The design of privatization plans is critical to the economic transformation of Central and Eastern Europe. Selling control of enterprises to foreign firms can maintain efficiency by creating large shareholdings, while foreign involvement may also transfer technology and managerial skills and improve product quality, operational efficiency and access to new product markets and international financial markets. Citizens or governments holding minority stakes can free ride on any resulting rise in the value of the privatized firm. In Discussion Paper No. 891, Research Affiliate Francesca Cornelli and David Li consider a government choosing from several potential foreign buyers for a large, domestic firm which must also determine the share of ownership to be sold with the control right. Its objective function is a weighted average of the revenues from the initial sale and the subsequent value of the privatized firm. These need not coincide, since foreign firms have interests both in the public value of the firm and also in the private benefits from controlling it; the latter are likely to be greater than in established market economies.

Cornelli and Li show that the number of shares sold over and above the minimum needed for control is critical in discriminating between foreign buyers with different motives. When the private benefits of control are small relative to the firm's total public value, the government should sell the minimum number of shares to the highest bidder, which will be the most efficient company. When private benefits are so high that the government cannot afford to discriminate, the highest bidder will be concerned solely with private benefits of control; the government should simply maximize its initial privatization revenues. Between these extremes, it faces a trade-off between current revenues and future efficiency; in such cases, the government should still sell control to the highest bidder, but it can guarantee that this is also the most efficient potential purchaser by raising the proportion of `additional' shares it sells with the size of the winning bid.

Large Shareholders, Private Benefits of Control and Optimal Schemes for Privatization
Francesca Cornelli and David D Li

Discussion Paper No. 891, February 1994 (AM)