The
Optimal
Government Shareholding
Stratem and
the
Cost
Structure
Chin-Shu
Huang,
Jea-Yao
Lee,
and
SLaikn-Shen
Ghenl
This paper analyzes government's optimal shareholding strate@ within the framework of the mixed oligopoly. It is found that: (1) When both public and domestic firms have the same cost coefficient, the government's best policy is to adopt the full mixed oligopoly. (2) When the cost coefficient of the public firm is lower than a threshold value, the government should opt for a full mixed-oligopoly policy. However, when the public firm's cost coefficient is higher than the threshold value, the govern- ment should privatize the public firnl completely and exit the market. The single mixed oligopoly is just an alternative proposal when it fails to transform all of the private firms into mixed ownership enterprises.
Keywords: Public firm, Mixed oligopoly, Privatization, Mixed ownership enterprise
JEL Classifiiation: D43, L2 1, L51
China had for long adopted planned economy by 1979, and it had seriously distorted her industrial structure and resource allocation. Beyond it, there were other issues waiting to be kclded with and improved upon: The loss of entrepreneurial compctitive- ness, insufficient labor incentive, and notorious rent seelung
* Professor, Department of Economics, National Chung Cheng University. Chia-Yi. TAIWAN, (Tel) +886-5-2720411 (ext. 34102). (E-mail) ecdahQccu. edu.tw: Assistant Professor, Department of Finance, Kao Yuan University, Iiaohsiung, TAIWAN, (E-mail) ccu1eeOseed.net.tw; Assistant Professor. De- partment of International Business and Trade. Shu-Te University, Kaohsiung. TAIWAN, (E-mail) chenssQmail.stu.edu.tw, respectively. We are grateful to anonymous referees for their helpful comments. All remaining errors are ours.
252 SEOUL JOURNAL O F ECONOMICS
problem. (Lin, Cai, and Li 1994). How to improve the production efficiency and raise the market competitiveness remains the quintessential issue for China's economic reform. Although a planned economy restrains the monopoly power of a state-owned enterprise (SOE), the SOEs are allowed to sell excess output a t market price. Besides, in the early stage of the gradual reform, non-state enterprises, compared to the dominant role of SOEs, play only a cameo role. Such a market incentive induces SOEs to produce more. Literature abounds regarding the SOEs' production behavior when there is no entry of non-state enterprises.1 (See Byrd (1989), Murphy, Shleifer, and Vishny (1992)' and Zhou (1994)) With the continuous implementation of the open policy, China is marching toward the socialism-market economy. Among all the factors needed in this transformation, the entry of lion-state enterprises is the essential one. It is widely regarded that non-state enterprises have become one of the main ingredients of China's economy. (Noughton 1994; Zhou 1997; Sullivan 1998; Huang and Li 2000; Huang, Liu, and Wang 2001, etc.) Needless to say, China's economic reform has achieved some appreciable results. In the wake of bubbling reform of the SOE, China intends to promote the concept of a modem enterprise system in order to transform the SOEs into an independent economic unit in the market. Equity, one form of capital structure in modem enterprises, facilitates the separation of ownership from management in order to enhance both operational efficiency and capital efficiency. Form 1997 to 2001, the number of share-holding enterprises (or HOES) increases from 72,000 to 300,000, with the corresponding increase in number of employees from 6,437,000 to 27,466,000. In addition, realized annual revenue leaps form $RMB 831.1 billion to $RMB 5.6733 trillion. From the survey of PRC's national industrial union, a t least 25.7% of the private enterprises are transformed from SOEs to COEs while 8% and 13.9% are ready to merge or acquire SOEs respectively. According to Workers Daily, mixed ownership enter- prises account for around 40% of PRC's economy. In a half or one more decade, the percentage is expected to increase to around 80%.
'According to Qian and Xu (1995), the non-state enterprise refers to enterprises which are not owned by the state government. This includes COEs (collectively owned enterprises) and other types of enterprises such as privately owned, foreign invested and other joint venture enterprises.
THE OPTIMAL GOVERNMENT SHAREHOLDING STRATEGY 253
Wei Li-chun, Director of Research Office of the State Council, has recently pointed out that PRC is going to make shareholding enterprises the model system of SOEs, according to the resolution of PRC's three-central committees. The government's determination to promote mixed ownersl?ip economy suggests that China's government has more comprehensive and deeper understanding of the relationship between SOEs and non-SOEs. Mixed ownership system translates into a mixed economy equipped with state, collective, and other non-state capitals. Its purpose is to assert SOEs' dominant role and exert their leadership and efficiency in production. This is comparable to the privatization of enterprises in industrialized countries. Since 1980, the major effort has been made to minimize red tape, loss of competitiveness, and the rigidity of the internal organizational structure, and a s such has enhanced the efficiency of SOEs. Take British Telecommunication Corporation for example, the British government periodically sold out shares of the corporation: Releasing 50.Z0h, 25.9%, and 20.7% of its equity in
1984, 1991, and 1993 respectively, instead of a full-fledged priva- tization a t one time. Thus, the process of the privatization, the role and function of the state capital in a mixed ownership economy may well adjust to the changing economic environments.
