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Privatization in the presence of foreign competition and strategic policies


Recent evidence shows that developing and transition economies are increasingly privatizing their public firms and also experiencing rapid growth of inward foreign direct investment (FDI). In an international mixed oligopoly with strategic tax/subsidy policies, we analyze the interaction between privatization and FDI. We find that the incentive for FDI increases with privatization. However, the possibility of FDI reduces the degree of privatization. Our paper shows that FDI policies reducing the fixed-cost of undertaking FDI may need to complement the privatization policies to attract FDI and to improve domestic welfare.

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  1. Baer (1994) shows that, as the state ownership in Latin America reduces, the presence of foreign capital increases. Using annual data of eight Asian and nine Latin American and Caribbean countries for 1990–99, Gani (2005) shows that privatization is positively correlated to FDI. Focusing on the Central and Eastern European countries (CEECs), Merlevede and Schoors (2005) have shown that privatization history positively affects FDI.

  2. In a Cournot oligopoly setting, Mukherjee and Suetrong (2009) show that privatization and FDI are mutually reinforcing.

  3. Production tax could be in the form of stumpage or natural resources consumption tax—a tax to help ensure the long run sustainability by making people be more aware of natural resource consumption.

  4. Before 1996, the auction of shares of the Indian public sector enterprises was restricted to dispersed domestic investors only (Kapur and Ramamurti 2002). Countries often restrict foreign individuals and firms from acquiring domestic firms, or apply special restrictions to foreign firms in certain industries, as is the case in Malaysia and the Republic of Korea (UNCTAD 2000). Bortolotti et al. (2002) points out that of the 650 major privatization deals reported in the Privatisation International dataset, only around 150 involved an equity issue on non-domestic markets.

  5. See Vickers and Yarrow (1991), Schmidt and Schnitzer (1997) and Pal and White (1998) for overviews of the privatization literature.

  6. \(F\) captures all the start-up costs of a new plant, including the adjustment cost of learning to operate in a new institutional and financial environment.

  7. Our assumption implies that privatization is more irreversible than FDI, which is more irreversible than tax/subsidy policy and it is more irreversible than output decision.

  8. The domestic country’s product tax rate is indeterminate for \(\alpha =0.\) This is because a fully nationalized firm sees the tax as transferring funds from the firm to the government without affecting welfare, which is what the firm maximizes. From (5) and (6) with \( \alpha =0,\) \(t\) drops out of the firm’s objective function: The tax does not affect the firm’s behavior.

  9. The motive for subsidization to extract rent from the firms in competing countries dates back to seminal work by Brander and Spencer (1985).

  10. See Appendix D for proof.

  11. See Appendices B and C for the proof.

  12. We show in Appendix E that \(\alpha _{R}^{*}<\alpha _{F1}\).

  13. See Kellenberg (2009) for a survey of the literature on environmental regulation and FDI.

  14. For details, see our working paper (Dijkstra et al. 2012).

  15. High cost needed to serve the foreign market may prevent the domestic firm from entering the foreign market. Das et al. (2007) show that there is a significant fixed cost of exporting. Moreover, buyer-seller networks may be important for both international trade and investment (Greaney 2003), and high network costs may prevent the foreign firm in the model from serving the export markets.


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The author would like to acknowledge the support through a Research Project Funding (Ref: ECO2010-18680) from Ministerio de Ciencia E Innovacion, (Ministry of Science & Innovation), Spain. We thank an anonymous referee of this journal for the useful comments and suggestions received. The authors are solely responsible for the views presented here but not their organizations. The usual disclaimer applies.

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Correspondence to Anuj Joshua Mathew.



Appendix A: maximum value of \(c\):

We see from (14) and (24) that \( q_{p}^{x}\) and \(q_{p}^{R}\) are positive respectively for:

$$\begin{aligned} c&< \bar{c}(\alpha ,s)\equiv \frac{1}{2\alpha +4}\left( s+\alpha +s\alpha +3\right) , \end{aligned}$$
$$\begin{aligned} c&< \hat{c}(\alpha )\equiv \frac{3-\alpha }{\alpha +\alpha ^{2}+3}. \end{aligned}$$

We further see that:

$$\begin{aligned} \frac{\partial \bar{c}(\alpha ,s)}{\partial \alpha }<0\quad \text { and }\quad \frac{d \hat{c}(\alpha )}{d\alpha }<0. \end{aligned}$$

Following (41), the least possible values of (39) and (40) are respectively:

$$\begin{aligned} c&< \bar{c}_{\min }\equiv \bar{c}(1,s)=\frac{s+2}{3} \end{aligned}$$
$$\begin{aligned} c&< \hat{c}_{\min }\equiv \hat{c}(1)=\frac{2}{5}. \end{aligned}$$

Comparing (42) and (43), we see that \(\hat{c}(1)<\bar{c} (1,s).\) Hence, the relevant constraint is (3).

