For decades, there has been a monopoly in telecommunications
services controlled by a stable firm, a public enterprise in most of the
world. The absence of competition was motivated by the existence of
large fixed costs in several parts of the network, whose duplication was
neither privately profitable nor socially desirable.
However, the telecommunications industry has been changing rapidly.
Due to technological improvement and the political movement toward
market liberalization, there is growing interest in substituting
competition and privatization for regulation and nationalization in the
telecommunications industry. The poor economic and financial performance
of many public enterprises and the cases of successful privatization
have been used as arguments for privatization and competition. In this
worldwide policy-transition situation, policy makers need to know under
what conditions privatization of the public enterprise will increase
In the economic literature there is conventional knowledge on the
benefits and costs of privatization. For example, Laffont and Tirole
(1993, pp. 637-59) and Viscusi et al. (1995, pp. 453-74) discussed the
important regulatory policy issues of public enterprises. Vickers and
Yarrow (1988, 1991) and Megginson and Netter (2001) used empirical
research to assess the effects of privatization as a public policy. They
concluded that enterprises operating under public ownership will be less
efficient than their private sector counterparts.
However, standard economic theory is not particularly helpful in
understanding the welfare effects of privatization in the
telecommunications industry. Little attention has been devoted to
incentives in publicly owned firms, even though a "natural
monopoly" has been widely used as an argument for regulatory
In the context of vertical integration, on the other hand, market
closure has for a long time been the prime policy concern. For example,
Economides (1998), Mandy (2000), Weisman and Kang (2001), and Hackner
(2003) have examined several academic debates on market foreclosure and
discrimination in the telecommunications industry.
The structure of the telecommunications industry is characterized
by an upstream monopolist who supplies an input essential to the
competitive downstream firms that are vertically integrated. In other
words, the monopolist provides the upstream services and the downstream
services as well, and also competes with several firms in the
competitive downstream markets. Thus the downstream market structure
consists of a mixed market. Because a public enterprise competes with
independent, profit-maximizing downstream firms in the
telecommunications industry, game-theoretic analysis on privatization
policy in vertically mixed market should be examined.
Theoretic research on privatization in a mixed market has been
widely studied. De Fraja and Delbono (1989, 1990) showed that welfare
might be higher when a public enterprise is a profit-maximizer rather
than a welfare-maximizer in an imperfect competition market model.
However, they did not consider the privatization effects on improving
productivity. Matsumura (1998) and Lee and Hwang (2003) considered the
possibility of partial privatization in a Cournot duopoly model and
showed that it is optimal for the government to sell some but not all of
its shares in public enterprises when there exist production-efficiency
effects of partial privatization.
This article considers the telecommunications industry with a
vertical market structure to investigate the welfare effects of
privatization in a mixed downstream market where public enterprise
competes with independent private firms. It is shown that the cost
advantage of the independent rivals improves welfare postprivatization.
It is also shown that a privatization policy in the telecommunications
industry will be well justified if the competition in the downstream
market is fierce and the access charge is regulated at certain level.
It then extends the basic model to discuss the policy implications
of privatization, which include the structural separation between
upstream and downstream firms, the role of leadership in public
enterprise, the objectives of the public enterprise and its managerial
incentives in agency relationship, the possibility of partial
privatization, and the strategic choice of access charge by the
The structure of this article is as follows: In section II, the
author constructs a simple Cournot model in a downstream market using
linear market demand and constant marginal costs, analyze two market
equilibria between pre- and postprivatization, and compare the welfare
results. The analysis finds the degree of cost advantage of the
independent rivals improves welfare postprivatization. Several
extensions with abstracted forms and policy implications on the issues
of privatization are discussed in section III. The final section gives
II. THE BASIC MODEL AND ANALYSIS
Consider a monopolist providing both an essential upstream and
downstream services. There are assumed to be k - 1 identical,
independent downstream rivals of the monopolist, where k [greater than
or equal to] 2. The author assumes that downstream firms provide a
homogenous product, and the inverse demand of a downstream market is a
linear form of P(Q) = a - bQ; where Q = [q.sup.m] +
[[summation].sub.j=1.sup.k-1][q.sub.j.sup.n] is the market demand, which
the monopolist provides with essential facilities in an upstream market,
[q.sup.m] and [q.sub.j.sup.n] represent the outputs of the monopolist
and rivals in a downstream market, respectively. Then, the author
denotes [q.sup.n] as the equilibrium output of the representative
independent rival in a downstream market. The author assumes that the
monopolist engages in Cournot competition against private firms in the
Production of the downstream service is of the fixed-coefficient
type. Each unit of the downstream output requires one unit of the
upstream service and a complementary input that may be self-supplied by
an independent rival. The marginal cost of the upstream service is c and
the regulated input price (or access charge) of the downstream market is
assumed to be fixed as r where r [greater than or equal to] c. (1)
The per unit cost of the complementary input is [s.sup.i], where
[s.sup.i] [greater than or equal to] 0 and i = m, n denote the
monopolist and the representative independent downstream rival,
respectively. In addition, for the traceable and interior solutions
throughout the analysis where both the monopolist and rivals produce the
nonnegative outputs in the coexistence equilibrium, the author needs the
following assumptions about [DELTA] [equivalent to] [s.sup.m] -
A1. [DELTA] [greater than or equal to] 0.
A2. [DELTA] [greater than or equal to] r - c.
A3. [DELTA] [less than or equal to] (r - c) + (a - r -
A1 indicates that there is an efficiency gap between the monopolist
and independent rivals, and the independent firms are more cost
efficient than the monopolist. Otherwise, the privatization policy
always decreases the welfare in the model. (2) A2 represents that the
efficiency gap is greater than the price-cost margin of the upstream
monopolist, which is nonnegative. It ensures that the monopolist is not
able to exclude the independent rivals from the downstream market. Thus,
the rivals will produce nonnegative outputs in the model. Finally, A3
implies that the efficiency gap is large enough that the inefficient
monopolist can produce the output in the downstream market. Otherwise,
the monopolist will not provide the downstream service in the model.
