DDP 698. Eytan Sheshinski and Luis Felipe López-Calva. "Privatization and its Benefits: Theory and Evidence." April 1999. 65 pp.

Privatization has been a key component of structural reform programs in both developed and developing economies. The aim of such programs is to achieve higher microeconomic efficiency and foster economic growth, as well as reduce public sector borrowing requirements through the elimination of unnecessary subsidies. Microeconomic theory tells us that incentive and contracting problems create inefficiencies due to public ownership, given that managers of state-owned enterprises pursue objectives that differ from those of private firms (political view) and face less monitoring (management view). Not only are the managers' objectives distorted, but the budget constraints they face are also softened. The soft-budget constraint emerges from the fact that bankruptcy is not a credible threat to public managers, for it is in the central government's own interest to bail them out in case of financial distress. Empirical evidence shows a robust corroboration of theoretical implications: privatization increases profitability and efficiency in both competitive and monopolistic sectors. Full privatization has a greater impact than partial privatization and monopolistic sectors show an increase in profitability that is above the component explained by increases in productivity, which reflects their market power. This poses an important challenge for the designers of regulatory policies. The change in employment at the firm level is ambiguous, though firms that are publicly traded show an actual increase in employment level after privatization. Based on the little available evidence, the distributive effects are shown to be sensitive to the market structure. From the macroeconomic perspective, no conclusive evidence can be drawn, but the trends are favorable in terms of public sector deficit, attraction of foreign direct investment, and stock market capitalization. Research on the distributive effects of privatization, as well as its impact on poverty, is needed.

JEL codes: D21, D61, D62, E65.

Key words: Privatization, soft budget constraint, natural monopolies, structural reform.

This report results from work done under a project on "Privatization and its Benefits: Theory and Evidence," sponsored by the Office of Economic and Institutional Reform, Economic Growth Center, Bureau for Global Programs, Field Support and Research, United States Agency for International Development under the Consulting Assistance on Economic Reform (CAER) II project, contract PCE-C-00-95-00015-00.

Eytan Sheshinski is Sir Isaac Wolfson Professor of Economics at The Hebrew University-Jerusalem and Program Director, HIID International Program on Privatization and Regulatory Reform. He has been a visiting professor at Harvard in several occasions, both at the Economics Department and the John F. Kennedy School of Government. This paper was written when he was a visiting professor at Princeton University.

Luis F. López-Calva is a doctoral candidate in Economics at Cornell University and has collaborated with the HIID privatization workshops, both in Cambridge and overseas, since 1997. He is currently a visiting student at the Economics Department at Harvard under the Ivy League Exchange Scholar Program.