Parallels between theories of the firm and of privatisation

In the Hart (2003) paper referred to in a previous post the parallels between theories of the firm and of privatisation are discussed in the opening section. The parallels are indeed great. Hart writes,

In spite of these differences, the issues of vertical integration and privatisation have much more in common than not. Both are concerned with whether it is better to regulate a relationship via an arms-length contract or via a transfer of ownership. Given this, one might have expected the literatures to have developed along similar lines. However, this is not so. Whereas much of the recent literature on the theory of the firm takes an 'incomplete' contracting perspective, in which
inefficiencies arise because it is hard to foresee and contract about the uncertain future, much of the privatisation literature has taken a ‘complete’ contracting perspective, in which imperfections arise solely because of moral hazard or asymmetric information.

My own view is that this is unfortunate. One of the insights of the recent literature on the firm is that, if the only imperfections are those arising from moral hazard or asymmetric information, organisational form – including ownership and firm boundaries – does not matter: an owner has no special power or rights since everything is specified in an initial contract (at least among the things that can ever be specified). In contrast, ownership does matter when contracts are incomplete: the owner of an asset or firm can then make all decisions concerning the asset or firm that are not included in an initial contract (the owner has ‘residual control rights’).

Applying this insight to the privatisation context yields the conclusion that in a complete contracting world the government does not need to own a firm to control its behaviour: any goals – economic or otherwise – can be achieved via a detailed initial contract. However, if contracts are incomplete, as they are in practice, there is a case for the government to own an electricity company or prison since ownership gives the government special powers in the form of residual control rights.

Hart is right in what he says about the importance of the incomplete contracts approach to both the theory of the firm and the theory of privatisation. What I find odd about the quote above is the comment,

Whereas much of the recent literature on the theory of the firm takes an 'incomplete' contracting perspective, in which inefficiencies arise because it is hard to foresee and contract about the uncertain future, much of the privatisation literature has taken a ‘complete’ contracting perspective, in which imperfections arise solely because of moral hazard or asymmetric information. (emphasis added)

While it is true that during the 1980s the theory of privatiastion was based around asymmetric information models, which really couldn’t explain the difference between state and private ownership endogenously, since around 1990 this shortcoming has been noted and countered via the application of incomplete contract theories.

The need for incomplete contracting models was highlighted by a number of ownership irrelevance results that apply to complete contracting models. These ownership irrelevance results can be illustrated by considering Sappington and Stiglitz's `Fundamental Theorem of Privatization' (Sappington and Stiglitz 1987) and Williamson's idea of selective intervention (Williamson 1986: Chapter 6). Traditionally the theoretical case for public ownership has rested on considerations of allocative efficiency - that is, the properties of resource allocation in the economy taken as a whole - while the case for private ownership has rested on the incentives and constraints that the market provides to ensure efficiency within the firms - that is, productive efficiency. The Sappington and Stiglitz, and Williamson results show that in a complete or comprehensive contracts world, allocative and productive efficiency will be the same under both public and private ownership. Hence it is not clear what advantages privatisation (or nationalisation) could bring under this framework.

The notion of selective intervention argues that the government can reach the same level of productive efficiency as the private sector by mimicking the actions of a private firm. If the government organises the firm in exactly the same way as a private owner would, if it uses the same incentive schemes for managers and workers, and if it deviates from such a policy only if there is the possibility of doing something strictly better than a private firm, then a nationalised firm should produce at least as efficiently as a privatised one.

Sappington and Stiglitz assume that the government's objective in choosing between public or private production is threefold:

• economic efficiency: the government wishes that whoever has the comparative advantage in production undertakes it;
• equity: the government has certain distributional objectives;
• rent extraction: the government wishes to extract as much of the producers rent as possible.

The 'Fundamental Theorem of Privatization' provides conditions under which all of these objectives can be attained perfectly via an auction whereby the potential producers bid to become the single supplier. It is assumed that the good is produced under conditions of increasing returns to scale so industry costs are minimised with a single producer of the good. The fundamental theorem requires at least two risk-neutral bidders who have symmetric beliefs about the least-cost method of production. Actual costs of production are only learned by the producer just before production takes place. The government has a valuation, v, of the level of output, Q, of the good. This valuation is given by v=V(Q). These conditions are refereed to as the 'ideal setting'.

Sappington and Stiglitz show that a simple auction will ensure that all the government's objectives can be reached perfectly. The government auctions off the right to be the good's sole producer and receive a (total) revenue of P(Q) for producing output level Q. The government sets P(.) equal to its own valuation of the level of output produced, i.e. P(Q)=V(Q). In other words, the production decision is delegated entirely to the producer and the producer is paid an amount exactly equal to the value to the government of the level of output produced.

This means that once actual production costs are revealed a profit maximising firm will face the problem Max V(Q)-C(Q), where C(Q) is the cost function. The result of implementing this scheme is that the firm submitting the highest bid (and thus becoming the producer) will subsequently select the level of production most desired by the government (the welfare maximising output), conditional on the realisation of actual production costs.

