Output fall

1. Output fall MA EITEI May 26th, 2009

2. Intro • In early transition accompanied by major output fall • This output falls coincided with price liberalization

4. Intro • Countries with Big Bang price liberalization clear pattern (PL, CZK, SK, RU, UKR) • Hungary gradual price liberalization, yet in 1991 dissolution of CMEA – international trading at world prices started • In RU and UKR ouptut fall already before price liberalization

5. Suggested explanations • Excess fall in aggregate demand due to stabilization policies • Problem: e.g. during biggest output fall, RU did not experience stabilization policies • Fall in aggregate supply – but how did it actually happen? One needs to know the mechanism, such a claim much too simple • Kornai (1993) – price liberalization induced changes in relative prices and contraction not accompanied by expansion

6. Formal models • Calvo and Coricelli (1994) – credit crunch hypothesis – stabilization policies led to high interest rates combined with hardening of budget constraints reduced output • Most likely not the whole story, again case of RU • Labor market frictions resulting from sectoral shifts – happen in other economies as well, also not too strong sectoral shifts directly after liberalization

7. Formal models • Network externalities –Sussman and Zeira (1994), model with new language (technology) replacing the old one • Monopoly behavior of companies after liberalization – Central Planners behaving like vertically integrated monopoly, liberalization led to multiple monopolies charging monopoly prices to downstream industries

8. Ad Monopoly argument • Initially objections the argument valid only for closed economy, international competition forcing competitive behaviour • Also evidence for RU that industry concentration lower than originally believed • Yet low concentration might be consistent with regional (instead of national) monopolies • Hence pro-argument – it takes time invest into new technologies to compete on less narrow markets, until then, monopolies might indeed be present

9. Disorganization effects of liberalization • Do not assume pre-existence of markets or their instantaneous creation • Helps understand how new markets emerge • Traditional models not appropriate – assume institutional basis, communication channels, information network already exist

10. Ad Disorganization effects • 2 models presented (both in Economics of Transition, Chapter 8, by Gerard Roland) • Model with inefficient bargaining and complementarities • Model with costly search and asset specificity

11. Ad Inefficient bargaining and complementarities • Liberalization induces disorganization of existing production links due to inefficient bargaining • Inefficient bargaining in turn due to lacking contracting institutions • In case these institutions were present, present production links would keep existing • Disorganization of production links accompanied by output fall

12. Blanchard and Kremer (1997) • Assume SOE needs n inputs to produce n outputs • Strong complementarities -> if even 1 input is missing, zero output • Each input provided by single supplier having alternative use of input for h • Suppliers distributed uniformly on [0,h*] with c.d.f. such that F(0)=0 and F(h*)=1 • h private information of supplier

13. Taske-it-or-leave offer given to each supplier of a price p by SOE • All suppliers identical ex ante, i.e. all offered the same price • If p=h*, production takes place for sure, suppliers getting rents h*-h • Yet if h*>1, net profits of SOE are n(1-h*)<0

14. Hence SOE might prefer to trade-off lower offer of p (and higher expected profits) against positive probability of disruption • Outcome – total output a function of h* and n • For intermediate values of h* output fall • The output fall happens due to ineficient bargaining • If efficient, in principle possible to pay to those having p<h compensation by others having p>h • In such a case joint surplus wuld have been higher – suppliers i with p<h(i) would have p+ε(i)=h(i), suppliers i with p>h(i) would have p-µ>h(i)

15. Changes in n (number of suppliers) • Also as n increases output falls more pronounced • Extreme case as n -> infinity, p->1 and see the figure

16. Interpretation of n • Captures complexity of production • Ceteris paribus the higher the complexity, the higher the output fall -> less developed countries should experience lower output fall (China)

17. Remember two key assumptions • Asymmetric information (and resulting inefficient bargaining) • SOE might possibly contract the outside option upon verification plus ε, which benefits supplier • Yet verification difficult, especially when legal system weak and underdeveloped • This was likely the case of transition economies right after price liberalization • Technological complementarities

18. Search frictions and specific investment • Roland and Verdier (1999a) • Inefficient bargaining not necessary for output fall • Liberalization means freedom of contracting • Price theory in this context not appropriate • Contract theory more convenient

19. Contrary to common job search models, existing production links are preserved during search • When a new match is found, existing production links break up

20. Key assumption – investment into relationship is relationship-specific • Specific investments severe the hold-up problem and reduce the ex-ante willingness to enter a relationship • Hence these investments are done only after a new long-term partner has been found

21. In other words, if agent plans to search one more period, it is not profitable for her to invest while searching • here output fall due to failure of enterprises to replace obsolete capital and a fall in investment demand

22. Main story of the model • agents searching at least one more period will not invest • Aggregate output might fall as a result due to fall in investment demand • Note capital market imperfections a la Calvo and Coricelli (1994) not needed as well as bargaining inefficiencies

23. Assumptions • Two sectors – consumption and investment goods sector • Endogenized outside options – two-sided matching n • In consumption sector, output depends on match quality • No search before liberalization • Random matching of H types • Relationship-specific investment – zero value if match splits + match has to be long-term for investment to be profitable • 2 periods assumed only

24. All search equilibrium • All agents search in period 1 and all agents search in period 2 except of H types that already formed HH pairs • For model solution see handouts

25. Ad negative externalities of the model -> lack of investment given search efforts (individually it is always better to search for H type) AND specificity • If no investment specificity (e.g. no investment necessary at all) -> socially costless search (present production preserved)

26. Evidence on Blanchard and Kremer (1997) • Konings and Walsh (1999) • 300 Ukrainian firms • Complexity of production (measured by # of major products produced) matters, but only for traditional firms and not for de novo firms