Appendix B: \(W_{h}^{R}\) as a function of \(\alpha \):

Differentiating domestic welfare \(W_{h}^{R}\ \)under FDI in (35) partially with respect to \(\alpha ,\) we see that there are two solutions to \(\partial W_{h}^{R}/\partial \alpha =0,\) which we call \(\underline{\alpha } \) and \(\alpha _{R}^{*}\):

$$\begin{aligned} \underline{\alpha }=c-3,\, \, \, \,\, \, \, \alpha _{R}^{*}=\frac{c}{2-c}. \end{aligned}$$

We see that \(0<\alpha _{R}^{*}<1\) and \(\underline{\alpha }\) is negative.

In order to determine whether these two stationary points are maxima or minima, we differentiate partially with respect to \(\alpha \) again:

$$\begin{aligned} \left. \frac{d^{2}\left( W_{h}^{R}\right) }{d\alpha ^{2}}\right| _{\alpha =\underline{\alpha }}&= \frac{1}{-4c+c^{2}+6}>0, \\ \left. \frac{d^{2}\left( W_{h}^{R}\right) }{d\alpha ^{2}}\right| _{\alpha =\alpha _{R}^{*}}&= -\frac{1}{4}\frac{\left( c-2\right) ^{4}}{ c^{2}-4c+6}<0. \end{aligned}$$

Hence, domestic welfare reaches a global maximum for \(\alpha \in \left[ 0,1 \right] \) at \(\alpha =\alpha _{R}^{*}\) as given by (44) .

Appendix C: \(W_{h}^{R}\) is not higher than \(W_{h}^{x}\) for \(\alpha =1\):

Setting \(\alpha =1\) in (35) we get the domestic welfare under FDI at \(\alpha =1\) as:

$$\begin{aligned} W_{h\left| \alpha =1\right| }^{R}=\frac{7c^{2}-8c+4}{12}. \end{aligned}$$

Similarly setting \(\alpha =1\) in (33), we get domestic welfare under export at \(\alpha =1\) as:

$$\begin{aligned} W_{h_{|\alpha =1|}}^{x\max }=\frac{\left( 7c^{2}-8c+4\right) -s\left( 3\right) \left( 2c-s\right) }{8}. \end{aligned}$$

From (45) and (46), we see that:

$$\begin{aligned} \frac{d\left( W_{h}^{x}-W_{h}^{R}\right) _{\left| \alpha =1\right| }}{dc}=-\frac{1}{12}\left( 7c+9s-4\right) <0. \end{aligned}$$

The minimum value of \(\left( W_{h}^{x}-W_{h}^{R}\right) _{\left| \alpha =1\right| }\) is at the maximum value that \(c\) can take. From (45), (46) and the maximum value of \(c\) given by (3), we see that:

$$\begin{aligned} \left( W_{h}^{x}-W_{h}^{R}\right) _{\left| \alpha =1\right| _{c_{\max }}}=\frac{1}{200}\left( -60s+75s^{2}+16\right) >0. \end{aligned}$$

Thus, we see that

$$\begin{aligned} W_{h\left| \alpha =1\right| }^{x}>W_{h\left| \alpha =1\right| }^{R} \end{aligned}$$

at \(\alpha =1.\) Also, setting \(\alpha =0,\)in (33) and (35) we see that:

$$\begin{aligned} \left[ W_{h}^{R}-W_{h}^{x}\right] _{\alpha =0}=\frac{1}{6}s\left( 2c-s\right) >0. \end{aligned}$$

Appendix D: \(\hat{F}\) could be negative at \(\alpha =0\):

Substituting \(\alpha =0\) into (31), we see that \(\hat{F}>0\) at \( \alpha =0\) for:

$$\begin{aligned} c>\check{c}\equiv 2s. \end{aligned}$$

Thus, we see that when \(c<\check{c}\), \(\hat{F}\) is negative at \(\alpha =0\).

Appendix E: \(\alpha _{R}^{*}<a_{F1}\):

If \(\alpha _{R}^{*}>a_{F1},\) it implies from (29) that \(\hat{F}\) should be positive at \(\alpha =\alpha _{R}^{*}\equiv \frac{c}{2-c}.\)

We see from (29) that \(\hat{F}_{\alpha =\alpha _{R}^{*}}>0\) for:

$$\begin{aligned} c>\mathring{c}\equiv \frac{1}{2}\sqrt{16s+1}-\frac{1}{2}. \end{aligned}$$

However, for this to be consistent with the model setting, \(\mathring{c}\) should be less than \(\hat{c}\) in (3). On comparison from (48) and (3), we see that \(\mathring{c}<\hat{c}\) for \(s<0.14.\) Thus, for cases where \(s<0.14,\) we see that \(\alpha _{R}^{*}>a_{F1}.\)

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Dijkstra, B.R., Mathew, A.J. & Mukherjee, A. Privatization in the presence of foreign competition and strategic policies. J Econ 114, 271–290 (2015).

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  • Privatization
  • Product tax/subsidy
  • Foreign direct investment
  • Trade
  • Privatization

JEL Classification

  • F12
  • F18
  • F21
  • L33