98-21
Privatization and Endogenous Strategic Trade Policy
JoAnne Feeney
University of Colorado at Boulder
and
Arye Hillman
Bar-lian University
PRIVATIZATION
AND ENDOGENOUS STRATEGIC TRADE POLICY
JoAnne Feeney!
University of Colorado at Boulder
Arye Hillman
1
Bar-llan University
May 1998
Abstract
This paper explores the interdependencebetween international financial markets, privatization, and
strategic trade policies. We examine an economywhere portfolio allocations chosen by risk-averse
agents reflect diversification incentives and incorporate rational forecasts of future trade policies.
Assuming a governmentresponsiveto demandsof its constituency,we show that ownershipstructure
will have a decisive impact on trade policy throughits effect on the lobbying activities of private agents.
Portfolios and trade policy are thus jointly determinedin political-economicequilibrium. Privatizationof
state-ownedindustry exertsan importantinfluence over local and foreign trade policy by expandingthe
scopefor individual diversification.
Key Words: Internationalfinancial markets,endogenouspolicy, privatization, strategictrade policy
JEL Classification:F13, D72, F36, F12
1 We would like to thank Ken Beauchemin,Rick Bond, Jim Markusen,Keith Maskus,and Jay Wilson for useful
discussionsand participantsat the Mid-West InternationalEconomicsand TheoryMeetings for helpful comments.
We are responsiblefor any remaining errors. Feeneygratefullyacknowledgesfinancial supportfrom the National
ScienceFoundation(grant#HRD-9637016)and the StemSchoolof Businessat New York University(while visiting
duringthe 1997-98academicyear).
Addressfor correspondence:JoAnneFeeney,Departmentof Economics,CampusBox 256, Universityof Coloradoat
Boulder, Boulder,CO 80309-0256;phone:(303)492-5923; fax: (303)492-8960;emai1:feeney@colorado.edu;
web:
http//:spot.colorado.edu/-feeney
1. Introduction
Recent events emphasize the growing interdependencebetween government policy and
international financial markets
The shifting patterns of ownership of flfffiS permitted through
international trade in equities alter the coalitions in support of particular policies and thereby change the
nature of governmentintervention. This paper focuses specifically on the influence of international
financial marketson the use of strategictradepolicies.
An extensive literature, beginning with a series of papers by James Brander and Barbara Spencer
(in 1983 and 1985), reveals the potential benefits from strategic trade policies with imperfectly
competitive internationalmarkets! These gains derive from the government's ability to indirectly
manipulatemarketshareamongoligopolies to shift profits from foreign firms to domesticones. While
the use of explicit exportsubsidiescontinuesto be prohibited by the World Trade Organizationas it was
under the GAn, countries often use indirect forms of interventionto provide export assistance.U.S
firms, for example,can benefit from low-interestloansmadeavailable throughthe Export-ImportBank
Since imperfect competition characterizes many international markets, the scope for strategic
interventionis potentiallyquite broad. We show that the applicationby governmentof suchpolicies will
be limited, however, by the nature of uncertainty in exporting finns' profits in conjunction with the
growing importanceof internationalfinancial markets.
The benefitsof profit shifting via strategicsubsidiesarise only when domestic firms are owned
primarily by domesticresidents. Lee (1990) and Dick (1993) show how the optimal strategicsubsidyis
reduced by higher degrees of cross-national ownership of fInnS. Our first objective, therefore, is to
endogenize the patterns of flml ownership, given the nature of technological uncertainty that characterizes
oligopolistic industries,in orderto detenninethe subsidythatemergesin a political-economicequilibrium.
While we expect ownership structure to affect the adoption of particular trade policies, we also know that
2 See also Grossman and Helpman (1985), Eaton and Grossman (1986), Krugman (1986), Grossman (1992), and the
survey by Brander (1995).
investorswill assessthe impactof future tradepolicies on equity valuesand dividendswhen selectingthe
assetsthat will comprisetheseportfolios. We therefore include not only the effects of uncertainty on
portfolio selection,but alsoforecastsof future tradepolicy, which itself is detenninedendogenously.
A source of uncertaintyfundamentalto industries potentially targetedby strategictrade policy
arises through technological competition (see Spencer and Brander, 1983): the first lInn to introduce a
technologicalinnovationincreases
its profits at the expenseof its competitors,and ownersof the innovating
finD gain while others lose.3 When equity in finDS is tradeable, risk-averse investors will reduce exposure to
this sort of risk by holding equity from each of the potentially innovating fInDS. We find, as implied by
Feeney and Hillman (1997) and Cassing (1996), that asset market developmenthas an important impact on
interventionist pressuresand policy outcomes. Our results help to explain the observation that governments
engage in strategic trade policies less than one might otherwise expect. Moreover, our analysis
emphasizes the role of endogenous ownership structlire in reducing the use of such policies, rather than
the threat of countervailing duties, other retaliatory mechanisms, or policy implementation difficulties.
Since ownershipstructureemergesas a critical determinantof .trade policy, our second and
primary objective concerns the role of state ownership of firms and privatization for strategic trade
policy. While in the U.S. private ownershipdominatesindustry, elsewheregovernmentsare heavily
involved in production In EasternEurope and the former Soviet Union, for example, state ownership
remains as the transition to marketeconomiescontinues. State-ownedindustry in Asia, Africa, Latin
America, and to a lesserextentWesternEuropeand North Americaalsocontributessubstantiallyto gross
domestic product. In many countries these sectors are currently undergoing privatization.
