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Privatization, Deregulation and Capital Accumulation

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In this paper we study how privatization and deregulation of production of intermediate goods influence capital accumulation. Our model is solved under three alternative scenarios: one where the intermediate sector is composed of a public monopoly under government control, one where the intermediate sector is dominated by a private monopoly, and one with a competitive intermediate sector. The comparison of these models suggests that the income benefits of state-to-market transitions are mostly due to increased competition on the deregulated market and that the privatization of state enterprises is not likely to generate significant changes in the economy when the public monopoly is replaced by a private monopoly. In fact, the model predicts that for high enough levels of public investment, a public monopoly would be preferred to a private monopoly in terms of the resulting aggregate income level. We find that elimination of monopoly rights can increase aggregate income by more than 20%.
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Privatization, Deregulation and Capital Accumulation



Gerhard Glomm
Fabio Méndez
Indiana University
University of Arkansas
Department of Economics
Department of Economics
Bloomington, IN, 47405
Fayetteville, AR, 72701
gglomm@indiana.edu
FMendez@walton.uark.edu



October 18, 2004

Abstract
In this paper we study how privatization and deregulation of production of intermediate
goods influence capital accumulation. Our model is solved under three alternative
scenarios: one where the intermediate sector is composed of a public monopoly under
government control, one where the intermediate sector is dominated by a private
monopoly, and one with a competitive intermediate sector. The comparison of these
models suggests that the income benefits of state-to-market transitions are mostly due to
increased competition on the deregulated market and that the privatization of state
enterprises is not likely to generate significant changes in the economy when the public
monopoly is replaced by a private monopoly. In fact, the model predicts that for high
enough levels of public investment, a public monopoly would be preferred to a private
monopoly in terms of the resulting aggregate income level. We find that elimination of
monopoly rights can increase aggregate income by more than 20%.

Keywords: Privatization, Deregulation, Public Monopoly, Private Monopoly,
Competition, Capital Accumulation

JEL Classification: E13, H11, 041, L33

We are grateful to B. Ravikumar for helpful comments.

Introduction

Since the early 1980’s, many countries have privatized and deregulated
intermediate goods industries like gas, electricity or telecommunications that had
traditionally been run by the government. The European Union, for example, has
adopted aggressive policies towards the elimination of all monopolies in the
telecommunication market and conducted a general privatization program whose sales
receipts amounted to more than 3% of GDP between 1985 and 1995 (Constantinou and
Lagoudakis (1996), Parker (1998)). In other regions of the world, countries like Australia,
Chile, Brazil, Argentina and the United States have implemented similar policies
(Winston (1993), Van der Vlies (1996), Vickers and Yarrow (1991)).
To the extent that these intermediate goods are complementary to either physical
or human capital, it is expected that any changes in their aggregate level of output or in
their productive efficiency would also have an impact on the rate of growth of the
economy. Stern (1993), for example, shows that energy use and quality can be a limiting
factor for economic growth, and that any factors that cut energy use would also reduce
aggregate income levels.
So far, the available empirical studies have not provided definite conclusions on
whether privatization (alone or combined with free market entry) has a positive impact on
productivity and hence on aggregate income (see for example Kay and Thompson (1986),
Cook and Kirkpatrick (1988), Wallsten (1999), and Domberger and Pigott (1994)).
Furthermore, as pointed out by Kay and Thompson (1986), it is difficult to distinguish
empirically whether any changes in productive efficiency or output are caused by
privatization or by increased competition. Part of the difficulty, at least, arises because

2

both privatization and market liberalization usually occur together within a short time
period.
The literature on the macroeconomic effects of privatization is relatively sparse
[see the survey by Sheshinsky and Lopez-Calva (2003)]. There is a small related
literature initiated by Parente and Prescott (1999, 2000) that studies whether and to what
extent differences in monopoly rights can explain differences in average income across
countries. Herrendorf and Teixeira (2003), for example, find that monopoly rights can
reduce aggregate income by a factor of over 7 which is almost three times as large as the
effect found by Parente and Prescott (1999). Herrendorf and Teixeira (2003) infer the
extent of monopoly rights from differentials in the relative price of non-tradables.
Instead of inferring the extent of monopoly power from such relative prices, here we take
the stand that monopoly power is likely to exist in the public production of intermediate
goods like public utilities or telecommunications and that the size of these sectors can be
directly estimated (see World Development Report (1997)).
Schmitz (2001) uses a two sector growth model to calculate the impact of
government production of investment goods on aggregate labor productivity to be about
30%. In these calculations Schmitz (2001) completely abstracts from the issue of
monopoly rights. Here we find that for a reasonable benchmark case elimination of
monopoly rights (public or private) can increase aggregate income (in the steady state) by
more than 20%.
There is also a literature on privatization in the context of the post-Soviet reforms
in Eastern Europe, which includes for example Aghion and Blanchard (1994), Alexeev
and Kaganovich (2001), Blanchard (1997), Castanheira and Roland (2000) and Roland

