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Political Economy of Economic Policy Lecture 4-5 Government institution: Organizational Forms and Incentives Based on Qian and Xu, 1993 and Maskin, Qian and Xu, 2000 Chenggang Xu Copyright @ Chenggang Xu How are governments organized? • Most countries in the world are too large to be ruled by their national governments alone • Regional and local governments are necessary • The relationship between national and sub-national governments has important impacts to incentives • Unitary state – A unitary state has a single ultimate sovereignty, the central government possesses all governmental authority – When delegating political power to regional governments, political power still ultimately rests with the central government • Any decisions they make can be overturned by the central government. – Examples: France, Japan, Britain, Italy, Spain, Indonesia. • Federal state – A federal state has a dual location of sovereignty, with authority divided between central and regional governments – The self-governing status of the regions is typically constitutionally entrenched and may not be altered by a unilateral decision of the central government – Examples: US, Germany, Russia, India, Brazil Fundamental Chinese institution: Regionally decentralized authoritarianism • Highly centralized personal controls – in contrast to a federal system – – – – – Provincial level officials are controlled by the central government Municipality level officials are controlled by their upper provincial governments Nested personnel controls over all lower level regional officials Personal control as incentive instruments for the central government to lead The central government can overrule subnational governments’ decisions • Highly decentralized in resource allocation – in contrast to an unitary state system – Example: land is de jury owned by the national government; de facto owned by subnational governments • Subnational governments run the economy – Most firms are either under direct control or under great influence of subnational governments • Regions (provinces, cities, counties) are relatively self-contained – Provide conditions for regional competition and regional experiments • The fundamental institution has been stable although the degree of decentralization varies over different periods Governance Structure of Chinese Economy Government as bureaucracy • Beyond property rights protection: the role of government – Contain social disorder • Mobilizing resources for development • Continental Europe and Japan in 19th Century • All governments are organized as bureaucracies • Bureaucracies are not restricted to governments (firms, churches, etc) • Centralized economies is an extreme for the role of government – Extreme cases are helpful for understanding Bureaucratic hierarchy Principal Agent 1 Agent 2 Agent 3 Centralized Economy vs. Market Economy • A pure centralized economy – No market – Only bureaucratic coordination • Within state-owned enterprises and between them • A market economy – Within firms: bureaucratic coordination – Between firms and households: market coordination • Transition from a centralized economy to a market economy – To replace bureaucratic coordination between firms by markets • Product markets; labor markets; financial markets; market institutions – Ownership of the firms – Legal protection of the property rights and enforcement of contracts Organizations of centralized economies and firms • A national economy should be organized as a single firm – Lenin (The State and Revolution), before the 1917 revolution • Stalin invited top Western executives of large firms to advise setting up a centrally planned economy, in the 1920s • All other centralized economies copied the Soviet model of central planning system • Importance in analyzing organizational forms – To understand operation of centrally planned economies – To understand transition – To understand firms in market economies Greatest possible role of government: Centralized economies -Under certain conditions, centralized economy help development -Russia created centralized economy in the late 1920s -From one of the poorest in Europe (1920s) to a super power (1950s-80s) - China copied centralized economy from USSR since 1950 -From one of the poorest in the world to a regional power -Under certain conditions centralized economy hinder development -Stagnation in USSR and CEE countries since mid 1970s -Reforms/transitions triggered by those problems -Great differences in reforms: Table: USSR vs. China GDP (million 1990 International Dollars) USSR China 1950 