The airline-frameindustryprovidesone exampleof governmentinvolvementin production in an
industry potentiallytargetedby strategictrade policy. This sectorconsistsprimarily of a privately owned
3 The importance of demand uncertainty for the optimal choice of trade policy instrument in oligopolistic markets is
examined in Cooper and Riezman (1989). Shivakumar (1993) considers the importance of the timing of the policy
implementation with uncertainty.
')
u.s. finn. Boeing, confronting a foreign competitor,Airbus, which is jointly owned by a number of
Europeangovernments.Investorsin boththe U.S. and Europe(and elsewhere)may oln stock in Boeing,
although these investors cannot diversify risk by holding stock in Airbus. Instead, the profits of such a stateowned fInn return to the private sector via one of two routes. If European governments distribute all the
profits from stateownershipto their citizensvia increasedgovernmentbenefitsor reducedtax obligations,
Europeanseffectively would hold nontradeableclaims to Airbus profits. Earningsof state-ownedfirms,
however,often becomeinternalrentsenjoyedby flnn employeesalone. We showthat the use of strategic
tradepolicies dependson which regimegovernsthe distribution of profits. Privatizationwould transform
the government distribution of state-finn profits, on the one hand, and the internal rents, on the other, into
tradeableclaims. As a consequence,
the ongoingprivatizationof industryin Europe,Latin America,Asia,
and the transition economies of EasternEurope may have unintended consequencesfor the trade policies of
not only the privatizing country, but also of its trade partners.~
We assessthe importanceof uncertainty, risk sharing and state ownershipfor strategic trade
policy by using the most basic model of finn competition, put forth in Branderand Spencer(1985), as
our benchmarkand modifying that settingaccordingly. With this initial structurewe ensurethat in the
absenceof thesemodifications strategicsubsidieswill be chosenby governmentto the benefit of local
consumers: We examine the decisions of risk-averse consumer/investorswho face uncertainty in
income due to the stochastic profits of firms.
These agents will choose portfolio allocations,
consumption,and lobbying activity. Lobbying will affect the policy implementedby governmentand
4 Boyko, Schleifer,and Vishny (1996)offer a modelto explain recentefforts acrossthe world to privatize,basedon
endogenousefficiency gains that arise in privatizedfirms due to optimizing behaviorof political agents.We abstract
from the efficiency differencessincethe distributionof profits, ratherthanthe amount,mattersfor our analysis.Also,
seeHillman and Ursprung (1996)for a simultaneousconsiderationof endogenousprivatizationand tradepolicy.
5Somemodificationsto the basic modelcaneliminatethesebenefitsevenin the absenceof portfolio diversification:
lack of governmentinformation on the strategicinteraction (Eaton and Grossman1986); retaliation (see Baldwin
1992); free entry (Horstman and Markusen1986,Markusenand Venables 1989); deadweightlosses in taxation
(Dixit 1988);generalequilibrium effects(Dixit andGrossman1986);and rentseeking(Mooreand Suranovic1993).
~
agentswill recognizethis link, and alsothe structureof the gamethat firms are playing, when assembling
portfolios. Using the benchmark model as our starting point, we will determine how policies differ in a
risky world and how privatization will affect policy choices.
We proceed in Section 2 to describe the economic and political environments and to present the
decisionproblemsof fmns and consumer/investors.In Section 3 we establishequilibriumportfolios for
home and foreign agents, detennine private-agentlobbying activity, and solve for the government's strategic
trade policy. We consider this fiTStwhen all fmns are private, and second when state ownership of the flnn
arises in one country. Section 4 summarizes our resultsand offers some concluding remarks.
2. The Economic and Political Environmen~
We considera world in which two rival finns, one located in the home country and the other in
the foreign country, are the sale producersof a good, x, and competefor salesof x in a third country's
market. Thesefinns face uncertainty in productioncosts (and thus profits), and in the home country,
costsmayalso be affected by a governmentexportsubsidy.6Internationalfinancial marketspennit trade
in the equity of private, but not state-owned,firms.
Firm and consumer/investor decisions occur in three distinct stages. First, assettrades take place
and portfolios are establishedat the end of period t to determine claims on period t +
finn profits
(stage1). At the beginningof period t + , whenassetmarketshaveclosed,cost shocksare realizedand
observed by all.
Given portfolios, the home governmentsubsidy is establishedthrough the political
process(stage2). As in the basic strategictrade policy model, the foreign governmentdoesnot consider
offering a subsidyto its export finn. Finally, finns independentlyand simultaneouslychoose output
levels (hiring the appropriateamountof labor)andthus salesto the third marketto maximizeprofits and
arrive at a subgarne-perfect Coumot-Nash Equilibrium (stage 3), At the end of the period, wagesare
6 It is beyond the scope of this paper to model the sources of the cost uncertainty that we presume arises from the
researchand development process. For such an analysis. see Bagwell and Staiger (1994).
4
.7
paid, assetmarketsfe-open,dividends are distributed and consumptionout of disposableincome takes
place. Any rearranging of portfolios occurs at this time to form stage one of the period t + 2 game.
Since technologyshocksare temporary,outputdecisionsand governmentpolicy are set for one period at
a time, and we solve this as a one-shotgame in eachperiod. Also, agentsin choosingportfolios fully
understandthe finns' and government'sdecisionprocesses.