Then, the profit functions for the monopolist and the independent
rival are given by, respectively,
(1) [[pi].sup.m] = (r - c)[k-1.summation over (j=1)][q.sub.j.sup.n]
+ (P(Q) - c - [s.sup.m])[q.sup.m],
(2) [[pi].sub.j.sup.n] = (P(Q) - r - [s.sup.n])[q.sub.j.sup.n].
In the profit function of the monopolist, the first term comes from
the access profit by selling access to the independent rivals, and the
second term comes from the operating profits by selling downstream
services in a downstream market.
The consumer surplus in the downstream market is then
(3) CS = [[integral].sub.0.sup.Q]P(v)dv - P(Q)Q,
and social welfare, which is defined as the simple sum of consumers
surplus and firms' profits, is given by
(4) W = [[pi].sup.m] + [k-1.summation over (j=1)][[pi].sub.j.sup.n]
(5) = [[integral].sub.0.sup.Q]P(v)dv - (c + [s.sup.m])[q.sup.m] -
(c + [s.sup.n])[k-1.summation over (j=1)][q.sub.j.sup.n]
The author assumes that the government maximizes social welfare
while the private firms focus on profits in the following analysis. This
implies that the monopolist will maximize social welfare in (4) when it
takes the form of public enterprise preprivatization, whereas it will
maximize its profit in (1) postprivatization. (3)
Now, the author will examine the equilibrium outcomes by the public
enterprise preprivatization and the outcomes by the privatized
monopolist postprivatization, respectively, and then compare the two
equilibrium outcomes. First, the author considers the preprivatization
case where the upstream monopolist takes the form of a public enterprise
and produces its output to maximize the goal of the government, the
social welfare function in (5). Then, the first-order condition for the
public enterprise with interior solution yields
(6) P(Q) = c + [s.sup.m].
Notice that at the equilibrium the market price is exactly equal to
the marginal cost of the monopolist, c + [s.sup.m], which is assumed to
be larger than the marginal cost of the independent rivals, r +
[s.sup.n]. This is so because the public enterprise is only able to
control its output level, not that of the rival when it maximizes social
welfare in the Cournot competition situation. (4) Notice also that the
operating profit level of the public enterprise is always nonnegative at
equilibrium if r [greater than or equal to] c. (5)
The first-order condition for the independent rival's profit
in (2) with the interior solution is as follows:
(7) P(Q) = r + [s.sup.n] + b[q.sub.j.sup.n].
Then, from the profit function in (2), the author knows that the
profit level of the rival firm in a downstream market is always positive
Using the equilibrium output of the representative rivals and
combining the equations in (6) and (7), one obtains the following
Cournot-Nash equilibrium output levels for the public enterprise and
(8) [q.sub.N.sup.m] = (X - kY)/b,
(9) [q.sub.N.sup.n] = Y/b,
where X = a - r - [s.sup.n] [greater than or equal to] kY and Y =
[DELTA] - (r - c) [greater than or equal to] 0 as assumed. Then,
[q.sub.N.sup.m] [greater than or equal to] 0, [q.sub.N.sup.n] [greater
than or equal to] 0, and [q.sub.N.sup.m] [greater than or equal to]
[q.sub.N.sup.n] if X - kY [greater than or equal to] Y, [q.sub.N.sup.m]
[less than or equal to] [q.sub.N.sup.n] if X - kY [less than or equal
to] Y. It means that an inefficient public enterprise might produce
greater output than the efficient independent rival firms
preprivatization. This is because the public firm extends the output to
where the market price is equal to its marginal cost even though it is
inefficient. In sum, in preprivatization, the total output is [Q.sub.N]
= (X - Y)/b and the equilibrium price is [P.sub.N] = C + [s.sup.m].
Next, the author considers the postprivatization case with the
upstream monopolist and thus, the privatized monopolist maximizes its
own profit function in (1). Then, the first-order condition for the
privatized monopolist with interior solution yields
(10) P(Q) = c + [s.sup.m] + b[q.sup.m].
Then, from the profit functions in (1) and (2), the author knows
that all firms in a downstream market have positive profits at
From the first-order condition of the individual rival in (7), one
gets the following Cournot-Nash equilibrium output levels:
(11) [q.sub.p.sup.m](X - kY)/b(k + 1),
(12) [q.sub.p.sup.n](X + Y)/b(k + 1).
Then, at the postprivatization equilibrium the efficient
independent firm produces greater output than the inefficient privatized
monopolist: [q.sub.p.sup.n] [greater than or equal to] [q.sub.p.sup.m].
In sum, under the privatized monopolist situation, the total output is
[Q.sub.P] = (kX - Y)/b(k + 1) and the equilibrium price is [P.sub.p] = a
- (kX - Y)/(k + 1).
Now, the author compares the two equilibrium outcomes pre- and
postprivatization. Notice that the output of the inefficient monopolist
decreases postprivatization, whereas output of the efficient independent
rival increases post-privatization: [q.sub.N.sup.m] > [q.sub.p.sup.m]
and [q.sub.N.sup.n] < [q.sub.p.sup.n]. This yields the following two
PROPOSITION 1. Suppose that the assumptions in Al, A2, and A3 hold.
Then, all firms produce nonnegative output and earn nonnegative profits
in the Cournot-Nash equilibrium in which we have:
(i) [Q.sub.N] > [Q.sub.P] and [P.sub.N] < [P.sub.p],
(ii) [[pi].sub.N.sup.m] < [[pi].sub.p.sup.m] and
[[pi].sub.N.sup.n] < [[pi].sub.p.sup.n].
