctly in this case, when the manager and politician can freely bribe each other - then the manager and the politician will reach the jointly efficient solution no matter what the initial allocation of income and control rights.

The importance of the above theorems is that they outline the conditions under which ownership of the firm does not matter. Of all the assumptions on which the irrelevance results hinge the most important requirement is that complete contingent long-term contracts can be written and enforced. But writing complete contracts is only possible in a world of zero transaction costs. In a positive transaction costs world only incomplete contracts can be written but contractual incompleteness creates a role for ownership - making decisions under conditions not covered in the contract. It is only within such an environment that we can explain why privatisation matters, that is, why the behaviour of state owned and private companies differ. This reliance on incomplete contracts means that the theory of privatisation can be seen as forming a part of the incomplete contracts framework explained in the subsection directly above.

These results also shows why the previous theoretical privatisation literature was largely unsuccessful. That literature took a `complete' or `comprehensive' contracting perspective, in which any imperfections present in contracts arose solely because of moral hazard or asymmetric information. But as Hart (2003: C70) notes
"[ ... ] if the only imperfections in are those arising from moral hazard or asymmetric information, organisational form - including ownership and firm boundaries - does not matter: an owner has no special power or rights since everything is specified in an initial contract (at least among the things that can ever be specified). In contrast, ownership does matter when contracts are incomplete: the owner of an asset or firm can then make all decisions concerning the asset or firm that are not included in an initial contract (the owner has 'residual control rights').

Applying this insight to the privatisation context yields the conclusion that in a complete contracting world the government does not need to own a firm to control its behaviour: any goals - economic or otherwise - can be achieved via a detailed initial contract. However, if contracts are incomplete, as they are in practice, there is a case for the government to own an electricity company or prison since ownership gives the government special powers in the form of residual control rights".

Thus privatisation matters only in an incomplete contracts world. In such an environment the allocation of residual control rights will differ and so the behaviour of publicly owned firms will differ from that of privately owned firms and thus ownership and therefore privatisation will become meaningful.

Schmidt (1996a) considers a monopolistic firm that producers a public good in a world of incomplete contracts. (Schmidt (1996a) is variant of Schmidt (1996b). 1996b considers the case of privatisation to an employee manager while 1996a applies to the case of privatisation to an owner-manager. While this second case is less realistic it is simpler and does not require the assumption that the manager is an empire builder that is utilised in 1996b.) His model is multiple period with the privatisation decision being made in the initial period. That is, the government must decide whether to sell the SOE to a private owner-manager or keep it in state hands and hire a professional manager to run it. Importantly knowledge concerning the firm's cost is private information known only by the firm's owner. Given this, privatisation amounts to a transfer of private information from the government to the private owner. In the next period the manager selects his effort level and the state of the world is then revealed. The importance of the manager's effort level is that it affects the probability of the state of the world. A high level of effort from the manager results in productive efficiency being enhanced and costs being lowered for any level of output. In the last period, the government selects the transfer scheme and payoffs are revealed.

When the firm is an SOE the government observes the firm's realised cost function and thus can implement the first-best allocation by choosing the ex post efficient level of production. But the manager's wage will be fixed, since contingent contracts can not be written, and thus independent of level of output. Given this the manager has no incentive to exert effort and the government knowing this will therefore offer him only his reservation wage.

On the other hand when the firm is in private hands the government does no know the exact cost structure of the firm. In an effort to get the private owner to produce the efficient level of output the government must provide an incentive via the payment of an informational rent.But if transfer are costly it will be impossible to implement the optimal allocation and therefore the cost to private ownership is an inefficiently low level of production. However given the rent payment provides an incentive to increase effort, productive efficiency is greater.

Schmidt's main conclusion is therefore that when the monopolistic firm produces a good or service which provides a social benefit, there is a trade-off between allocative and productive efficiency that needs to be considered when deciding if a firm is to be privatised. The equilibrium production level is socially suboptimal but the incentive for better management results in cost savings. Considered overall the welfare effect of privatisation should be positive for cases where the social benefits are small, but social welfare will be greater under public ownership for those cases where production exhibits large social benefits.

An important implication of this is that a case can be made for privatisation even when the government is a fully benevolent dictator who wishes to maximise social welfare. Even if all the deficiencies of the political system could be remedied it is still possible for privatisation to be superior to state ownership.

