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Infrastructure and Public Utilities Privatization in Developing

1. 35Only one firm produces at the equilibrium This is an artifact of the assumption of constant mar ginal costs which is used to isolate the sampling effect Models with non constant marginal costs yield qualitatively similar results see Auriol and Laffont 1993 Finally we assume that the government shuts down the least efficient regulated firm for the sake of readability It could instead transfer the best tech Ores nology to all regulated firms and share the optimal production among them The analysis would be unaltered 40 revelation mechanisms The equilibrium is defined as truthful Bayesian Nash equilibrium Each firm 7 1 2 sets its revelation strategy B such that it maximizes the expected profit given the cost distribution of the competitor j 4 i Let c 8 A G aS be the virtual cost Let B a cCc 2 vera f ONT prin O AB 33 The following lemma presents the structure of production and the welfare level of the duopoly under asymmetric information Lemma A2 Under asymmetric information only the firm with the lowest marginal cost pro duces Output and welfare levels are the levels obtained under symmetric information evaluated at the virtual cost QFP 61 82 QP c Bmin r 34 EWRD 21 SES P A K 35 Proof The proof is similar as in Auriol and Laffont 1993 Proposition 2 Monitoring a regulated duopoly is equivalent to monitoring a regulated monopoly for which the inves
2. An econometric analysis of Telecom Competition Privatization and Regulation in Africa and Latin America Journal of Industrial Economics 49 1 119 VAILLANCOURT ROSENAU P 2000 PublicPrivate Policy Partnerships MIT Press Cam 32 bridge WORLD BANK 1997 Toolkits for Private Participation in Water and Sanitation Washington D C World Bank WORLD BANK 1998 World Development Indicators Washington D C World Bank Acknowledgement We are very grateful to the editor of the World Bank Economic Review and three anonymous referees for their comments and suggestions We also thank Amann E Amir R and M Warlters for improvements of the paper We are especially indebted to Antonio Estache for detailed and insightful comments Any remaining errors are our own 33 Supplementary Section This supplementary section presents the proofs of Proposition 2 3 4 and 5 as well as the formal description of the duopoly case set out in Section 4 of the paper Infrastructure and Public Utilities Privatization in Developing Countries by Auriol E and Picard P M Figures and mathematical expressions referred in this supplementary section are to be found in the latter paper Appendix 1 Proof of Proposition 2 We have to show that 1 EAV K gt V K AF A VA gt 0 The maximal franchise fee denoted F is equal to the firm s ex ante profit ie F V K Therefore the above inequality is satisfied if V
3. a V B K gt 4V V K W V B K lt 0 c VEM K gt 0 35 Condition a yields a positive discriminant for P A 0 and thus implies the existence of two roots A and condition b and c imply positivity for both roots of P A 0 finally since P 0 gt 0 and limy_ 4o P A gt 0 under c we have that P A lt 0 for A Conditions b and c are satisfied if and only if K V B VEM o0 This interval is not empty since V o0 V B 2 E G B g 8 4b gt V B Then observe that the left hand side of condition a is equal to zero at K V B and increases for larger K Similarly the right hand side of condition a decreases with K and is equal to zero at K V oo Hence there exists a unique K V B V oo such that V B K 4V V oo K Solving this equation one can check that Rav i B VFM op z 26 V V To conclude we have just shown that conditions a b and c are satisfied for any K K V oo which is a non empty set Finally note that because F o0 gt 0 K lt VEM ov That is condition c is implied by the condition R gt F oo i e condition ii in Proposition 3 The complementary case K gt VEM oo is implied by condition i in Proposition 3 We deduce that K gt K Finally the project is privately feasible if V K gt 0 This implies an upper bound K lt V Putting
4. eF 18 1 A 2 Let AQ mey 1 a ntBay gt 0 VA gt 0 Let B A Egam e 8 d Eg c 8 A 2 Ea G o E c G A EB is smale EN Hanne Lot also A Bag e 9 2 20g The condition C1 defined in 40 is equivalent to a 2 A a B A gt 0 43 This condition which requires that a is large enough is not very strong For instance one can check that with a uniform distribution over 0 3 and with the convention that a ap condition C1 is equivalent to H a A 12a 8A A 2 12a 4 7A 1 2A 14 2A 44 59 gt 0 Under the assumption A1 i e a gt 2 it is easy to check that H a A is increasing in a for all gt 0 We deduce that H a gt H 2 A 136A 98 133 gt 0 VA gt 0 So for a uniform distribution assumption A1 is a sufficient condition to get C1 More generally let 1 2 a EA amp A A 41 If a is larger than a condition C1 is satisfied QED Lemma A3 yields the following more general version of Proposition 4 Proposition A4 Under assumption C1 a private duopoly is never optimal Proposition 4 shows that a private Cournot duopoly is never optimal The negative impact of market power and excessive entry are too strong compared to the positive effects here the sampling gains of a regulated duopoly In other words the advantage of private structures with liberalized prices disappears once the market allows the entry of more than one f
5. paternalistic or political behaviors as they seek to protect employment in Shapiro and Willig 1990 governments are malevolent The main conclusion of the above two strands of literature is that privatization improves the internal efficiency of firms Megginston and Netter 2001 in a literature review covering 65 empirical studies at the firm level confirm that private firms are generally more productive and more profitable than their public counterparts However in increasing returns to scale industries the efficiency gains are not automatically passed along to consumers Changing the ownership structure does not solve the problem of lack of competitive pressure see Nellis 1999 The present paper belongs to the traditional literature on regulation with adverse se lection see Laffont and Tirole 1993 It ignores the moral hazard issue that is discussed at length in the aforementioned papers about soft budget constraint to focus on alloca tive efficiency and macro fiscal balancing issues A utilitarian government maximizes a weighted sum of consumer surplus and transfers from to firms The weight on transfers is the opportunity cost of public funds As it is standard in the regulation literature we assume that the government is able to commit and to offer complete contracts so that TEstache 2002 shows that technical productive efficiency gains generated by Argentina s 1990s util ities privatization have not been transmitted to
6. Credit and Banking 22 3 357 369 BURGESS and STERN 1993 Taxation and Development Journal of Economic Literature vol 31 2 pp 762 830 CREMER H MARCHAND M and THISSE J F 1989 The Public Firm as an Instrument For Regulating an Oligopolistic Market Oxford Economic Papers 41 283 301 DEBANDE O and G FRIEBEL 2003 A Positive Theory of Insider Privatization WDI University of Michigan DP 37 DEWATRIPONT M and MASKIN E 1995 Credit and Efficiency in Centralized and De centralized Economies Review of Economic Studies 62 4 pp 541 56 30 DAVIS J OSSOWSKI R RICHARDSON T and BARNETT S 2000 Fiscal and Macro economic Impact of Privatization I M F Occasional Paper 194 ESTACHE A V FOSTER and Q WODON 2002 Accounting for Poverty in Infrastruc ture Reform Learning from Latin America s Experience World Bank Institute Development Studies ESTACHE A 2002 Argentina s 1990 s utilities privatization a cure or a disease Working Paper World Bank ESTACHE A and Q WODON 2006 Infrastructure and Poverty in Africa mimeo World Bank EVANS P B 1989 Predatory Developmental and Other Appartuses A Comparative Political Economy Perspective on the Third World State Sociological Forum 4 4 p 561 87 GUASH J L 2004 Granting and Renegociating Infrastructure Concessions the World Bank Institute of Development Studies Wa
7. ket liberalization is optimal whenever the entry fixed cost K is lower than K AV 24See the Appendix on WBER Website 25This result may look at odds with theories where private structures perform better with larger number of entrants see for instance Vickers and Yarrow 1991 and Segal 1998 A basic difference in our model lies in the intensity of competition that exists within private and regulated structures Private firms compete in quantities so that the addition of a firm does not fully eliminate market power and profits In contrast information costs dramatically fall when a second firm is added in the regulated market see Auriol and Laffont 1993 6Since the distribution function g stochastically dominates g 3 and since a c 3 A 4b decreases in 3 we deduce that V A gt VEM A However the larger is the lower is the impact of the sampling gain and the smaller is the government s preference for regulated duopoly 22 5 Optimal industrial policy Under complete information the government can always replicate the production decisions of private firms so that privatization is never optimal The optimal industrial policy varies from no production regulated monopoly to regulated duopoly according to whether the investment cost K is large medium or small Under asymmetric information information costs alter this result Still the optimal decision depends on the fixed cost K Let K PN be the threshold su
8. 1993 Lemma 1 Under asymmetric information the optimal production and the ex ante wel fare of a regulated monopoly are those of the symmetric information case evaluated at the virtual cost c 8 A QO Bao BA 14 EW M 142 Fe 2 K l 15 Since c 8 gt 8 we deduce that QEM 6 lt QF M 8 for any 8 Moreover since c G X increases in 8 the distortion is higher at larger marginal costs Indeed by lowering the production of inefficient firms the government reduces the overall incentive to inflate cost report This strategy lowers the firm s informational rent and the cost of information revelation Comparing 9 and 13 it is easy to verify that V M A lt V for all A gt 0 Hence the ex ante welfare of a regulated monopoly is lower under asymmetric information than under symmetric information EW A lt WP 3 3 Regulation versus privatization We are now ready to compare the welfare level generated by a private monopoly with that of a regulated monopoly We first consider the symmetric information case Proposition 2 Under symmetric information public regulated monopoly dominates pri vately feasible monopoly whether the latter is franchised or not Proposition 2 is intuitive Under symmetric information a benevolent government cannot do worse than a private monopoly because for any realization of 3 it can always replicate the outcome of the private firm Nevertheless for large o
