Governance in the Wild: a Theory of State Vs. Private Firms Under Weak Institutions
Abstract: We study how weak constraints on the government affect private contracts and the ownership of firms. To discourage expropriation, a social contract must give the government a stake in firm output. However, this reduces the firm owners’ incentives to honor business contracts with suppliers, undermining their credibility. This tension disappears if suppliers contract directly with the government, which we interpret as a state-owned firm. Our model therefore predicts that under weak political institutions, contracting with the government may be second-best efficient if private business contracts are not verifiable, and hence require self-enforcement. We discuss evidence on privatizations in developing countries, and on the emergence of private firms in East Asia, which is consistent with our model’s predictions. Our model has broader implications for contracting in the shadow of power, including the effect of corporate governance on the design of intra-firm hierarchies.
