Economics 216: The Macroeconomics of Development

1. Economics 216:The Macroeconomics of Development Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Kwoh-Ting Li Professor of Economic Development Department of Economics Stanford University Stanford, CA 94305-6072, U.S.A. Spring 2000-2001 Email: ljlau@stanford.edu; WebPages: http://www.stanford.edu/~ljlau

2. Lecture 12Strategies for Transitionfrom a Planned to a Market Economy Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Kwoh-Ting Li Professor of Economic Development Department of Economics Stanford University Stanford, CA 94305-6072, U.S.A. Spring 2000-2001 Email: ljlau@stanford.edu; WebPages: http://www.stanford.edu/~ljlau

3. The Transition from a Centrally Planned Economy to a Market Economy • The meaning of transition • Replacement of administrative allocation by market allocation • Replacement of administered prices by market prices • Can a transition be achieved without creating losers? Lawrence J. Lau, Stanford University

4. A Centrally Planned Economy • Enterprises and households are assigned rights to and obligations for fixed quantities of commodities at fixed plan prices • The rights and obligations are enterprise- and household-specific • There are governmental sanctions for failure to fulfil the obligations under the plan Lawrence J. Lau, Stanford University

5. The Dual-Track ApproachAdopted in the Chinese Transition (1) • The “Plan Track”--the pre-existing central plan remains and its rights and obligations continue to be enforced by the government • The “Market Track”--all markets are instantaneously open, with prices determined by supply and demand • Producers are given autonomy and incentive to plan their production and participate in the market, provided obligations under the plan are fulfilled • Consumers are completely free to plan their consumption and participate in the market, given allocated consumption goods and fulfillment of labor obligations Lawrence J. Lau, Stanford University

6. The Dual-Track ApproachAdopted in the Chinese Transition (2) • Planned profits and losses (taxes and subsidies) of enterprises remain the same • Differences between plan and market prices make feasible lumpsum transfers • Continued planned consumer goods deliveries enable the maintenance of the pre-reform standard of living as a floor Lawrence J. Lau, Stanford University

7. The Political Economy of the Dual-Track Approach • No one is worse off--“Reform without Losers” • “Grandfathering” of “Vested Interests” • Autonomy and incentive on the margin • Creation of new, reform-oriented “Vested Interests” • Minimizing opposition and maximizing support • But: CAN IT BE EFFICIENT? Lawrence J. Lau, Stanford University

8. A Preview • Theoretical Analysis--under what conditions can the “Dual-Track” approach achieve both efficiency and Pareto-improvement simultaneously? • Partial Equilibrium • General Equilibrium • Empirical Evidence--the Chinese experience Lawrence J. Lau, Stanford University

9. Theoretical Analysis:Partial Equilibrium

10. Two Types of Market Liberalization • Limited Market Liberalization (price PM and quantity QM) • Market resales of plan-allocated goods by either enterprises or households are not permitted • Market purchases by planned suppliers for fulfilling plan-mandated delivery quotas (e.g. sub-contracting) are not permitted • Full Market Liberalization (price PE and quantity QE) • Market resales and market purchases for redelivery are all allowed by a planned supplier or a rationed user, as long as the rights and obligations under the plan are all fulfilled • QP = plan quantity; PP1 = plan price (below PE); and PP2 = plan price (above PE) Lawrence J. Lau, Stanford University

11. Interpretation of the Plan-Allocated Delivery Quotas under Full Market Liberalization • A put option on the part of the planned supplier to sell fixed quantities at the plan price to the rationed users • A call option on the part of the rationed user to buy fixed quantities at the plan price from the planned suppliers • Since both options are exercisable at the same fixed plan price, at most one of the options can have positive value at market equilibrium • These options can be “bought and sold” in lieu of the physical deliveries Lawrence J. Lau, Stanford University

12. Assumptions of the Model • A closed economy • Feasibility of the original plan • Continued enforcement of the plan track • Profit and utility maximization by the economic agents • Full liberalization of the market track Lawrence J. Lau, Stanford University

13. Two Cases • QP, the plan quantity, is less than QE, the market equilibrium quantity • QP, the plan quantity, is greater than QE, the market equilibrium quantity Lawrence J. Lau, Stanford University

14. Efficiency in Demand Rationing and Supply Planning • Efficient demand rationing implies that the rationed goods are allocated to the most deserving users, that is, those whose willingness to pay is the highest (marginal utility or marginal productivity is the highest) • The demand curve is the aggregation of the willingness to pay of the potential users • Efficient supply planning implies that the production is assigned to the most efficient producers, that is, those whose marginal costs are the lowest • The supply curve is the aggregation of the marginal costs of the potential producers Lawrence J. Lau, Stanford University