9. G a Indeed larger cost uncertainty implies stronger informa tion asymmetry between firms and governments and hence larger information rent in the regulated structures 4 Liberalization reform the duopoly case We next briefly explore the optimal industrial organization when the fixed cost K becomes smaller or equivalently when the value of operating the firm after investment V becomes larger We compare a regulated duopoly la Auriol and Laffont 1993 with a private duopoly modeled as Cournot duopoly with asymmetric information between firms To simplify the exposition franchising is ruled out in the sequel A4 F A 0 In the present model the benefit of choosing a regulated duopoly henceforth RD orig inates from the sampling gain as first analyzed by Auriol and Laffont 1993 That is variable costs are lower in a duopoly because the regulator is able to choose the most efficient supplier among two firms Monitoring a regulated duopoly then is equivalent to monitoring a regulated monopoly for which the investment level is 2K and the marginal cost is min 61 G2 Since we assumed that 3 and 6 gt are independently and identically distributed min 681 G2 is distributed according to gmin 3 2 1 G B g G Let vra fe in BB 18 22Tn the last two decades some industries such as telecommunication have experienced dramatic tech nological and or demand changes resulting both in a decrease in fixed costs
10. ac uk 1 Introduction Over the last 25 years low income countries have drastically reduced their share of state ownership In most cases governments have privatized public assets because of critical budgetary conditions While international financial organizations like the World Bank or the IMF made privatization programs a condition for economic assistance during the 1980s debt crisis governments have been keen on using privatization proceeds to relax their budget constraints The fiscal benefits of privatization are not limited to the divesture proceeds of state owned enterprises SOE which has been estimated around 50 billion per year in non OECD countries Mahboobi 2000 Gibbon 1998 2000 They also encompass the possible termination of recurrent inefficient subsidies to the latter The paper studies the impact of macroeconomic fiscal balancing objectives on the privatization decision in regard to infrastructure and public utilities in low income countries Privatization brings well known economic costs when industries are characterized by strong economies of scale Infrastructure and utilities owners benefit from market power By giving up the direct control of firms operations governments lose control over prices to the disadvantage of consumers In theory this could be avoided by auctioning off markets on the basis of the lowest product service price see Estache Foster and Wodon 2002 However Guasch 2003 shows in a survey o
11. and an increase in demand 3For the sake of conciseness we exclude the case of mixed duopolies with a regulated and a private firm See Cremer et al 1989 and Picard 2001 for a policy discussion about mixed duopolies 21 It is the monopoly expression V in 13 where the density function g has been replaced by gmin 8 For the sake of exposition the next result is established under the assumption that G Z is the uniform distribution The Proposition applies for a more general distribution 4 Proposition 4 Assume that the firms marginal cost are independently and uniformly distributed over 0 3 and that assumption A1 and A4 hold then a private duopoly is never optimal In a regulated duopoly only the firm with the lowest marginal cost produces This max imizes productive efficiency By contrast in private duopoly equilibrium there is exces sive entry and inefficient allocation of production The advantage of private structures hence disappears once the market allows the entry of more than one firm For very profitable market segment the optimal choice is thus between regulated monopoly and regulated duopoly Let K re be the value of the fixed cost such that the govern ment is indifferent between a regulated monopoly and a regulated duopoly i e such that EW EW wy SE vA VHC 19 RM RD Under asymmetric information the sampling gain is measured by K so that mar RM RD
12. benevolent regulation for at least some value of the opportunity cost of public funds Proposition 3 Suppose that assumptions AO to A3 hold and that the fixed cost K lies in the non empty range defined by Condition CO Then two cases are possible i lim 400 F A gt VEM 00 K there exists a unique threshold A such that privati zation dominates regulation if and only if A gt 5 ii limy F A lt V M o0 K there are two thresholds A and A lt such that privatization dominates regulation if and only if 20When F F EW M 1 A 14 2d V 1 A V K whereas EWEM A V 2 1 A V K The two functions have a common asymptote with slope V K see figure 1 17 EW In other words for any value of the franchise fee function F which includes the case F 0 there exists a range of fixed costs K and of costs of public funds so that the government prefers privatization Figure 1 illustrates Proposition 3 The bold solid curve represents the ex ante welfare of regulated monopoly under symmetric information RM and the bold dotted curve displays ex ante welfare under asymmetric information RM The ex ante welfare of regulated monopoly is non monotone in A It is higher for low or high values of A than for intermediate ones The thin solid straight lines represent the two boundaries of the ex ante welfare of a private monopoly PM i e for F A F and f
13. consumers The benefits were captured by the industry because of inefficient regulation private or public ownership is irrelevant The paper hence draws the line between pub lic and private ownership as the choice between regulated public firms and unregulated private ones Since the government is residual claimant of the public firms profit and loss and since it wants to avoid the threat of service interruption under asymmetric information money loosing firms are subsidized while more productive firms earn infor mational rents Production is distorted to reduce these information costs which in turn diminishes consumer surplus Privatization reduces the need to subsidize low profitability firms and to distort their production below the monopoly level due to the adverse selec tion problem Privatization is used for projects that have low profitability or low social benefits To avoid the technicality of an additional principal agent problem the private owner is assumed to be the firm s manager The welfare comparison is hence between a benevolently regulated firm and a private monopoly charging the standard monopoly price Finally our model can be related to the theory of public private partnerships PPP that has deserved a recent attention in national and international funding institutions see Vaillancourt Rosenau 2000 IMF 2004 The idea behind PPP is to make governments purchase the service rather than the asset that is associated to
14. pay for the firm but comes at the cost of high prices and lower network growth for consumers Developing countries have generally failed to establish credible regulatory bodies because of gov ernments inability to commit For instance the concessions granted to private operators following the divestiture of Latin America public firms were renegotiated after an average 2 1 years only Laffont 2001 See also Guash 2004 the outcomes of private monopolies so that privatization is never optimal However un der asymmetric information between governments and firms privatization may dominate public ownership because the presence of information rents makes subsidies socially more costly In the paper a main factor in privatization decisions is the opportunity cost of public funds which captures the tightness of government budget constraint We show that the privatization decision is a monotone function of this opportunity cost of public funds when the profitability of a market is low as it is for instance the case of infrastructure such as roads or of utilities service to the poor For low opportunity costs i e for wealthy gov ernments public ownership dominates privatization whereas the reverse holds for large opportunity costs i e for financially strapped governments To illustrate this result consider the specific case where the government cannot finance an infrastructure project e g a water distribution network in a poor neighbo
15. regulated duopoly However excess entry and weak competition in private Cournot duopolies will generally preclude this RD PD structure from being socially desirable To be more specific let K A be the value of the fixed cost such that the regulated duopoly yields the same welfare level as the private duopoly i e such that EW EW The government prefers a regulated duopoly to a private RD PD PD PM duopoly if and only if K lt K A On the other hand if K gt K defined in equation 29 the government prefers a private monopoly to a private duopoly We deduce that if a laa PD PM C1 K A gt K a private duopoly is never optimal Indeed if the government prefers a private duopoly over PD PM a private monopoly i e K lt K under C1 it also prefers a regulated duopoly rather PD PM RD PD than the private duopoly i e K lt K implies that K lt K A so that the private duopoly is never optimal Condition C1 is likely to be satisfied because the Cournot equilibrium presents larger ineffi ciency than the equilibrium in regulated duopolies where the government set the output levels 42 To illustrate this point suppose that there is no information asymmetry and no uncertainty 6 B so that there is no sampling gain Then the welfare under a regulated duopoly is equal to WEP A 2 1 A HAV K whereas the welfare under private Cournot duopoly 28 is equal to SV 2K and the welfare un
16. result is also consistent with developing countries use of concession lease or greenfield contracts such as build operate and transfer BOT programs for highways sanitation or water networks Third when market segments are even more profitable we show that privatization choice is restricted to intermediate opportunity costs of public funds The government finds it optimal to set up a public firm for large enough opportunity costs of public funds Very poor countries are plagued with financial problems and welcome the potential revenues that can be extracted from a public firm Privatization of profitable public utilities such as fixed lines or international telecommunication services is therefore not efficient Finally the market segment can be so profitable that a second firm is able to enter the market Then privatization with price liberalization is not optimal As shown in the booming mobile telecommunication industry regulation is a keystone for successful liberalization reforms In contrast to many contributions on privatization our discussion has focused on the two issues of allocative efficiency and macroeconomic financial constraint The empirical literature in development studies provides replete evidence of the relationship between those two issues in natural monopoly and oligopoly markets located in developing coun tries Nevertheless as noted in the Introduction improvements in productive efficiency associated to privatizati