510243 239903 1960 1980 1989 1998 2001 843434 448727 1709174 1046781 2037253 2044100 1124868 3873352 1343230 4569790 Objective of Reforms - Abolishing the vertical relationships between SOEs and the government. - Replacing the bureaucratic inter-firm coordination by market coordination. - How to do it? - In economics, do we know how to create markets from scratch? - Privatization (change of ownerships); Reform/establish financial institutions; Reform/establish legal institutions - Why reforms results are so different in FSU, CEE and in China? Why do performances of reforms in China and in EEFSU so different? - Sharp difference between reform performances: - In 1978-2002 Chinese per capital GDP was increased by 500% In 1989-98 FSU economies per capital GDP was reduced by 50% - Why? - Reform strategy difference: gradual (China) vs. Big bang (EEFSU) - However, China studied gradual reforms in EE - Development stage: backward advantage (China) vs. Overindustrialization (EEFSU) - However, is backwardness always beneficial? Africa? 1800-1950 China? - Current Chinese per capita GDP is similar to that of Russia - not as backward as people might thought Explain performance by organizational forms • Both China and EE-FSU were centrally planned economies • EE-FSU were organised on the principle of functional specialisation - Every SOE was under the control of a specialized ministry (Uform) - Each ministry’s function complements with other ministries’functions. -the Chinese economy was organised into an M-form. -Most SOEs were under the control of regional governments. -Each region is relatively self-contained. Soviet Union (U-form) Central Gov't Steel Ministry SOE AS SOE BS Chemistry Ministry SOE AC SOE BC different organizational forms of centrally planned economies China (M-form) Central Gov't Province A SOE AS SOE AC Province B SOE BS SOE BC Scale Economy & Planning Complexity Firm Sizes: China, EEFSU and the West, 1988 (Employment per Firm) Czechoslovakia The Soviet Union Hungary China Italy 2,930 806 460 145 96 Planning indicators, late 1970s China 760 Always < 1000 Soviet Union 12,000,000 Fundamental institution: Regionally decentralized authoritarianism • Authoritarian regime with decentralized regional economies – Central government controls key factors • Appointment of governors; National law; Mass media; tax rule; plan quota for land use, for environment, etc. – Regional governments run the economy (Wong, 2005; WB, 2002) • More than 99% SOEs are under regional government control • Almost all firms in non state sector are under regional government control (regulation and resource allocation) – Path dependent: the fundamental institution – regionally decentralized authoritarianism – is evolved in history before reform started (Perkins, 1964, 1975, 1977; Granick, 1990; Qian and Xu, 1993; Naughton, 1991, 1995) • First wave of regional decentralization: late 1950s • Second wave of regional decentralization: ‘The Cultural Revolution’ Decentralization: Chinas vs. Other Countries (Wong, 2005) Nations China 2003 Developing Countries 1990s Transition Countries 1990s OECD Countries 1990s Other Large Countries 1990s Sub-National Expenditure/National Expenditure (%) 70 14 26 32 Germany India Japan 40 46 61 Russia USA 38 46 Regional decentralization and Successful earlier reforms • Almost all successful earlier reforms are based on regional experiments, regional competition • Basic reform policy is for regional competition: ‘let some regions become rich first’ • Regional experiments initiated by regional governments – Household responsibility system initiated by Fengyang and promoted to regions nationwide • Regional experiments initiated by the central government and promoted nationwide later – Special economic zones – Fiscal decentralization: started in Jiangsu Impacts of regional decentralization on growth GDP Growth Per capita GDP (10000Yuan) Per capita GDP Growth % 1978 2004 % 9.4% 379 2880 8.1% Jiangsu 12.4% 430 7024 11.3% Zhejiang 13.1% 331 6586 12.2% Guangdong 13.4% 369 6040 11.4% Average of above 12.9% 377 6550 11.6% Liaoning 9.0% 680 5214 8.1% Jilin 9.7% 381 3068 8.4% Helongjiang 7.9% 564 3321 7.1% Average of above 8.8% 542 3868 7.9% National More Regionally Controlled More Centrally Controlled Growth and Regional Decentralization (Lin and Liu, 2000) • It is a reduced form regression model on impacts of major reforms on growth • Fiscal decentralization (FD) significantly affects growth • Regional decentralization based reforms and variables – Household responsibility system (HRS) – The share of non-SOEs' output in the total industrial output (NSOESH) – The growth