Mixed duopoly, privatizationand the shadow cost of public funds

The purpose of this paper is to investigate the effect of privatization in a mixed duopoly, wherea private firm competes in quantities with a welfare-maximizing public firm. We consider twoinefficiencies of the public sector: a possible cost inefficiency, and an allocative inefficiencydue to the distortionary effect of taxation (shadow cost of public funds). Furthermore, weanalyze the effect of privatization on the timing of competition by endogenizing thedetermination of simultaneous (Nash-Cournot) versus sequential (Stackelberg) games usingthe model developed by Hamilton and Slutsky (1990). The latter is especially relevant for theanalysis of privatization, given that results and policy prescription emerged in the literaturecrucially rely on the type of competition assumed. We show that privatization has generallythe effect of shifting from Stackelberg to Cournot equilibrium and that, absent efficiency gainsprivatization never increases welfare. Moreover, even when large efficiency gains are realized,an inefficient public firm may be preferred....