17. the provision of a public good or of a good for which there is a potential market failure On the one hand PPPs are seen by governments as a vehicle to shift investment costs out their books and or safeguard the execution of projects that would otherwise hardly materialize given their budget constraints On the other hand PPPs are praised for their potential benefits in terms of productive efficiency As we rule out the possible productivity inefficiencies to focus on 8When government is able to offer the same contracts to public and to private firms as in Baron Myerson 1982 and in Laffont Tirole 1986 or in the form of bribes to private firms as in Kornai 2001 both structures have the same degree of contract completeness so ownership is irrelevant Public private partnerships PPP can be used to harden the firms budget constraints as we discussed earlier and can be used to bundle complementary tasks such as the construction and the operation of infrastructure projects see Hart 2003 Martimort and Pouyet 2006 the allocative inefficiencies it is therefore no surprise that the benefits of privatization are aligned to this first view that emphasizes the fiscal benefits of privatization The paper is organized as follows Section 2 presents the model and the main assump tions Section 3 compares the performance of private and regulated monopolies while Section 4 briefly discusses the duopoly case Section 5 derives the optim
18. the regu lated regime managers of duopoly are offered incentive compatible contracts with asymmetric information between the two firms and between firms and goverment Finally we derive a suf ficient condition that guarantees that regulated public duopolies dominates laissez faire private duopoly Note that we restrict our attention to the situation in which all firms are either regulated or privatized The restriction that the same ownership structure applies for all the firms in the market is made for the sake of simplicity It indeed helps the exposition by avoiding cumbersome comparison with an additional industry structure The mixed oligopoly where some firms are regulated while other are run by private investors has been partially studied in the case of complete information by Cremer Marchand and Thisse 1989 and Picard 2001 They show that the presence of a single high cost regulated firm can be used to increase welfare by raising output and lowering prices in oligopolistic markets Here we go further by deriving sufficient conditions under which a regulated duopoly always bring more welfare than a private duopoly Private duopoly leads to excessive entry and productive inefficiency both firms produce although one is more efficient than the other By contrast in the regulated duopoly only the most efficient firm produces The mixed duopoly cannot bring the benefit of this sampling gain It suffers from the same drawback as
19. to imperfect income taxation It is assessed to be around 0 3 Snower and Warren 1996 In developing countries low income levels and difficulties in implementing effective taxation programs are strong constraints on the government budget The tax revenue GDP ratio for 1995 for example was 36 1 for OECD countries see the OECD website versus 18 2 for developing countries based on a sample Tanzi and Zee 2001 Since the opportunity cost of public funds is higher when everything else being equal government revenue is lower the opportunity cost of developing countries should be higher than 0 3 As a benchmark case the World Bank 1998 suggests an opportunity cost of 0 9 However the value is much higher in countries that are heavily indebted 3 Privatization of natural monopoly When K is large a natural monopoly emerges N 0 1 Regulation aims at correcting the distortion associated with monopoly pricing Theory suggests that welfare should never be smaller under regulation than under laissez faire because at worse a benevolent regulator should be able to mimic the choice of a private firm We show that it is not always the case under asymmetric information 3 1 Private monopoly The production level of a private monopoly henceforth PM is not controlled by the government The government can nevertheless control the entry of the firm by auctioning the right to operate Let F A gt 0 be the exogenous franchise fee that
20. unit of money from the government to the firm That is government pursues multiple objectives such as the production of public goods the regulation of non com petitive industries or the control of externalities under a single budget constraint The opportunity cost of public funds is the Lagrange multiplier of this constraint It tells how much the social welfare can be improved if the budget constraint is relaxed by one dollar It includes foregone benefits of alternative investment choices and spending In practice any additional investment in infrastructure or public utilities implies a reduction of the production of essential public goods such as national security law enforcement or any other commodities that generate externalities such as health care and education It may 13To find out how AO is computed see the Appendix made available in WBER Website 14t is different from the marginal cost of public funds MCF which measures the dead weight loss created by a marginal increase of a specific tax rate see Warlters and Auriol 2005 10 also imply a rise in the level of taxes or public debt All these actions have a social cost which must be traded off with the social benefit Symmetrically when the government is able to tax an industry the social benefit generated by the additional revenue must be compared with the reduction in consumer surplus In advanced economies A is usually assumed to be equal to the deadweight loss due
21. 3 2 p 352 72 RAITH M 1996 A General Model of Information Sharing in Oligopoly Journal of Eco nomic Theory 71 1 pages 260 88 SAKAI Y 1985 The Value of Information in a Simple Duopoly Journal of Economic The ory 36 1 36 54 SHAPIRO C 1986 Exchange of Cost Information in Oligopoly Review of Economic Stud ies 53 3 p 433 46 SPENCE M 1976 Product Selection Fixed Costs and Monopolistic Competition Review of Economic Studies 43 2 217 35 WALRAS L 1936 Etudes d Economie Politique Aplliqu e Th ories de la Richesse Sociale Lausannes F Rouge 47
22. A gt 0 1 4 EAV K gt 3V K A V K or equivalently if 4 1 A gt 3 2A 1 2A which is always true VA gt 0 Appendix 2 Proof of Proposition 3 We prove this proposition in four steps Step 1 Regulation is preferred to privatization if and only if EW A gt EW A By virtue of equation 15 this inequality is equivalent to 1 A _ eu 3 2 V A A A K gt V K AF 22 SATYAM A 1 A K gt SV K AF A 22 Developing V A defined in equation 13 one can check that RM 1 2 A RM V A V V B 23 eae ee oa 25 where terms V E a 8 4b and VM E a p a 40 and B E G 8 a 6 g 6 b are all positive by virtue of assumption Al Substituting 23 in 22 and dividing the right and left hand side by we get after some straightforward computations Reg Priv gt V s B 2A 2 14 2rA 1 2 VE os KE FO 24 34 It is easy to check that the left hand side of 24 denoted LHS A is a decreasing and convex function of A Similarly under the assumption A2 the right hand side of 24 denoted RH S is decreasing and convex The following proof relies on the property that two decreasing and convex functions can intersect only once twice or none Step 2 For 0 expression 24 is equivalent to V gt 0 which is always true We deduce that for small enough regulation dominates privatization For A 00 two case
23. Infrastructure and Public Utilities Privatization in Developing Countries Emmanuelle Auriol and Pierre M Picard Abstract Should governments in developing countries promote private ownership and deregulated prices in non competitive sectors Or should they run publicly owned firms and regulate prices at the expense of rents to insiders We develop a theo retical model to answer these questions which are normative The analysis focuses on the governments trade off between fiscal benefits and consumer surplus in the privatization reforms that occurred in non competitive sectors Under privatization the control rights are transferred to private interests and public subsidies are elimi nated This benefit for tax payers comes at the cost of a price rise for consumers We show that in developing countries where budget constraints are tight privatization and price liberalization may be optimal for low profitability industries However for more profitable industries privatization and price liberalization are suboptimal Finally once a market gives room for more than one firm governments prefer to regulate the industry In the absence of a credible regulatory agency regulation is achieved through public ownership Emmanuelle Auriol Toulouse School of Economics ARQADE and IDEI E mail eauriolQcict fr Pierre M Picard SoSS University of Manchester and CORE Universit catholique de Louvain E mail Pierre Picard manchester
24. V In this case a private firm finds it profitable to enter and supplies its output at the monopoly price In contrast to the first case countries now have the alternative to orga nize supply through the use of a private firm The optimal industrial policy is monotone in the opportunity cost of public funds A a public regulated firm is preferred if A is small enough and privatization is preferred otherwise In Figure 2 the case for public regulated firm is still represented in the white area and denoted RM and the case for privatization M PM is represented by hatched area above the curve K and denoted PM Here privati zation becomes an appealing alternative compared to public provision Indeed consider the situation of a poor country s government that is unable to finance an infrastructure project as in the case of small water networks or generation facilities i e K lies above the curve KEM and below V A is high enough If a private firm proposes to invest in the infrastructure in exchange for the freedom to charge monopoly pricing it is optimal to let this firm do so Indeed it is better to have a privately owned and operated infrastructure with monopoly price distortion than no infrastructure at all By continuity this conclu sion still holds when the government gets a not too large benefit from financing the infrastructure Developing countries offer many examples of such privatization processes through their use of concession l
