Economics and Politics of Alternative Institutional Reforms

In a model with heterogeneity in managerial talent, we compare the economic and political consequences of reforms aimed at reducing fixed costs of entry (deregulation) and improving the efficiency of financial markets (financial reform). The effects of these reforms depend on the market where control rights over incumbent firms are traded. In the absence of a market for control, both reforms increase the number and the average quality of firms, and are politically equivalent. When a market for control exists, financial reform induces less entry than deregulation, and endogenously compensates incumbents, thereby encountering less political opposition from them. Using this result, we show that financial reform may be used in the short run to open the way for future deregulation. Our model sheds light on the privatization and reform experiences of formerly planned economies as well as on the observed path of reforms in economies of the Organisation for Economic Co-operation and Development.