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Market Structure and Privatization Policy under International

Competition

Joint work with Yoshihiro Tomaru

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Plan of the Presentation

(1) Rough Sketches of the Model and Results

(2) Mixed Oligopoly

(3) Four Lines of Related Literature on Mixed Oligopoly

(4) Model Formulation

(5) Results and Implications

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Rough sketch of the model

(1) The government chooses the level of production subsidy s.

(2) One welfare-maximizing state-owned public firm (firm 0) competes against n profit maximizing private firms in Cournot fashion (or Stackelberg) .

nθ foreign private firms, n(1-θ) domestic private firms (n and θ are exogenous)

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Our main concerns

(1) Relationship among welfare-improving effect of privatization, n and θ under optimal subsidy policy.

(2) What is the desirable role of the public firm, whether public leadership or private leadership yields higher welfare under optimal subsidy policy

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Results

(1) Privatization more likely improves welfare when n is larger and θ is smaller.

→The government should improve the competitiveness of the market before the privatization of the public firms

(2) Private leadership is better when θ is small, and public leadership is better when θ is large.

→The public firm should take leadership when the foreign penetration in the product market is large.

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Mixed Oligopoly, Mixed Market

State-owned public firms compete against private firmsState-owned public firms compete against private firms

Examples in JapanExamples in Japan

Banking: Postal Bank, DBJ, Iwate BankBanking: Postal Bank, DBJ, Iwate Bank

Housing Loan: the Public House Loan Corporation Housing Loan: the Public House Loan Corporation

Life Insurance: Postal Life Insurance (Kampo)Life Insurance: Postal Life Insurance (Kampo)

Overnight Delivery: Japan PostOvernight Delivery: Japan Post

Energy: Public Gas Corps (Narashino, Fukui,...)Energy: Public Gas Corps (Narashino, Fukui,...)

Broadcasting: NHK Broadcasting: NHK

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Examples of mixed oligopoly in other countries

Banking: Postal Banks (New Zealand, U.K., GermanBanking: Postal Banks (New Zealand, U.K., Germany,...) y,...)

Automobiles: Renault, VWAutomobiles: Renault, VWMedicine: Public Institute in BrazilMedicine: Public Institute in BrazilNational Defense, Aviation: EADS, Airbus National Defense, Aviation: EADS, Airbus Airline: National airlines (Swiss, Belgian, France,Airline: National airlines (Swiss, Belgian, France, 　　 ItaIta

ly, Indonesia...)ly, Indonesia...)Overnight Delivery: USSP Overnight Delivery: USSP Energy: Electricite de France, Gas de France, MacquaEnergy: Electricite de France, Gas de France, Macqua

rie, rie, Broadcasting: BBCBroadcasting: BBC

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Classical discussions of public firms

Why do public firms exist?

(1) Natural monopoly

(a) Public firm monopoly

(b) Regulated private firm monopoly

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Natural Monopoly

P

Ｙ

AC

D

0

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Classical discussions of public firms(2)

Why do public firms exist?

(2) Unprofitable market

(a) Public firm monopoly

(b) Private firm monopoly with subsidy (compensation of deficit from public funds)

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Non-Profitable Market

P

Y

AC

D

0

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Classical discussions on state-owned public firms

→→Public firm is the monopolist Public firm is the monopolist

In real economies, public firms are not always In real economies, public firms are not always monopolists. monopolists.

Public firms do not always face significant economy Public firms do not always face significant economy of scale, which guarantees monopoly by the of scale, which guarantees monopoly by the public firm.public firm.

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Differences between public and private firms

(1)Public firms are less efficient than private firms.

→Many empirical works do not support this view (and many other papers do support this view).

(2) Difference of objective function

→Private firms maximize their own profits, whereas public firms might care about social welfare.

This paper, as well as many other papers on mixed oligopoly, assume that the public firm’s objective is welfare.

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Problem(1)(1) How to provide incentives for welfare

maximization?