25. al industrial pol icy Section 6 summarizes our results and offers some concluding remarks For the sake of conciseness all proofs are set out in an Appendix that is made available on the website of the World Bank Economic Review 2 The model The government has to decide whether an industry characterized by increasing returns to scale should be under public or private control We call regulation regime the regime in which the government controls the production of a public firm The government s control rights are associated with accountability on profits and losses That is it must subsidize the firm in case of losses whereas it taxes the firm in case of profits In contrast we call private regime the regime in which the government imposes no control on the operations of a private firm and it takes no responsibility for the firm s profits or losses That is no transfer is possible between the government and the private firm once production has begun This is of course a simplification In practice government might subsidize the private sector However subsidies are lower under private than under public ownership which is what matters for the results Similarly private firms do not pay tax on profit but they can pay an entry fee 10For instance in Burkina Faso government subsidies to SOEs went from 1 42 percent of GDP in 1991 to 0 08 percent of GDP in 1999 as a result of privatization Af DB OECD 2003 This is an artifact o
26. ch that the government is indifferent between a regulated monopoly and no production i e such that EWM A 0 It is easy to check that 2 2 1 2 K A vena 20 where VEM A is defined equation 13 Similarly let K A be the value of the fixed cost such that the government is indifferent between a regulated monopoly and a private monopoly i e such that EW EW It is easy to check that RM PM 2 1 4 PM Neca o 3V oe 21 The next result is presented under the assumption that G is the uniform distribution This result nevertheless applies to more general distribution Proposition 5 Assume that the firms marginal cost are independently and uniformly distributed over 0 3 and that assumption A1 and A4 hold Then the optimal industrial policy under asymmetric information is to set e no production if K gt max V K A e a private monopoly if Key lt K lt V a regulated monopoly if K TA lt K lt min KK V or if V lt K lt K A 27See the Appendix on WBER Website 23 e a regulated duopoly if K lt RN K4 2V KPM o0 NN ANKAR Figure 2 Optimal Industrial Policy avmn_ ov Because developing countries have large opportunity costs of public funds they may implement industrial policies that strongly differ from those implemented in advanced economies This statement is depicted in Figure 2 that illustrates Propositi
27. der private monopoly is equal to 3V K Ob viously private duopolies dominate private monopolies for small enough fixed costs that is for K lt y 3V BV However if fixed costs are small the welfare under regulated duopoly is also large It is then easy to check that 2 1 A HAV K gt SV 2KVA gt 0i K lt eV In words the welfare under regulated duopoly is larger than the welfare under private duopoly for any value of the opportunity cost of public funds when the private duopoly dominates the private monopoly This implies that a private duopoly is never optimal Now let us introduce information asymmetry and uncertainty In this case two additional and opposite effects are at work on the one hand sampling gains raise the welfare under regulated duopolies and on the other hand the increase in the cost variance increases the output and the welfare of Cournot private duopolies see 28 In the case of uniform distribution or of large demand the first effect dominates so that a private duopoly is never preferred by the government Lemma A3 Condition C1 is satisfied if the cost 3 is uniformly distributed over 0 6 or if a is large enough Proof Condition C1 is equivalent to 18 1 A RD 1 2A 110 gt 40 Gt ayiersy O ZV ietsi a o Simplifying by 4b 40 is equivalent to 18 1 2 9 1 2A 11lo Es a c B d gt Eg a SE MEGAN CFIN EN Ga 8 gt Ba le 8
28. duced down to the break even point I 0 That is tEM P Q Q K BQ Substituting this expression in 5 and maximizing W with respect to Q yields gimp tA 8 8 1 2 b 10 Inserting Q in 5 and computing the expected value of W gives the ex ante welfare under symmetric information 1 EW Oy 14 tr x 11 where V is defined in equation 9 The government invests K in a regulated firm only if 11 is positive The ex ante welfare increases linearly in V and is non monotone in A if V gt K it decreases for small A and increases for large A This deserves a comment For small the government incurs small social costs of transferring money to the regulated firm It then chooses quantities that are close to the first best level which means a price that is close to marginal cost That is lim oQ a 8 b and 14 therefore pss 6 At this price the regulated monopoly cannot recover its fixed cost The loss is compensated by a public transfer to the firm t K gt 0 By continuity the government will subsidize the regulated firm as long as remains small enough In contrast for large A the government is more interested in receiving transfers from the public firm than in maximizing consumer surplus In the limit it seeks the maximal revenue from the state owned firm so that it chooses the production level of a private monopoly lim oQ a 3 2b QP It m
29. ease or greenfield contracts For instance many devel oping countries have started build operate and transfer BOT programs where private 25 firms finance the sunk costs associated to highways in exchange for a 10 30 years licence to exploit it in a monopoly position Similarly China Malaysia Thailand implemented such programs in water and Chile Mexico in sanitation World Bank 1997 In many places the privatization process is less formal For instance in Sub Saharan Africa wa ter and electricity services are offered by an informal sector made of thousands of small scale private and unregulated providers see Auriol and Blanc 2007 As predicted by the theory they serve the middle class and the poor at prices that are much higher than the public utilities prices A recent survey estimates that nearly half of urban dwellers in Africa rely on such private services for water Kariuki and Schwartz 2005 We can now discuss our third case where K is lower than K co Observe at the out set that contrary to the second case the optimal industrial policy is no longer monotone in A This property which has already been discussed in Proposition 3 is reflected in Figure RM PM is non monotone in A For the sake of exposi min K A K 0 Then as 2 by the fact that the curve denoted K RM PM RM PM i RM PM l tion let us define K as the minimum of K e K and let us discuss fixed costs belonging
30. enous franchise fee 12 0 V K Similarly a monopoly is socially valuable if it brings ex ante positive welfare Comparing 7 and 8 it is easy to check that monopolies are socially valuable but privately infeasible if V lt K lt sy Decreasing franchise fees Because public funds are costly the ex ante welfare EW increases linearly with F A The maximal entry fee that the government can collect is the maximum price a risk neutral entrepreneur would agree to pay for the monopoly concession F max 0 V K In practice international capital flows de pend on country risk ratings so that developing countries government do not collect F see Brewer and Rivoli 1990 Because of the service of their debt the perception of corruption in the administration the social instability the lack of transparency and pre dictability of their political and judicial institutions private investors especially foreign ones are very reluctant to invest in developing countries In the context of our model a bad rating translates into a large That is countries characterized by a large are also countries that get low privatization proceeds To capture this idea we make the following assumption A2 F A 0 F is non increasing and weakly convex in gt 0 16The ratings reflect the ability and willingness of a country to service its financial obligation See for instance Global Risk Assessments web site
31. esult of the government s cost benefit analysis The social benefit obtained from the cash flows generated by the public firms divesture and from the termination of subsidies to unprofitable public firms are balanced against the loss in consumer surplus induced by the higher prices in priva tized industries and the foregone revenues from profitable public firms Since our model is static it is not designed to study the transition regime between public and private owner ship It compares social welfare under private and public ownership in industries market segments where some investments need to be sunk To get clear cut results privatization corresponds to a case where ownership is private and prices are free It is close but not equivalent to laissez faire because entry remains regulated i e through license and entry fees Public ownership corresponds to a case where entry and prices are regulated This approach is robust from a theoretical point of view Indeed if as we show privatization with laissez faire dominates state ownership with benevolent regulation privatization also dominates in situations where prices are liberalized to a lesser extent and regulation is not benevolent The dominance of privatization over benevolent regulation is not obvious Indeed the deadweight loss created by monopoly pricing is the rationale for setting up public ownership in the first place Under perfect information governments are able to mimic
32. et explicit value for a we make the assumption of a uniform distribution of 9 over 8 6 Using 12 and 13 under the uniform distribution equation 17 is equivalent to 4E 1 2A a 8 X a p 3 2A 1 2 E a One can divide the right hand side and the left hand side by a and check that depends on B a and G a only Since under the uniform specification the demand intercept a satisfies Al if and only if a gt 28 we get that 0 lt bja lt B a lt 0 5 Table 1 displays A for the various admissible values of 3 a and B a n d B a 0 0 0 1 02 03 04 B a 0 1 1 14 2 0 2 0 71 1 07 z 0 3 0 52 0 66 0 99 0 4 0 42 0 48 0 60 0 90 0 5 0 35 0 38 0 44 0 54 0 81 Table 1 Minimal opportunity costs A above which privatization can be preferred The opportunity cost of public funds is generally assessed to be around 0 3 in in dustrial countries see for instance Snower and Warren 1996 and higher in developing countries We conclude that if demand and cost functions are reasonably approximated by linear functions and satisfy assumption Al which is an empirical issue A lies below the 1The simulation results are robust to other statistical specifications e g normal distribution 20 range of the opportunity costs prevailing in developing countries The results in Table 1 also highlight that privatization is more likely as technological uncertainty rises i e A decreases with 3
