Ownership Versus Environment: Why are Public Sector Firms Inefficient?

In this paper, we disentangle the sources of public sector inefficiency using 1981-1995 panel data on manufacturing firms in Indonesia. We consider two leading hypotheses: (1) public sector enterprises are inefficient due to agency-type problems or (2) public sector enterprises are inefficient because of the environment in which they operate, as measured by the soft budget constraint or barriers to competition. The two models are nested in a production function framework. The empirical results provide support for both models. Public sector enterprises shielded from import competition or with access to soft loans are significantly less efficient than their private sector counterparts. In addition, changes in ownership have large, independent effects on efficiency: in 1993, a full privatization is estimated to increase plant-level total factor productivity by 23 percentage points. Even without privatization, however, eliminating soft loans could raise total factor productivity by 8 to 9 percentage points.