→ This is the central issue for the public firm's monopoly

If we assume that the public firm is a welfare-maximizer under the monopoly, it is absolutely obvious that the first best is achieved by definition.

→No unsolved research problem remains. Thus, researchers never assume that the public firm is a welfare maximizer when they consider monopoly situation.

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Problem(2)(2) Is the welfare-maximizing behavior by the public

firm efficient?

→This problem never appears in the public firm's monopoly.

This question makes sense in mixed oligopoly because welfare-maximizing behavior by the public firm might worsen welfare through strategic interaction between public and private firms.

→This is the central issue of mixed oligopoly

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De Fraja and Delbono(1989)

(1) Cournot-type (quantity-setting competition, simultaneous-move, no product differentiation)(2) No cost difference between public and private firms. (3) Linear demand and quadratic cost function. (4) The private firm maximizes its own profits given outputs of other firms. (5) The public firm maximizes social welfare given outputs of other firms. →The public firm chooses its output level so that the price equals to its marginal cost.

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Results Compare the pure economy (after the privatization) to the mixed economy (before the privatization)→Privatization of the public firm might improve welfare WP >WM or WP<WM.WP >WM more likely takes place when the number of private firms are large.

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Intuition(1) Privatization of the public firm reduces public firm's output q0

(2) Privatization increases each private firm's output q1 →production substitution from the public firm to the private firms. (3) Privatization decreases total output q0 +nq1 Effects (1) and (3) reduces welfare and effect (2) improves welfare. Effect (2) may be the strongest, leading to an improvement of welfare.(2) is stronger and (3) is weaker when m is larger→Privatization morel likely improves welfare when n is larger.

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Production substitution

q1

reaction curve

after privatization

reaction curve of the private firm

0

reaction curve before privatization

q0

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More detailed explanation of intuition

Privatization of the public firm reduces q0 and increases q1 (production substitution). Before Privatization p=c0' >c1' →Public firm's marginal cost is higher than private firm's → Production substitution from public to private economizes production costs →Welfare-improving →Privatization reduces total production level and so consumer surplus → Welfare-reducing It is possible that the former effect dominates the latter effect.

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Contribution of De Fraja and Delbono(1989)

(1) No cost difference between public and private firms → privatization does not improve production efficiency (2) Public firm's objection: welfare →No agency problem in the public firm (3) No additional policies by regulation, tax, or subsidy after privatization. ⇒Ideal circumstances for the existence of public firm. Against assumptions for the advocators of privatizations. → Nevertheless, privatization might improve welfare

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Assumptions of De Fraja and Delbono(1989)

Many researchers in this field believe that the assumptions above are plausible, but many other researchers (as well as I) make these assumptions for strategic purposes.(1) Even without cost differences, privatization improves welfare. →If public firm is less efficient, much more.(2) Even without any agency problem in the public firm, privatization improves welfare. →If public firm has agency problem, much more.

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Why quadratic costs？

Constant marginal cost yields problems Constant marginal cost yields problems

If marginal costs are constant and no cost differences If marginal costs are constant and no cost differences exists, the public firm's monopoly yields the first exists, the public firm's monopoly yields the first best.best.

→ → It is nonsense to discuss mixed oligopoly in such a It is nonsense to discuss mixed oligopoly in such a circumstance. circumstance.

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How to avoid this problem? (1) Using constant marginal costs and assuming cost

differences between public and private firms. Mujumdar and Pal (1998),Pal (1998),Matsumura (2003a),Matsumura and Ogawa (forthcoming)

First best is achieved by the marginal cost pricing of the private firm.

The private leadership yields the second best where only private firms produce and the price is equal to the marginal cost of the public firm.

It is the equilibrium in the observable delay game.

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How to avoid this problem? (2) Using increasing marginal costs. De Fraja and

Delbono (1989),Fjell and Pal (1996), White (1996), Matsumura and Kanda (2005), Heywood and Ye (2009a), Wang et al (2009), The paper presented yesterday.

