Privatization: Soft budgets vs. soft price regulations

Public sector firms face a “soft budget” constraint in the sense that the government can bail them out for the losses they incur. Hence, managers can follow their own interest or favor special interest groups without worrying much about the costs of such actions. In short, soft budgets tend to promote corruption.

One solution to this soft budget driven corruption is privatization with a firm pre-commitment on the part of the government to not bail out the firm in the future. So, we should expect greater satisfaction with privatization among consumers in countries that are more corrupt. According to a recent study by Martimort and Straub (2009), quite the opposite is happening in Latin America. Consumer dissatisfaction with privatization efforts over the last two decades has increased, and especially so in countries that are more corrupt or where corruption has increased over time (see figure below the jump).

How do we explain this apparent paradox? The Martimort and Straub study proposes a plausible answer. Post privatization, the firm and the government officials can collude to raise the price charged from the consumers. The extra revenue so generated is shared by the firm and the government officials. The study dubs this hypothesis as “soft price” regulations. So, corruption via soft budget constraints is replace by one through soft price regulations. The latter form of corruption is heavier on the middle class (they pay higher prices and benefit more from public services) while the former is heavier on the richer individuals (they pay higher taxes). This explains the greater dissatisfaction with privatization among the masses.

Although the evidence provided by the study on the privatization and soft price regulation linkage and that between soft price regulation and corruption is far from conclusive, the soft price regulation hypothesis is a potential challenge to privatization worthy of further analysis.

Source: Taken from Martimort and Straub (2009, Fig. 3).
Note: Higher values of the Corruption index imply less corruption as measured by the International Country Risk Guide. The vertical axis shows changes in dissatisfaction with privatizations between 1998-2003 using data from Latinobarometro.