Proposition 1 indicates that (i) the consumer surplus is decreasing
but (ii) the profits of both individual firms and total industry profit
([[pi].sup.m] + [k - 1][[pi].sup.n]) are increasing postprivatization.
It means that it is beneficial for the firms, although it might be
harmful for the public to implement a privatization policy. Hence,
privatization might be harmful to social welfare when the privatized
monopolist reduces its output level too much. Put differently, the
inefficient monopolist might be beneficial to social welfare when the
inefficient monopolist produces greater output that could not be
produced by more efficient firms. As a result, only when the
welfare-increasing effects of cost reduction from the private firms is
greater than the welfare-decreasing effects of the reduction in total
output from public enterprise, social welfare will increase
postprivatization. Therefore, welfare will be increasing in
psotprivatization if the superiority of the cost efficiency of the
independent rivals outweighs the negative effects of the decrease in
total output. Proposition 2 indicates the condition where social welfare
is increasing postprivatization.
PROPOSITION 2. Define R [equivalent to] (X - kY)/2([k.sup.2] - 1)
[greater than or equal to] 0. Then, one has [W.sub.N] [less than or
equal to] [W.sub.P] if R - [DELTA] [less than or equal to] 0 or
[W.sub.N] [greater than or equal to] [W.sub.P] if R - [DELTA] [greater
than or equal to] 0.
Proposition 2 shows that the welfare change in postprivatization
depends on the relative size of the cost efficiency gap between the
monopolist and the rivals. A few remarks are in order.
First, one can see that R = 0 when [DELTA] = (r - c) + X/k and R is
decreasing in [DELTA]. It implies that there exists a unique threshold
level of the efficiency gap such that privatization improves the
welfare, that is, [W.sub.N] [less than or equal to] [W.sub.P].
Specifically, R [less than or equal to] [DELTA] if [DELTA] [greater than
or equal to] (X + k[r - c])/(sk[.sup.2] + k - 2). Thus, privatization is
beneficial to society only when the efficiency gap between the
monopolist and the rivals is large. In sum, the cost efficiency
superiority of the independent rivals will be a necessary condition to
improve welfare postprivatization.
Second, R is decreasing in k while R = (X - 2Y)/6 [greater than or
equal to] 0 when k = 2. It implies that the welfare in postprivatization
tends to be increasing as the number of downstream firms is increasing.
Therefore, privatization will be beneficial to society only if the
competition in the downstream market is sufficient. (7)
Finally, R is increasing in r. It implies that welfare
postprivatization will be decreasing if the regulated access charge (the
input price of a upstream service) is high. In particular, privatization
directly benefits society only if r [less than or equal to] c +
([DELTA][2k[.sup.2] + k - 2] - X)/k. Thus, the necessary condition to
increase social welfare is [DELTA] [greater than or equal to]
X/(2[k.sup.2] + k - 2). Otherwise, privatization is always harmful to
social welfare. Therefore, it is important for the regulatory agency to
maintain the regulated access price at a certain level even
III. EXTENSIONS AND DISCUSSIONS
In the telecommunications industry, it is common for an upstream
monopolist to supply an essential input to private firms operating in
the downstream market. Furthermore, usually in developing areas, such as
Asian, European, and Latin American countries, the upstream monopolist
has taken a form of a public enterprise. Therefore, the downstream
market has consisted of a mixed market where the public enterprise
competes with independent private firms.
Recently, the government activated both privatization and
competition policies in mixed markets. Now, it is a real concern of
policy makers whether the privatization of the upstream public firm,
which will induce the upstream monopolist to engage in profit-maximizing
strategies, yields welfare-increasing outcomes in the market. In the
simple model presented, the welfare implications of privatization depend
primarily on the relative cost efficiency between upstream monopolist
and downstream firms. However, there are many other important policy
aspects that have been abstracted for reasons of tractability and
simplicity. The article will extend the analysis into several
theoretical issues and discuss some policy-relevant implications.
A. Vertical Separation and Competition Strategies
The author has confined the analysis into the vertical integration
model where the upstream monopolist vertically integrates the downstream
firm and competes against the other independent rival firms. However, as
shown in Proposition 2, in certain conditions of the cost-efficiency
gap, the public enterprise could not bring about greater social welfare
compared to the case where it is a privatized firm. This is because the
public enterprise in a downstream market produces greater output than
that when it is privatized, that is, [q.sub.N.sup.m] >
[q.sub.p.sup.m] even though it is inefficient compared to the rival
From a different policy perspective, if the public enterprise can
be separated into an independent upstream firm and independent
downstream firm, and the upstream firm can be managed in a form of
public enterprise while the downstream firm is privatized, the market
outcomes will be the same as those of complete privatization of the
public enterprise. In this case, without privatizing the public
enterprise in both upstream and downstream markets together, the
government can increase social welfare in the telecommunications
However, it might be technologically or politically inefficient to
separate the vertically integrated monopolist into two markets. (8) For
example, if high technology can be applied to the connection (bundling)
between the upstream and downstream services (through coutilizing
facilities and human resources), then it will be optimal to integrate
two markets vertically because technological economies and dynamic
investments (e.g., stable supply of telecommunications services) could
be realized. Politically, in addition, it might lead to huge social
costs to separate the historical public utility into different firms if
the government cannot make an agreement among employees and public
citizens. Therefore, before separating into independent upstream and
downstream firms, it is necessary both to check if there are
technological or political linkages between two markets and to consider
how the regulatory agency is able to treat these problems without high
For instance, the Korean government announced plans to privatize
its electricity power utility (Korea Electric Power Corporation), which
was a government-invested monopolist that supplied electric power in
Korea. During 2001, the Korean electric power industry underwent major
changes as its power generation unit was separated into six subsidiaries
and the Korea Power Exchange was inaugurated. In addition, the power
generation subsidiaries are supposed to be privatized, and it is
preparing separate power distribution units. But there still remain many
debates between the government and employees (or even the public).