If there is no cost difference between public and private firms, at the first best all firms chooses the same output level. It is not always achieved in mixed oligopoly since public and private firms have different objectives.

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How to avoid this problem? (3) Dropping the assumption of homogenous goods.

Monopolistic competition: Anderson et al. (1997), Matsumura et al (2009)

Linear demand (quadratic utility function) with product differentiation: Fujiwara (2007)

Mill pricing location model: Cremer et al. (1992), Matsumura and Matsushima (2003,2004), Inoue et al (2008),

Delivered pricing location model: Matsushima and Matsumura (2003,2006), Heywood and Ye (2009b)

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How to avoid this problem? More general Costs : Matsumura (1998, 2003b), Kiyo

no and Tomaru (forthcoming)

Discuss both (2) and (3): Matsumura and Shimizu Shimizu (forthcoming)

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Partial Privatization

De Fraja and Delbono: The public sector holds whole De Fraja and Delbono: The public sector holds whole shares in the firm (nationalization) or the private shares in the firm (nationalization) or the private sector holds whole shares in the firm (privatization)sector holds whole shares in the firm (privatization)

In the real world, we observe many firms with mixture In the real world, we observe many firms with mixture ownership (partial privatization) ownership (partial privatization)

NTT, JT, Iwate Bank, Hokuriku Electric Power NTT, JT, Iwate Bank, Hokuriku Electric Power Company, VW, Renault Company, VW, Renault

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Matsumura (1998)

(1) Cournot-type (quantity-setting competition, simultaneous-move, no product differentiation)(2) No restrictions on the cost differences between public and private firms. (3) The objective function of the public firm is the weight sum of social welfare and its own profits.（ Partial Privatization) U0= (1-α) W+ απ0

(4) General demand and general costs. The government chooses s and s affects α. After observing α firms compete in the product market.

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Results α =0 is optimal only if it yields public monopoly. →If we allow partial privatization, no privatization (full nationalization) never becomes optimal.

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Intuition

(1) Suppose that α =0. A slight reduction of =0. A slight reduction of α reduces public firm's output q0 .

Since p=c0', this effect is negligible (second order) ←envelope theorem (2) Reducing α increases private firm's output q1 Since p>c1', this effect is nonnegligible (first order) ⇒(2) dominates (1).

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Four Lines of Related Literature on Mixed Oligopoly(1)

(1) Relationship between Market Structure and (1) Relationship between Market Structure and Privatization PolicyPrivatization Policy

Privatization more likely improves welfare when the Privatization more likely improves welfare when the market is more competitive (when the number of market is more competitive (when the number of private firms is larger).private firms is larger).

De Fraja and Delbono (1989), Han and Ogawa De Fraja and Delbono (1989), Han and Ogawa (2007,2009), Matsumura and Shimizu (forthcoming)(2007,2009), Matsumura and Shimizu (forthcoming)

All papers ignore the subsidy policyAll papers ignore the subsidy policy

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Related Literature (2)

(2) Desirable Role of Public Firm, whether public leadership or private leadership yields higher welfare

When private firms are domestic, private leadership yields higher welfare. Pal (1998), Matsumura (2003a)

When private firms are foreign, public leadership yields higher welfare. Matsumura (2003b)

These outcomes are equilibria in the observable delay game. Pal (1998), Matsumura (2003b), Matsumura and Ogawa (2010)

All papers ignore the subsidy policyAll papers ignore the subsidy policy

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Related Literature (3)(3) International competitionPublic firm maximizes domestic welfare→The public firm's behavior is dependent on whether

its rivals are domestic or foreignIf the rivals are foreign, the public firm becomes more

aggressive. Fjell and Pal (1996)←De Fraja and Delbono (1989)Pal and White (1998) ← Strategic Trade Policy Strategic Trade PolicyMukherjee and Suetrong (2009) ← FDI FDIChang (2005), Chao and Yu (2006), Fujiwara (2006) ←

partial privatization version

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Related Literature on Mixed Oligopoly(4)

(4) Privatization Neutrality Theorem (PNT)

(4-a) Privatization does not affect welfare under simple optimal subsidy policy, unit production subsidy.

