Privatization Under Political Ties

ABSTRACT I study a product differentiation model with endogenous entry where a politically connected public firm competes with a private one. Consumers are heterogeneous in their willingness to pay. I argue that—because of political ties—the public firm may mimic the preferences of the consumer with the median willingness to pay. I show that as privatization (i.e., the weight on profits in the public firm's objective function) increases, the equilibrium market structure shifts from a welfare‐inefficient public monopoly to a duopoly. Under duopoly, the public firm can set a relatively low price to attract and please the median consumer. In this way, the public firm gains market shares and, consequently, market power. In equilibrium, the public firm can then end up being more profitable than its private, profit‐seeking competitor. Finally, I show that full privatization is not socially optimal.