Machiavellian Underpricing

Machiavellian Underpricing

Université de Toulouse I - Department of Economics; Centre for Economic Policy Research (CEPR)
University of Amsterdam; Centre for Economic Policy Research (CEPR)

Much academic literature on privatization has focused on the question of the efficiency gains associated with private property rights, the appropriate regulatory framework for privatized firms. There has been a more recent literature on the optimal design of the sale given the general uncertainty and the political risk inherent in the transaction (Perotti, 1995; Schmidt, 1998).

The empirical evidence on sales has confirmed the importance of political factors in the design of the sales. In this paper we take a radically different view from the usual normative approach about how privatization should be done and analyse an explicit political economy context to determine how politicians prefer to design sale programs.

We show that a privatization sale may be structured by a market-oriented, right wing government in order to ensure participation by the median class, in order to modify its voting preferences vis a vis the opposition, which favors more income redistribution. If appropriately designed, the share allocation at the sale align the interests of the median class with capitalists and thus make privatization politically feasible (and irreversible).

Specifically, a targeted share allocation the party will be re-elected to power because the median class becomes ex post averse to redistributive policies which would reduce the value of their shares. As it is in general illegal to target share allocations in large sales to specific groups of investors and not to others, the government has to use its control over the price of the offering. For the median class to choose to acquire enough shares to shift its political allegiance, the government needs to underprice the shares. As this leads to rationing, the government can then devises a self-selecting rationing scheme. We find that since income inequality makes the middle class more interested in redistribution, underpricing and rationing are increasing in social inequality.

This general result has already found strong empirical evidence in the literature (Jones et al, 1998) . In certain extreme situations firms shares may be sold at zero price, as in voucher privatizations; more generally zero-price share distributions may break self-fulfilling equilibria. Intuitively, there is an equilibrium in which investors do not believe other median class investors will buy shares at the sale, anticipating a victory by the opposition; such a belief can become self-fulfilling. A share distribution (directly to citizen or via investment or pension funds) rules out this possibility. In the case when only a fraction of shares needs to be sold before an election, the rest may be optimally sold later at an auction designed for richer investors.

Shifting the preferences of the middle class may be impossible when strong ex ante political constraints require large upfront transfers to insiders, reducing the value which may be distributed through the privatization program, or when social inequality is extreme.

JEL Classifications: G32, P31, L33

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Contact Information for ENRICO C. PEROTTI (Contact Author) (Email address for ENRICO C. PEROTTI )
University of Amsterdam
Roetersstraat 18
Finance Group
Amsterdam 1018 WB
+31 20 525 4159 (Phone)
+31 20 525 5285 (Fax)

(No e-mail address available for ENRICO C. PEROTTI )
Centre for Economic Policy Research (CEPR)
90-98 Goswell Road
London EC1V 7RR
United Kingdom

Contact Information for BRUNO BIAIS (Email address for BRUNO BIAIS )
Université de Toulouse I - Department of Economics
Place Anatole-France
F-31042 Toulouse Cedex
+33 561 128 598 (Phone)
+33 561 128 637 (Fax)

(No e-mail address available for BRUNO BIAIS )
Centre for Economic Policy Research (CEPR)
90-98 Goswell Road
London EC1V 7RR
United Kingdom

Suggested Citation
Biais, Bruno and Perotti, Enrico C., "Machiavellian Underpricing" (January 1998).

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