In the Laffont and Tirole (1991) model a firm is assumed to be producing a public good with a technology that requires investment by the firm's manager. In the case of a public firm this investment can be diverted by the government to serve social ends. For example, the return on investment in a network could be reduced by the government if it were to allow ex post access to the general population. Such an action may be socially optimal but would expropriate part of the firm's investment. A rational expectation of such an expropriation would reduce the incentives of a public firm's manager to make the required investment. For a private firm, the manager's incentives to invest are better given that both the firm's owners and the manager are interested in profit maximisation. The cost of private ownership is that the firm must deal with two masters who have conflicting objectives: shareholders wish to maximise profits while the government purses economic efficiency. Both groups have incomplete knowledge about the firm's cost structure and have to offer incentive schemes to induce the manager to act in accordance with their interests. Obviously the game here is a multi-principal game which dilutes the incentives and yields low-powered managerial incentive schemes and low managerial rents. Each principal fails internalise the effects of contracting on the other principal and provides socially too few incentives to the firm's management. The added incentive for the managers of a private firm to invest is countered by the low powered managerial incentive schemes that the private firm's managers face. The net effect of these two insights is ambiguous with regard to the relative cost efficiency of the public and private firms. Laffont and Tirole can not identify conditions under which privatisation is better than state ownership.

In the Shapiro and Willig paper discussed above privatisation is considered in a context where the regulator pursues a different agenda from the framer. Assume that either information about profitability is known before investment is decided upon or that there are costs to rasing public funds. In these cases the neutrality results of Shapiro and Willig don't hold. The equilibrium behaviour of the minister who is in charge of the firm is virtually unconstrained and he will set the activity levels of the firm as to maximise his utility. The regulator of the private firm has a more complex problem to deal with. This involves the designing of regulatory scheme which ensures non-negative profits for the firm. Given this is a case of optimal regulation under asymmetric information we would expect to see the firm enjoying informational rent, which are proportional to the activity chosen. As public funds are costly to raise these transfers are costly to the state.

The trade-off in this model is driven by how easily the public official can interfere with the operations of the firm. If the public official's objectives are the same of the (welfare maximising) framer, i.e. the public official has not private agenda, then public ownership is optimal. In this case private ownership reduces performance since the firm extracts a positive information rent. But when there is a private agenda then a reduction in discretion may increase welfare. Politicians find it easier to distort the operations of a firm in their favour when that firm is an SOE and under the direct control of the minister. The regulated private firms does earn a positive rent but is less subject to the control of the regulator. This means that regulated private firms are likely to out perform SOEs in poorly functioning political systems,which are open to abuse by the minister, and where the private information about the profitability of the firm is less significant. This makes it easier for the regulator to get the firm to maximise social welfare.

In Boycko, Shleifer and Vishny (1996) information problems do not explain the difference between public and private firms. Here it is differences in the costs to a politician of interfering in the activities of the different types of firms that explains the effects of privatisation. The starting point of the paper is the observation that public firms are inefficient because they address objectives of politicians rather than maximise efficiency. One common objective for a politician is employment. Maintaining employment helps the politician maintain his power base. In their model Boycko, Shleifer and Vishny assume a spending politician, who controls a public firm, forces it to spend too much on employment. The politician does not fully internalise the cost of the profits foregone by the Treasury and by the private shareholders that the firm might have.

Boycko, Shleifer and Vishny argue privatisation can be a strategy to reduce this inefficiency in state-owned enterprises. By privatisation they mean the reallocation of control rights over employment from politicians to a firm's managers and the reallocation of income rights to the firm's managers and private owners. The spending politician will still want to maintain employment and can use government subsidies to `buy' excess employment at the private firm. In this model the advantage of privatisation is that it increases the political costs to maintaining excess employment. It is less costly for the politician to spend the profits of the state-owned firm on labour without remitting them to the Treasury than it is to generate new subsidies for a privatised firm. Given that voters will be unaware of the potential profits that a state firm is wasting on hiring excess labour they are less likely to object than they are to the use of taxes, which they know they are paying, to subsidise a private firm not to restructure. This difference between the political costs of foregone profits of state firms and of subsidies to private firms is the channel through which privatisation works in this paper.

