Privatization, Underpricing, and Welfare in the Presence of Foreign Competition

• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/jpet.12095
• Author: BIBHAS SAHA,ARGHYA GHOSH,MANIPUSHPAK MITRA
• Date: 01 June 2015

PRIVATIZATION,UNDERPRICING,AND WELFARE IN THE

PRESENCE OF FOREIGN COMPETITION

ARGHYA GHOSH

University of New South Wales

MANIPUSHPAK MITRA

Indian Statistical Institute

BIBHAS SAHA

University of East Anglia

Abstract

We analyze privatization in a differentiated oligopoly setting

with a domestic public firm and foreign profit-maximizing

firms. In particular, we examine pricing below marginal

cost by the public firm, the optimal degree of privatization,

and the relationship between privatization and foreign own-

ership restrictions. When market structure is exogenous,

partial privatization of the public firm improves welfare

by reducing public sector losses. Surprisingly, even at the

optimal level of privatization, the public firm’s price lies

strictly below marginal cost, resulting in losses. Our analysis

also reveals a potential conflict between privatization and

investment liberalization (i.e., relaxing restrictions on for-

eign ownership) in the short run. With endogenous market

structure (i.e., free entry of foreign firms), partial privatiza-

tion improves welfare through an additional channel: more

Arghya Ghosh, School of Economics, University of New South Wales, Sydney 2052,

Australia(a.ghosh@unsw.edu.au). Manipushpak Mitra, ERU-Indian Statistical Institute,

Kolkata-700108, India (mmitra@isical.ac.in). Bibhas Saha, School of Economics, Univer-

sity of East Anglia, Norwich, NR4 7TJ, UK (b.saha@uea.ac.uk).

Ghosh and Mitra are thankful to University of New South Wales (UNSW) and Indian

Statistical Institute (ISI), respectively, for hospitality and support during numerous visits.

Financial support from Australian Research Council (ARC) is gratefully acknowledged.

Received February 17, 2013; Accepted March 12, 2013.

This is an open access article under the terms of Creative Commons Attribution License,

which permits use, distributon and reproduction in any medium, provided the original

work is properly cited.

C2013 The Authors. Journal of Public Economic Theory Published by Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (3), 2015, pp. 433–460.

433

434 Journal of Public Economic Theory

foreign varieties. Furthermore, at the optimal level of priva-

tization, the public firm’s price lies strictly above marginal

cost and earns positive profits.

1. Introduction

In several industries such as energy, steel, airlines, and banking, public or

state-owned firms co-exist and often compete with private firms (Matsumura

and Matsushima 2004). Public firms represent up to 40% of value added

and 10% of employment in some OECD countries (Long and St¨

ahler 2009).

These shares are even higher in developing and transition economies. Over

the years however, the poor performance of public firms has prompted

Canada, Europe, Japan, the United Kingdom, and more recently the

developing economies in Asia and Latin America to embark on privati-

zation (Gupta 2005, Dong, Putterman, and Unel 2006). Most developed

Western economies were already open when they embarked on privatiza-

tion. Mukherjee and Suetrong (2009) note that privatization and trade

liberalization coincided in several developing and transition economies.

Privatization in a closed economy setting has been studied extensively

in the literature on mixed oligopoly.1However, as the discussion above

suggests, open economy considerations are at least equally important for un-

derstanding the welfare implications of privatization. This paper contributes

to the small yet growing literature on privatization in an open economy

setup where domestic public firms compete with foreign private firms (see,

e.g., Fjell and Pal 1996, Pal and White 1998, Barcena-Ruiz and Garzon

2005, Long and St¨

ahler 2009, Matsumura, Matsushima, and Ishibashi 2009,

Mukherjee and Suetrong 2009).

We consider two interrelated questions. First, does privatization necessar-

ily improve welfare in an open economy setting? Second, what are the effects

of privatization on the financial health of public firms? We address these

questions in a differentiated mixed oligopoly where a welfare-maximizing

public firm competes with profit-maximizing foreign firms. As is standard in

this literature (see Matsumura 1998, Fujiwara 2007, Long and St¨

ahler 2009)

we assume that a partially privatized firm maximizes a weighted average of

its own profit and welfare where the weight attached to profit captures the

extent of privatization.2Analyzing privatization in this environment, we find

two fairly robust results:

1See, for example, De Fraja and Delbono (1990), Cremer, Marchand, and Thisse (1991),

Anderson, de Palma, and Thisse (1997), and Matsumura (1998).

2Fershtman (1990) suggested an alternative approach to modeling privatization, in which

the weights are assigned to reaction functions, instead of to the objective functions.