3

(2000). Our paper is distinct from the post-Soviet privatization literature since we do not
study whole-scale privatization of (almost) all productive activity, but rather only
privatization of one relatively small, albeit important sector of the economy.
In this paper, we analyze some of the general equilibrium implications of state-to-
market transitions. We examine separately the consequences of both privatization of
public enterprises and deregulation of intermediate markets. By privatization we mean
simply a transfer from public to private allocation decisions. By deregulation we mean
changing the industrial organization from monopoly to competition.
We present a model of capital accumulation under three alternative scenarios: one
where the intermediate sector is composed of a public monopoly with investment
decisions constrained by government control, one where the intermediate sector is
dominated by a private monopoly, and one with a competitive intermediate sector. In
doing this, we abstract completely from any changes due to productivity differences
between public and private firms and concentrate on the effects on capital accumulation.
That is, we assume that all firms have access to the same production technology.
Unlike the literature mentioned above on privatization in the post-Soviet context
our paper focuses on privatization of one sector in a market economy. We assume that
the publicly produced good is an intermediate input in the production of consumption
goods. This sector could be telecommunications or electric power generation. We
explicitly model public finance of investment in the intermediate goods sector. We allow
for several post-privatization market structures such as monopoly and perfect
competition. Finally, we allow various elasticities of substitution between privately and
publicly provided inputs in the production technology.

4

The results of these theoretical models suggest that the benefits of state-to-market
transitions are mostly due to increased competition on the deregulated market, and that
the privatization of state enterprises by itself is not likely to generate significant changes
in the economy. In fact, the model predicts that for high enough levels of public
investment, a public monopoly would be preferred to a private monopoly in terms of the
resulting aggregate income level. Furthermore, the model points out that the gains from
deregulation vary according to the production technology parameters chosen and thus,
that they are also likely to vary from one country to another as the availability of natural
and human resources vary.
The following section describes the theoretical models and defines the
equilibrium for the economies. Sections 3 and 4 present the solutions to the model and
analyze the results. Finally, Section 5 contains the conclusions and the directions for
future research.

1.
The Model
The economy is populated by a large number of individuals, which we set equal
to one. Each individual lives forever, is endowed with k0 units of capital at time zero and
with one unit of labor in each period, supplies labor and capital inelastically in exchange
for the before-tax wage rate w and the before-tax rental price of capital q .
t
t
The individual’s utility function takes the form

1 σ
∑∞  c
t
t
β 

 ,
σ
t=0
1− 

5

where β is the discount factor, ct represents consumption of final goods at time t and 1/σ
is the elasticity of inter-temporal substitution. Every period the individual divides his
total income between consumption at period t, ct and investment at period t, it. In
addition, capital depreciate at the rate δ regardless of the specific use to which they are
put.
Two goods are produced in this economy: a final good Yt that is used for
consumption and an intermediate good Et that is used completely in the production of
final goods. In this sense, the role of Et is similar to the role of many intermediate goods
like electricity, gas, coal, or general energy that are used in almost all production
processes. For simplicity, we assume that this intermediate good is not consumed directly
by the individuals.
The final good is produced competitively by a large number of firms that use the
same constant returns to scale technology, which is given by
α
Y
ρ
ρ
ρ

1
t =
α
A θ
( K
1
(
)E )
N
.
(1)
F ,t +
−θ t
F ,t
Here KF, t and NF, t represent the amount of capital and labor used in the production of
final goods at time t respectively, A is total factor productivity and ρ and α are constants
that measure the degree of substitutability and the marginal products of the factors in the
production function. Since the technology exhibits constant returns to scale, we can
assume that there is one firm and that Yt is aggregate output.
The intermediate good E is produced using the constant returns to scale
technology
γ
−γ
E
K N
,



(2)
t =
1
I ,t
I ,t

6

where KI, t and NI, t represent capital and labor used in the production of intermediate
goods at time t respectively, and γ is a positive constant. Notice that since the production
function in equation (2) exhibits constant returns to scale we abstract from any natural
monopoly issues. This is similar to Schmitz (2001) who also assumes constant returns to
scale in all activities, even if they are carried out by the government. One benefit of the
constant returns to scale assumption is that it allows us to model monopolies and
competitive markets in one unifying framework. In this model there are thus no
efficiency reasons at all for a public or a private monopoly.
As explained before, this intermediate good is assumed to be produced under
three alternative regimes: public monopoly, private monopoly and perfect competition.
In the public monopoly case, we assume the government captures any positive profits πg
generated by the intermediate industry and uses them in the same way as any other type
of revenue. In the case of a private monopoly, we assume that any positive profits
obtained by the firm, πp, are distributed equally among the individuals; and finally, when
the intermediate industry behaves competitively there are no profits.
The government in these economies taxes labor and capital income at the
common rate τ. This tax rate is exogenous and assumed to be constant over time. In the
perfect competition and private monopoly cases, we assume that total taxes collected are
redistributed back to the consumers in the form of a lump-sum transfer T. In the case of
the public monopoly, in addition to finance transfers, total taxes collected together with
public monopoly profits πg are used in order to finance investment in the capital used to
produce the intermediate good. Specifically, we assume that a fraction ψ of total
government revenues is used to finance investments in capital for the public firm and the

