Governance in the Wild: a Theory of State Vs. Private Firms Under Weak Institutions

Abstract: We study a model in which an agent may sell essential inputs to a private or a state firm. We show that the two firms rely on different “social contracts” with the government to sustain production. In the state firm the government must promise not to expropriate the seller and to pay for his inputs. For the private firm to be sustainable, the government must promise not to expropriate the seller and the firm’s owner, and to enforce their contracts. We show that it is harder (easier) for the government to credibly make the promises needed to sustain the private firm, relative to those needed to sustain the state firm, when political constraints on expropriation and contract enforcement institutions are weak (strong). Our model explains why privatizations in developing and transition countries with stronger pre-existing institutions have succeeded, while those in countries with weaker institutions have failed. More broadly, our model provides a theoretical framework to understand the relationship between institutions and the organization of production.