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The authors would like to thank Jacques Artus, Izak Atiyas, Richard Haas, Mohsin Khan, Ashok Lahiri, Mauro Mecagni, Arvind Panagariya, Anoop Singh, and especially Carlos Végh for their comments and insights. The paper has benefitted from comments by participants in a joint seminar organized by the Research and European I Departments of the International Monetary Fund. The views expressed here are of the authors and do not necessarily reflect those of the IMF.
Calvo and Frenkel (1991) identify several obstacles hindering reform in centrally planned economies.
Borensztein and Kumar (1991), in their survey of the various privatization proposals in Eastern Europe, describe the distributive aspects of several privatization schemes.
The collapse of CMEA trade and terms of trade shocks have affected state enterprises significantly. In addition, uncertainty over commercial, trade, and domestic policies during the transition has increased.
Sahay (1991) presents a mixed economy framework with private downstream and public upstream sectors. Her model highlights the allocative inefficiency that arises when the upstream suppliers allocate intermediate input quotas to downstream firms on the basis of installed capacity.
Opening up the economy to foreign trade may be a way of creating a competitive environment. However, as argued by Newbery (1991), concentrated industries are well placed to lobby for protection. In addition, trade liberalization does little to impose competitive pressure on nontraded sectors.
While recognizing the importance of several factors that are currently inhibiting the privatization process, for analytical purposes we assume that the bare elements of structural and institutional reforms required to begin privatization are in place.
If, for example, demand shocks are considerably more critical than supply shocks, it may be desirable to privatize the upstream sector first even if there are few upstream firms and the elasticity of supply of raw materials is low.
There are many sectors in a typical economy; the purpose here is to look at any two sectors that are linked to each other through an intermediate goods market. In this sense, the analysis presented here is within a partial equilibrium framework. Alternatively, the analysis under perfect competition may be thought of as relevant to an open economy in which raw materials and final goods are traded goods, while the intermediate input is nontraded.
The subscripts G and g stand for the good states of nature while B and b for bad states of nature. The state of nature is good when final goods prices are high and raw material prices are low, and bad when the reverse holds.
This informational assumption highlights the inability of state-owned firms to adjust production to the optimum level. Alternative assumptions regarding the ability of public and private firms to respond to shocks can also be made. The qualitative results would remain unchanged, however, as long as public firms are less responsive to shocks in the private sector than private firms.
Productivity shocks can easily be introduced without altering the basic thrust of the arguments presented in this paper.
Such an assumption provides a simple way of capturing public sector rigidities and analyzing their effects. All other forms of public sector inefficiency are abstracted from. The objective here is to highlight how public sector rigidities affect the flexibility of the private sector, hence affecting the choice of which sector to privatize first.
For example, it is difficult to imagine how a downstream potato chip producer can expand production without more potatoes. Even if substitutes for the intermediate input exist, downstream firms can only expand production if more of the substitutes are available. As long as the substitutes are also produced by state enterprises, however, additional inputs will not be available.
Firms in the state sector could also be modeled to behave like oligopolists. The assumption of perfect competition in the state sector helps in isolating the distortions associated with the inflexibility of the public firms.
Different numbers of firms in each sector are introduced to highlight their significance on the results under oligopoly. Note, however, that the primary distinction between perfectly and imperfectly competitive firms arises from the assumption regarding price-taking behavior and not from the number of firms that exists in that sector.
In a Cournot game, each firm conjectures that when it changes its output the other firms will keep their output fixed. In equilibrium, no firm has the incentive to change its level of output given the output of other firms.
The simple linear demand and supply functions are assumed for analytical convenience.
The model with both sectors being publicly owned is not developed in the paper, but can easily be demonstrated analytically.
An important caveat to this argument is that if on relative efficiency grounds privatization were to occur despite oligopoly considerations, experience from market economies shows that some form of regulation will ultimately have to be enforced either through anti-trust laws or by ensuring easy entry of new firms in this sector in the future.
To the extent that such firms already extract oligopoly rents (even when they are under state ownership), privatizing these firms will not create new distortions.
This is not to say that some enterprise restructuring is not proceeding in other countries of Central and Eastern Europe; this restructuring, which includes breaking up some large enterprises, is not holding up their privatization process.