33. etween no production private monopoly regulated monopoly or regulated duopoly First of all recall RM RD that K defined equation 36 is the value of the fixed cost such that the govern ment is indifferent between a regulated monopoly and a regulated duopoly i e such that EW EWP X A regulated monopoly is preferred to a regulated duopoly if and only RM RD ifkK gt K A Similarly a regulated monopoly is preferred to no production whenever RM PM K lt K A defined equation 20 It is preferred to privatisation whenever K lt K A RM defined equation 21 Comparing equations 20 and 21 one can check that K RM PM gt A for all A gt defined equation 17 for A lt privatization is never an option so RM PM that K A is not defined Moreover using the fact that gmin 8 lt 2g 8 one can check that VEP A lt 2V so that K A rai PERS oan A gt Kk We deduce that if K gt K regulation is never optimal On the other hand if K gt V privatisation is not possible Putting all the pieces together yields the result 46 Additional References FUSS M M MESCHI and L WAVERMAN 2005 The Impact of Mobile Phones on Eco nomics Growth in Developing Countries The Economist March 12th p p 78 PICARD P M 2001 Optimal Employment Subsidies and Market Structures in Industries with Unemployment Oxford Economic Papers 5
34. f 600 concession contracts from around the world that in practice the contracts are tendered for the highest transfer or annual fee Because fee payments rise with the profitability of the privatized firms many governments choose policies that increase the firms profitability such as exclusivity periods and price liberalization Prices are sometimes increased ahead of privatization in order to reduce Megginson and Netter 2001 estimate that between 1980 and 1996 it went from 16 to 8 of GDP Using a panel of 18 developing countries Davis et al 2000 show that budgetary privatization proceeds have been used to reduce domestic financing on a roughly one for one basis 3Wallsten 2001 studies the impact of the exclusivity period on the privatization price of twenty telecommunication firms in fifteen developing countries Two thirds of the countries chose to allocate exclusivity periods for an average of 7 42 years Exclusivity more than double the price private investors the SOE financing gaps and attract buyers This has been for instance the case in Zim babwe Kenya and Senegal where governments increased electricity prices by 10 after reaching an agreement with Vivendi Universal see Af DB OECD 2003 An unaccounted part of price increases stems from the termination of illegal connections Birdsall and Nellis 2002 Estache Foster and Wodon 2002 AfDB OECD 2003 The present paper studies the privatization decision as the r
35. f public funds bailout becomes costly and governments prefer to privatize the public firms cash the divesture proceeds and let private entrepreneurs manage firms Yet for high enough opportunity costs of public funds the privatization decisions differ as gov ernment finds it valuable to hold up on industries rents Government does not privatize profitable segments it prefers to operate them and to set private monopoly prices to reap maximal revenues This non monotonicity result has potentially important policy impli cations That is while divestiture of profitable public firms may be optimal in advanced economies it is not necessarily so in developing countries where budget constraints are tight and market institutions are weak More specifically the model suggests that pub lic utilities in developing countries should focus on market segments where incomes and willingness to pay are high They also should set prices high so that the government can used the public firms profit to subsidize new connections or other public goods Finally when firms profitability substantially rises the market leaves room for more than one firm We show that for large profitable markets regulation of duopoly always dominates privatization with price liberalization Market liberalization hence corresponds to the divestiture of a historical monopoly and the introduction of new entrants according to a regulatory scheme It does not correspond to lais
36. f the formalization In the static model below it is optimal for the government to sell the firm ex ante i e while it is in a position of symmetric information vis vis the firm rather than to tax its profit ex post i e once the firm has learned its cost parameter and has an informational Demand We consider a normal good The inverse demand function for Q gt 0 units of the commodity is given by P Q a bQ 1 where a gt 0 and b gt 0 are common knowledge The gross consumer surplus is therefore SQ f Plede aQ 30 2 Firms We focus on infrastructure and utilities These industries require to sink large investments Technically they involve increasing returns to scale technology so that cost functions are sub additive As in Baron and Myerson 1982 this is simply modeled by assuming that the cost function includes a fixed cost K gt 0 and an idiosyncratic marginal cost 3 To produce q units of the commodity firm i 1 N has the following cost function Firm i must make the investment K before discovering 3 The s are independently and identically distributed on the interval 3 B according to the density and cumulative distribution functions g and G This law is common knowledge We denote the expectation operator by E the average marginal cost by EG and the variance of marginal cost by o var 3 Neither the government nor the competitors of firm i observe 3 The fixed cost K is large s
37. generated by Argentina s 1990s utilities privatization have not been transmitted to consumers According to the author the benefits were captured by the industry because of inefficient regulation The lesson to be drawn here is that privatization being defined as a move from regulation to laissez faire is not optimal When the ratio K V is low the consumer surplus is large Regulation then is a key component of successful privatization reforms 37For more on the telecommunications reforms in developing countries see Auriol 2005 38For instance Fuss Meschi and Waverman 2005 estimates that in a typical developing country an increase of ten mobile phones per 100 people boosts growth by 0 6 percentage points The growth dividend is similar to that of fixed lines phones in developed countries in the 1970s 45 Appendix 4 Proof of Proposition 5 In this appendix we prove the general version of proposition 5 i e for general distribution of cost parameter Proposition 6 Suppose that assumptions AO to A4 hold Under condition C1 the optimal industrial policy under asymmetric information is to set e no production if K gt max fv Ke RM PM e a private monopoly if K A lt K lt V RM RD RM PM RM e aregulated monopoly if K A lt K lt min K A v orif V lt K lt K A RM RD e a regulated duopoly if K lt K A Condition C1 implies that a private duopoly is never optimal The choice is b
38. imics the private firm behavior 3 2 2 Asymmetric information Under asymmetric information is not observed by the government To entice the firm to truthfully reveal its cost incentive compatibility constraint must be added to the problem Taking this constraint into account implies that in the government objective function the marginal cost 8 is replaced by the virtual cost see Laffont and Tirole 1993 c B A b G 12 The virtual cost includes the marginal cost of production 3 and the marginal cost of a CW To avoid the technicalities of bunching we make the information acquisition z 3 classical monotone hazard rate assumption 1 A3 G g is non decreasing We deduce that c 3 A gt 3 and by A3 that c 8 A increases in 8 and A Let Mave P aB A VO i 13 19When the hazard rate is not monotone increasing the virtual cost 12 and thus the regulated output 14 are not monotone Then output is not an invertible function of the type 8 and the government is unable to infer the type of each firm by observing its output level Being unable to separate the types of firms it is obliged to bunch various types in a same contract 15 It is the function V in 9 evaluated at c 6 A instead of 3 This implies that VEM A decreases in Following the Baron and Myerson s 1982 approach we deduce the following lemma which proof is standard see Laffont and Tirole
39. ing profit depending on the realization of technical demand uncertainties A private entrepreneur who bets her own assets or the shareholders ones in the firm is accountable for these profits and losses In contrast under regulation accountability lies on the government side the business risk is borne by the government that has to grant ex post subsidies to unprofitable firms Under asymmetric information the regulated firm uses the transfers to acquire a positive informational rent The government prefers that the private sector takes over when the social cost associated with the rent outweighs the social benefit of controlling the firm s operation As suggested by condition C0 and shown Section 5 this ultimately depends on the profitability of the industry market segment Aa 3 4 Numerical Assessment for A Proposition 3 shows that independently of the privatization proceeds and fees privatiza tion with prices liberalization dominates a benevolent regulation under public ownership 19 for intermediate value of A The relevance of this result depends on what intermediate value means If is very high in practice privatization will never be optimal The lowest value of the opportunity cost for which privatization becomes attractive is obtained when the highest franchise fee F applied see figure 1 It solves EW A EW M A This equation is equivalent to A 1 A V 2 3 2A 1 Qa V 17 To g
40. ion corresponds to the divestiture of the historical monopoly and the introduction of new entrants As shown in Proposition 5 this is not equivalent to laissez faire In practice prices and entry remain regulated to protect consumers against collusion and predatory behavior through licences and price caps for instance This is important because in profitable industry the consumer surplus is high Monopoly pricing then has more impact on welfare than it has on low profitability industry In the framework of our model the divestiture of the historical monopoly is motivated by a drop of the ratio K V That is by smaller fixed costs and or by larger product demand In figure 2 this corresponds to a downward shift where industry structures move from regulated monopoly to regulated duopoly The mobile and internet segment of the telecommunication industry provides an example of such a drop Introduction of wireless technologies has significantly reduced the fixed costs to operate networks whereas the demand for communication has steadily increased Consistently with our model many developed and developing countries have deregulated their domestic telecommu nication industry Wallsten 2001 who studied telecom reforms in Africa and Latin America found that privatization by itself does not yield improvements but that privatization combined with an independent regulator does Similarly Estache 2002 shows that technical productive efficiency gains