rate of per capita investment (GI) • Variables with insignificant impacts to growth – Financial strength of a region: Fiscal capacity (FISCAP): 3-year moving average of per capita GDP – Impacts of urbanization and the size of the population on economic growth: The percent of rural population (POPSHR) and the total population (TPOP) – Price liberalization: relative price of farm products to non-farm products (FPMP) Growth and Regional Decentralization (1970 to 1993. Lin and Liu, 2000) Fiscal Decentralization and Non-state Sector Development (Jin, Qian and Weingast, 2005) China vs. FSU-CEE Reforms: With or without Higher Level Competition • Chinese regions are in tough competition – ‘Getting rich first’ as a reform slogan – Regions (provinces, cities) are ranked • FSU ministries/regions were not in competition – Competitions happened only at bottom level – High level officers/managers incentives are more important • Why cannot FSU mimic Chinese practice? • What prevents FSU from competition? Organizational forms affect incentives (1) • Chinese local governments were given greater incentives to introduce reforms than their counterparts in the EEFSU • M-form is better than U-form in providing managerial incentives • managers need incentives and should be awarded conditional on performance. • performance may not be perfectly correlated with managerial effort due to the uncertainty faced by firms. • if a similar region performs well a failing manager is hard to find excuse => it is desirable to make the manager’s reward conditional also on his performance relative to that in other regions. Organizational forms affect incentives (2) • why cannot the same be done in a U-form? • Comparing specialized ministries (U-form) is more difficult than comparing self contained regions (M-form) • e.g. Comparing apples with banans vs comparing a basketof-fruits with another basket-of-fruits. Principal-agent model solution (one agent) • The principle choose incentive scheme t(q(.)) to maximize expected profit: Max E [r(g(e, ε)) - t(g(e, ε))] e, t(.) s.t. e ε argmax E [V(t(g(e', ε)))] - H(e) E[V(t(g(e', ε)))] - H(e) U (IC) (IR) • The solution is: t = T(q). • Var(ε) and/or corr(e, q) => e induced by t. Principal-agent model setup (multi-agents) • Principal's utility: Up(r(q)-t) = i {ri (qi)- ti} • Agent's utility: Ui (ti, ei) = V(ti) - H(ei) • Optimal incentive scheme t(q(.)) Max i E{ri (qi(ei, εi)) – ti(qi(ei, εi))} e, t(.) ei ε argmaxE[V(ti (g(ei', εi)))]-H(ei) e i' E[V(ti (g(ei', εi)))] - H(ei) U (IR) s.t. (IC) Principal-agent model setup (multi-agents) • In general, ti = Ti (qi, qj, qk) • In a linear case, ti = aiqi + ajqj + akqk • ai 0, aj 0, and ak 0, if cov(εi, εj) > 0 , cov(εk, εi ) > 0 , cov(εk, εj) > 0 : agent i competes against agents j and k. • aj = 0, and ak = 0 if cov(εi, εj) = cov(εk, εi ) = cov(εk, εj) =0. • If εi εj and εk are perfectly correlated, a yard-stick competition (rank agents by their relative performance) can serve as a filter for these shocks such that performance can be inferred from output independent from shocks. => achieve first best. • Organization may affect information set εi εj and εk Information and Incentives: Intuition • Hard to compare apples with bananas • Easier to compare one basket of fruits with another basket of fruits • Organisation as a basket of different tasks – U-form (specialisation in tasks): put all apples into one basket and all bananas into another basket – M-form (based on region): mix apples and bananas into baskets Organisational Forms & Incentives(U) U-form Organisation X1A Top Shock Output: , X1B , X2A , X2B Ministry 1 Shock 1 Output: X1A , X1B Plant 1A Shocks 1, A Output: X1A Plant 1B Shocks 1, B Output: X1B Ministry 2 Shock 2 Output: X2A , X2B Plant 2A Shocks 2, A Output: X2A Plant 2B Shocks 2, B Output: X2B Organisational Forms& Incentives(M) M-form Organisation Top Shock Output: X1A , X2A, X1B , X2B Region A Shock A Output: X1A , X2A, Plant 1A Shocks 1, A Output: X1A Plant 2A Shocks 2, A Output: X2A, Region B Shock B Output: X1B , X2B Plant 1B Shocks 1, B Output: X1B Plant 2B Shocks 2, B Output: X2B Basic model • Output of plant ir • The cost of effort e is C(e) where C(0) = 0, and C’(e)>0, C’’(e)>0 • A manager’s utility is U(t) – C(e) – e is unobservable – t is the compensation, which depends on output {xir} • The organizational problem to choose – a set M of managers and – a set of reward schemes for each manager j so as to maximize the expected net output – Subject to IC: e* = argmax E{U(t)-C(e)} – and IR : E{U(t)-C(e)} U Information and Incentives • The general central point: different organizational forms give