15. Efficient Rationed Demand andEfficient Planned Supply Lawrence J. Lau, Stanford University

16. Inefficient Rationed Demand andEfficient Planned Supply Lawrence J. Lau, Stanford University

17. Inefficient Rationed Demand and Efficient Planned Supply: Limited Market Liberalization Lawrence J. Lau, Stanford University

18. QP + QM> QE:Over-Production under Limited Liberalization • If PM<PE, then every potential user with a willingness to pay greater than or equal to PE is an actual user • There may be actual users whose willingness to pay is less than PE • Thus, QP + QM> QE • If PM>PE, then every potential supplier with a marginal cost less than or equal to PE is an actual supplier • There may be actual suppliers whose marginal costs are greater than PE • Thus, QP + QM> QE Lawrence J. Lau, Stanford University

19. PM> PE under Efficient Planned Supply • Under efficient planned supply, the actual total supply in the economy will be produced by the suppliers with the lowest marginal costs • Thus, QP + QM> QE implies PM> PE Lawrence J. Lau, Stanford University

20. Efficient Rationed Demand andInefficient Planned Supply Lawrence J. Lau, Stanford University

21. Efficient Rationed Demand and Inefficient Planned Supply: Limited Market Liberalization Lawrence J. Lau, Stanford University

22. QP + QM> QE:Over-Production under Limited Liberalization • If PM<PE, then every potential user with a willingness to pay greater than or equal to PE is an actual user • There may be actual users whose willingness to pay is less than PE • Thus, QP + QM> QE • If PM>PE, then every potential supplier with a marginal cost less than or equal to PE is an actual supplier • There may be actual suppliers whose marginal costs are greater than PE • Thus, QP + QM> QE Lawrence J. Lau, Stanford University

23. PM< PE under Efficient Rationed Demand • Under efficient rationed demand, the actual total demand in the economy will be used by the users with the highest willingness to pay • Thus, QP + QM> QE implies PM< PE Lawrence J. Lau, Stanford University

24. Inefficient Rationed Demand and Inefficient Planned Supply Lawrence J. Lau, Stanford University

25. Inefficient Rationed Demand and Inefficient Planned Supply: Limited Market Liberalization Lawrence J. Lau, Stanford University

26. QP + QM> QE:Over-Production under Limited Liberalization • If PM<PE, then every potential user with a willingness to pay greater than or equal to PE is an actual user • There may be actual users whose willingness to pay is less than PE • Thus, QP + QM> QE • If PM>PE, then every potential supplier with a marginal cost less than or equal to PE is an actual supplier • There may be actual suppliers whose marginal costs are greater than PE • Thus, QP + QM> QE Lawrence J. Lau, Stanford University

27. Plan Quantity < Market Equilibrium Quantity Proposition 1: • (1) The combined output of the plan and market tracks under limited liberalization of the market track is greater than or equal to the fully liberalized market equilibrium quantity; and • (2) The market equilibrium price under limited liberalization is greater (respectively, less) than or equal to the market equilibrium price under full liberalization of the market track if planned supply (respectively, rationed demand) is efficient. Lawrence J. Lau, Stanford University

28. Plan Quantity < Market Equilibrium Quantity Proposition 2: • Independently of the initial conditions concerning the plan price and the degree of efficiency of rationed demand and planned supply: • (1) The dual-track approach with either limited or full liberalization of the market track is Pareto-improving; and • (2) The dual-track approach with full liberalization of the market track achieves full economic efficiency. Lawrence J. Lau, Stanford University

29. Inefficient Rationed Demand and Inefficient Planned Supply:PlanQuantity>MarketQuantity Lawrence J. Lau, Stanford University

30. Inefficient Rationed Demand and Inefficient Planned Supply:PlanQuantity>MarketQuantity Lawrence J. Lau, Stanford University

31. Efficient Rationed Demand and Efficient Plan-ned Supply: Plan Quantity>Market Quantity Lawrence J. Lau, Stanford University

32. Plan Quantity > Market Equilibrium Quantity Proposition 3: • Independently of the initial conditions concerning the plan prices and the degree of efficiency of rationed demand and planned supply: • (1) The dual-track approach with limited or full liberalization is always Pareto-improving; and • (2) The dual-track approach with full liberalization achieves efficiency if the rights and obligations under the plan are enforced in terms of the rents. Lawrence J. Lau, Stanford University