41. irm i e when it is very profitable This result may look at odds with theories where private structures perform better with larger number of entrants see for instance Vickers and Yarrow 1991 and Segal 1998 A basic difference in our model lies in the intensity of competition that exists within private and regulated structures Under privatization private firms compete in quantities so that the addition of a firm does not fully eliminate market power and profits In contrast under the regulation regime information costs dramatically fall when a second firm is added in the regulated market Regulation is then more attractive This result is congruent with the theory of adverse selection in which a rise in the number of agents reduces the cost of information revelation see Auriol and Laffont 1993 The case where regulated duopoly is preferred to 36Tf we had considered that firms operating in the same industry have correlated costs we would have used this correlation to implement yardstick competition reducing further the cost of information revelation see Auriol and Laffont 1993 44 RM RD regulated monopoly is depicted in Figure 2 by the hatched area below the curve K denoted RD The fact that a private duopoly is not optimal sheds light on the link between market liberal ization on the one hand and technological and or product demand changes on the other hand Market liberalization often referred to as deregulat
42. monopoly markets The paper shows that in poor developing countries privatization of public utilities profit centers is socially inefficient By eliminating cross subsidies between vari ous market segments or industries privatizations have hence generally increased the fiscal costs related to unprofitable segments and have reduced political support from harmed usually poor consumers Estache and Wodon 2006 Trujillo et al 2003 The final case in our discussion takes place at sufficiently low fixed costs With a large surplus at stake Proposition 4 shows that a private Cournot duopoly is never optimal Governments choose between regulated public structures with one or two firms depend ing on whether shadow costs of public funds are small or large In Figure 2 a regulated duopoly is preferred to regulated monopoly in the hatched area below the curve K aes denoted RD This last case sheds light on the relationship between market liberalization on the one hand and technological improvement and or product demand growth illus trated by a fall in the ratio K V on the other hand Market liberalization corresponds to the divestiture of the historical monopoly and the introduction of new entrants but is not equivalent to laissez faire Prices and entry should remain regulated to protect consumers against firms tendency to reduce competition by setting their capacity levels or even to organize collusion and exert predatory behavior not modeled in thi
43. nds OECD Financial Market Trends 76 p 43 64 MARTIMORT D and J POUYET 2006 Build it or not Normative and Positive Theories of Public Private Parnerships CEPR Discussion Paper No 5610 MASKIN E 1999 Recent Theoretical Work on the Soft Budget Constraint American Economic Review 89 2 421 25 NELLIS J 1999 Time to Rethink Privatization In Transition Economies International Finance Corporation Discussion Paper 38 PICARD P M 2001 Optimal Employment Subsidies in Industries with Unemployment Com plete Information Ozford Economic Papers 53 2 352 72 SCHMIDT K 1996 Incomplete Contracts and Privatization European Economic Review Vol 40 569 580 SEGAL I 1998 Monopoly and Soft Budget Constraint Rand Journal of Economics 29 3 569 609 SHAPIRO C and WILLIG R 1990 Economic Rationale for the Scope of Privatization DP 41 Princeton University SHLEIFER A and R VISHNY 1997 A survey of Corporate Governance Journal of Fi nance vol 52 2 pp 737 83 SNOWER A and WARREN R 1996 The Marginal Welfare Cost of Public Funds Theory and Estimates J of Public Economics 61 289 305 TRUJILLO L E QUINET and A ESTACHE 2002 Dealing with Demand Forecasting Games in Transport Privatization Transport Policy 9 pp 325 334 VICKERS J and YARROW G 1991 Privatization an Economic Analysis MIT Press WALLSTEN S 2001
44. o that the maximal number of firms N that can survive under laissez faire is small To be more specific we make the following assumption a Ep o 16b 4b advantage Empirical evidence shows that developing countries rely on entry fees to raise revenues from AO K gt firms see Auriol and Warlters 2005 12To keep the analysis simple we consider a linear product demand However the results are robust to more general demand function For instance models with iso elastic demand functions require numerical simulations but yield similar results Computations are available on request Assumption AO implies that N lt 2 13 The firms are profit maximizers The profit of firm 7 1 N is IL P Q G C bi qi K ti 4 where t is the net transfer that the firm gets from the government subsidy minus tax and franchise fee Government It is utilitarian and maximizes the sum of consumer and producer surpluses minus the social cost of transferring public funds to the firm s The transfer to the firm s can either be positive i e a subsidy or negative ie a tax The government s objective function is N N WSO DOGO 5 where A is the opportunity cost of public funds For A close to 0 the government maxi mizes the consumer surplus for larger A the government puts more weight on taxpayers surplus i e on transfers Opportunity cost of public funds Term 1 measures the social cost of trans ferring one
45. on 6 in A K space For the sake of exposition we limit our discussion to four cases that depend on the profitability of the market segment Profitability is assessed by the difference between the operating profit of the private firm V and the fixed cost level K In the following discussion V is fixed to a constant and K is successively decreased The first case occurs for large fixed costs K gt V The market segment is not privately profitable and is socially beneficial only if the shadow cost of public funds A is small enough The optimal industrial policy is therefore to set up a public regulated firm for low or to supply nothing at all for high A Public regulated monopolies that are desirable 24 under asymmetric information are depicted by the white area denoted RM while the case for no production corresponds to the area denoted This is a case for public provision and ownership of firms in unprofitable segments Examples are rural infrastructure projects e g a secondary road rural electrification that are supplied only by wealthy nations and that are usually used at marginal cost by rural population Poor countries face an opportunity cost of subsidizing such infrastructure that is higher than their social returns As a result they choose not to offer such infrastructure or try to get rid of the unprofitable public firms in charge of them The second case occurs for smaller fixed costs that belong to the range K o0
46. on have also been highlighted in the theoretical and empirical literature We hope that the present contribution may help the reader to find a balance between those issues 29 References AfDB OECD 2003 African Economic Outlook OECD AFD Hydroconseil SEURECA 2005 Projecto de Reabilitaao das Redes de Agua Potavel da Aglomeraao de Maputo rapport ANANIA L 1992 The Protean Complex Are Open Networks Common Markets in the Economics of Information Network Ed by C Antonelli North Holland AURIOL E and J J LAFFONT 1993 Regulation by Duopoly Journal of Economics and Management Strategy 3 507 533 AURIOL E 2005 Telecommunication Reforms in Developing Countries Communication amp Strategies special issues WSIS November 2005 pp 31 53 AURIOL E and P M PICARD 2005 Government Outsourcing Contracting with Natural Monopoly CEPR DP 5643 AURIOL E and M WARLTERS 2005 Taxation Base in Developing Countries Journal of Public Economics 89 4 625 46 BARON D and R MYERSON 1982 Regulating a Monopolist with Unknown Costs Econo metrica 50 911 930 BIRDSALL N and J NELLIS 2002 Winners and Losers Assessing the distributional impact of privatization the Center for Global Development Working Paper Number 6 BREWER L T and P RIVOLI 1990 Politics and Perceived Country Creditworthiness in International Banking Journal of Money
47. or F A 0 VA gt 0 Depending on the franchise fee function F A the welfare function associated to a private monopoly varies between these two bounds A ae ee A Ao do A Figure 1 Welfare for Private and Regulated Monopoly 18 Proposition 3 establishes that privatization with price liberalization dominates a benev olent regulation under public ownership for at least intermediate values of opportunity costs of the public funds On the one hand when the franchise fee F A is large i e F A gt V co K VA gt 0 the opportunity costs supporting privatization belong to an unbounded range oo The optimal industrial policy is monotone in A On the other hand when the franchise fee falls below the threshold VM oo K the optimal industrial policy is non monotone in A For intermediate values of privatization with price liberalization dominates regulation under public ownership The opposite conclu sion holds for lower and larger value of A Observe that the preference for private feasible monopolies is not explained by the possibility of collecting franchise fees As shown in the Appendix even with no fee F A 0 the interval Ao Ao where privatization dom inates regulation is non empty see figure 1 The intuition for this result is as follows A private entrepreneur enters the business if his her firm is ex ante profitable After the investment the private firm makes a large or a low operat
