June 15, 2005

Why are public-sector firms inefficient?

Privatization is not the only way to improve the performance of public-sector enterprises. A study of Indonesian firms shows that less drastic changes can lead to similar gains in productivity.


Since the late 1980s, many countries with large public sectors have embraced privatization as a path to increased productivity and economic growth. But while public-sector enterprises tend to be less efficient than their private counterparts, government ownership may not be the real cause of the problem. In a study of Indonesia’s manufacturing sector, Professors Ann Bartel of Columbia and Ann Harrison of UC Berkeley found that reforming the operating environment in public-sector firms yields productivity gains comparable to those achieved through privatization.

According to the conventional view, the inefficiency of public-sector firms stems from a principal-agent problem: the government is either unable or unwilling to properly supervise the firms’ managers. Bartel and Harrison explored an alternative hypothesis that environmental factors like soft budget constraints and lack of competition are responsible for the firms’ poor performance. If the operating environment is to blame, could reducing subsidies and exposing the firms to increased competition induce them to perform like private-sector firms, even without a change in ownership?

Bartel and Harrison examined data for all public and private manufacturing firms in Indonesia between 1981 and 1995, a period when the government was pursuing a program of privatization, trade liberalization and banking-sector reform. The researchers looked at such variables as degree of public ownership, access to government loans and foreign share of investment. They used import penetration as a proxy indicator of trade policy.

The researchers’ analysis shows that the degree of public ownership by itself is not a good predictor of firm performance. In combination with soft budget constraints or trade protectionism, however, government ownership does have a significant negative impact on productivity. In other words, there may be an agency problem associated with public ownership, but the problem manifests itself only when the government provides subsidies or shields firms from import competition or foreign ownership.

The data show that for a given level of government financing and domestic and foreign competition, public-sector firms perform worse than their private counterparts. Bartel and Harrison calculated that when a public firm is fully privatized, its productivity rises by an average of 1.6 percentage points. But they found that changing the environment in which a public-sector firm operates achieves similar results. If state financing of new investment is reduced from 100 percent to 70 percent, the firm’s productivity will improve by 1.6 percentage points. Likewise, if import penetration rises by 3 percentage points or foreign ownership in the firm increases by 0.75 percentage points, either change will produce the same gain in productivity as full privatization.

Reforming the environment represents a more incremental change than privatization and is often much less painful politically. When privatization is not politically feasible in the short run, environmental reforms can be an effective precursor to full or partial privatization. Many of the privatizations that took place in Indonesia between 1989 and 1995 were partial; these generated a much smaller contribution to overall productivity growth than environmental reforms implemented during the same period. The results of this study suggest that the most effective approach to transforming public-sector firms is one that combines environmental reforms with privatization.

 

Ann Bartel is the A. Barton Hepburn Professor of Economics and director of the Human Resource Management Program at Columbia Business School.

Read the Research

Ann Bartel, Ann Harrison

"Ownership Versus Environment: Why Are Public Sector Firms Inefficient?"

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