The Costs and Benefits of Privatization: An Incomplete Contracts Approach

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Abstract
This article develops a model of a privatization using an incomplete contracts approach. We argue that different allocations of ownership rights lead to different allocations of inside information about the firm, which in turn affect both allocative and productive effieciency. Privatization is seen as a commitment device of the government to credibly threaten to cut back subsidies if costs are high in order to give managers better cost-saving incentives (a “harder budget constraint”). The cost of privatization is that allocative efficiency is distorted.