Policy%20Consideration%20on%20Privatization%20in%20a%20Mixed%20Market%20%20-%20An%20IO%20Approach%20-

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Policy Consideration on Privatization in a Mixed
Market - An IO Approach -

• Sang-Ho Lee
• Chonnam National University, Korea
• sangho_at_chonnam.ac.kr

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Historical Backgrounds

• Since 1980s, industrial policy reform of
  privatization and competition in the transitional
  economy is a remarkable historic event of
  institutional evolution.
• - Russian style vs. Chinese style
• Since 1980-90s, the governments in developed and
  later developing countries, such as African,
  Asian, Eastern European, and Latin American
  countries, have activated or have planned to
  activate liberalization policy of privatization
  and competition.

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Why Not Public Firm?

• Theoretically, public firm is one of the economic
  instruments utilized by the government to correct
  market failures and to reach an improvement in
  social welfare under the condition of either
  imperfect competition in the industries or public
  goods provision.
• However, the poor economic and financial
  performances of many public firms and the cases
  of successful privatization in some developed
  countries have been used as arguments for the
  industrial policies of privatization and
  competition.

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Policy Reform of Privatization

• A government-owned company in the public sector,
  which is privatized (via voucher system, initial
  public offerings or direct public offerings,
  merger acquisition, or publicly-held share
  buyback), becomes public-owned company now in the
  private sector.
• But, a private-owned company in the private
  sector, which goes public (via IPO), becomes a
  public-owned company still in the private sector.

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Public Firms in Mixed Markets

• Nowadays, public firm operates in the market with
  private competitors.
• For example, public firms in mixed market include
• - Banking Postal Bank (Korea, Japan, New
  Zealand, U.K., Germany)
• - Automobiles Renault (France), VW (Germany)
• - Medicine Public Institute (Brazil)
• - Airline National airlines (Swiss, Belgian,
  France)
• - Overnight Delivery USSP (USA), Japan Post
  (Japan), Korean Post (Korea)
• - Energy Public Gas Corps (Japan, France)
  Electricity (France)
• - Broadcasting BBC (UK), NHK (Japan), KBS
  (Korea)

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This paper

• considers a simple economic model of mixed market
  where the public firm competes with private firm.
• reviews the welfare effect of the industrial
  policy reform in the process of privatization and
  points out the fundamental efficiency trade-off
  in privatization policy, in terms of the cost
  efficiency gap between two different
  organizations.
• extends the analysis into the case that the
  government faces a foreign competitor and compare
  the welfare consequences.
• discusses several important industrial policy
  implications on the issues of privatization.

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The Structure of the Paper

• (1) Theoretical Backgrounds and Motivation
• (2) Basic Model of Monopoly Market
• (3) Mixed Duopoly Model
• (4) Competition with a Foreign Firm
• (5) Discussions on Industrial Policy Implications

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Theoretical Background Differences between
public and private firms

• - Debate 1 Public firms are less efficient than
  private firms.
• ? Some empirical works do not support this
  view, but many other papers support this view,
  from the theoretical and practical reviewers.
• - Debate 2 They have different objective
  functions.
• ? Private firms maximize their own profits,
  whereas public firms might care about social
  welfare in general.

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Debate 1 Managerial incentives of public firms(1)

• the absence of capital market monitoring they
  may invest too little or too much, since they are
  not given the stocks options that would encourage
  them to take a long-term perspective
• the absence of labor market monitoring public
  firm is not subject to takeovers and its managers
  are therefore less concerned about losing their
  jobs
• the soft budget constraint problem public firm
  is not subject to the discipline of the
  bankruptcy process because the government will
  always bail it out in case of difficulty
• the principal-agent problem governments are
  subject to the pressure of interest groups to
  direct the behavior of a public firm so as to
  enhance the welfare of these groups

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Debate 1 Managerial incentives of public firms(2)

• ? no intention from job safety
• ? no incentive from improper compensation
• ? no creation from risk averse
• All these factors reduce managerial incentives of
  taking care of efficient production, so that a
  public firm with greater managerial discretion
  might act more inefficiently than a
  well-organized private firm.