Therefore, it is expected that there are ongoing social costs in both
the privatization and separation processes.
On the other hand, there is the other policy debate on
privatization and separation in the telecommunications industry. One
might argue that without separation between upstream and downstream
firms, the welfare could be increased if the public enterprise acts as a
Stackelberg leader. (9)
As an intermediate step toward dynamics, the public enterprise can
make a strategic situation where it restricts its choice to gain
strategic advantages. For example, if the public enterprise can act as a
leader in a mixed market, it will be able to set [q.sup.m] =
[q.sub.P.sup.m] to induce the rival firms to produce [q.sub.P.sup.n],
which would give the same market outcomes as privatization of the
However, the question remains whether the inefficient public
enterprise can be a leader in the telecommunications market. If the
public enterprise can commit its output level to the rival firms in a
credible way and the rival firms take its commitment into consideration
effectively, then the public enterprise can obtain the same social
welfare level with that of postprivatization. But if the public
enterprise lacks leadership and cannot commit its output level in
advance, then the strategy of choosing [q.sup.m] is not a best response
of the monopolist when the rival produces [q.sub.P.sup.n]. As has been
shown, [q.sub.P.sup.m] is not the equilibrium output for the monopolist
under a Cournot-Nash type competition, where the monopolist is in
interactive strategic competition with rivals. Therefore, it is
important for a public enterprise to find an effective way to hold and
sustain the role of leadership in the mixed market structure. If
Stackelberg leadership is not available to the public enterprise, then
policy makers should consider privatization of the public enterprise as
Finally, one might also consider the other competition pattern in
the telecommunications market where downstream firms set fees
competitively. (10) For example if the downstream firms compete in the
form of Bertrand price competition, the market price will be determined
at P(Q) = r + [s.sup.n] in (7) and thus, [q.sup.m] = 0 at equilibrium,
irrespective of nationalization or privatization. It implies that the
welfare level does not depend on the privatization policy as long as
there exists price competition among the firms in a downstream market.
In sum, the welfare consequences of a privatization policy depend
not only on the competition patterns of between upstream and downstream
firms, that is, Cournot versus Stackelberg, but also on the competition
patterns within downstream firms, that is, Cournot versus Bertrand.
B. Objectives of the Public Enterprise
In the basic model, it is worthwhile to reconsider the objective
function of the public enterprise, which was defined as the total social
welfare in (5). This comes from the assumption that the public
enterprise maximizes social welfare, the objective of the government. In
the ideally hypothesized environment where the government has complete
information and absolute authority, the public enterprise will maximize
social welfare. However, due to incomplete information or costly
monitoring, the objective of public enterprise will differ from that of
government. The theoretical treatment of the ownership effects deduced
from the property rights and principal-agent perspectives should be
considered to examine the efficacy of the incentive system that is
designed to maximize the efforts of the agents.
One of the policy considerations to capture the interest of the
government is that the public enterprise will be guaranteed to support
its nonnegative operating profit. For example, if r < c, the
operating profits level of public enterprise will be negative at
equilibrium, that is, [[pi].sup.m] = (r - c)(k - 1)Y/b in (1). In this
case, the government needs to subsidize a lump-sum subsidy to support
the public enterprise in the market equilibrium. If not, the enterprise
may not survive. To meet the nonnegative operating profit conditions,
for instance, the government might transfer the public funds when the
public enterprise takes loses in the business. Then, the objective of
the government will be CS + (k - 1)[[pi].sup.n] + [[pi].sup.m] + (1 -
[mu])T, where T is the lump-sum transfer to the firm and thus, [mu]T
captures the cost of the extra distortions created elsewhere in the
In the analysis, however, if the public enterprise maximizes social
welfare, the equilibrium outcomes in this market are the same in
Proposition 1, as long as the transfer has the form of a lump sum.
However, the amount of transfer might be increasing postprivatization
since the rivals' output level, for which the monopolist should
provide the access service with a negative price margin, will be
increasing, that is, [q.sub.N.sup.n] < [q.sub.P.sup.n]. Therefore,
the welfare will likely be decreasing postprivatization.
In the past, in fact, governments in developing areas considered
telecommunication services as basic public infrastructure, and thus
tried to encourage the usage of telecommunications services by both
setting the access price below its cost and subsidizing the operating
deficits of the public enterprise. However, it became a policy concern
that subsidization yielded not only social welfare loss but also social
costs of public funds. In recent years, therefore, the government has
changed its policy to set the access price at the exact cost level. (12)
The other regulatory possibility of the government is that the
public enterprise might be regulated to maximize the consumer surplus
only under the constraint of its nonnegative operating profit. (13) Then
the objective of the public enterprise is to maximize a part of social
welfare instead of total social welfare, where, without considering the
rival's profit in (2), it maximizes the consumer surplus in (3)
with its own profit constraint in (1). Specifically, the objective
function of the public enterprise will be CS + [lambda][pi][.sup.m]
where [lambda] [greater than or equal to] 0. Note that it is simply the
sum of consumer surplus and monopolist's own profits when [lambda]
= 1. Then, assuming the interior solution again, the first-order
condition is as follows:
P(Q) = (c + [s.sup.m]) - b(Q - [lambda][q.sup.m])/[lambda].