2.1 ProductionStructureand Equity Returns
The home and foreign producers of x constitute a duopoly, eachfirm produces x solely for
export, and home and foreign sales are denoted Xl and X2, respectively. In each country the remainder
of the economy is consolidated into a single perfectly competitive industry which produces the
consumption good, y. Output of the home and foreign industries is denoted yl and y2, respectively, and
y acts as the numeraire. The third country imports x and uses its own production of y as payment. With
stochasticcosts,profits of firm i are given by
(1)
where the randomnessin profits is indicated by the tilde and the specific time and state notation is
suppressed until dividends are defined in equation (4). Finn profits, expressed in y units, depend on the
relative price at which the good sells in the third market, p( X), on the level of sales, Xi, on the firm's
total costs, Ci (Xi), and on a per-unit subsidy, ei, shouldone be offered by the governmentof country i
(with e2 = 0 by assumption). The government'schoice of a subsidydependsin deterministicfashionon
lobbying as put forth in section2.2. The equilibrium relative price dependsinversely on total sales,X,
while costsdependon finn output and the realizationof the 'cost' or 'technology' shock. To simplify
comparison of equity prices in the next section, we assume that firms' cost functions differ only due to
the realization of the cost shocks. Also, y production in all three countries is detenninistic.
5
<0,
The x sector is assumed small relative to the y sector in the traditional sense -the
wage is
determined in the y sector and the x finn may employ labor at that wage. The y sector is perfectly
competitive and outputis producedwith labor and a sector-specific(capital)input. Labor and capital are
fixed in supply and immobile acrosscountries.The wage equalsthe constantvalue of labor's marginal
product in sector y and the return to capital is given by the nonstochastic value of its marginal product.
The optimal productionchoice,madeoncecostsare revealed,satisfiesthe first-order condition,
(2)
a1!xi
axi
and the associated second-orderconditions (7r~i < 0 ).8 We assume that home and foreign output levels
act as strategicsubstitutesby restrictingthird-countrydemandto be linear, which guarantees1r:i < 0 and
1r;f < o. Also, a changein a firm's own outputcreatesa larger effect on its profits than doesa changein
the competitor's output (Jt'i~i< Jt'iji for i * j ).9
A subsidy offered by the home government lowers the firm's marginal cost and allows it credibly
to expand sales to the third market. This leads to the well-known results that home market shareand
profits rise, while foreign finn profits fall by an even greateramount:
(3)
a1rxl
il trx2
aT>O,
ilel
When the home and foreign firms are owned entirely by own-countryresidents,a small subsidy,funded
throughnon-distortionarytaxation,raisesdomesticwelfare and reducesforeign welfare. The presenceof
uncertainty will not alter thesechangesin profits, but will lead to internationalrisk sharing which alters
the identities of the beneficiariesand losersfrom the home subsidy.
7The labels firm and industry will be used throughout the paper to refer to the x and y sectors, respectively.
8Primes and subscripts denote partial derivatives.
9 See Brander and Spencer (1985) or Brander (1995) for further details on the nonstochastic model and derivations
of the effects of a subsidy, and see Appendix 2 for expressions of second-orderconditions.
6
The profits earnedby firms form the basis of dividend paymentson firm equity. Equity in the x
firm in each country is either traded in international equity markets, or not, if a firm is owned by the
government.
Equity in the y industry, by contrast, is always tradeable. By normalizing to one the
number of total equity shares associated with each firm, the dividend, is,xi (s) , paid on equity in firm Xi
in period t and state s equals total firm profits as given in eq. (1):
(4)
In the y industry, equity providesa claim on the nonstochasticreturnto capital:
()' yi = ri Ki
(5)
fori=1,2,
I
where ri and Ki denote the constant marginal revenue product of capital and the total supply of capital,
respectively, in country i.
2.2 EndogenousPolicy Choice
We proposea simple mechanismthat links policy outcomesto private agents' interests.Since
salesofx occur only in the third-countrymarket,the government'srelevanttrade policy instrumentis an
export subsidy.lOWe deviatefrom the basic model only by assumingthat the homegovernmentresponds
to political pressurefrom its constituentsin deciding on this subsidy. The resolution of the political
processfollows portfolio decisionsand realization of the cost shocks,and precedesthe simultaneous
output decisions made by flfDlS.ll
The interests of private agentsare made known to the governmentthrough lobbying activities,
and lobbying affects the subsidyoffered to the domesticx sectorin the currentperiod. In particular,we
10We are restricting our analysis to the case of Cournot competition and thus to the use of a government subsidy.
Bagwell and Staiger (1994) find in an environment with stochastic costs that when an increase in R&D lowers
expected costs, a government R&D subsidy is optimal regardless of the form of product market competition.
11 One can also envision a world where agents lobby ex ante, but in so doing it would be necessary to incorporate
the dual goals of such lobbying: rent shifting and insurance via trade policy. By considering the ex post decision, we
are isolating the profit-shifting motive behind lobbying.
7
assumethe home government's offer of a subsidy, e1(s) = e( s) , increases with the effort, e(s), allocated to
lobbying by the home agent in state s:
(6)
e(s) = e(l(s»)
where
This general representation captures the influence of private agents on public policy in the context of
political competition or political support maximization under representative democracy (as in Hillman 1989,
Hillman and Ursprung 1988, Ursprung 1990, Grossmanand Helpman 1994, or Rodrik 1995) or under direct
democracy(as in Mayer 1984). In theseenvironments,lobbying reflectsthe extentof political support,in
the form of real resources,offered to a representativein exchangefor a subsidyor to a candidatewho
promisesa subsidy. In direct democracy.it reflectsthe degreeto which the medianvoterfavorsa subsidy.
Whenthe presenceof a democraticsystemitself is in doubt, lobbyingrepresentsthe political supportgiven
to the regime in power in exchange for a subsidy.12
2.3 Consumer/lnvestorProblem
Assettrade takesplacebeforethe resolutionof uncertainty,but with completeinformation on the
distribution of the technologyshocksand the natureof the political process With exceptionsfor cases
where an x firm is state-owned,the home agentis initially endowed with complete ownershipof the
home x finn and y industry, while the foreign agent owns the foreign finn and industry. We imposethe
following symmetry conditions in order to simplify the derivation of portfolio allocations under the different
regimes: preferencesare identical acrossagents;cost shocksare drawn from the samedistribution, are
perfectly negatively correlated across countries, and are identically and independently distributed over time;
the y dividendsand the wage are the sameacrosscountries.13These imply that in the absenceof any
possibility of strategic subsidies, expected x dividends are the same across countries, and with y dividends
12 See also Austen-Smith (1995) and Anderson (1996) who model political support as attempts to buy access to
presentinformationto political agents.