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Debate 2 The objective of public firm

• welfare maximization hypothesis benevolent
  government
• ? information and authority monitoring
  problem
• Intention captured incentive and public choice
• ? politics in conflicts and self-interest
  (beneficial lobby and power)
• Incentive principle-agent relationship btw
  public firms and government
• ? multiple units in government and moral
  hazard
• Trade-off between managerial inefficiency and
  adjusted-welfare maximization (or between
  interests conflicts)
• Mixed oligopoly market can be feasible solution
  in practice.

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Motivation

• - On the path of liberalization policy of
  privatization and competition, from the
  perspective of normative approach, the industrial
  policy implications based on the welfare effect
  of post-privatization should be examined.
• ? The proper degree of liberalization in a mixed
  oligopoly will depends on the industrial
  environment of competition (i.e., demand and
  cost) and the structure of ownership.
• ? Literature review with the simple economic
  model is necessary to understand the economic
  reasoning of privatization policy

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Basic Assumptions on Mixed Market
1. cost difference between public and private
firms Nett (1994), Lee and Hwang (2003),
Matsumura and Matsushima (2003) 2. different
objective function profit vs. welfare
maximization Matsumura (1998), Cook and
Fabella(2002), Lee and Hwang(2003) 3.
simultaneous-move game Pal (1998), De
Fraja and Delbono(1989), Lee (2006) 4.
homogeneous Products Cremer et al.
(1991), Matsumura and Matsushima (2003) 5.
competition between public and foreign private
firms Fjell and Pal (1996), Pal and
White (1998), Matsumura(2003)
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Some Results (Preview)

• (1) Under the sufficient cost efficiency gap
  between two different organization, combined
  policy of privatization and competition will
  improve the welfare
• gt The government should improve the
  competitiveness of the
• market in privatizing the public firms
• structural policy on the degree of
  competition
• -gt external incentive.
• (2) If the cost efficiency gap between two
  different organization is small, neither
  competition with foreign firm nor privatization
  policy improve the welfare
• gt The government should improve the cost
  efficiency of the public firm before privatizing
  the public firm
• managerial policy on the production
  efficiency
• -gt internal incentive.

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II. The Basic Setup

• - Notations
• qi Firm i's output / Q Total output
• p(Q)a-bQ inverse market demand
• c production cost (c0 public firm gt c1
  private firm gt c2 foreign firm)
• pi firm i's profit
• CS consumer surplus
• W social welfare (simple sum of profits and
  consumer surplus)
• Regimes
• 0 nationalization monopolistic public firm
  (welfare maximization)
• 1 privatization monopolistic private firm
  (profit maximization)
• 0c mixed duopoly (public-owned incumbent and
  private entrant)
• 1c pure duopoly (privatized incumbent and
  private entrant)
• f foreign competitor (private entrant)

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The Monopoly Market

Assumption 1 the cost efficiency gap between
private firm and public firm exists in the
principle-agency relationships the principal and
the agent will incur positive monitoring costs,
and there will some divergence between the
agent's decisions and the principals decision.
Proposition 1. (Fundamental Trade-Off in
Privatization) The welfare in post-privatization
increases only if the cost efficiency gap between
the public firm and private firm is sufficiently
large. gt the welfare change under
privatization policy depends on the relative size
of the cost efficiency gap between the public
firm and private firm
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The Duopoly Market (Model)

• Strategic interactions in a Cournot Duopoly
  Game
• Players public firm and private firm
• Strategies Cournot output competition
• Payoff welfare (public firm) and profit (private
  firm)
• 0c mixed duopoly under the simple competition
  policy
• 1c pure duopoly under the combined policy of
  competition and privatization

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The Duopoly Market (Results)

• If there is no entry cost, competition will
  reduce the market price and thus will increase
  the welfare, compared to the privatized monopoly
• If the cost efficiency gap is large, policy
  combining privatization with competition will
  increase the welfare than the mixed duopoly
• If the cost efficiency gap is small, simple
  competition policy will increase the welfare

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The Duopoly Market (Results)

• Proposition 2. The welfare in post-competition
  policy will be the highest if the cost efficiency
  gap between the public firm and private firm is
  relatively small, i.e., efficient competition.
• However, if the cost efficiency gap between
  the public firm and private firm is relatively
  large, policy combining privatization and
  competition will increase the welfare.
• privatization policy will not always give a
  welfare-improving result without competition.
  Therefore, the government should improve the
  competitiveness of the market in privatizing the
  public firms structural policy on the degree of
  competition
• -gt entry problem with technological (sunk cost
  or fixed cost) and political issue

