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Lecture 6. Partial reforms
Lecture outline
• Problems with partial reforms in general
• Enterprise reform, price reform, labor
market and wage reform, external sector
reform, financial sector reform
• Problems with specific partial reforms
• “Pitfalls of Partial Reforms” paper and
Chinese experience
• Other examples of partial reforms
General problems with partial
reforms
• “Second-best” principle in economics
• In modern economy everything depends
on everything else (very hard to reform in
steps)
• Internal consistency of STE’s (reforming
one thing can cause another to get worse)
• Problem of commitment (partial forms are
relatively easy to undo, and therefore
people do not think they will last)
Enterprise reform
• More independence for managers w.r.t.
what to produce and whom to sell to
• Fewer planning indicators
• Lower targets
• Enterprises are encouraged to enter into
contracts with other state-owned
enterprises and non-state entities
Price reform
• Increased price flexibility (to allow for
stronger price signals)
• Three categories of goods:
- rigidly controlled prices
- prices flexible within certain range
- complete flexibility
(The last two types of prices could be
negotiated between supplier and
customer)
Other reforms
• Wage reform:
more leeway for enterprises to adjust workers’
wages, both relative and the entire wage fund
• External sector reform:
- reduction or even elimination of special
currency exchange rates;
- ability of enterprises to engage in international
trade on their own
• Financial sector reform: two-tiered banking
(central bank & other banks), commercialization
of some banks
Problems with price reform
• If some prices are fixed, it might be a bad
idea to let other prices fluctuate
• Officials still tried to influence prices
• Under state ownership of capital, flexible
prices do not reflect relative scarcities
Problems with enterprise reform
• Planners forced enterprises to produce
beyond lower targets
• Enterprises wanted planned input
allocations
• “Wrong” relative prices
• Enterprises were not allowed to go
bankrupt
Problems with wage reform
• Wage is just another price and so all
problems with partial price reform exist
here too
• Workers exerted pressure on
management to raise wages
• Management did not have strong
incentives to resist nominal wage
increases
Effective price under shortages
If prices are fixed and shortage (i.e. , excess
demand) exists, then other mechanisms
(e.g., queues, black markets) have to be
used to ration available supply. If queues
are used, then the effective price is P =
P0 + wt, where P0 is the fixed price, t is the
time spent in a queue, and w is the value
of the time (implicit wage)
Nominal wage increases and
welfare when prices are fixed
Example: Let demand D=30-10P+I/10 and
supply S=L/5 where P=“effective” price,
I=income, and L=labor (in hours). The
economy has 10 workers, working 8
hours/day.
(1) Let wage/hour, W1=1, then I1=80, P1=2.2
(2) Let W2=2  I2=160 and P2=3
If P0=1 (fixed price), queues would be longer
in (2) than in (1)
Nominal wage increases and
welfare when prices are fixed
Another problem: Let Q=L1/2 and let prices
be fixed at P=1.
Denote wages by w and work hours by L.
Market equilibrium: PQ=wL  L*=(P/w)2
(1) Let w1=1  L1*=P2 and Q1=P=1
(2) Let w2=2  L2*=P2/4 and Q2=1/4<Q1
L2<L1 because of the need to queue up for
goods, which implies Q2<Q1.
Other problems with partial reforms
• Foreign trade liberalization and subsidized
goods
• Growth of informal economy due to
- commitment problems
- wage inflation
- rents from dealing with private firms
- private firms as fronts for informal
activities
Pitfalls of partial reforms
• 1987-8 still controlled prices, but
permission of private firms - cooperatives,
greater discretion over output and
customer choice (suppliers get more
contractual freedom in choice of their
customers)
Pitfalls of partial reforms
Consider:
• Market for timber
• Two uses of timber: box-cars and houses
• Timber is produced in the state sector,
which delivers planned quotas at a price
set by planners below market clearing
price
Pitfalls of partial reforms
Main assumptions
• Demand curves represent the true
marginal valuations of timber
• Producers are on their supply curves and
not forced to produce more
• Initially timber is rationed efficiently, so
that marginal valuations of timber are the
same in both industries
“Pitfalls of Partial Reforms” (initial
efficient rationing)
Partial reform introduces
• The price at which the timber industry can
sell timber to the box-car industry is fixed,
but the price to the housing industry is
freely negotiable
• Timber supplier can sell to whoever offers
a higher price
“Pitfalls of Partial Reforms”
“Pitfalls” (initial inefficient rationing)
Chinese experience
(dual track reforms?)
California electricity market reform
• Deregulation of supply prices (distributors
bought electricity in a spot market)
• No long-term purchase contract allowed
• Caps on retail prices paid by consumers
• When spot market prices exceeded
capped retail prices, distributors lost
money and engaged in non-price rationing
• Distributors went bankrupt, creating
additional problems