If we interpret the government's valuation of output, V(Q), as being gross consumer surplus and assume that production costs have been revealed, then the firm's problem, Max V(Q)-C(Q), is to maximise the sum of producer and consumer surplus which implies productive and allocative efficiency.

With risk neutral firms initially sharing symmetric beliefs about the costs of production, the auction will result in the government capturing all the, ex ante, producer rents. Thus the government can ensure its ideal outcome via delegation of production even without any knowledge of the costs of production.

The argument made above was that Williamson's notion of selective intervention shows that state owned enterprises will be as productively efficient as private firms, in addition to their assumed allocative efficiency, and that the Sappington and Stiglitz theorem shows us that private firms can also be both allocatively and productively efficient. In other words, we have argued that the nature of ownership is irrelevant to the performance of a firm. Other neutrality results are to be found in Shapiro and Willig (1990), and in the context of full corruption, i.e. where unrestricted bribes between the manager of the firm and the politicians are allowed, Shleifer and Vishny (1994) show neither privatisation nor corporatisation matter for the final allocation of resources.

The shortcoming of both arguments is that they are based on the implicit assumption that it is possible to write a complete or a comprehensive contract for the entire life of the firm. To illustrate this point, look again at the Sappington and Stiglitz auction scheme and consider the commitment problems involved. For such an auction to work, the government must, at the time of privatisation, be able to commit itself - and all future governments - to actually paying the social valuation of output, V(Q), to the private owner at all times in the (possibly distant) future. That is, it must be possible to unambiguously specify, in a contract, the government's valuation of production for all possible states of world such that this agreement can be enforced by the courts. Otherwise the private owner will rationally expect that once any necessary relationship specific investments have been made, the government will exploit the fact that such investments are sunk costs and will expropriate the owner's quasi-rents and therefore a private owner will not invest efficiently. This will result in the government's most preferred outcome not being achieved. Selective intervention also fails unless contracts can cover all states of the world. As Williamson comments, ``[t]he impossibility of selective intervention arises in conjunction with efforts to replicate incentives found to be effective in one contractual/ownership mode upon transferring transactions to another. Such problems would not arise but for contractual incompleteness [ ... ]." (Williamson 1996: 178). As with the Sappington and Stiglitz auction there are commitment problems with selective intervention. Here the government must be able to commit itself - and all future governments - to intervene only when its economically advantageous, e.g. to deal with externalities. In particular it must be able to commit not to intervene for political reasons, such as requiring productively inefficient overmanning to reduce unemployment in the run up to an election. Such commitment is credible only if it can be made part of an enforceable contract, which is only possible in a complete or comprehensive contracting environment.

The great advantage of a complete/comprehensive contracts environment is that it allows for the complete depoliticisation of firms. With a contract covering all possible circumstances, political opportunism can be eliminated since there are no contingencies in which politicians are are able to exercise any control rights and thus commitments to non-interference are credible and soft budget constraints can be avoided. Thus in a world where contracts which cover all possible states of the world cannot be written, i.e. if only incomplete contracts are possible, the Williamson and Sappington and Stiglitz results will not hold and allocative and productive efficiency may differ depending on ownership. Within such an incomplete contracts framework firms can be politicised since the politicians, as owners, have residual control rights. A theory of privatisation (or nationalisation) is only possible within such a framework, a necessary condition for a such a theory is having a firm's performance depend on the firm's ownership, and incomplete contracts allow this to happen.

The point here is that all this was known by around 1990 and by the mid-1990s incomplete contract models were turning up in the literature - see, for example, Schmidt, K. (1996a) and Schmidt (1996b), with working paper versions even earlier. Given this it does seem at bit add to be saying in 2003 that "much of the privatisation literature has taken a 'complete' contracting perspective". Incomplete contracting models of privatisation has been available for around 10 years prior to Hart's article.

• Sappington, David E. M. and Stiglitz, Joseph E. (1987). 'Privatization, Information and Incentives'. Journal of Policy Analysis and Management, 6(4): 567-82.
• Schmidt, Klaus (1996a). 'Incomplete Contracts and Privatization'. European Economic Review, 40(3-5): 569-79.
• Schmidt, Klaus (1996b). 'The Costs and Benefits of Privatization: An Incomplete Contracts Approach'. The Journal of Law, Economics & Organization, 12(1): 1-24.
• Shapiro, Carl and Willig, Robert D. (1990). `Economic Rationales for the Scope of Privatization'. In Ezra Suleiman and John Waterbury (eds.), The Political Economy of Public Sector Reform and Privatization, Boulder: Westview Press, 55-87.
• Shleifer, Andrei and Vishny, Robert W. (1994). 'Politicians and Firms'. Quarterly Journal of Economics, 109(4) November: 995-1025.
• Williamson, Oliver (1996). The Mechanisms of Governance, New York: Oxford University Press.