8
and the wagealsothe same,homeand foreign agentshaveequalex-antewealth. Also, we assumethirdcountry agentsdo not engage in trade in claims to home or foreign x fmns.14
The representativeagentof the home country chooseslobbying effort and selectsa portfolio of
assetsto maximize expected lifetime utility:
(7)
where utility, u(), over consumption, YTd(s), in period 1"and state s is increasing, strictly concave, and
exhibits constant relative risk aversion, f3 is the discount factor (0 < f3 < 1), E, is the expectations
operator given infonnation available at the end of period t, and l 1"(s) denotes time engaged in lobbying
activities, where time is valued at v(.), for v'() > 0, v"() > 0, v(O)= 0, and v'(O) = 0
The foreign agent
solves an analogous problem, but with lobbying set at zero.
The agent'sallocation of time to working is inelasticallyset at one unit. so labor incomeequals
the nonstochastic market wage, w
The agentis also endowedwith one unit of free time which maybe
divided between leisure and lobbying.
Dividend income depends on the shares of each equity held.
Finally, the home agent may be subject to a tax, Tt"(s), imposed to finance the export subsidy. The home
agent's budgetconstraintat the end of period t is thus givenby
(8)
13 Perfect negative correlation simplifies the exposition and is not critical
for the results; independence in
realizations, for example, generatesthe same diversification and policy outcomes. See Section 3.
14If this complexity were included, the third-country agent would only want to buy shares in risky x firms (and sell
some shares in its nonstochastic y industry) if doing so would cause income to covary positively with the world price
of x (and the country's expenditure on x). This is not in general the case, however. By (4) we can see that an
adverse technology shock which raises costs and increases the price of x will reduce the x equity return. Thus,
ownership of x equity will deliver lower income precisely when the third country's terms of trade have deteriorated.
We also rule out shon sales,so the third country's residents have no interest in x equity.
9
where income, I,(s), dependson the period-t (vectors of) equity shares,ex-dividend equity prices, and
dividends, denoted at, qt(s), and <>t(s),respectively, and the portfolio purchased at the end of period t
that pays off in period t +
is at+\
The dividends are defined in (4) and (5), while equity sharesand
prices are endogenous. The foreign agent faces an analogous budget constraint, albeit without the tax.
The x equity holdings will be denoted by ar,x; and
a;..ri for home and foreign
agents,
respectively,wherethe secondsubscriptdistinguisheshome from foreign firm equity (i=1,2). The equity
holdings in the y sector are analogously defined as at,y; and a,.,y;, Absent the time notation, the home
agent's portfolio
is a=(aXl,aX2,aYl,aY2)'
with the foreign agent's given analogously, but with
asterisks. All equity is subjectto a no-shoTt-sales
restriction: 0 ~ a ~ 1 .Asset-market clearing requires
homeand foreign holdingsof eachequity to sumto one.
Maximization of expectedlifetime utility requirestwo decisionsby the home agent: first, upon
realization of current finD cost shocks and income uncertainty, the agent must choose lobbying effort;
second,facing uncertaintyregardingnext period's income, the agentmustchoose current consumption
and the portfolio allocationswhich detenninenext period's state-contingent
income.The state-contingent
lobbying decision,and thus subsidy,in any future period dependson the agent's ponfolio and the agent
will recognize this when detennining the optimal portfolio allocation. Fonnally, the period-t problem is:
(9)
max
y,d,l"a'+1
subjectto
\It
0 ~ f. t (S)~ 1, 0 ~ a'+1~ 1
where 1; (s) = e(f. I (s)) x, 1(s). The period-t consumption, lobbying, and portfolio choices must satisfy the
following first-orderconditionsfor an interior solution:
10
(10) (a)
ah'/(s) a1;(s) -v'(f,(s))
=0
for j = xl,x2,yl,y2
(c)
The lobbying choice will be zero whenever (lOb) is negative at f t (s) = 0, and one when (lOb) is positive
at f. t (s) = 1. We rule out the latter case by assuming sufficiently rapid diminishing returns to lobbying
and increasing marginal costs of lobbying. The Euler equations, (1 Oc) and (1 Od), can be solved to
determine relative prices of equity, q',"i(S) and q,.Yi(S), in terms of the numeraire, y,(s) for the home
agent:
(11) (a)
-
= L fJ1"-t
1"=,+1
'U/(Yt"d(S))
}+ COV~
~:~d(~
,b";'j~:~~~l
,
U'(Ytd (s))
}
Since the total shares of equity have been normalized to one, each price reflects the total market value of
the firm or industry. While eachprice dependson current, realizedmarginalutility, relative equity prices
are independentof this numeraireeffect. Also, since only period-t dividendsare affected by the period-t
choice of lobbying, these(ex-dividend)prices will not be affected by the resultingsubsidy. Expectations
of future subsidies,however,will affectcurrentequity prices.
