Privatization and Restructuring: An Incomplete-Contract Approach

Abstract

Introduction One of the main problems of privatization in transition economies is the non-viability of many industrial firms which are to be privatized: unless the firm is restructured. it should be closed down because it is not worthwhile to run the firm in a market - economic environment. Now consider the privatization of a single enterprise which can be made viable by appropriate. restructuring activities. This raises the following questions : should it be the government which restructures or the private buyer? Or should both share in the task of restructuring? And if so, in which way should they share in this task? Moreover: what is the best sequencing of restructuring and privatization? These questions are addressed in the present paper. Let us assume that for political reasons the government wants to privatize quickly. This makes it impossible to wait until the value of the firm is precisely known. At least part of the restructuring must be performed under a veil of uncertainty. These restructuring efforts of the government or of the private buyer are faced with a hold-up problem. Restructuring is firm-specific : it refers to the particular firm in question and cannot be resold to anybody else. Hence the restructuring investments have the same properties as the relationshipspecific investments in the Williamson1 (1985) setting. Restructuring efforts are non-verifiable before a court. Moreover, the privatization contract cannot be made contingent on the value of the firm. At the moment of contracting, there is simply too much uncertainty about this value. Therefore, only an incomplete contract can be written at the exante stage. The Williamson-type hold-up problem arises because the division of net surplus from the sale of the firm cannot be fixed ex ante and the contracting parties cannot be prevented from renegotiating the initial contract terms when the value of the firm finally had become known. At the moment of renegotiation, the restructuring costs are sunk; hence, they do not influence the division of the net surplus from privatization. The parties anticipate that their restructuring efforts will not be rewarded at the renegotiation stage and underinvest. The hold-up problem in incomplete contracts has recently been addressed by quite a few excellent papers. Hart and Moore2 (1988) developed a formal framework of the problem in a model where one unit of a homogeneous good may be traded between a private seller and a private buyer who both engage in relationship-specific investments prior to the production of the good. Hart and Moore assume at-will contracts. This means that, in case of legal disputes between the parties, the court is unable to decide which; party is responsible for an eventual breach of the initial contract. Accordingly, the inclusion of breach penalties into the initial contract is unfeasible; the completion of the project after the initial innovation phase is a voluntary decision of both agents. In this setting. Hart and Moore proved that there is no solution to the holdup problems: there will always be underinvestment in the relationship-specific efforts. It is impossible in their model to achieve the first best, except in some singular cases. Further papers like Chung (1991)3, Aghion-Dewatripont-Rey (1994)4 and Noldeke-Schmidt (1995)s switched from the HartMoore setting to specific performance contracts or to option contracts, respectively, and showed that then the first best can be achieved. All of these papers deal with private trade where a private seller and a private buyer enter a long-run relationship which consists of an innovation stage and a production stage. In the present paper this setting is transferred to privatization. The innovation stage is identified with investments under certainty which the buyer has to carry out in order to make the firm run. In a sense, we assume that the firm is 'produced' by the private buyer since the former socialist regime has only left an empty shell which must be filled with life in order to survive in a market-economic environment. …