Privatization with Political Constraint: Auctions versus Private Negotiations

Abstract

This paper investigates the design of privatization mechanisms in emerging market economies. We identify an emerging market economy by the political constraints that limit the set of viable privatization mechanisms. Our objective is to explain the striking diversity of privatization mechanisms observed in practice and the frequent use of an apparantly suboptimal privatization mechanism: private negotiation. We develop a simple model wherein privatization is to be carried out by a government agent who plays favorites among bidders and is potentially disciplined by forthcoming elections. We find that it is the degree of political constraints that determines which mechanism is more successful in raising funds. If the political environment is such that the privatization agent himself aims at raising the fair value for the company, the privatization auctions and private negotiations are equally successful in raising public revenues. If, however, political constraints distort the agent's incentives, then one mechanism outperforms the other. In particular, if the distortion is moderate, then private negotiations can raise more value for a successful enterprise than privatization auctions. In this case the agent may play favorites among bidders, but to the extent he cares about price, he will use his bargaining power to negotiate his target price. If, however, the distortion is severe so that the agent lacks sufficient motivation to raise a fair price for the company, then privatization auctions will outperform private negotiations. Even though the agent may play favorites among the bidders, he would not put pressure on the bidders to raise the price during negotiations. In a privatization auction, in contrast, the presence of other bidders, regardless how informed they are, induces competition and places a lower bound on the equilibrium winning bid. We further find that information disclosure laws may have negative welfare implications: they may help the privatization agent to collude with some of the bidders to the disadvantage of noncolluding bidders. Our theory provides further regulatory implications for privatization procedures in emerging market economies.