Merrill and Schneider (1966) first explore the case in which the government affects the operation of a n industry via a public firm that maximizes social welfare while competes with a profit- maximizing private firm in the market. 'llney showed that entry of a public firm into the industry could indeed improve the social welfare by reducing the market price and increasing the quantity. Such an industry characterized by competition between the public and private firms is lrnown as mixed oligopoly. In recent years, study of the mixed oligopoly has received more and more attention. Some relevant issues such as market strategies of public firms, subsidy and tax policies of the government, privatization of public firms and strategic trade policy are widely discussed under the model of mixed oligopoly. (See De Fraja and Delbono (1989). Cremer, Marchand, and Thisse (1989), Fershtman (1990), Katsoulacos (1994).
Barros (1995), White (19961, George and La Manna (1996). Fjell and Pal (1996). and Pal and White (1998)).
Some of the prior studies are on the full privatization of SOEs; that is, the transformation from pure public to pure private ownership firms. Little attention has been paid to the partial
254 S E O U L JOURNAL O F E C O N O M I C S
privatization where the government still retains some shareholding. Mastsumura (1998) indicates that neither the pure public nor the pure private is socially optimal in the duopoly and closed economy model. And he states that the government should indirectly control the target function of the firm through shareholding in order to achieve the optimum privatization. His paper, however, neglects how the optimum privatization is affected by the existence of foreign firms and the number of domestic firms.
Recently, Weng, Lo, and Liu (2003) have extended the models of Matsumura (1998) and Fjell and Pa1 (1996), and discussed the
optimum privatization of the SOE within the framework of mixed oligopoly when both public and private firms have homogeneous technology. Our paper argues that the degree of optimum priva- tization increases with the number of domestic private firms. However, the effect of the number of the foreign firms on the optimum privatization cannot be determined: It depends on the ratio of domestic firms to foreign firms. Interestingly, De Fraja and Delbono(1989) compare the social welfare under four marlret structures: Oligopolistic market of nationalization, mixed oligopoly with Cournot competition, the public firm acting as a Staclcelberg leader, and pure private oligopoly. I t is found that the social welfare under nationalization always outperforms that under the public firm with the Staclrelberg leadership, which is in turn better than that under Cournot-1Vash competition in mixed and pure oligopoly. The assumption of homogeneous technology may have accounted for this result, which leads to the conclusion that the best policy of the government is to take over all the private firms: Nationalization.
In other words, the conclusion of Weng, Lo, and Liu (2003) may not lead to the best policy for the society or government. In this paper, it is suggested that under the goal of social welfare maximization, the government can not just sell off its stock shares, but should also adopt a more comprehensive optimal policy by taking the market structure and operational efficiency into consideration. That is, in the presence of great discrepancy in the operational efficiency among public and private firms, the optimum policy may be a full privatization. But if the discrepancy is not significant, by changing the shareholding of all the private firms could be the optimum policy in terms of welfare improvement.
THE OPTIlMAL GOVERNMENT SHAREHOLDING STR4TEGY 255
discuss how a government determines the optimum privatization of public firms when private firms have the same and different cost structure in comparison to the public firm. We compare social welfare and the government policies under full mixed ownership, single mixed ownership and full privatization policy. In what follows, section I1 discusses the assumption. Section 111 focuses on the government's optimum shareholding policy in the case when the cost coefficient is the same. Section
IV
investigates the same when the cost coefficient is different. Section V explores the dynamic effect of government sell-off. Section VI provides a conclusion and suggestions for future studies.PI.
TheModel
We assume that there are one public firm, rn domestic private firms and n foreign private firms in a market of Cournot competition with the demand function given by P=a-Q, where Q is the total output, Q=qs+
C Z l
qpi+Cj'=l q ~ .-
q,, qpi and q ~ i are outputfor the public firm, the i th private firm and the j th foreign firm respectively. The cost function2 of the public firm is Cs=F+
(csq:/2), where c, is a constant (cs>O) and F denotes the fixed
cost. (F>O). The larger c, is, the less efficient the firm will be. The cost structures for the private firm and the foreign firm are C,i=F+
2
(c, q2,i/2) and CJ =F+ (c, q j / 2 ) respectively, where c,, > 0 , and c, 2 c,,
indicating that the efficiency of the private firm is no less than that of the pubIic firm. Without the loss of generality, we assume that F = O . That is, the entry cost is not considered here.
Given the assumption above, the profit functions for the public, the private, and the foreign firms are a s follows:
This research. following the previous literature, assumes that all firm's costs (entry cost) are zero. See Weng, Lo, and Liu (2003). Pal and White (1998). White (1996), and Fjell and Pal (1996) for reference.