Home and foreign agents' portfolio and lobbying decisions give rise to a political-economic
equilibrium, which we define asfollows:
11
Definition:
A political-economic
equilibrium consists of:
a pair of portfolio allocations, a and a*," a choice of lobbying effort, f(s);
e(f(s));
an export subsidy,
sales of x, Xl(S) and X2(S),"home and foreign consumption, yd(s) and yd*(S);
goods
and equity prices, p( s) and q( s)
that satisfy:
(i) firm and consumer first-order
conditions, in (2) and (10);
(ii) budget and time constraints, (9);
(iii) the no-shorr-sales constraint on assets,(9); (iv) the non-negativity constraint on lobbying, (9);
(v) asset-market clearing conditions
Sincecostshocksare purely temporary,the equilibrium may be state-dependent,
but not time-dependent.
Time notation will be eliminated wheneverclarity is not compromised. The portfolios, lobbying
activities, and policies will dependon which of three regimes(complete privatization, state-ownership
with profit distribution, and state-ownership with rent appropriation) characterizes the rival economies.
3. Political-EconomicEquilibria
3.1 CompletePrivatization
We first consider the choice of strategictrade policy when all finns are owned by the private
sectorand equity is tradeable in internationalmarkets. We establish the following politicalc-econornic
equilibrium for this regime:
Equilibrium 1 (No StateOwnership). Thepolitical-economicequilibriumwhenall firms are ownedby the
private sector consists of."
Portfolios, a = (~,~,
1,0) and a* = (~,~, 0,1); lobbying, f(s) = 0 'if s; subsidy,e(s)= 0 'if s;
and X2(S) satisfying (2) given e=O; firm values, q;; =q;2'
p = p( X(s)),jor
X(s) = Xl(S)+X2(S).
12
and relative commodityprice,
d*
When agents anticipate e(s) = f(s) = 0, they expect by (4) the profits and thus dividends of home and
since underlying cost shocks are drawn from the samedistribution. With a xi = a;i = t, homeand foreign
budgetconstraintsgive consumptionas:
w=w
and 8,1 = 8,2
Consumption
is nonstochastic
since
Corr{ c5xl (s). c5x2 (s)} = -1.
Non-
stochasticconsumptionleads to a known intertemporalmarginal rate of substitution of unity so the
covariance tenDSin the asset-pricing equations (11) disappear.15
Since the expected values and variances of the home and foreign fInns are the same, (11) implies
thatfirms' marketvalueswith internationalequitytrade, q;;, areequalized:
Since agents correctly anticipate the policy outcome and the corresponding equity values when
establishingportfolios, home and foreign agentshave the sameex-antewealth. Each agentthus owns
exactly half of the home and foreign firms in equilibrium (satisfying asset-market-clearing
conditions),
while retaining all of the y industry in the agent's own country of residence.
It remains to be confIrmed that e(s) = ((s) = 0 in equilibrium. Given the portfolios described
above, the condition governing the lobbying choice, (lOb), becomes:
£,(s)=O
15Note that with a zero correlation, for example, consumption would retain a stochastic element, but would still be the
same acrosscountries ex post. That delivers the same value for the covariance terms so that equity prices are equalized
across agentsat theseportfolio allocations, and home and foreign finDShave the same relative value. This also holds for
Equilibrium 2.
13
3.2.1
Since total profits of home and foreign firms fall with a home subsidy (by (3)), the term in square
brackets on the left-hand side is negative. The portfolio that eachagenthas acquired makesthe home
agent indifferent to the pure (zero-sum) shifting of profits that the subsidy creates, but makes the agent
worse off as a consequenceof the reduction in aggregateprofits.16Consequently,a comer solution with
f.( s) = 0 arises as lobbying is constrained to be non-negative. Since no political support is offered for
strategictrade policy, the political processgives rise to a zero subsidyin everystate of nature. Home and
foreign sales of x follow (2) for e = 0 and p( X (s)) is determined accordingly
3.2 State Ownershipand StrategicSubsidies
We now considercircumstanceswhere the foreign competitoris state owned. The home firm
remains privately owned, and its equity continues to be tradeable in international markets. Portfolios
consist only of three assets: a
= (aXI ' ayl ' a)'2)
for the home
agent and with
asterisks
for the foreign
agent. The distribution of the profits earned by the foreign firm is important here. We begin by
assumingthat foreign profits of the state-ownedfinn accrue indirectly to foreign residents via state
expenditureswhich provide consumptionthat is a perfect substitutefor y. We also considerthe policy
outcome when the foreign profits becomeinternal rents appropriatedby employeesof the foreign firm,
while residents at large receivenone of the proceeds. This allows us to detennine how privatization
abroadaffectsthe use of strategictrade policy by the governmentof its traderival.
Foreign Firm Profits Indirectly Distributed
The returns from the state-owned firm are distributed to foreign private-sector agents via lump sum
transfers, g*(s)= 1CX2(S),which introduces a source of uncertainty in foreign consumption that is not
16 Since i) T Ii) I. = Xl .e'( e) > 0 at e(I.) = 0, the second term is zero, while f(s) = 0, v'(f(s)) = 0, so the costs of
lobbying are strictlypositive.
14
-
= Et I.f31'-t
(16)
1'=t+1
All gains from equity trade are thereby exhaustedand asset-marketclearing is satisfied.
Confinnation of this policy outcome for theseportfolios is found through reexaminationof (1 Db),
( )
aer(s)
() }-v ' (l,s)-u
air s
' ( d ( )) a1;(s)
y, S
() <O
ai, s
at
£,(s)=o,
for a xl = a x2 = o. With a complete buyout of the domestic firm by foreigners, domestic investors lose all
interestin this industry, as they neitherconsumeits output nor enjoy its dividends. The home political
processgives rise to a zero subsidy in every state. Firms' state-contingent output levels, which reflect the
We see that state ownershipof imperfectlycompetitive fmns will not by itself invoke strategic
subsidies. Privatizationof state-ownedfinns in this environmentwill have no impact on the extent of
strategic subsidies used by the government of one's competitor in trade. If there are limitations on the
tradability of foreign wealth embodied in its competitive sector. however. a buyout of the domestic fIrm may
not be possible. Alternatively, such buyouts may be prevented by tradeability limitations in the home x
sector arising from principal-agent problems, or in some countries from explicit government restrictions on
complete foreign ownership. In these casesthe home agents will retain some of the risky domestic flrm and
may benefit from lobbying as determinedby (lOb). This situation arises when rent appropriationtakes
placeandso is analyzedexplicitly in the followingcase.
