This paper looks at the economic, rather than ideological, justification for state-owned
enterprise(SOE) reform, focusing on the problems of asymmetric information and incomplete
contracts. When incentive schemes and objectives are examined separately under public vs.
private provision, it seems clear that the case for privatization comes from the objective side,
rather than the incentive side. Through corporatization and listing of shares on the stock
market, SOEs can adopt much of market-based sanctions and incentives. What they cannot
easily imitate is private firms' focus on the objective of profit maximization. While
voters-taxpayers want SOEs to correct for market failures and promote social welfare,
politicians and bureaucrats may use SOEs to pursue their private objectives by transferring
public resources to their supporters or even engaging in outright corruption. Privatization can
serve as a means of removing these potentially distortionary objectives if it can be
For privatization to prove effective, however, it must be a part of a comprehensive package
involving the participation of at least some large shareholders who have enough stake in the
firm to monitor management as well as concomitant improvements in market institutions.
After all, market-based sanctions and incentives lose much of their effectiveness under diffuse
ownership, overprotected management, soft budget constraints, and limited competition.
Market liberalization thus must be accorded priority if privatization is to lead to increased
efficiency. It must also be noted that private provision could be inferior to public provision in
some cases, especially when opportunities for "cutting corners" are significant.