48. ows that the presence of asymmetric information does not alter this result of wasteful competition Lemma A1 Under asymmetric information there is excessive entry Privately feasible duopolies 5 11 o 4 5 o are socially undesirable whenever 3V A a oR K lt 3V tag on The set of values of fixed costs defined by the condition in Lemma A1 is not empty One can indeed show that that condition is equivalent to a gt EG v30 which is true under assumption Al Therefore the ex ante welfare is higher if a private monopoly is legally set and if entry is prevented Indeed firms do not internalize the social cost of the investment duplication in their entry decision As a result they enter too often in the industry Regulated duopoly Under the regulated regime managers of duopolies are offered incentive compatible contracts with asymmetric information between the two firms and between firms and goverment We first examine the case of symmetric information and the sampling gain benefiting to the government We next turn to the case of asymmetric information The sampling effect under symmetric information The timing is the same as for a regulated monopoly with the following differences the investment K is made in the two regulated firms henceforth RD and the marginal cost parameters with 7 1 2 are independently drawn Under symmetric information the transfers t to 39 the regulated firms i 1 2 which are sociall
49. pportunity costs of public funds a regulated monopoly under symmetric information does not bring much 16 more welfare than a private monopoly when the latter pays the maximal franchise fee F 2 Tn other words the welfare of a regulated monopoly coincides with the welfare of a private monopoly for large A From this argument we can infer that the additional cost introduced by the asymmetry of information in the regulated monopoly gives a welfare advantage to the private monopoly for sufficiently large A That is under asymmet ric information the welfare function of the regulated monopoly has an asymptote with negative or positive slope lim EW A A It is easy to check that _ EW A _ eM im 7 ye oo K 16 is smaller than V K We deduce that privately feasible monopolies can dominate regulated monopolies Let the fixed cost K satisfy the following condition co V gt K gt v a BY with B E E The interval defined in condition CO is non empty Indeed 24 E Bow lt lis 2 e gt 0 which is always true since V gt VEM o0 The left we equivalent to hand side of condition CO implies that the fixed cost is small enough so that a monopoly is privately feasible see 7 The right hand side implies that the fixed cost is large enough so that the monopoly is not too profitable Proposition 3 presents the main result of the paper Under condition CO privatization dominates
50. rhood Privatization is an appealing alternative as it is better to have a privately owned and operated infrastructure even with monopoly distortion than no infrastructure at all By continuity the result still holds when the government is able to finance the infrastructure Nevertheless the above monotonic relationship between privatization and tightness of budget constraint breaks down when natural monopolies are sufficiently profitable and when governments are not able to recoup large enough franchise fees or divestiture pro ceeds Such situations often stem from the difficulty met by developing countries to attract investors when they auction off profitable SOEs We show that with underpriced public assets the privatization decision is optimal only for intermediate values of the opportu nity cost of public funds The intuition goes as it follows as before when opportunity cost of public funds is small the bailouts of firms by governments are cheap and it is optimal to keep firms public to set prices close to marginal costs and to subsidize the 5According to Trujillo Quinet and Estache 2002 there exist rarely more than two bidders who participate in developing countries auctions for major concession contracts Therefore SOEs are often sold at a discount to avoid the embarrassment of unsuccessful sales see Birdsall and Nellis 2002 firms to guarantee a break even situation For intermediate value of the opportunity cost o
51. s hold either lim 4 LHS A gt lim y 4 RHS A which is equivalent to F 00 lt R or lim _ 4 LHS A lt lim 4 RHS A which is equivalent to R lt F 00 where R VEM o0 K Consider first the case R lt F oo This condition implies that for large enough privatization is preferred to regulation Since it is the reverse for A low enough we deduce that LHS X and RHS cross once and only once This proves part i of proposition 3 Step 3 Consider next the case R gt F co This condition implies that for large enough A regulation is preferred to privatization Since this is also true for low enough A we deduce the following possibilities first LHS X and RHS A never cross in which case regulation is always preferred to privatization second they cross twice which yields part ii of proposition 3 This ultimately depends on K Step 4 To complete the proof of proposition 3 we need to show that there are at least some values of the parameters such that LH S X and RHS A cross twice Since privatization is less attractive for smaller franchise fees a sufficient condition is that LH S and RHS A crossing twice for F 0 Simplifying expression 24 and using F A 0 we get that privatization is preferred to public ownership if and only if P X 2 V 00 K A V B K A V 2 lt 0 25 Inequality 25 is satisfied for A A with 0 lt A lt under three conditions
52. s paper With a large surplus at stake ownership is not the key to the allocative efficiency problem regulation 9Tn the USA a federal excise tax on telephony services was created in 1898 Tax s opponents argue that it is distortive while its proponents insist on the revenues need It is hard to get around this argument At a tax rate of 3 tax collection reached USD 5 185 billions in year 1999 USA government budget 30 On the whole this non tax revenue is more important for developing than opposed to industrial coun tries comprising about 21 percent compared to 10 percent of total revenue Burgess Stern 1993 pp 782 27 is the key Empirical evidence supports this result 6 Conclusion In this paper we compare the welfare of a public firm with regulated prices to the welfare of a private firm with liberalized prices for different values of opportunity costs of public funds We show that the privatization decision non trivially depends on the value of opportunity costs of public funds and on the profitability in the market segment where the firm operates Since the opportunity cost of public funds is higher in developing countries than in developed countries optimal privatization policies are likely to differ between those countries We have highlighted four cases First a market segment can have a so low profitability that no private firm is able or willing to cover it Such a situation is typically encountered in secondar
53. sez faire This is a major concern in developing countries because they usually lack the human resources and the institutions to implement an effective regulation 1 1 Relationship with the literature It is well known that public ownership generates inefficiencies because it encourages gov ernments to bail out or subsidize money losing firms Such inefficiencies were first coined by Kornai 1980 as the soft budget constraint problem This problem explains many in efficiencies occurring in socialist economies such as shortages or low price responsiveness Interesting surveys are available in Kornai 2000 and Kornai Maskin and Roland 2002 Since less efficient firms are allowed to rely on government funding they lack the financial discipline required for efficient management For instance under contract incomplete ness soft budget constraints affect the level of investments made by public managers By hardening the firm s budget constraint privatization helps restore investment incentives The transfer of public to private ownership is therefore often advocated as a remedy for the poor economic performance of public enterprises see for instance Dewatripont and Maskin 1995 Schmidt 1996 and Maskin 1999 Another concern about public owner ship is the governments lack of economic orientation For instance in Kornai and Weibull 1983 Shleifer and Vishny 1997 Debande and Friebel 2003 governments demonstrate
54. shington D C GIBBON H 1998 Worldwide Economic Orthodoxy Priv International 123 p4 5 GIBBON H 2000 Editor s Letter Privatization Yearbook London Thomson Financial p1 HART O 2003 Incomplete Contracts and Public Ownership Remarks and an application to Public Private Parterships Economic Journal 113 p C69 C76 KARIUKI M and J SCHWARTZ 2005 Small Scale Private Service Providers of Water Sup ply and Electricity A Review of Incidence Structure Pricing and Operating Characteristics World Bank Working Paper n WPS3727 KORNAI J 1980 Economics of Shortage Amsterdam North Holland KORNAI J 2000 What the Change of System from Socialism to Capitalism Does and Does Not Mean Journal of Economic Perspectives 4 1 27 42 KORNAI J 2001 Hardening the Budget Constraint The experience of the post socialist countries European Economic Review 45 1573 99 KORNAI J MASKIN E and ROLAND G 2002 Understanding the Soft Budget Constraint Discussion Paper University of California Berkeley KORNAI J and J WEIBULL 1983 Paternalism Buyers and Sellers Markets Mathemat ical Social Sciences 7 153 69 31 LAFFONT J J 2001 Enforcement Regulation and Development mimeo IDEI Toulouse LAFFONT J J and J TIROLE 1993 A Theory of Incentives in Procurement and Regulation MIT press MAHBOOBI L 2000 Recent Privatization Tre
55. sumption Al Substituting qi G1 5 G2 in 4 and 5 we compute the ex ante firm profit and the industry welfare of the Cournot duopoly 4 5 o EIP ce aes 4 2 9 Is 7 27 16 11 o EWP a 2 ue 9 18 2p 28 A duopoly is privately feasible if the two firms are ex ante profitable It means that expression 27 should be positive A private duopoly is socially desirable if it brings more welfare than decrease Empirically Wallsten 2001 finds using panel data of 17 developing countries that exclusivity periods i e temporary monopoly position can double the firm s sale price i e F in telecommunication industry 33For more on Cournot competition under asymmetric information see Sakai 1985 Shapiro 1986 and Raith 1996 34The expected profit of N firms playing a generalized Cournot competition is Ey WH Aa K with N gt 1 We deduce that if Y 39 lt K lt 23 then N 0 1 2 This yields assumption AO 38 a private monopoly That is if EWP gt EWP Let KPP PM e the level of fixed cost such that the government is indifferent between a private duopoly and a private monopoly i e EW EW From 8 and 28 we compute 5 11 o KED EM Ve 29 18 18 2b e Walras 1936 and Spence 1976 have shown in a context of symmetric information that industries with increasing returns to scale were characterized by excess entry The next re sult sh
