DP3992 The Proper Scope of Governments When Costs are Contractible

Author(s): Dag Morten Dalen , Espen R Moen

Publication Date: July 2003

Keyword(s): privatization , ownership , incomplete contracts

JEL(s): L33 , L51

Programme Areas: Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP3992.asp

We discuss the relative merits of public and private ownership. Our starting point is the analysis of Hart, Schleifer and Vishny (HSV), who apply an incomplete contract framework to study the difference between private and public ownership. Our analysis departs from HSV’s model in two aspects. First, we allow for cost-sharing contracts between the government and the firm. Second, we assume that the manager of a private firm may incur additional costs in order to produce private benefits, or perks (alternatively, this may reflect cross-subsidization). Managers in publicly owned firms do not have the same opportunity to produce perks, as the government when it owns the firm can monitor the manager’s costs more closely. The cost-sharing contract allows the government to govern the incentives for cost reductions in a privatized firm, and the government can thereby reduce the private firm’s incentives to dump quality in order to save on costs. This comes at a cost, however, as a low-powered incentive contract increases the manager’s incentives to consume perks. We show that if quality dumping is important, public ownership is still preferable to private ownership.