Shleifer and Vishny (1994) is a continuation of research stated in Boycko, Shleifer and Vishny (1996). As with the 1996 paper Shleifer and Vishny assume that there is a relationship between politicians and firm mangers that is governed by incomplete contracts and thus ownership becomes critical in determining resource allocation. As noted above the Shleifer and Vishny model is a game between the public, the politicians and the firm managers. The model derives the implications of bargaining between politicians and managers over what the firms will do. A particular focus is on the role of transfers between the private and state sectors including subsidies to firms and bribes to politicians.

To consider the determinants of privatisation and nationalisation Shleifer and Vishny utilise what they term a "decency constraint" which says that the government cannot openly subsidise a profitable firm. To do so would be seen as politicians enriching their friends. The first, obvious, point made is that politicians are always better off when they have control rights. Control brings political benefits, via excess employment, and bribes, to allow a reduction in the excess employment. Both the Treasury and the politicians prefer nationalisation. (Remember that as a SOE the Treasury has income rights and the politician has control rights.) to subsidising a money-losing private firm. Control brings bribes and even without bribes politicians get a higher level of employment and lower subsidies when they have control. The Treasury likes the smaller subsidies that come with nationalisation. When it comes to profitable firms politicians like control or Treasury ownership because these firms have a strong incentive to restructure since the profits go to the private owners and they lose little in terms of subsides due to the decency constraint. To ensure the firms achieve political objectives politicians need control. Given the decency constraint politicians don't want managers who have control rights to also have large income rights since the decency constraint means smaller subsidies are lost if employment is cut and income rights mean the managers gain from restructuring and maximising profits. Politicians who have control prefer higher private and lower Treasury ownership since higher private ownership implies higher bribes. Without bribes the private surplus is extracted via higher levels of employment.

Given that politicians like control, Why would they ever privatise a firm? To explain privatisation the interests of taxpayers must become more prominent. Given this the decision to privatise then becomes the outcome of competition between politicians who benefit from government spending (and bribes) and politicians who benefit from low taxes and support from taxpayers. We would expect privatisation to take place when political benefits of public control are low, and the desire of the Treasury to limit subsidies is high. This is most likely to occur when the political costs of rasining taxes to pay subsides is high and when the political benefits from excess employment are low.

The final paper to be considered is Hart, Shleifer and Vishny (1997). Again in this paper information problems are not the driving force of the analysis of contracting out. The provider of a service, either public or private, can invest his time in improving the quality of the service or reducing the cost of the service. The important assumption is that investments in cost reduction have negative effects on quality. Investments are non-contractible ex ante. For the case where the provider is a government employee he must obtain approval from the government to implement any innovation he has created. Given that the government has residual rights the employee will gain only a fraction of return on his investment. This gives him weak incentives to innovate. If the service provider in an independent contractor, i.e. the service has been contracted out, then he will have stronger incentives to both cut costs and improve quality. This is because he keeps the returns to his investment. The downside to private provision is that the incentives to cut costs are strong and the provider does not fully internalise the negative effects on quality of the reductions in cost. With public provision the incentive for excessive cost cutting are reduced as are the incentive for innovation and quality improvements. Costs are always lower under private ownership but quality may be higher or lower under a private owner. Hart, Shleifer and Vishny argue that the case for public provision is generally stronger when (i) non-contractible cost reductions have large deleterious effects on quality; (ii) quality innovations are unimportant; (iii) corruption in government procurement is a severe problem. On the other hand their argument suggests that the case for privatisation is stronger when (i) quality-reducing cost reductions can be controlled through contract or competition; (ii) quality innovations are important; (iii) patronage and powerful unions are a severe problem inside the government.

  • Bos, Dieter (1991). Privatization: A Theoretical Treatment, Oxford: Oxford University Press.
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  • Shapiro, Carl and Robert D. Willig (1990). `Economic Rationales for Privatization in Industrial and Developing Countries'. In Ezra N. Suleiman and John Waterbury, (eds.), The Political Economy of Public-Sector Reform and Privatization, Boulder: Westview Press.
  • Shleifer, Andrei and Robert W. Vishny (1994). `Politicians and Firms', Quarterly Journal of Economics, 109(4) November: 995-1025.

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