3.2.2 Foreign Firm Profits as Intra-Firm Rents
A second scenario under state-ownershiprecognizes the possibility that rents may be appropriated
by firm workers,managers,or political agents. Foreigncitizens at large (distinguishedfrom the group of
rent-beneficiaries) face no risk. but have lower wealth and consumption since they receive no indirect return
16
from the statefirm. We assumethat foreign x employeesconstitutea small fraction. n, of the population,
derive income primarily from the x sector, and have negligible claims to y sector capital by comparison. The
foreign agent that trades in international equity markets then representsthe foreign citizens at large. In this
setting, we establishthe following political-economic equilibrium:
Equilibrium 3 (Foreign State Ownership with AppropriatedProfits).
With sufficientlydecreasing
marginal costs,thepolitical-economicequilibriumwhentheforeign finn is state-ownedand its profits are
appropriatedby its employeesconsistsoft
Portfolios,a = (r ,I, ro) and a* = (1- r, O,I-ro) with + < r < 1 and 0< ro < 1.. homelobbying,
l(s) > 0 ":t s.. subsidy,
e(s) > 0 ":t s.. consumption.
yd (s) = w + y8xt (s)+ 8)0. + co. 8)02 -T(s)
and
yd. (s) = (1- n)w. + (1- r )8XI(s)+ (1- ro}8)'2; sales,Xl (s) and X2(S)satisfying(2)for e(s)> 0;
equity values, q;; Iq;2 > 1, and p = p(X(s))
for
X(s) = XI(S)+X2(S).
The home agentreceives a share of the foreign industry, (J), in exchange for selling a share, 1- r, of the
home finn. This exchangereflects the relative value of the home flnn in terms of the foreign y industry and
equatesrelative equity prices across agents (see Appendix 1 for derivation):
w
(18)
I./3'-'{E, {O;I(S)}}
~!=~
-'='+1
Q',Y2(S)
-I./3'-'
'='+1
{O;2}
I./3'-' {E, {O;I(s)}}
= ,om
COV{O;I
(S),U'(Y:(S))}
+
-I-
(homeagent)
I./3'-'{O;2 E,{u'(Y:(S))}}
,=m
Cov{o;(s),u'(y:'(s))}
(foreign agent)
for y:(s) and y:*(s) as statedin Equilibrium3. The first termsin (18) are identical for homeand foreign
agents regardless of portfolio allocations, while the second tenD is the risk premium which captures the
amountby whichthe price of the equity is reducedto compensateagentsfor bearingrisk and dependson
the amountof the risky equity held. If r = 1 , homeconsumptionis stochastic,while foreign consumption
dependsonly on the nonstochasticwage and returns from y-sectorcapital. Hence, the covarianceterm
17
y.
for the foreign agent would be zero, while the covariance tenD for the home agent would be negative (see
Appendix 1). With the home agent's relative price of Xl equity less than that of the foreign agent, some
of this equity will be sold in exchange for claims to the foreign y industry. At the other extreme where
r = 0, the home agent's consumptionwould not be risky, so the covariancetenD for home would be
zero, while the foreign agent's relative valuation would be lower due to a negative covariance term.17
Hence, r mustlie betweenzeroand one. Sincethe foreignagentreceivesno incomefrom the local x firm,
however,we know thatex-antewealthof the home agentexceedsthat of the foreign agent. Consequently,
constant relative risk aversion preferences guarantee that in equilibrium the home agent retains more than
half the homefirm: ~ < r < 1.18
A subsidywill be soughtif this share of the increasedprofits is large enoughto offset the tax
neededto fund a (marginal)subsidy.This is detenninedby (lOb), expressedhereas:
(19)
J
[ aOtXl(s)
U'(Y:(S)1Yo
~W ]
~
ae,(s)}
ae,(s)
~-V'(f.I(S))
>0
at
t'r(S)=O
Dropping time subscriptsand substitutingfor a subsidy'seffectson profits and taxes,this becomes:
f(s) = 0
a e( s)
since v'( f(s)) = 0 and e(s)= 0 at f(s) = o. The sign of this tenDdependsonthe sizeof r, the specification
of inverse demand,and the nature of costs. We can simplify this condition further as:
If r = O. the homeagenthasno interestin ~e homex flrIn. so t(s) = e(s)= T(s)V's in sucha case.
18 See Merton (1971) for a proof that the share of wealth invested in a risky asset (Xl) rises with income for agents
with constant relative risk aversion preferences. or see Hakansson (1987) for a more general discussion.
18
With constantmarginal costs, a.t"2(S)/ae(s)= 1/3p'(X(s)). In this case,solving for r reveals that the
home agent must retain over three-quartersof the home fInn before lobbying will be worthwhile. Given that
Y;<y<
this may occur and will be more likely the greater is the difference in wealth between the two
agents. The presenceof decreasing
marginalcosts,however,lowers substantiallythe minimum ownership
share of the home firm that will motivate the home agent to lobby. With decreasingmarginal costs, we have
instead(seeAppendix2):
(21)
a X2 (s) -1t';1
-1
-a-;{lJ"-D- p,(",2-4"'+3)
where 1("reflects the degree of decreasingmarginal costs with 1("= c" / p' for 0 < 1("< 1. By inserting this
into (20) we can solve for the minimum ownership share of the home firm for which (20) holds. As 1Crises
from 0 (constant marginal costs) to I, that minimum falls from .75 to 0, as shown in Figure 1. When the
actual share retained equals or exceedsthat minimum. a positive subsidy will be anticipated by both agents
in all future periods. 19 This subsidy will shift rents to both horne and foreign investors at the expense of the
employeesof the foreignstate-owned
finn.
