Misallocation and Privatizing when Firm Value is Unknown: an Agency Model and Application to the Case of Poland

Abstract: This paper studies privatization as an agency problem, where ex ante neither investor nor the state know the productive value of the capital stock in a given firm. We study the case of an economy in transition from a centrally planned to a market-based system. Because under central planning prices did not provide adequate incentives, many of the firms to be privatized are characterized by a suboptimal combination of capital and labor. Our model replicates well the stylized features of privatization processes, as described by novel and unique data on privatization in Poland. We study the optimal pricing strategy by the state and buying decision of the investor. We allow for a variety of firms to be sold (denoted by the extent of misallocation) and heterogeneity of investors (denoted by the extent of capital constraints). We study whether privatization leads to improved allocation of resources in that economy, i.e. the effective use of resources. We also study two policy instruments – employment guarantees or investment guarantees – as potential policy tools to improve allocative efficiency of the economy.