White (1996), Tomaru (2006), Kato and Tomaru (2007), Hashimzade (2007)

(4-b) Public Leadership, private leadership, mixed Cournot, and private oligopoly yield the same welfare under optimal subsidy policy above.

Poyago-Theotoky (2001), Tomaru and Saito (2010)

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Privatization Neutrality Theorem

Privatization Neutrality Theorem: Privatization does not matter under optimal subsidy policy.

It implies that if the optimal subsidy policy is adopted, discussing mixed oligopoly or privatization policy does not make sense.

Most of the results in mixed oligopoly literature have quite limited implications and importance if this theorem is really robust.

Destructive Result, Disaster for researchers in this field.

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Intuition behind PNT

Suppose that all firms are symmetric. Consider the private oligopoly.

The first best is achieved when P=ci' (price =marginal cost) ~ all firms choose the same output level

It is achieved by the production subsidy s*.

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Intuition behind PNTSuppose that one firm is nationalized. Suppose that

all of remaining firms do not change their outputs.

The nationalized firm, which is welfare-maximizer, never changes its output .

All remaining private firms obviously have no incentive to change their outputs.

→s* yields the first best outcome in the mixed oligopoly.

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Condition for PNTWhen I explain the intuition behind PNT, I do not use

any of the conditions

(1) profit-maximizing private firms

(2) homogeneous product market,

(3) single public firm

and so on.

All we use is the conditions that the first best is achieved at the symmetric equilibrium, that the first best is achieved by controlling outputs only, and that the pubic firm is welfare maximizer.

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Robustness of PNTPrivatization Neutrality Theorem is far from robust:

(1) PNT obviously does not hold when there is cost difference between public and private firms.

(2) PNT does not hold unless all firms are domestic.~ This paper

(3) PNT does not hold at free entry markets

~Cato and Matsumura

(4) If there is an excess burden of taxation, PNT does not hold. ~Matsumura and Tomaru, another paper

(5) PNT does not hold if firms control two or more independent variables

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Notationsm: Number of private firms θ: ration of foreign private firmsqi: Firm i's output, Q: Total output Ci(qi) =0.5(qi)2 : Firm i's production costP(Q)=a-Q: linear demand function πi: Firm i's profit, W: domestic social surplus, Superscript S: Equilibrium value at the second stage gameSuperscript M, P, L, F: Equilibrium value in the mixed Cournot oligopoly, private oligopoly, public leadership, private leadership

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The Model

Players: government, firm 0 (public firm), mθ foreign foreign private firms, private firms, m(1-θ) domestic private firms, domestic private firms, Payoffs: domestic welfare (government、 firm 0), Its own profits (private firms)

(1) Government chooses s (unit production subsidy) . .(2) Given m, θ and s, firms face Cournot competition and s, firms face Cournot competition (Section 3) or Stackelberg Competition (Section 4)(Section 3) or Stackelberg Competition (Section 4)..

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Optimal Subsidy Rate

Suppose that θ>0.(1) sP and sM can be either positive or negative(2) sP is decreasing in θ, while sM can be either increasing or decreasing in θ.(3) Either sP > sM or sP < sM is possible.

(3) implies that privatization neutrality theorem on subsidy rate does not hold.

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Resulting Welfare

Suppose that θ>0. WP >(<) WM when n is large (small).(a) Privatization neutrality theorem on welfare holds only when θ=0.(b) Privatization more likely improves welfare when the market is more competitive.

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Public Leadership, Private Leadership

Suppose that θ>0. Public leadership more likely yields larger domestic welfare than the private leadership when n is larger and θ is larger. Privatization neutrality theorem on welfare again holds only when θ=0.

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SummaryPrivatization Neutrality Theorem is quite vulnerable.→We can continue to make intensive researches on

mixed oligopoly without bothering PNT. Competition , Privatization , and Trade Policies are very

closely related.