A Tale of Two Reforms

Abstract

The paper identifies the absence of well-functioning product markets in transition economies as a sufficient initial condition under which big bang, a radical reform, reduces output initially, while a Chinese-style reform increases output. Under central planning, the state integrates monopolistic state enterprises. Big bang dismantles central planning and liberalizes prices. In this decentralized environment, imperfect competition in the presence of roundabout production linkages creates pecuniary externalities in the sense that a price increase by one enterprise raises other enterprises' costs and reduces their demands. Each individual enterprise maximizing its own profits doesn't take into account the externalities and therefore tends to take actions that lead to lower output in a short-run Nash equilibrium. The Chinese reform regulates enterprises intramarginally by forcing them to fulfill planned output quotas at planned prices, and liberalizes only marginally by allowing them to sell above-the-quota outputs at market prices. While the intramarginal regulation reduces the deleterious effects of the externalities, the marginal liberalization encourages enterprises to produce beyond the quotas, leading to an output expansion in the short run.

JEL Classification: P21, L11, D57