7

rest is redistributed back to the consumers. In addition, we assume that the government
budget is balanced in each period.
The representative final goods firm’s problem can be expressed as



max F(K , E , N ) – q
F ,t
t
F ,t
t KF,t – rt Et – wt NF,t

(3)
{K ,N ,E}
F
F
α
s.t.
F(K , E , N ) =
ρ
ρ
ρ
1 α
A θ
( K
1
(
)E )
N
,
F ,t +
θ


F ,t
t
F ,t
t
F ,t
given qt, rt and wt,
where rt represents the price per unit of intermediate good E at time t, and the firm takes
all prices as given.
The individual’s utility maximization problem can be expressed as

1
c σ
max
t
t
β





(4)

∑∞ 





(c ,i )
σ
t t t =0 t =0
1− 
s.t.
∑∞ p [(1-τ)(q
p [c
t
t kt + wt) + Tt + πp,t]= ∑

t
t + it]
and

t=0
t=0
kt+1=(1-δ) kt + it ,
given Tt, πp,t, wt, qt, pt, τ and k0.
Here pt represents the price of a unit of consumption at time t relative to a unit of
consumption at time t +1, and πp,t represents profits from the private monopoly (if any).
Since population size is normalized to unity, individual capital stocks and individual
consumption are equal to aggregate levels. From now on, we will use upper case letters
to denote both.

Finally, in equilibrium the capital and labor markets must clear. That is to say, at
all times it must be true that
Kt = KF, t + KI, t, (5)

8

1 = NF,t + NI,t .



(6)
Then, the model is solved under the three alternative specifications for the market
structure of the intermediate sector.
2.1
The Case of Public Monopoly Intermediate Sector
We chose to model the public monopoly case as a firm that maximizes profits
given an exogenous amount of capital that is determined by the government’s investment
IG. While the objective function of public sector enterprises is by no means
uncontroversial, our profit-maximization assumption provides a convenient comparison
to the case of a private monopoly, where profit maximization is more natural.
Furthermore, as pointed out by Ramamurty (1991), accounting practices and performance
measures for state-owned enterprises often resemble those of private firms.
We assume that public capital follows the following pattern:
KI, t = (1-δ) KI, t-1 + IG,t, (7)
where, as mentioned before, government investment in public capital IG,t is modeled as a
fixed fraction ψ of total government revenues at time t, which are given by the sum of
total tax revenues and total monopoly profits at time t. That is,
IG,t = ψ [πg,t + τ (qt Kt + wt)].
(8)
The remaining fraction (1-ψ) of the government revenues is redistributed back to the
consumers as the lump sum transfer T.
Given these assumptions, the public monopolist’s problem can be expressed as
max (
r E ) E w N
(9)
t
t
t
I t,
{ N }
I
s.t.
γ
γ

E
K N
,
t =
1
I t,
I t,
given r(Et), KI,t, wt .

9

Here, the inverse demand function for the intermediate good r(Et) corresponds to the
representative final good firm’s input demand function resulting from its maximization
problem as stated by (3).
2.2
The Case of Private Monopoly Intermediate Sector
This alternative scenario presents two important variations with respect to the one
presented in section 2.1. First, the intermediate sector production is now conducted by a
private monopoly. Second, the amount of capital used by the intermediate firm is no
longer determined by public investment but by the firm itself. Thus, the monopolist’s
problem can be written as
max r( E )E w N q K
(10)
t
t
t
I t,
t
I t,
{ N K
,
}
I
I
s.t.
γ
γ

E
K N
,
t =
1
I t,
I t,
given r(Et), wt, qt;
where the inverse demand function r(Et) is identical to the one used in the public
monopoly case.
2.3
The Case of Perfect Competitive Intermediate Sector
Since the intermediate good technology exhibits constant returns to scale, there is
no natural monopoly case. We thus can model this sector to be competitive. When the
intermediate good is produced by a number of competitive firms, the representative
intermediate good firm’s problem can be written as
max r E wN q K


(11)
t
t
I t,
t
I t,
{ N K
,
}
I
I
s.t.
γ
γ

E
K N
,
t =
1
I t,
I t,
given rt, wt, qt.

10

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