Such an outcome, by (3) and (4), raises future dividends of the home fino and lowers profits of
the foreign firm and, by (II) and its foreign analogue, leads to an increase in the value of the home firm
relative to the foreign finn:2Oa {Q;;/q;2}/ ae(s)
1
..
> 0 for a = (r , 1, (J))and a. = (1- r , 0, 1- (J)) .
e=O,a.a
This effect is positive since in everystate db'XJ(s)jde(s) > 0 and d1!X2(s)/de(s)< o. Consequently,
state ownership of the foreign fInn raises home agent wealth relative to foreign agent wealth, since all
agentsanticipatea positive exportsubsidyand incorporatetheseexpectationsinto current equity values.
19Since t < r < I , decreasingmarginal coststhat place that minimum at one-half or less guaranteesthat the home agent
lobbies the government. A subsidy will arise with a smaller degree of decreasingmarginal cost, the larger is r .
20The relative wealth held in tradeable y equity of the foreign x workers i.sassumedto be sufficiently small as to be
negligible for the determination of assetprices in the foreign country.
19
Privatizationof the foreign state-owned
finn, that delivers tradableclaimsto finn profits into the
privatesector,will lead to further diversificationof portfolios as in Equilibrium I. This will eliminatethe
use of the strategic subsidy by its trade rival, will increase the market value of the foreign finn relative to the
homefirm, and will raise foreignwealth.
4.3 HomeFirm State-Ownedand AppropriatedRents
State ownership of the home firm, when profits are appropriatedby a narrow group of firmaffiliated agents,gives rise to the appearanceof two types of agentswithin the homecountry: one type
(A) works and owns claims to the y sector capital income, while the other (B) is the group of x
employees,who havecapturedthe rentstherein,own no claims to y capital income,andcomprisea small
faction (n) of the population. Portfolios now consist of a = (a.t2 ,ayl ,aY2) for the home A agent and
with asterisks for the foreign agent. We establish the following political-economic equilibrium:
Equilibrium 4 (Home Firm StateOwned). Thepolitical-economicequilibriumwhen theforeign firm is
state-owned
and its profits are appropriatedby thefirm's employeesconsistsof
Portfolios, a = (1- v, 1- .u,o), a* = (v, .u,1) fort
consumption, y~(s) = (l-n)w+(l-
< v < 1 ,. lobbying f(s) > 0 'V s,. subsidy e(s) > 0 'Vs,.
v). 0.t2(S)+ (l-.u)'
and yd*(s)=w*+v8.t2(S)+.u8YI+8Y2,.
Oyl -(I-n)T(s),
y~ = nw+ trXI(S)- nT(s),
sales, XI(S) and X2(S) satisfying (2) given e>O;
unequal
firm equity values, q~ Iq;2 > 1, and p= p(X(s)) for X(S)=Xl(S)+X2(S).
Risk-sharingwill occur as the home agentsellssharesof yl to the foreign agentin exchangefor part of
the risky foreign finn. Since the foreign agentis the wealthier, the home agentwill hold less than haIf
the risk associatedwith the foreign finn. The portfolio equilibrium is opposite in fonn to that in
Equilibrium 3 since the identity of the state-owned finn has been shifted from foreign to home. In this
case,however,the home A agenthasno incentiveto lobby for a subsidyto the home x firm, since no
incomeaccruesfrom that source(as in Equilibrium 2). The home employeesof the x firm, by contrast,
20
form a more narrow group whoseincome is closelytied to x profits. Theseagentswould enjoy all of the
increasein dividends that follow the imposition of a subsidy. Furthermore,the financing cost of the
subsidy would be spread across the entire population, so their tax cost would effectively be zero.
Reinterpretationof (19) indicatesthat theseagentslobby for an export subsidyin all statesof nature:
(21)
t'B(S) = 0
= 0 for all statesand v'(O)= O. The subsidyis granted
through the political process and transfers income from foreign agents to the narrow group of x-affiliated
agentsin the homecountry. Analogousto Equilibrium3, the subsidylowers the value of the foreign firm
relative to the (shadow)value of the homefirm.
Privatization that permits the ownership of x firm profits to be exchanged across agents would
reduce the political pressuresfavoring strategic subsidiesin the home country. The foreign agent
benefits from privatization in the home country sincethe elimination of the subsidyincreasesforeign
marketshareandprofits relative to those of the homefirm.
S. Concluding Remarks
A comparisonof the four political-economicequilibria reveals the interdependencebetween
portfolio allocations,privatization, and strategictrade policies. One impedimentto the diversification
neededto eliminate a subsidy equilibrium can arise from restricted accessto international financial
markets,and anotherthrough state-ownershipof firms. Our results suggestthat privatization may have
broadereffectsthanotherwisethoughtdue to the endogenous
responseof trade policy.
When equity in both firms is tradeable,uncertaintyand international financial marketscreate
assetportfolios that induce a country to abandonthe use of strategic subsidies. This occurssince the
profit shifting createdby suchsubsidiesmerelyreallocatesdividends within an agent's portfolio and the
aggregatenegativeeffect on profits reducesthe total value of the agent's portfolio. The presenceof a
21
home bias in portfolios persists (see Tesar and Werner 1995), however, and if such bias exists in
industries subjectto strategicinteraction, lobbying for subsidieswill arise.