rise to different information, which determines incentives • The specific central claim: if there is less "variation" in shocks across regions than across industries, the M-form dominates the U-form from the standpoint of incentives U-form Organisation X1A Top Shock Output: , X1B , X2A , X2B Ministry 1 Shock 1 Output: X1A , X1B Plant 1A Shocks 1, A Output: X1A Plant 1B Shocks 1, B Output: X1B Ministry 2 Shock 2 Output: X2A , X2B Plant 2A Shocks 2, A Output: X2A Plant 2B Shocks 2, B Output: X2B M-form Organisation Top Shock Output: X1A , X2A, X1B , X2B Region A Shock A Output: X1A , X2A, Plant 1A Shocks 1, A Output: X1A Plant 2A Shocks 2, A Output: X2A, Region B Shock B Output: X1B , X2B Plant 1B Shocks 1, B Output: X1B Plant 2B Shocks 2, B Output: X2B Top/Bottom Level Managers’ Incentives in M/U-form • Top manager’s reward depends on: – M-form: {X1A , X2A, X1B , X2B} – U-form: {X1A, X1B , X2A , X2B } • Plant 1A manager’s reward depends on: – M-form: {X1A X2A, X1B , X2B } – U-form: {X1A X1B , X2A , X2B } • Plant ir manager’s reward depends on: – {Xir Xjr, Xjs , Xjs }for industries i,j regions r,s Different Level Managers’ Incentives in M/U-form Prop 1: Given any incentive scheme tη(x1A, x2A, x1B, x2B) for the top manager in the M-form, there exists an equivalent scheme tη'(x1A, x2A, x1B, x2B) for the top manager in the U-form and vice versa. Similarly, given any incentive scheme tir for the industry i manager under the region r manager in the M-form, there exists an equivalent scheme tri' for the region r manager under the industry i manager in the U-form, and vice versa. • The same is not true of middle-level managers. • The middle managers’ sphere of control are partitioned differently for M-form and U-form – In the M-form, the region A and B managers affect respectively, whereas – in the U-form, the industry 1 and 2 managers affect respectively. Analyse Middle Level Managers’ Incentives: Information set comparison • Two music CDs (CD1 and CD2) with the same Beethoven Symphony number 9 • One CD is noisier than another – Noisier CD is worse than the other • How to measure: – If add noise to CD1 (by a noise generator) can make CD1 sounds the same as CD2 – CD1 is better than CD2 • The same principle can be used to compare information set for organizations Further simplified model U top X1 X2 xi = ei + εi, i = 1, 2 (ε1, ε2): joint normal distribtn M top XA XB xr = er + εr , r = A, B (εA, εB): joint normal Middle Managers’ Incentives output in industry i: xi = ei + εi, i = 1, 2 ei is the effort of the manager in charge of shock εi output in region r : xr = er + εr , r = A, B er is the effort of the manager in charge of shock εr • (ε1, ε2), (εA, εB) follow joint normal distribution • • • • • σr2 = Var(εr), r=A,B; σAB = Cov(εA, εB); • Conditional variation: Var(εA εB) = σA2 - (σAB)2/σB2 • σi2 = Var(εi), i=1,2; σ12 = Cov(ε1, ε2); • Conditional variation: Var(ε1 ε2) = σ12 - (σ12)2/σ22 • Suppose Var(εA εB) < Var(ε1 ε2) • Managers’ preferences: U(t) - C(e) Can M-form imitate U-form? U top X1 X2 M top XA XB M use information xA , xB, z such that xA - αxB + z = x1 in distribution βxB+γ = x2 in distribution Middle Managers’ Incentives (2) • Fix manager 2’s & manager B’s effort as e' • Set noise generator as – – – – z N[αe' , Var(ε1 ε2) - Var (εA εB)] α = σAB/σB2 - σ12/(σ22σB2)½, β = (σ22/σB2) ½, γ = (1-β)e’ • Show: random variables (x1, x2) and the same distribution: • E(xA - αxB + z) = e - αe' + αe' = e = Ex1 • E(βxB + γ) = βe' + (1-β)e' = e'= Ex2 (xA - αxB + z, βxB+γ) have Middle Managers’ Incentives (3) • Var(βxB + γ) = β2 Var(xB) = σ22 • Cov(xA - αxB +z, βxB +γ) = βσAB2 - αβσB2 = σ122 • Var(xA - αxB + z) = σA2 - 2ασAB + α2σB2 + [Var(ε1 ε2) - Var (εA εB)] = σ1 2 • (x1, x2) = (xA - αxB + z, βxB + γ) in distribution • M-form can imitate U-form by adding noise z • Manager A in M-form can have incentives at least as good as manager 1 in U-form Middle Managers’ Incentives (4) Proposition: If both min { Var (εAεB), Var (εBεA) } < min { Var (ε1ε2), Var (ε2ε1) } and max { Var (εAεB), Var (εBεA) } < max { Var (ε1ε2), Var (ε2ε1) }, then both managers A and B can be given better incentives than manager 1 and 2. Empirical Test • Test the conditional variations • Chinese data: 520 state-owned enterprise from 1986 to 1991 • Compare the Chinese organizational form (M-form) with a hypothetical U-form. – In this U-form, all firms would be organized into hypothetical industrial ministries • Compare conditional variances of regional and industrial shocks under M-form and U-form arrangements. Data and methodology • The data set contains industry classification codes (30 industries) and