# I. Introduction

Understanding the rationale behind direct state participation in markets through state-owned enterprises (SOEs) is critical to the design of appropriate SOE reform policies. Not all SOEs are equal as they can participate in a diverse and wide range of economic activities in the economy. As evidenced in the novel WB Global Business of the State (BOS) database, there is a large heterogeneity in the sectors where the state intervenes as a market player. The economic costs and benefits from this intervention can also vary substantially depending on the type of economic activity where the SOEs operate.

This paper proposes how to classify economic activities where the state can be present as a market player based on their intrinsic characteristics and associated market failures.<sup>1</sup> Economic theory provides an efficiency-based rationale to identify instances (market failures) in which a non-profit-maximizing SOE would be able to pursue optimal policies (bringing benefits that improve overall welfare), provided that state capture<sup>2</sup> and other inefficiencies or distortions generated by public ownership (the costs) would not outweigh the benefits of SOE presence. Following the Industrial Organization (IO) literature that analyzes the exercise and control of market power (Tirole, 2014), this paper proposes how to classify the economic activities where the state can be present as a market player based on the intrinsic economic characteristics and market failures. In doing so, the paper contributes to filling the gap on how to connect IO research on the differences across markets and industry dynamics with the policy agenda related to the role of the state in markets.<sup>3</sup> The comprehensive taxonomy presented in this paper rationalizes the potential presence of SOEs at the level of disaggregated economic sectors and by doing so avoids a “one-size-fits-all” approach to analyzing the economic footprint of the state in markets. An efficiency-based rationale for SOE presence suggests heterogeneity of the companies with state participation across sectors, as they may be characterized by different technological and market features. Economic theory can provide guidance to distinguish between those sectors in which markets are able to achieve an efficient market equilibrium, such that there is no economic rationale for SOE presence, and those in which the presence of an SOE might potentially bring economic benefits. While the economics literature has analyzed individual sectors to understand market failures, SOE performance, and reform potential, no systematic attempt has been carried out to analyze sectors based on standard industry classifications that are sufficiently disaggregated to resemble specific markets, and thus more appropriate for determining SOEs’ potential impact on market efficiency. The analysis at the level of specific markets is justified on the basis of the industrial organization (IO) literature. The starting point of any competition analysis is the relevant market, which encompasses a product (service) dimension and a geographical dimension. The product dimension

> 1 Although there can be social or political rationale to justify state participation in certain economic activities, this paper only focuses on the efficiency-based rationale of state presence in markets. This is because social or political justifications can be country specific as well as subject to the agenda or preferences of policy makers. To avoid this country specific approach and minimize subjectivity, we base our classification only on efficiency criteria that are based on economic theory and empirical evidence documented in the IO literature.

> 2 Hellman and Kaufman (2001) define state capture as the efforts of firms to shape the “rules of the game” (laws, policies, and regulations of the state) to their own advantage by providing illicit and non-transparent private gains to public officials. In the case of SOEs, these gains take different forms. According to the OECD’s 2017 Survey of anti-corruption and integrity in SOEs, the top ten corruption risks observed in companies with instances of corruption cases include: 1) violations of data protection and privacy, 2) stealing or thefts of goods from the company, 3) fraud, 4) receiving bribes, 5) favoritism (nepotism, cronyism and patronage), 6) non-declaration of conflict of interest, 7) procurement/contract violations (delivering sub-par goods/services, violating contract terms with suppliers), 8) illegal information brokering, 9) receiving kickbacks, and 10) interference in decision-making.

> 3 There are two main waves of research in Industrial Organization. A key focus of the first wave of IO research was empirical industry research. This originated with Bain (1951, 1956) and dominated the 1960s. Much of this early inter-industry literature was concerned with the relationship between market structure, firm conduct, and market performance.IO research at the time shifted from case studies towards an inter-industry approach, as summarized by Schmalensee (1989). The first wave of IO research was later superseded by a second generation of theoretical IO. Tirole (1994) explains that this development was due to the fact that empirical inter-industry research fell short of establishing causal mechanisms. Empirical applications of this second wave are generally sector- and market-specific, not cross-sectoral, recognizing that industries are different and providing new knowledge to regulators to understand market power (Tirole, 2014).

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