Using the first-order condition for the representative independent
rival in (7), one can get the following equation in the Cournot-Nash
[q.sup.n] = Y/b - (Q - [lambda][q.sup.m])/[~.[lambda]]
Thus, if 1 [less than or equal to] [lambda] [less than or equal to]
Q/[q.sup.m], (14) the market price and the rival's output level
will be lower than the outcomes in (6) and (9), where the public
enterprise maximizes total social welfare. Consumer surplus and the
inefficient public enterprise's output will be certainly increasing
compared to (6) and (8), respectively. Therefore, social welfare will be
certainly decreasing compared to the case where the public enterprise
maximizes total social welfare instead of maximizing a part of social
welfare. It implies that in the case that the public enterprise
maximizes some parts of social welfare there is a greater possibility to
increase social welfare of postprivatization.
On the other hand, based on the principal-agent theory, the author
can also incorporate the existence of information asymmetry and the
absence of competition mechanism in the public sector to explain the
nontotal social welfare-maximizing strategies of public enterprise. That
is, the realistic alternative for the objective of the public enterprise
could be to consider private incentives in the public ownership
environment. For example, it is possible for the manager of the public
enterprise to incur self-interested and inefficient expenditures, such
as waste in the form of goldplating, (accounting and managerial)
cross-subsidies to the other businesses, excessive employee
compensation, and so on. Such "wasteful" expenditures can
arise from political reasons, lack of manager's incentives to
economize, or principal-agent problems in general. (15) These wasteful
expenditures return fringe benefits to the decision maker of the public
It is also noteworthy that the most important policy aspect of
privatization for the government is to induce the public enterprise to
achieve cost efficiency by reducing its managerial inefficiency. (16) In
other words, the policy makers tend to believe that an inefficient
production cost level of the privatized public enterprise would be
decreasing and finally, will be equal to the cost level of the
independent private firm in postprivatization.
The author will assess this policy view by incorporating the
managerial inefficiency of the public enterprise into the model. For
simplicity, let [s.sup.m] = [s.sup.n] + e, where e(0 [less than or equal
to] [e.bar] [less than or equal to] e [less than or equal to] [bar.e])
denotes the managerial inefficiency term in the objective function of
the firm, such as wasteful expenditure, which is independent of the act
of production. The author will assume that this expenditure will cause
fringe benefit per output, g(e), where g' > 0, and cost
(management compensation from the principal) per output, h(e), where
h' < 0, for the manager of the firm and thus for the society as
well. Denoting d(e) [equivalent to] g(e) - h(e), where d' > 0,
the author then has the following profit function of the monopolist and
[[pi].sup.m] = (r - c)[k-1.summation over (j=1)][q.sub.j.sup.n] +
(P(Q) - c - [s.sup.n] - e)[q.sup.m],
W = ([[integral].sub.0.sup.Q]P(v)dv + d(e)[q.sup.m]) - (c +
[s.sup.n] + e)[q.sup.m] - (c + [s.sup.n])[k-1.summation over
Thus, the manager of the public enterprise will maximize W +
d(e)[q.sup.m], the sum of social welfare, the goal of the government,
and its total fringe benefits, whereas the manager of the privatized
firm will maximize [[pi].sup.m] + d(e)[q.sup.m], the sum of its profits
and its total fringe benefits, respectively. Then, it is easily shown
that in certain conditions for d', specifically 1/2 < d'
< 1, the monopolist will set e = [e.bar] when it acts as a privatized
firm in postprivatization, and e = [bar.e] when it acts as a public
enterprise in preprivatization.
Then, one obtains the following two propositions.
PROPOSITION 3. Suppose that [s.sub.N.sup.m] > [s.sub.P.sup.m] =
[s.sup.n] and [DELTA]' = [s.sub.N.sup.m] - [s.sup.n]. Then, at the
Cournot-Nash equilibrium one has:
(i) If X - kY > [DELTA]', [q.sub.N.sup.m] >
[q.sub.P.sup.m], [q.sub.N.sup.n] > [q.sub.P.sup.n], [Q.sub.N] >
[Q.sub.P], and [P.sub.N] < [P.sub.p].
(ii) If X - kY < [DELTA]', [q.sub.N.sup.m] <
[q.sub.P.sup.m], [q.sub.N.sup.n] < [q.sub.P.sup.n], [Q.sub.N] <
[Q.sub.P], and [P.sub.N] > [P.sub.p].
Proposition 3(i) indicates that privatization might be harmful to
social welfare when the privatized monopolist reduces its output level
too much, which is the same policy implication in Proposition 1. But,
Proposition 3(ii) shows that social welfare will be always increasing
under post-privatization since the production of the inefficient firm is
displaced with the production of more efficient firms and thus, the
total output provided is increased.
PROPOSITION 4. Define R' [equivalent to] (X - kY -
[DELTA]')[.sup.2]/2(kX - [k + 1]Y + [r - c]). Then, one has
[W.sub.N] [less than or equal to] [W.sub.P] if R' - [DELTA]'
[less than or equal to] 0 or [W.sub.N] [greater than or equal to]
[W.sub.P] if R' - [DELTA]' [greater than or equal to] 0.
Proposition 4 shows that the welfare change postprivatization
depends on the superiority of the cost efficiency between pre- and
postprivatization. If X - kY < [DELTA]' in preprivatization,
then R' < 0 and thus [W.sub.N] < [W.sub.P]. This result comes
from the reduction of the wasteful expenditures postprivatization.
However, if X - kY > [DELTA]' preprivatization, then the welfare
effects of privatization in Proposition 2 applies. That is,
privatization is beneficial to society when (1) the efficiency gap
between the public enterprise and the rivals is large, (2) the
competition in the downstream market is enough, and (3) the access
charge is regulated not too high.
C. Partial Privatization
During privatization, the government may be able to manage the
activities of the privatized firm by controlling its portion of shares.
