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Aasim M. Husain, currently an Economist in the Southeast Asia and Pacific Department, was in the Research Department when this paper was written. He holds degrees from Rice University and the University of Pennsylvania.
Ratna Sahay, an Economist in the European I Department, is a graduate of New York University.
The authors would like to thank Jacques Artus, Izak Atiyas, Richard Haas, Mohsin Khan, Malcolm Knight, Ashok Lahiri, Anoop Singh, and especially, Carlos Végh, for their comments and insights. The paper has also benefited from comments by participants in seminars held at the IMF and at the University of Pennsylvania.
Calvo and Frenkel (1991) have identified 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.
As Tirole (1991) has pointed out, a key specificity of the transition process in Eastern Europe is the unusually high level of uncertainty in the firm’s environment. Large exogenous shocks, such as the collapse of Council on Mutual Economic Assistance (CMEA) trade and the deterioration in the terms of trade, have significantly affected most of the formerly centrally planned economies. In addition, rapid changes in commercial, trade, and domestic policies (Table 1) during the transition have exacerbated the uncertainty facing decision makers.
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 currently inhibit the privatization process, for analytical purposes we assume that the bare elements of structural and institutional reforms required to begin privatization are in place.
Table 1 indicates that the recent record of Central and Eastern European economies in liberalizing prices and trade is fairly impressive.
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, this analysis is presented 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, and the intermediate input is nontraded.
The subscripts G and g stand for the good states of nature, and B and b, for the 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 may 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.
Alternatively, as approaches Pj (no downstream uncertainty), the allocation to upstream public firms approaches the optimal allocation of resources in the benchmark case, and efficiency losses go to zero.
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 public firms.
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.
Different numbers of firms in each sector are introduced to highlight their significance in 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 exist in that sector.
Simple linear demand and supply functions are assumed here for analytical convenience.
The model with both sectors 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 antitrust laws or by ensuring easy entry of new firms in the future.
Recognizing that the ultimate objective of any privatization scheme would be to maximize consumers’ welfare, we assume that welfare decreases monotonically with higher deviations of output from the first-best solution. A direct approach to evaluating welfare would be to incorporate a representative agent (at the expense, of course, of complicating the analysis considerably) maximizing utility of consumption and leisure. In the presence of public sector inflexibilities in responding to market signals, welfare losses could be shown to occur when under-or overproduction leads to suboptimal choices over consumption and providing labor services.
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.