State ownershippreventsone firm's stock from trading in equity marketsand insteaddirects its
profits either to governmentor to intra-finn rents. In the fonner case,when foreign agentsacquire all
sharesof the homefirm, the home agenttakesno interestin strategicsubsidiesso that none are granted
by the homegovernment.In the latter case,homeagentsretainmorethan half the home firm which may
be enough to generate a subsidy under constant marginal costs. If not, sufficiently decreasing marginal
costs guaranteethat lobbying for intervention occurs and the resulting export subsidy will increasethe
value of equity in the home firm relative to that of the foreign firm. When the profits of a home state-
owned finn are retainedby its employees,income for this groupremainsclosely tied to the x finn, and
the political processestablishesan export subsidy.
We conclude, therefore, that the privatization of a foreign state-owned finn would remove all
incentives for the home governmentto provide a subsidyand would raise the value of the foreign firm
relative to its home-country trade rival.
Privatization of a home state-owned firm, in any form that
ultimately pennits trade in equity of the firm, eliminates the pro-interventionist contingent at home,
which creates a political climate that institutes free trade. In this case privatization has the paradoxical
effect of loweringthe value of the home firm, relative to the equilibrium with state ownership,sincethe
export subsidyis not offered.
22
}>o
Appendix
1. RelativePrices
Using equations (IIa) and (lIb) we can determine the relative prices of the home fiml's equity in temlS
of the foreign industry equity for homeand foreign agents,respectively:
~:.::11 =
Qr,Y2(S)
i;~=
Q;,y2(S)
where
(A2)
Q"y2(S) =
After substituting for Qr,y2and Q;,Y2'these can be expressed as in (18), The covariance tenus in (18)
depend on consumption and consumptiondepends on the portfolio allocations. In the case of
Equilibrium 3, consumption for home and foreign agents is given by:
yd(S)=
W+r8Xl(S)+8Yl
+ro.8y2
and yd*(S)= w. +(1-y)8xl(s)+(1-co)8Y2
Since utility is strictly concave:
This latter covariancetermcan bederivedexplicitly for the home agentas:
Hence,when r = , the homeagent'srelative price will include a negativecovarianceterm, while the
foreign agent'scovariancetenDwill be zero. The oppositeoccursfor r = O.
23
-1>0
2. Conditions for Strategic Subsidiesfor Different Cost Structures
An export subsidy arises in equilibrium when home agents lobby the government. We derive the
minimum ownership share, ax)' of the home firm (when owning none of the foreign firm) that generates
an export subsidy. The decision to lobby is governed by (19), which is reproduced here (with all time
subscriptssuppressedfor notationalsimplicity) for the casewhenthe foreignfirm's stockis not traded in
equity markets (due, fOTexample, to state ownership):
ae(( s))- } -V'(l(S))-U'(yd(S))~
at
f(s) = 0
S
home flnn profits increase by the amount
aT(s)
( ) = Xl (s)- ae(s)
bY
rise
taxes
and
X(S))_+XI(S)
p'(
XI(S).
((S )) >0
ae(s)
at
s
at
s
)
yields:
and v'(f(s)) =0),
aX2(S)
=
a8XI(s)
(so e(s)=O
al
.Substitution
Evaluated at f(s)=O
S
(
at.
ae(s)
Xl(S)op'(X(S)) ~+xl(s)
]-xl(S)}.~>
This condition can be simplified since we know u'(.) > 0, ae(s)jae(s»
axl.
dX2(S)
1+ p'( X(s)). -a-;w-
2.1 Constantmarginal costs.
of a strategicsubsidyby the homecountry.
24
0
at
f(s) = 0
0, and Xl(S) > 0, which leaves:
"II
2.2 Diminishingmarginalcosts.
Subscripts denote partial
derivatives of firm i's profits with respect to firm i's or j's output.
State notation is suppressedfor
simplicity. The second-orderconditions with linear inverse demand and non-constantmarginal costs are:
(A9)
(a)
1r)) = 2p'-c))
.
2P' -C22
1CII < 1C12 and
1C;2 < 1C;1
1t"22=
where
<0
(b) 7r\2 = 7r;\ = p' < 0
< 0
Let
c)) =c~
=c
In this case, (A9)(a) can be expressedas
1Cii= 2p' -c" < o. The degree of diminishing marginal costs is captured by 1(. where c" = 1(.P'.
Restricting /( to less than two satisfies both second-orderconditions.
1(< 2 .
When 1(= 0, marginal costs are
constant, and 0 < K"< 2 allows for decreasingmarginal costs. Replacing c
with 1C
p'
in solving for the
changein foreignfirm outputyields:
(AIO)
1
ax2(S) -~=
ae(s) -D
p'(1(2 -41( + 3)
The minimum ownership share required for the subsidy equilibrium, ~J'
falls with the degree of
.,
diminishingmarginalcosts: a xl =
1(- -41(+3
As 1Crises from 0 (constant marginal costs) to 1, ax)
1("2 -41("+4
falls from. 75 to 0 as shown in Figure I
25
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28
Minimum Ownershipof Home Firm
for Implementationof StrategicSubsidies
0.8
0.7
0.6
~ 0.5
~
.c
Cf)
§ 0.4
E
.2
~ 0.3
0.2
0.1
0 .I
0.00
I
0.10
I
I
0.20
I
I
0.30
I
I
0.40
I
I
I
0.50
I
0.60
kappa
Figure 1
29
I
I
0.70
I
I
0.80
I
I
0.90
I
.
1.00