Public and Private Transactions in the Shadow of Coercive Power

Abstract: We study a simple economy where a seller may either deal with a private buyer or with the state. We show that to induce the seller to transact, the state’s ruler must establish different kinds of reputations in the two governance regimes. Under public contracting, the ruler must credibly commit to compensate the seller. Under private contracting, the ruler must commit not to expropriate the seller and to enforce the buyer’s promise to compensate her. Thus, it is comparatively harder (easier) for the ruler to establish the reputation necessary for private contracting when political constraints on expropriation, and judicial institutions supporting ruler’s enforcement, are weak (strong). This implies that in contrast with the conventional wisdom, contracting with the state creates, rather than destroying, value under weak institutions. Our model provides a theory of the costs and benefits of privatization, the optimal patterns of foreign direct investment, and more generally, the optimal allocation of contracting roles among public and private actors.