Rapid privatization in the reforming planned economies of Central and Eastern Europe has become a popular policy prescription among economists. A primary virtue of private ownership, they argue, is that it enhances firms’ ability to respond to market signals, thereby helping the economy achieve an efficient allocation of resources. However, simultaneous privatization of all economic sectors in a short time is largely precluded by these countries’ limited administrative capacity. Under these circumstances, some sectors will necessarily be privatized before others. A relevant question to ask, then, is whether privatization can be optimally sequenced in different sectors.
This paper assesses allocative efficiency gains that accrue under alternate sequences of privatization of different sectors in an economy. Specifically, it analyzes an economy linked vertically with two sectors—an upstream sector producing intermediate inputs and a downstream sector producing final goods. Two types of market signals—the market price of raw materials (reflecting their scarcity) and the market price of final goods (reflecting consumer demand)—are introduced in the model. A distinction between public and private firms is made by assuming that private firms are more responsive to the market signals than are public firms.
Efficiency gains are shown to be maximized when the sector facing relatively less uncertainty is privatized first. Thus, if shocks to the demand for final goods are more critical than those to the supply of raw materials, it is optimal to privatize the upstream sector first. On the other hand, if supply shocks are relatively large, the downstream sector should be privatized first.
An important characteristic of the formerly centrally planned economies is the high concentration of firms in almost all sectors. This gives rise to fears that privatization could potentially lead to the creation of monopolies or oligopolies. Thus, distortions that may be introduced by privatizing highly concentrated sectors must be considered when determining the optimal sequencing of privatization.
When oligopolistic markets and inflexibilities associated with state ownership are considered jointly, the optimal sequencing of privatization depends on market structure considerations—the number of firms and the elasticity of demand and supply in the two sectors—as well as on the relative variability of the shocks the two sectors face. If the market structures of the two sectors are similar, the choice of which sector to privatize first should be based on the variability of supply shocks relative to demand shocks. On the other hand, if the variability of the shocks in the two sectors is comparable, the sector with the less concentrated market structure should be privatized first.