56. the pieces together yields condition C0 K K V This complete the proof of proposition 3 It is independent of the cost distribution Appendix 3 The Duopoly Case In this appendix we derive the optimal industrial organization presented in Section 4 of the paper When the fixed cost K is sufficiently low private and regulated duopolies are feasible and may be optimal We compare two market structures First we study the welfare proper ties of the duopoly under laissez faire and asymmetric information between firms Under the private regime duopoly is modeled as Cournot quantity setting duopoly with asymmetric in formation between firms Second we study the nature of the sampling gain in the regulated duopoly structure under asymmetric information Indeed many contributions in procurement and regulation theory emphasize that despite sub additive cost functions it can be optimal to 36 have several producers in a regulatory setting A regulated duopoly can be better than a reg ulated monopoly because it reduces prices through yardstick sampling competition In the present model the firms marginal cost are independent and identically distributed The benefit of choosing a regulated duopoly originates from the sampling gain as first analyzed by Auriol and Laffont 1993 The sampling gain results from the government s ability to choose the least cost technology out of the two possible technologies offered by the duopoly Under
57. the private duopoly in the sense that it leads to productive inefficiency In what follows we leave aside the study of mixed duopoly to focus on the sampling gain As presented in the paper we rule out franchising The results are nevertheless robust to more favorable specifications of the franchise fee 32Considering F gt 0 would reinforce the bias in favor of the private monopoly in the sequel because PD PM franchise fees are higher with a private monopoly than with a private duopoly i e K would 37 A4 F A 0 Private duopoly Private duopoly PD here after is modeled as Cournot duopoly with asymmetric information between firms Each firm gets private information on its own marginal cost but it is not informed about the competitor s marginal cost As in any Cournot game each firm maximizes its profit taking the other firm s output as given The timing of the game is as follows First both firms simultaneously make the investments K Second each firm i 1 2 learns the realization of its own marginal cost 8 and chooses its production level g The equilibrium concept is Bayesian Nash equilibrium qi arg max Eg a olg G5 Aia Vi 1 2 5 4 Due to the linear shapes of the demand and cost functions firm 2 s optimal strategy is equal to q 6i 2a EB 38 6b 33 The existence of a duopoly with both firms producing at the equilibrium requires that a gt 33 E 2 which is true under as
58. the private firm 11 pays to the government in order to operate in the product market This franchise fee depend on the economic condition of the country through the value of A The private monopoly contemplates the following sequential choices First the monopoly chooses to enter the market by paying the franchise fee F A and by making the investment K If it enters then nature chooses the marginal cost 3 according to the distribution G The private firm learns and chooses a production level Q After the realization of 3 the private firm never pays or receives a transfer from the government The private monopoly s profit is TPM max P Q Q 8Q K F A The optimal production is independent of K and F A a p 2b Qru 6 If a is smaller than the firm s marginal cost 3 the production level falls to 0 In order to rule out corner solution in the sequel of the paper we assume that a is not too small 3 34 EH Al a gt max 23 8 o Substituting Q in equations 4 and 5 we get the ex ante profit and welfare of a private monopoly EI V K Fi A 7 EWPM A sv K F 8 where a Aa p 9 is the profit of operating the firm after the fixed investment is made A monopoly is privately feasible if it is ex ante profitable This requires that V gt K and that F A 15 Auriol and Picard 2005 discuss the privatization of a monopoly with ex post renegotiation and endog
59. tment level is 2K the marginal cost is c Bmin A and Bmin is distributed according to RM RD Gmin Let K A be the value of the fixed cost such that the government is indifferent between a regulated monopoly and a regulated duopoly i e such that EW EWR A RM RD a 1 A RD RM K 2 vA VEM A 36 RM RD Under asymmetric information the sampling gain is measured by K A We can write 36 as RM RD 11 B 2 K min The function is integrated by part which yields after straightforward computations gee 1 1 A f dc 3 STEN 2a c B Gmin B G B d8 38 Al RM RD The function K A is positive because the distribution function Gmin 8 stochastically dominates G 3 because a c 8 A is a positive function under A1 and because the virtual cost is a decreasing function de B _ GB d A g6 We deduce that RM RD 1 1 B G ye f ET EEN ER E 39 rry ff C D FH Erel GOA 39 RM RD It is easy to check that K A is a decreasing function of A both ESSEEN and the virtual cost c 8 A decreases with In other words the larger is the lower is the impact of the sampling gain and the smaller is the government s preference for regulated duopoly Private versus regulated duopoly We have seen in Section 3 that private monopoly can be preferred to regulated monopoly By extension private duopoly could also be preferred to monopoly or
60. to the interval K RTR the shadow cost of public funds A increases the optimal industrial structure successively switches from a public regulated firm to a private firm and then switches back to a public regulated firm The difference with the second case above lies in the fact that when A is sufficiently large the government seeks to extract the maximal revenue from the public firm by setting high prices This case shows that whereas the divestiture of a profitable public firm may be optimal in countries with intermediate costs of public funds it is not necessarily optimal in developing countries where budget constraints are tight and market institutions are weak The fixed line and long distant segment of the telecommunication industry illustrates the non monotonicity result A PTT s yearly revenues especially charges from international call were used by governments to subsidize mail service or to ease yearly budget deficits Given this public convenience and necessity the interests 28 Trujillo et al 2003 show that transport privatization leads to a reduced need for public investment 26 of third world governments are often diametrically opposed to telecom policies of priva tization and network deregulation favored by wealthy nations Anania 1992 Although advanced economies also care for the revenues generated by their utilities their effective taxation systems make them less greedy to the potential revenues of natural
61. www grai com links htm 1TFor instance in 1999 foreign direct investment FDI inflows to the 49 least developed countries 10 of the world population was 0 5 of total world FDI flows Since less than 10 of this investment was cross border merger and acquisition including privatization privatization proceeds are lower in poor countries than in rich ones despite sometimes a large number of privatizations 18The theory of predatory governments provides another justification for the assumption A2 see for instance Evans 1989 13 3 2 Regulated monopoly Under public ownership the government which is accountable for the profits and losses of the firm monitors the production of the regulated monopoly RM hereafter The timing is as follows The government first decides to make the investment K Second nature chooses the marginal cost 3 according to the distribution function G Third the firm s manager learns 3 but the government does not The government proposes a production and transfer scheme Q t Finally the regulated firm reveals the information and production takes place according to the contract QA tO We first study the benchmark case of regulation under symmetric information 3 2 1 Symmetric information When the government observes the realization of 8 it solves maxjg W s t IE gt 0 with W and II defined in 5 and 4 Since A is positive transfers to the regulated firm are costly and must be re
62. y costly are reduced until firms break even t a bQ qi Big K Substituting this expression into the welfare function yields WED S Q P Q Q 1 A Gig b2q2 2K The welfare function is linear in q and q2 Optimizing it with respect to q we deduce that q QFP gt 0 if B min 3 G2 and gf 0 otherwise The optimal production level coincides with the level of the regulated monopoly defined in equation 10 Q 61 32 Q min G1 62 Monitoring a regulated duopoly is equivalent to monitoring a regulated monopoly for which the investment level is 2K and the marginal cost is distributed as Bmin min 61 32 that is with the law Jmin B 2 1 G B g P 30 The ex ante welfare of the regulated duopoly under symmetric information is 1 RDx f min EWRP y 2 14 y r K 31 where B a 8 Vee Onin 8 AB 32 b The facts that gmin stochastically dominates g and that a 8 4b decreases in 3 imply that V gt V Then comparing 11 and 31 the ex ante welfare is larger under a regulated duopoly than under a regulated monopoly if the sampling gain measured by 2 ven V 1 A 14 2A is larger than K the duplicated investment Asymmetric information Under asymmetric information the two regulated firms must be enticed to reveal their private information to the government By the revelation principle the analysis is restricted to direct
63. y road or electrification projects in a low density area A public firm is then the natural option provided that the opportunity cost of public funds is not too high Otherwise the service is not offered Empirical evidences are consistent with this result The fraction of people in poor rural areas that do not have access to any service is larger in developing countries than in advanced economies Second the market segments can be sufficiently profitable to allow the entry of a pri vate firm We show that privatization with price liberalization then dominates regulation if and only if the opportunity cost of public funds is large enough As a result the provi sion of utility services and infrastructures is more market oriented in developing countries than in developed ones This is consistent with factual evidences For instance Kariuki and Schwartz 2005 estimate that nearly half of urban dwellers in Africa i e the middle class and the poor rely on private providers for water service The private informal 31For instance in telecommunication industry in African and in Latin America Wallsten 2001 found that privatization does not yield improvements but that privatization combined with an independent regulator does For more on telecommunication reforms in developing countries see Auriol 2005 28 providers are bridging the utilities service gap at a high cost their prices are up to 10 times the prices of public providers The

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