location codes (20 provinces) for each firm. • Use log-linear Cobb-Douglas production function to estimate industry-specific shocks (θ) and regionspecific shocks (δ). • For every industry i, region r, and period t, dummy variables DitI and DrtR: coefficients as proxies for θ and δ. Regression model • Where, Estimate region and industry shocks • Due to an identification problem, regional and industrial shocks cannot be estimated directly. • By dropping the dummy variables of one region and one industry, and estimate the coefficients of the dummy variables for the remaining regions and industries relative industry-specific and relative region-specific shocks are estimated • : estimated relative shocks by using the shocks in one region and one industry as a benchmark • Take region C and industry 3 as benchmarks. – A time series of relative shocks is obtained from the regressions – Treat the estimated time series as if they were real shocks – Use the estimated time series to calculate conditional variations Comparing Industrial and Regional Variance and Conditional Variance (by Province) Evidence: existence of yardstick competition • Previous evidence suggest China can benefit from yardstick competition • Were yardstick competition actually used in China? • Need evidence on promotions of regional government officials based on relative performance evaluation. • The Chinese political system is still under one-party rule – The representation of a region in the Party Central Committee indicates the status and power of the regional government officials. • A province's representation in the Party's Central Committee is used as a proxy for the promotion chances of officials in that province. – Normalize the representation by using the "per capita number of Central Committee members" as an index • Measure economic performance of a province by its growth rate in "national income" Relative performance index & relative reward index • To investigate how the change of relative ranking in economic performance lead to the change of relative ranking in political power • Region r’s relative economic performance index measures the change in rank in economic performance between 1976 and 1986 • Region r’s relative political reward index measures the change in rank in political position between 1977 and 1987 • The convex third terms in EINDEX and PINDEX: staying at the top requires greater reward than staying at the bottom • Evidence: Exist Regional Yardstick Competition PINDEXr = - 0.453 + 1.76 EINDEXr, R2 = 0.671. (0.246) Further Evidence of Regional Competition Economic Performance v Political Turnover (Li and Zhou, ‘Political Turnover & Personal Control in China,’ JPubE, 2006) • Turnover of top provincial leaders, y – Turnover data in China between 1979 and 1995 • Hypothesis: The probability of promotion for provincial leaders increases with the provincial economic performance – Prob(y) = f(y*) • Suppose central government makes promotion/termination decisions based on a performance score of provincial leaders, y* • Assume y* = xβ + ε, – x: provincial GDP growth rate; ε : follow a normal distribution. Variables affecting promotion • But only turnover of a provincial leader is observable, y = 0 for a termination, if y* ≤ a1 = 1 for remaining at the same level, if a1< y* ≤ a2 = 2 for a promotion, if y* > a2 – Cutoff point 1: for remaining at the same level (or termination) – Cutoff point 2: for promotion (or no promotion) • Promotion may be related to connections with the center. The central connection variable: = 1, for provincial leaders having previous experience or holding joint-appointment in the central government = 0, otherwise. Economic Performance v Provincial Leaders’ Turnover Dependent variable: Prob(turnover) (0=termination, 1=same level, 2=promotion) Caveats • The MQX theory implicitly assumes that the government has a well defined and measurable objective, such as GDP growth rate or attracting FDI – Yardstick competition on that objective can be organized • Yardstick competition may not work – If the government faces multiple tasks and some tasks are not well defined; or – If some tasks are more difficult to be measured than others • The evidence on yardstick competition condition in China is limited – No data on Russia – Its data has only 6 years whereas a formal test requires a much longer time series • The political economy evidence is preliminary – Although the performance is lagged there still exist potential endogeneity problem: – Past political power of a regional government may have long lasting impacts that it may affect future economic performance of the region