33. Plan Quantity > Market Equilibrium Quantity: Efficiency Achieved through Payment of Rents • If PP1 is less than PE, then all planned suppliers with marginal costs above PE will have an incentive to pay off rationed users with willingness to pay below PE with a payment equal to PE-PP1 • The potential loss to these planned suppliers from physical delivery exceeds PE-PP1 • The potential gain to these rationed users from accepting physical delivery is less than PE-PP1 • Thus, the planned suppliers with marginal cost above PE should try to purchase the call options in the market at price PE-PP1; the rationed users with willingness to pay below PE should try to sell their call options in the market at price PE-PP1 • Both groups are better off then if physical delivery is effected Lawrence J. Lau, Stanford University

34. Feasibility of the Original Plan • (1) The production plan for each producer is feasible; • (2) The consumption plan for each consumer is feasible; • (3) Material balance holds for the economy as a whole; and • (4) The consumption plan for each consumer is affordable at the plan prices. Lawrence J. Lau, Stanford University

35. Continued Enforcement of the Plan Track • No different from contract enforcement in a market economy • Focus of enforcement shifted from total physical production to inter-enterprise deliveries • Pre-existing rents can be protected without the enforcement of physical deliveries • Enforcement against consumers may be difficult • Credibility of state enforcement is crucial Lawrence J. Lau, Stanford University

36. Full Market Liberalization is Necessary for Full Economic Efficiency • Under the “Dual-Track” approach, full market liberalization is necessary at the outset to assure both Pareto-improvement and efficiency • A sequential approach of implementing first limited market liberalization and then full market liberalization does not possess the Pareto-improvement property Lawrence J. Lau, Stanford University

37. Applicability to the Chinese Economy • Feasibility of the original plan • Credibility of continued enforcement • “Contract responsibility system” • Full market liberalization Lawrence J. Lau, Stanford University

38. Theoretical Analysis:General Equilibrium

39. The Model • l goods • m producers with production set Yi • n consumers with consumption set Xj • lth good is leisure; consumers have only leisure endowment Lawrence J. Lau, Stanford University

40. The Status Quo • a national production plan v = (v1, ..., vm) • a national consumption plan c = (c1, ..., cn) • q=(q1, ..., ql) the plan price • An economy under central planning is characterized by (v, c, q) Lawrence J. Lau, Stanford University

41. Feasibility of the Original Plan • (i) The production plan for each producer is feasible • (ii) The consumption plan for each consumer is feasible • (iii) Material balance holds in the aggregate; and • (iv) The consumption plan for each consumer is affordable at the plan prices Lawrence J. Lau, Stanford University

42. The Big-Bang Strategy • The central plan is abolished • All markets are instantaneously open • Producers are completely free to plan their production • Consumers are completely free to plan their consumption Lawrence J. Lau, Stanford University

43. The Openness of All Markets • Both the Big-Bang and the Dual-Track strategies require that all markets are open for economic efficiency • In particular, market resales of plan-allocated inputs and consumption goods, and market purchases of outputs for re-delivery are allowed • There are two prices for each good, PP, the plan price and PE, the market price Lawrence J. Lau, Stanford University

44. Efficiency of a Dual-Track Equilibrium • A Dual-Track Competitive Equilibrium is Efficient Lawrence J. Lau, Stanford University

45. Physical Implementability • What happens if the equilibrium aggregate gross output is less than the plan aggregate gross output for at least one good? • Simultaneous physical delivery then becomes impossible • Recycling through the market with (infinite) subdivisions of the plan period provides a solution Lawrence J. Lau, Stanford University

46. Pareto-Superiority of a Dual-Track Equilibrium • A Dual-Track Competitive Equilibrium is Pareto-Improving, by construction Lawrence J. Lau, Stanford University

47. The Dual-Track Strategy • Combines plan and market • “Contract Responsibility” system • Autonomy and incentive on the margin • Efficiency achieved immediately • Reliance on existing institutions and Information Lawrence J. Lau, Stanford University

48. IsChinese Economic Reform Gradualist? • No! Efficiency is instantaneously achieved as if under a “Big Bang” reform • Efficiency is achieved because both the prices and quantities of goods allocated within the plan are fixed • Chinese economic reform appears gradualist because the population is protected from shock (pain) Lawrence J. Lau, Stanford University

49. The Importance of the Physical Implementability Constraint • A “shortage” economy under the Plan implies that equilibrium aggregate gross output is likely to exceed plan aggregate gross output • Economic growth is also likely to increase the equilibrium aggregate gross output through its effects on the intermediate and consumption demands over time Lawrence J. Lau, Stanford University

50. The Role of State Power • Enforcement of contracts • Credibility of the state, and expectations thereof, affect enterprise (and household) behavior, and hence compliance with the State Plan (post reform) • Multiple equilibria (outcomes) possible, depending on credibility of the state Lawrence J. Lau, Stanford University