Privatization is a key element in the East European economies' transition to the market, which differs critically from privatization in the West, since it is taking effect in a non- market environment. Poland's experience of stabilization and liberalization in 1990 reinforced the common view that the share of private ownership must reach a certain `critical mass' to reap the full benefits of a genuine market environment: state firms responded to the reduction in demand with a sharp contraction in overall output, but there was very little supply response to relative price changes.

In Discussion Paper No. 612, Research Fellows Gérard Roland and Thierry Verdier attribute the slow progress of privatization in Eastern Europe to private investors' reluctance to buy state assets while the potentially high transitional unemployment arising from enterprise restructuring could provoke a political backlash. In their model, private firms' efficiency increases with the size of the private sector. This positive externality provides a prima-facie case against gradualism, although there may be a coordination problem since private investors make their acquisition decisions independently. Below a certain `critical mass', even though privatization raises overall economic efficiency and workers' net real income, expectations that a future government will reverse part of the privatization programme may lead to a sub-optimal equilibrium with a `low' level of effective privatizations, regardless of the ideological preferences of the government. A high expected level of privatizations above this critical mass allows the economy to reap the full benefit of the scale economies associated with the size of the private sector; this alleviates the unemployment problem and eventually leads to full privatization.

Roland and Verdier argue that the free distribution of equal numbers of shares in the privatized enterprises to the population may provide a means of avoiding the risk of coordination on the `bad' equilibrium. Provided that these free shares account for a low enough proportion of the total to leave private investors in full control, such a policy may enhance the credibility and thus the irreversibility of a privatization programme.

Such free distribution of shares reduces the private investor's profit share, however, which raises the sunk cost required to restructure the privatized enterprise relative to the profit flows derived from such investment. Moreover, even if privatization policies become credible, multiple equilibria may still arise since profitability continues to depend on the expected size of the private sector. When the costs of restructuring are relatively high, free distribution of shares to the population may therefore reduce the attractiveness of such investment or even worsen the privatization outcome relative to the case where the government cannot credibly commit to maintain its privatization policy.

Privatization in Eastern Europe: Irreversibility and Critical Mass Effects
Gérard Roland and Thierry Verdier

Discussion Paper No. 612, February 1992 (IM)