From complete to incomplete (contracts): A survey of the mainstream approach to the theory of privatisation

Abstract

Privatisation is a common, yet controversial, policy in many countries around the world, including New Zealand. In this essay, we survey the literature on the theory of privatisation to see what insights it provides to the privatisation debate. We divide the literature into two periods defined by their relationship to the theory of the firm. In the period up to 1990, the literature followed the theory of the firm in using a complete or comprehensive contracting modelling framework. By the end of the 1980s, the ownership neutrality theorems highlighted a major weakness with this approach. The contemporary (post-1990) literature took advantage of incomplete contracting models to explain the difference in the behaviour of state and privately owned firms.

Keywords:

• privatisation
• incomplete contracts
• theory of the firm

JEL Classification:

• D23
• H11
• L33

Acknowledgements

The author thanks two anonymous referees for comments that improved the paper.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. See endnote 5.

2. For more details, see, for example, Duncan and Bollard (1992), Evans, Grimes, Wilkinson, and Teece (1996) and Barry (2002, 2011, 2012) for discussions of privatisation in New Zealand. Duncan (1996) looks at public enterprise reform more widely than just privatisation.

3. See Jackson and Price (1994, p. 5) for examples.

4. Hart (1995, p. 11–12), for example, has a short section entitled ‘An omitted topic: public ownership’. Hart writes ‘[a] very important topic not considered concerns the optimal balance between public and private ownership. [ … ] This issue has always been a central one in the economic and political debate, but it has attracted new attention in the last few years as major industries have been privatized in the West and the socialist regimes in Eastern Europe and the former Soviet Union have dissolved’.

5. For surveys of the results of empirical studies of privatisation, see Bortolotti and Siniscalco (2004), Kikeri and Nellis (2004), Megginson (2005), Megginson and Netter (2001), Sheshinski and López-Calva (2003), Shirley and Walsh (2000) and Yarrow (1986). See also the ‘Forum on Privatisation’ in CESifo (2005). Gupta, Schiller, Ma, and Tiongson (2001) is a survey of the literature on the effects of privatisation on job losses and wages. A survey on privatisation in transition countries is Havrylyshyn and MacGettigan (1999). Claessens and Djankov (2002) look at privatisation in Eastern Europe. The Latin American experience is covered in Chong and López-de-Silanes (2003, 2005) and Nellis (2003b). Privatisation in Sub-Saharan Africa is discussed in Nellis (2003a). A survey on privatisation in the developing world, in general, is provided in Parker and Kirkpatrick (2003). For studies of the European experience with privatisation, see Parker (1999) and Köthenbürger, Sin, and Whalley (2006) which contains chapters on Austria, Denmark, Finland, France, Germany, Italy, Ireland, The Netherlands, Spain, and the United Kingdom. For other views on the British privatisation experience, see Pollitt (1999), Part 2 of Vickers and Yarrow (1988), and Yarrow (1993). On the French experience, see Dumez and Jeunemaitre (1994) and Schmidt (1999). Gökgür(2006) looks at the case of Turkey. La Porta and López-de-Silanes (1999) analyse the Mexican privatisation program. For a discussion of privatisation in Malaysia, see Sun and Tong (2002). For differing viewpoints on the privatisation experience in Russia, see Boycko, Shleifer, and Vishny (1995), Kokh (1998), Nellis (1999), Radygin (2003), and Brown, Earle, and Gelbach (2013). The performance of newly privatised firms in China is studied in Wei, Varela, D'Souza, and Hassan (2003). In addition, see Table 1.3, p. 22–24, in Megginson (2005) for a more comprehensive listing of country studies describing national privatisation programs.

6. For overviews of this literature, see Bös (1989, 1991), Domberger and Piggott (1986), Rees (1994), Vickers and Yarrow (1988), Yarrow (1986), and Yeaple and Moskowitz (1995).

7. This idea is important, since it means that several well-known, pre-1990, approaches to the firm that can be seen as offering insights into the differences between public and private firms are now perceived as falling outside of the mainstream approach to privatisation. One such approach is the ‘managerial approach’ to the firm, e.g. Baumol (1959, 1962), Williamson (1964, 1970), and Marris (1964). Managerial models start from the twin ideas that ownership and control are separated and that managers, just like other economic agents, act in ways that promote their own interests. But within these models, maximising assumptions are still maintained. The obvious question this gives rise to is, What is maximised? For Baumol (1959), it is assumed that managers maximise sales subject to a profit constraint, and for Baumol (1962) the firm's objective is to maximise the growth rate of sales. Marris (1964) also assumes growth maximisation subject to a rate of return constraint. In the Marris model, a manager has an incentive to grow a firm past its profit maximising size, since manger's salaries are higher in larger firms. Williamson (1964, 1970) assumes a more general managerial utility function. His managerial discretion models let managers make a trade-off between ‘slack’ (some form of utility for the manager) and profits. The important point for our proposes is that these models utilise standard neoclassical assumptions including the use of complete contracts. Another section of the non-mainstream literature is centred on the old property rights approach (OPRA) (e.g., Alchian, 1965, 1969; Barzel, 1997; Demsetz, 1967), and its outgrowth the nexus of contracts view of the firm (e.g., Alchian & Demsetz, 1972; Cheung, 1983; Fama, 1980; Jensen & Meckling, 1976). As Foss and Foss (2001) detail during the 1960s and 1970s, there was an intensive, if still not fully resolved, debate within the OPRA concerning the question, From the economic viewpoint, what does it mean to own an asset? This is in contrast to the contemporary mainstream question of, Does it matter who owns an asset? It is this latter question that is most relevant to issues to do with the boundaries of a firm – two assets owned by the same people are part of the same firm, whereas those same assets are in different firms if they are owned by different groups of people – including those between public and private firms. The major defect, from the viewpoint of mainstream authors, in the OPRA is its reliance on complete contracts. As noted in the ‘The neutrality theorems’ section, under complete contracts, public and private ownership give the same outcome and this has lead the mainstream privatisation literature to largely ignore approaches such as the managerial and OPRA. This under appreciation by the mainstream means that the insights that the above approaches offer to the analysis of privatisation have been left largely underdeveloped.

8. Martimort (2006) discusses this theorem in detail and gives conditions for it to hold under complete contracts.

9. A simple example of this mechanism is given by Bös (1991, p. 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.

10. Schmidt (1996a) is a variant of Schmidt (1996b). Schmidt (1996b) considers the case of privatisation to an employee manager, while Schmidt (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 Schmidt (1996b).

11. Technically, the multi-principal distortion is similar to the double marginalisation on two complementary goods sold by non-cooperative monopolists.

12. As an SOE, the treasury has income rights and the politician has control rights.

13. See Maskin (2002) and Aghion and Holden (2011, p. 190–193) for non-technical discussions.