Private and Public Firms in the Shadow of Coercive Power

Abstract: We study the governance of firms under imperfect institutions. We present a model where firms operate in a territory governed by a powerful ruler, and we study conditions under which the ruler can simultaneously commit to punish defaults on intra-firm agreements, and not to expropriate the firm’s manager and worker, by entering a self-enforcing social contract with them. We show that if the manager and the worker are employees of the ruler (public firm), the ruler is less tempted to expropriate them compared to the case where the worker is an employee of the manager (private firm). At the same time, in a public firm, the ruler’s failure to pay the worker cannot be punished coercively, so defaulting on intra-firm contracts is more tempting than in a private firm. As a result, privatizing a public firm may undermine the credibility of the underlying social contract, and thus reduce the firm’s productivity and output, when institutions do not constrain the ruler’s power to expropriate, and when the ruler cannot easily verify defaults on intra-firm contracts. Importantly, we obtain these results after holding the production technology, parties’ preferences, and internal organization constant across the two firms’ types. By emphasizing institutions as a key determinant of the choice between public and private firms, our theory offers new testable implications for industrial policy and the timing of privatization in both developed and developing countries.