256 SEOUL JOURNAL O F ECONOMICS
We assume that all finns, except for the public firm, seek maximum profit while the goal of the public firm is to maximize social welfare. The welfare maximization problem for the public firm is:
...
Max. S W = n , + C S + x n,~
(4.1 i = 1 (4)
B
where C S =
so
P ( x ) & - P Q = Q ~ / z , denotes the domestic consumer surplus.We assume that the government attempts to achieve the privatization by selling the stock, and a s such enables the public firm to turn into a mixed ownership enterprise. Furthermore, we also assume that the proportion of the private shareholding is B (0 I9
<
11, while that of the government shareholding is (1 - 19). Being a mixed ownership enterprise, the decision of the firm rests on the goals of both government and the private sector. It is, therefore, assumed that a convex combination of the profit and social welfare can be expressed in terms of optimal shareholding. Thus, the maximization problem for the mixed ownership enterprise is:3We assume that, the optimum decision of shareholding and the output is based on a full information sequential game. It is essentially a three-stage game. First, government chooses the best shareholding policy.4 Then, given the optimum shareholding policy,
3See Katsoulacos (1994) and Weng. Lo, and Liu (2003). To simplify the model, we also assume that the mixed ownership enterprise has the same cost coefficient as that of the public firm. In other words, the government's release on stocks can only affect the firm's production level, but has little impact on the production efficiency.
4The government choose the optimal number of mixed ownership firms h* between 0 and m + l . However, we, in this study, assume that the government can issue seasoned equity offerings or acquire more equities without extra cost, and the mixed ownership firms have their fixed cost zero. These assumptions will result to comer solution to the optimal number of mixed ownership finns. On the other hand, to contrast with before literature, we only study full nationalization, single mixed oligopoly, full mixed oligopoly, and full privatization, these four strategies in this
THE OPTIMAL GOVERNMENT SHAREHOLDING STRATEGY 257
the government decides the optimum sell-off. Finally, the mixed ownership enterprise has the Cournot eornpetition with all other firms in the market. To achieve the subgarne perfect Nash equilibrium for government's best shareholding, we use backwards induction.
A. Cournot Competition in Single Mixed Oligopoly
To obtain the Cournot solution (q%, q;i, and
dj),
the deratives of Equation (2) a t qpi, Equation (3) at qrj and Equation (5) a t qs must equal zero. Solving these three first order conditions for q$, q;i, andGj,5 we have
We further have
P ,
Q*, and CS*:a2(1+n+rnB+(rn+n)cs+~p12
cs*
=2 ~ :
where N 1 = l + n + B t r n B + ( l + B)cp+c,(l+rn+n+cp).
Proposition 1
When the private shareholding ( 0 ) of the public firm (a single
research.
The second order conditions are assumed to hold. That is, (
a2§/
8q:) =258 SEOUL JOURNAL O F ECONOMICS
mixed ownership enterprise) is greater, the market price and the output of any firms (including domestic ones and the foreign ones) will increase. The output of the public firm, the total output of the marlre-t and the consumer surplus is expected to decrease.
From the proposition 1, it is found that the reduction of public firm's shareholding decreases its output and causes the private firms to produce more output. The influence of the former dominates the latter.6 leading to the reduction of the overall market output, pushing up the market price, and decreasing the consumer surplus.
Substituting the Equations (6)-(9) into the Equations (1)-(3), we get:
E"roposition 2
If the private shareholding of the public firm is greater, the profit of both the domestic and the foreign firms are expected to increase. Moreover, if the privatization of the public - -
firm
is not adequate ( 0 < 0, 0={(1 +cp)(l + n + c p ) + n ( l +rn+n+cp)cs)]/{(l +cp)(l +m+2n+cp) + n ( l +rn+n+cp)cs]), the profit of mixed ownership enterprise will rise a s well; otherwise, it will decrease.The variation on the proportion of equity sell-off certainly will affect public firm's profit. Its profit moves in the same direction with the private shareholding 0 first, before s w e ~ n g toward the opposite directions. Given that d nz/d0= (MR,
-
MCs)dqs/dO, andWe can express this result as
I
-2;
I>1rnxtn--l. dq:i d d doLet
8
.
.
((n- 1 -c,,)c3/(2+2cp+ nc,) and 8 2 8 , it follows immediately that nsrO. It is to be pointed out that,3<
8.
TIIG OPTIMAL GOVERNIMIFNT SHARiFWOLDING STRATEGY 271
greatly if one considers the following scenarios. First what is government's best shareholding policy when firm's cost structure and demand structure are dominated by uncertainty. Second, relationship between best shareholding policy and industrial development, structure change (merger, entry and exit of firms, etc.)
in a n industry are considered. In addition R&D, the production quality, and the trade policy remain challenging topics for future research.
(Received 20 June 2005; Revised 29 March 2006)
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