In other words, there is a possibility that full privatization, where
the government sells all its shares in a public enterprise, is not
fulfilled at once. Thus, the government might determine the degree of
privatization instead of the extreme full privatization.
In the public economics literature, De Fraja and Delbono (1989) and
De Fraja (1991) examined the efficiency of full privatization in an
oligopoly market. Extending their works, Matsumura (1998) and Lee and
Hwang (2003) considered the possibility of partial privatization and
showed that it is optimal for the government to sell part (but not all)
of its shares in public enterprises in the context of mixed duopoly.
To examine the possibility of partial privatization in the model,
let the privatization parameter be [mu], which takes a value in a unit
interval [0,1], and a higher value of [mu] indicates a higher degree of
privatization. In particular, [mu] = 1 represents full privatization,
and [mu] = 0 indicates no privatization. Then, for any given degree of
privatization, the partially privatized monopolist will maximize the
weighted average of the payoff to the government W and its own profit
Thus, one can specify the objective of the partially privatized
firm as follows: (17)
(13) [U.sup.m] = (1 - [theta])W + [theta][[pi].sup.m].
Note that the fully privatized monopolist ([mu] = 1) will maximize
its usual profit in (1), whereas the fully public enterprise ([mu] = 0)
will maximize social welfare in (5), the sum of consumer surplus and
The first-order condition for [U.sup.m] yields
(1 - [theta])[[[partial derivative]W]/[[partial
derivative][q.sup.m]]] + [theta][[[partial
derivative][[pi].sup.m]]/[[partial derivative][q.sup.m]]] = 0,
p(Q) = c + [s.sup.m] + [theta]b[q.sup.m].
Using the first-order condition of the rivals in (7), the
Cournot-Nash equilibrium output levels are given by
(14) [^.q.sup.m] = (X - kY)/b(k[theta] + 1),
(15) [^.q.sup.n] = ([theta]X - Y)/b(k[theta] + 1).
The effects of the government's decision parameter [mu] on the
equilibrium level of output can be easily shown as follows: [[partial
derivative][^.q.sup.m]/[partial derivative][theta] < 0, [partial
derivative][^.q.sup.n]/[partial derivative][theta] > 0, and [partial
derivative][^.Q]/[partial derivative][theta] = [partial
derivative][^.q.sup.m]/[partial derivative][theta] + (k - 1)[partial
derivative][^.q.sup.n][partial derivative][theta] < 0. Thus, as the
degree of privatization increases, the public enterprise's output
decreases but the rival's output increases and totally, the
equilibrium market output decreases monotonically.
To investigate the optimal degree of privatization of a public
enterprise, the author needs to check the following condition for the
optimum degree of privatization that maximizes the government's
(16) [dW]/[d[theta]] = [[[partial derivative][q.sup.m]]/[[partial
derivative][q.sup.m]]] + [[[partial derivative][q.sup.n]]/[[partial
Substitution of equilibrium conditions in (14) and (15) into this
equation in (16) yields
[dW]/[d[theta]] = [[X - kY]/[b(k[theta] + 1)[.sup.2]]] x ([DELTA] -
[theta](k - 1)(X - kY)/(k[theta] + 1))
It is noteworthy that dW/d[mu] takes a positive sign at [mu] = 0.
Therefore, the no privatization of the public enterprise is not an
optimum in this model. The author thus obtains the necessary conditions
for the existence of a positive interior solution for [mu], which is
that dW/d[mu] takes a negative sign at [theta] = 1, that is, [DELTA]
< (k - 1)(X - kY)/(k + 1) or [DELTA] < (k - 1) (X + k[r - c])/(k +
1). It implies that the full privatization is socially beneficial only
when the cost efficiency gap is sufficiently high, [DELTA] [greater than
or equal to] (k - 1)(K + k [r - c])/(k + 1). Otherwise, the partial
privatization is socially beneficial in the model.
D. Discrimination and Access Charge
When policy makers consider privatization policy, there is a
concern about market foreclosure in which the profit-maximizing,
privatized integrated firm may have an incentive to discriminate the
access from the rival firms to the upstream market and thus earn a
strategic gain by increasing the costs of downstream competitors.
In the regulatory economics literature of the telecommunications
industry, there have been discussions on discriminating access charges
from the private monopolist. Economides (1998), for example, claimed
that the incentive to discriminate is independent of the relative
efficiency of the monopolist and the independent rivals. But, Weisman
and Kang (2001) showed that discrimination always arises in equilibrium
when the monopolist is no less efficient than its rivals in the
downstream market. Sibley and Weisman (1998) analyzed the
interrelationship between the market size and the incentive of
discrimination in the telecommunications industry. Empirically, using
the data of the U.S. telecommunications market, Mandy (2000) tested the
parameters that affect the monopolist's incentives to discriminate
and concluded that there is an incentive to discriminate in the U.S.
The author will examine the possibility of discriminating access
charge under postprivatization and its welfare effects in the model.
First, from the market equilibrium outcomes in (8) and (9) of
pre-privatization, and (10) and (11) of postprivatization, one has
[partial derivative][p.sub.N.sup.m]/[partial derivative]r > [partial
derivative][q.sub.P.sup.m]/[partial derivative]r > 0 and [partial
derivative][p.sub.N.sup.n]/[partial derivative]r < [partial
derivative][q.sub.P.sup.n]/[partial derivative]r < 0. It means that
the higher access charge is preferable to the monopolist, whereas the
lower access charge is beneficial to the rival firms. In addition, the
output effects of access charge in the case of preprivatization is
stronger than that of postprivatization. In this sense, it will be the
main policy concern for the regulatory agency who seeks to make fair
competition in the telecommunications industry, to set the access charge
not too high in either pre- and postprivatization.
