1. On privatization methods in Eastern Europe and their implications
Philippe Aghion and Olivier J. Blanchard

2. The need of restructuring
Restructuring has many dimensions, it requires:
expertise, which is not available inside the firm;
new capital;
the closing of some activities in the firm: this leads to plant closings and layoffs.
As a result, many top managers are laid off, in particular those who do not have the skills required to run the firm in the market economy.

3. Restructuring requires outside ownership
‘Defensive’ restructuring: reducing employment and closing some of the largest loss-making activities.
Vs.
‘Strategic’ restructuring: those more radical measures that allows the firm both to survive the initial shock and to grow over time.
Surveys in Central Europe show that the only firms that give evidence of strategic restructuring are mainly under foreign ownership. (Czech Republic, Estonia)
Main reason: the inability of firms to raise the required amount of capital and pay for expertise under inside control.

4. Political constraints require insider privatization
Insider privatizations were more common (Russia, Poland, CIS and former Yugoslavian countries).
When central planning disappeared, SOEs were in fact controlled by insiders. They could largely block or sabotage outsider privatizations, either at the level of the firm or at the political level.
Why did outsider privatizations play such a limited role in transition?
The risk of layoffs and unemployment is, of course, an unattractive option for insiders (managers and workers).

5. Legend n = number of the workers x = product per worker
y = product per worker after restructuring
R = reservation wage (wage equivalent of being unemployed: benefits + prob)
w = market wage
λ = replacement rate ( equal to 1 )
qb = maximum price an outsider will pay for one share of the firm
qs = minimum price at which each worker will sell his share

6. Resale conditions qb = y - w qs + R = ( y - w ) + R
If the selling and the buying price are the same, the resale will take place:
qs = qb = y - w
Advantage for outside investors: in countries in transition (Russia), most workers-shareholders have liquidity problems and no access to credit. This leads them to sell at a lower price than qs. They will accept this if investors will give them only a fraction of the profit per share.

7. Collusion among workers
Although the restructuring is socially desirable (constant employment and increased output), workers-shareholders collude and share the fear of a future unemployment in case of sale. There will be no sale if the cost of being unemployed (w - R) is larger than the net surplus generated by restructuring (y - x).
2 main factors:
The probability of unemployment, λ, under outsider privatization. As long as λ is positive, this will make the resale more unlikely. Outsiders may offer employment guarantees (Eastern Germany).
The cost of unemployment, w - R. The larger it is, the more there will be opposition to resale and to restructuring.

8. Workers vs. Managers
Considering managers, the resale will take place if the highest price investors are willing to pay for the firm as a whole exceeds the ‘bribe’ which must be paid to the manager to compensate for the risk of being laid off.
On the contrary, it will fail if the benefits of control for the manager is larger than the total increase in the product of the firm.
Why?
Managers tend to collusion more than workers: this makes the resale more unlikely.
The risk of unemployment is a more negative outcome for managers than for workers.
There are fewer managers than workers.

9. Back to political constraints
If firms are initially given to insiders, privatization should be designed so to avoid collusion in resale → if not, it may prevent resale and restructuring.
But if no collusion → resale will always take place → individual interest for each worker to sell his/her share → but workers could end collectively worse.
R + (y - w) < x
R + ( y - w ) → what workers get from the resale: reservation wage + proceeds from the sale of the firm.
x → what workers get under the status quo
y - x < w - R
Same condition as the condition under which no resale if workers collude.

10. Back to political constraints 2
This result suggests that if privatization is designed in order to avoid collusion when reselling, the workers will likely oppose.
According to the authors, is still better to design privatization in order to avoid collusion and face the political opposition, for the following reason:
If privatization allows for collusion and privatization takes place, workers could still collude to prevent resale and there’s little the gov. can do.
By contrast, if privatization is designed to avoid collusion, the government could implement it despite the opposition of the workers → Keeping the firms under the control of the state is not an option: under privatization workers gain more, and they will chose this path even if they know that will eventually led to resale.

11. Shares to outsiders A proportion of shares can be sold to outsiders.
If α = is the proportion of the share given to the insiders →
(1 - α) = proportion of the shares given to outsiders at the start of the privatization.
Let’s assume that:
y - x > w - R and (x > R) → This implies that
under pure insider privatization (α = 1) if they can collude, workers will agree to resale and if they cannot, they will agree to privatization and resale.

12. Shares to outsiders 2
Instead, under pure outsider privatization ( α = 0 ) workers, if they can collude will oppose resale and if they cannot, they will oppose privatization.
THE QUESTION: What is the minimum value of α ( called α*) such as privatization, resale and restructuring will take place?
FIRST CASE: If privatization does not prevent collusion in resale → under collusion workers will resale only if they are collectively better of as a result.
resale condition → R + α(y - w) ≥ x ; that can be written: α ≥ α* ≡ (x - R) / (y - R)
Under our assumptions α* is between 0 and 1. If this condition is satisfied resale will take place and workers’ condition will improve. Knowing that resale will take place, workers will accept privatization in the first place.

13. Shares to outsiders 3
SECOND CASE: If privatization prevents collusion in resale. The resale will always take place, at price y - w → the investors are willing to pay for the firm.
When resale has taken place, insiders will end up with R + α ( y - w ) ≥ x
that becomes: α ≥ α* ≡ (x - R) / (y - R)
The value of α* is the same in both the first and the second case and for the same reason. In this case collusion is not feasible and the anticipation that resale will occur after privatization leads the workers to oppose it, unless they know that they will be better off after resale.
For the same reasons of the previous section, the authors believe that governments should design privatization in order to avoid resale, by imposing it at a lower value of α than α*.

14. Shares to outsiders 4 α* = 1 - (y - x) - (w - R) / (y-w)
The determinants of α* that can be rewritten as:
α* = 1 - (y - x) - (w - R) / (y-w)
The minimum share going to insiders can be lower the worse initial condition (low x) or the more productive the firm after restructuring (high y).
Another factor that determines the share is the market condition, measured by the cost of being unemployed (w - R): if the market conditions get worse → the cost of being unemployed will rise → the share which has to go to insiders will be higher. This because the higher cost of being unemployed must be compensated with higher payments.

15. Conclusions
Insider privatization should be set so as to reduce the room for collusion in resale, for example by allowing workers to trade shares anonymously, avoiding the firm’s involvement, and avoiding the creation of non-voting shares that are difficult to resell.
Privatization should be more generous to workers than to managers and this depends largely by the first point, because especially in large firms, it’s easier to bribe a manager into giving up the benefits of control than to bribe a coalition of workers that may lose their job.
Subject to political constraints as many shares as possible should be given or sold to outsiders at the initial privatization stage. This leads to the creation of a market of shares that makes anonymous selling easier and collusion harder.