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Competition with a Foreign Firm

• Assumption 2 the cost efficiency gap between
  domestic and foreign private firms technological
  and managerial advantages in production
• gt policy combining competition with a foreign
  firm and privatization on the public firm will
  yield a spill-over effect in the market through
  leaning on technological and managerial skill
  (neighboring effect)
• - From the perspective of ownership, not from the
  management aspect, the profit of foreign firm is
  not included in the social welfare function
• - comparison between 0cf(mixed duopoly market)
  and 1cf(pure duopoly market)

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Competition with Foreign Firm (Results)

• competition policy with foreign firm will not be
  necessary to increase the welfare
• If the cost efficiency gap is large, policy
  combining privatization and competition will
  increase the welfare than the mixed duopoly
• If the cost efficiency gap is small, neither
  competition policy nor privatization policy will
  increase the welfare

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Competition with a Foreign Firm (Results)

• Proposition 3. If the cost efficiency gap
  between the public firm and private foreign firm
  is small, neither competition policy nor
  privatization policy increase the welfare.
• However, if the cost efficiency gap is large,
  the welfare in post-combined policy of
  competition and privatization will be the
  highest.
• Competition policy will not always give a
  welfare-improving result. Therefore, the
  government should improve the cost efficiency of
  the public firm before privatizing the public
  firms competing with foreign firms
• -gt managerial policy on improving internal
  efficiency in principle-agent relationship
  managerial service innovation and internal
  incentive mechanism

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Discussions and Extensions

• What we have learned from the above analysis is
  that the welfare implications of industrial
  policy reform depend primarily upon the relative
  cost efficiency between private firm and public
  firm.
• However, in comparing the trade-off in
  privatization policy, there are many other
  important policy aspects, in terms of not only
  internal and organizational issues on managerial
  incentives, but also external and structural
  issues on market competition.
• We provide some important aspects of industrial
  policy for further discussions

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Discussions
(1) Product Differentiation and Product Quality
- Matsushima and Matsumura(2003) herd
behavior of private firms with similar strategies
and asymmetric behavior of public firm -
Hart et. al.(1997) quality distortion effect of
private firms from cost reduction or price
regulation - multi-dimensional approach
should be reexamined (2) Competition Patterns
- De Fraja and Delbono(1989)
welfare-increasing leadership - Matsumura
and Kanda(2005) endogenous market structure
- Jiang(2006) Cournot vs. Stackelberg and Nash
bargaining - Matsumura(2007) sequential
privatization and welfare effect
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Discussions
(3) Industrial Structure and Transaction Cost
- Lee(2006) vertical structure and open access
policy - foreclosure fair competition
issues should be incorporated - Sappington
and Stiglitz(1987) transaction cost issue -
separation political and technological issues
are important (4) Objective Functions of Public
Firms - Cook and Fabella(2002) comparison
of unspecified objectives - Matsumura(1998)
weighted welfare between CS and PS -
Grossman and Helpman(1995) weighted welfare
between W and the benefit from lobby -
NPO(non-profit-organization) the economic roles
and behaviors
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Discussions
(5) Political Incentives - Levy(1987)
political election and organizational
inefficiency - multi-level governance
structure and conflicts - Jensen and
Meckling(1976) agency problem in private firm
with ownership and managers - incentive
mechanism on the ownership structure (6) Partial
Privatization - Matsumura(1998) control of
weighted welfare - Lee and Hwang(2003)
efficiency improvement and information sharing
- golden share property rights (before, in,
after) the process of privatization
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Conclusion with Policy Implications
(1) It is not always true that the privatization
policy on public firm will have a beneficial
effect, as long as the cost efficiency gap is not
sufficiently large. (2) However, even though the
cost efficiency gap between domestic public firm
and foreign private firm is not large,
privatization policy might be beneficial to the
mixed society from the long term viewpoint. (3)
Under the competition with foreign firms, full
privatization (i.e., fully authorized private
firm) might not be socially beneficial until the
market is very competitive the interim process
of partial privatization. (4) The IO analysis
should be complemented with the political economy
issues in real world - reducing the power
of labor union of public firm - raising
government revenue for the deficit with small
government
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Many Thanks !! and Happy New Year of 2008 !!!

• Contact me at
• sangho_at_chonnam.ac.kr