This concern can be also applied to social welfare. From the
welfare function in (5), one obtains the following relationship at each
[partial derivative]W([q.sub.P.sup.m], [q.sub.P.sup.n])/[partial
derivative]r < [partial derivative]W([q.sub.N.sup.m],
[q.sub.N.sup.n])/[partial derivative]r < 0.
It indicates that the welfare effects of lowering access charge in
postprivatization is stronger than that of pre-privatization. Thus, it
will be socially beneficial to set the access charge as low as possible.
For instance, under the assumption A3 in section II, the author has the
following optimal access charge rate for the society:
r* = c - (a - k[DELTA] - c - [s.sup.n])/(k - 1).
Notice that r* = c when k goes to the infinity. Notice also that r*
< c when (a - k[DELTA] - c - [s.sup.n])/(k - 1) > 0 or [DELTA]
< (a - c - [s.sup.n])/k, that is, the cost efficiency gap is
sufficiently small. (18)
On the other hand, if the monopolist can set the access price r by
its own will postprivatization, it may strategically engage in
discriminatory behavior in a downstream market by setting the higher r.
Then, it might reduce the welfare-increasing effects of privatization
because the efficient rivals would produce less output. However, as long
as the cost efficiency of the rival firms is superior to the monopolist,
the monopolist can earn higher profits from access service if the rivals
increase their outputs postprivatization. Therefore, there is a
trade-off for the monopolist between profits arisen from the increment
of its own output when rivals decrease their outputs and profit arisen
from the access of the rivals when they increase their outputs.
To investigate this, the author can find the following
profit-maximizing level of access charge from the profit function of the
monopolist in (1):
[r.sub.P] = c + ([k + 3]X - [k - 1]Y)/2(k + 1),
[r.sub.P] = (a + c - [s.sup.n])/2 - (k - 1)[DELTA]/2(k + 3).
A few remarks are in order. First, [r.sub.P] > c. It implies
that the privatized monopolist will set a higher access charge then the
possible access charge rate under preprivatization. This fact might call
for the intervention of the regulatory agency to control the access
charge rate in post-privatization.
Second, [partial derivative][r.sub.P]/[partial derivative]k < 0.
It means that the monopolist's profit-maximizing access charge will
be reduced when the government introduces more competitive rivals in a
downstream market. Therefore, an open access policy of the upstream
essential input is important in the telecommunications industry.
Finally, [partial derivative][r.sub.P]/[partial derivative][DELTA]
< 0. If the efficiency superiority of the independent rivals prevails
sufficiently, then it will be still socially beneficial for society to
privatize the public enterprise in certain conditions even though the
monopolist is able to discriminate the access charge postprivatization.
Compared to the result of Proposition 2, however, welfare will be
reduced under postprivatization. (19)
On balance, the regulatory agency needs to construct an appropriate
access charge regulation for the privatized monopolist and implement
open access policy for the rivals in a downstream market. (20)
This article has considered a simple vertical network structure of
the telecommunications industry where a public enterprise supplies the
essential network service to downstream private firms while the public
enterprise competes with the independent firms in a mixed downstream
market. Then, the author examined the equilibrium outcomes between pre-
and postprivatization and compared the welfare effects of privatization
of the public enterprise.
The analysis has shown that the cost advantage of the independent
rivals in a downstream market improves the welfare if the upstream
public enterprise is privatized. It is also shown that competition
policy or open access regulation including access charge regulation are
required to improve social welfare postprivatization. Therefore, the
recent trend of both privatization and competition policy in the
telecommunications industry is well justified. The author has also
discussed several policy debates on the process of privatization in the
telecommunications industry. Current policy issues, including vertical
separation between upstream firm and downstream firms, the role of
leadership of the public enterprise, the objectives of the monopolist
and its managerial incentives in agency relationship, the possibility of
partial privatization, and the strategic choice of access charge of the
privatized monopolist, have been examined with abstracted forms.
For future policy consideration, it is worthwhile to investigate
the financial treatment in the process of privatization and/or the
fundraising effects of privatization for the government. These
policy-relevant concerns should be carefully investigated before the
government implements the privatization process of the public enterprise
in the telecommunications industry.
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Eggs: Only the Data Know Whether Sabotage Pays." Journal of
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Sappington, D. E. M., and D. S. Sibley. "Regulatory Incentive
Policies and Abuse." Journal of Regulatory Economics, 5, 1993,
Sibley, D. S., and D. L. Weisman. "The Competitive Incentives
of Vertically Integrated Local Exchange Carriers: An Economic and Policy
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Vickers, J., and G. Yarrow. Privatization: An Economic Analysis.
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*This is a revision of a paper presented at the KASIO and KIEA fall
conference (2003, Seoul), Chonnam National University (2003, Gwangju,
Korea), Fudan University (2003, Shanghai), and Western Economic
Association International 79th annual conference (2004, Vancouver). The
author is grateful for the comments and suggestions made by Oz Shy,
Yongyeop Sohn, Jongguk Park, Zhao Chen, Zonglai Kou, Margriet F.
Caswell, Kristen Monaco, and two anonymous referees. This study was
financially supported by Chonnam National University in the 2003
Lee: Associate Professor of Economics, Chonnam National University,
300 Yongbong-dong, Bukgu, Gwangju, South Korea. Phone 82-62-530-1553,
Fax 82-62-530-1559, E-mail firstname.lastname@example.org
1. In the telecommunications industry, the input price of the
downstream market is regulated by the government or the regulatory
agency such as the Federal Trade Commission in United States. The
rationale of access charge regulation can be found in Laffont and Tirole
(2000). In the following analysis, the author assumes that access charge
r is fixed both pre- and postprivatization. Section III will discuss on
the welfare effects of changing access charge in postprivatization.
2. To focus on the welfare effects arisen from the cost difference,
the author assumes that [s.sub.i] is independent of the ownership
structure, that is, [s.sup.i] is fixed both pre- and post-privatization.
Section III will incorporate the possibility of cost reduction of
postprivatization where [s.sup.m] = [s.sup.n].
3. There might be a discrepancy between the goal of the government
and that of the public enterprise. See Laffont and Tirole (1993) on this
point. The author will review the principal-agent relationship in
4. Section III will discuss about the possibility of leadership of
public enterprise and commitment problem.
5. From the profit function in (1), the author knows that the
operating profit level of a public enterprise depends on the price-cost
margin of the upstream market. Section III will examine the objective of
public enterprise under the possibility of negative operating profits
and public transfer.
6. The straight calculation yields the outcomes of propositions and
thus, the proofs of all propositions are omitted.
7. In a mixed model with identical and increasing marginal costs,
De Fraja and Delbono (1989, 1990) showed that if the market is
sufficiently competitive, then it is socially better for the public
enterprise to maximize its own profit instead of maximizing welfare.
8. There might be another theoretical issues on the increase of
transaction costs between two markets or/and double marginalization
effects when the public enterprise is privatized at both markets and
maximizes its own profits in the upstream market. On this point, see
Viscusi et al. (1995).
9. The competition patterns of Cournot or Stackelberg depend on the
strategic economic environments among firms. In the economics
literature, therefore, many studies have considered the order of play in
a game and compared the results of Cournot and Stackelberg. On this
point, see Dowrick (1986), De Fraja and Delbono (1989, 1990), Anderson
and Engers (1992), and Vives (1999), among others. For example, De Fraja
and Delbono (1989, 1990) show that if the public enterprise is able to
act as a leader to induce Stackelberg competition in a mixed market, it
is possible to increase its social goal.
10. In general, the price competition model can be applied for the
case of product differentiation where the firms sell different products
to consumers. Laffont and Tirole (2000), for example, provide the model
of network competition in the telecommunications market. In a
product-differentiated market, however, the symmetry between Cournot
quantity competition and Bertrand price competition can be established
with the duality argument. See, for example, Vives (1999).
11. Cook and Fabella (2002) considered the model in which the
state-owned enterprise maximizes an unspecified objective function and
examined the theoretical treatment of the welfare and political economy
dimensions of the choice between public ownership and privatization.
12. On the theoretical treatments on the access price regulation
including ECPR (Efficient Component Price Rule) or LRIC (Long-Run
Incremental Cost), see Baumol and Sidak (1994), Sibley and Weisman
(1998), and Laffont and Tirole (2000).
13. The regulatory incentives of the government to take care of
market price or consumers surplus will yield the Ramsey solutions. On
this point, see Vickers and Yarrow (1988).
14. From the second-order condition, it is sufficient to hold that
[lambda] [greater than or equal to] 1.
15. The managerial inefficiency is defined as "waste" and
"abuse" in the literature on the agency model of regulatory
economics. On modeling of the managerial inefficiency, for examples, see
Vickers and Yarrow (1988), Sappington and Sibley (1993), Laffont and
Tirole (1993), and Cook and Fabella (2002).
16. Haskel and Sanchis (1995) and Lee and Hwang (2003) claim that
one of the goals of the privatization policy will be to reduce the
managerial X-inefticicncy of the public enterprise and to obtain the
dynamic efficiency of the privatized firm.
17. For the case that r < c, the nonnegative operating profit
constraint should be taken into the consideration of the government. For
example, if the government subsidizes a transfer to the firm, the
firm's profit will be [[pi].sup.m] + T while social welfare will be
W + (1 - [mu])T, where T is the lump-sum transfer paid to the firm and
thus, [mu]T captures the cost of the extra distortions created elsewhere
in the economy. Therefore, the partially privatized firm will maximize
[^.U.sup.m] = (1 - [theta])(W + [1 - [mu]T] + [[theta]([[pi].sup.m] + T)
= (1 - [theta])W + [theta][[pi].sup.m] + (1 - [mu] + [theta][mu])T =
[U.sup.m] + (1 - [mu] + [theta][mu])T. If T is the lump-sum style, then
the analysis will be exactly same to the following examination. On the
other hand, if T is dependent of the negative size of the operating
profit, [[pi].sup.m], the government should devise an appropriate
subsidy scheme. Simply, if the government subsidizes the exact amount of
the negative size of the operating profit, T = -[[pi].sup.m] and thus,
the subsidized profit level of the firm will be zero. In this case, one
can rewrite that [^.U.sup.m] = (1 - [theta])(W + [1 -
[mu]]-[[pi].sup.m]) = (1 - [theta])(2 - [mu])([1 - [beta])W +
[beta][-[[pi].sup.m]]) where [beta] = (1 - [mu])/(2 - [mu]). Therefore,
the author can also analyze the welfare effects of the partial
privatization with the similar process in the following examination.
18. Panzar and Sibley (1989) showed that a welfare-maximizing
regulator can set the marginal price of an upstream input below its
marginal cost to offset downstream market power and thereby induce
downstream firms to produce the efficient level of outputs.
19. Numerical example: Let a = 10, b = 1, c = 0, k = 2, and
[s.sup.m] = 5. Assuming that regulated access charge r = c under pre-
and postprivatization, then, from the Proposition 2, one has [W.sub.P]
< [W.sub.N] when [s.sup.n] is below about 4.29 or [DELTA] > 0.71.
But if the privatized monopolist can set the access charge, [r.sub.P] =
4.5 - 0.42[s.sup.n]. Then the welfare is increasing under
postprivatization only when [s.sup.n] is below about 3.62 or [DELTA]
20. In reality, even postprivatization, the government keeps the
regulatory power to control the access charge by organizing independent
regulatory institutions, such as OFTEL in the United Kingdom and FTC in