A Tale of Two Reforms

I present a unified theoretical framework that attributes output collapse to price liberalization and decentralization of the formerly integrated monopolistic industrial structure in the former Soviet bloc, and output expansion in China to marginal marketization and intramarginal regulation. In the model economy, all industries are interdependent in that they rely on each other for intermediate inputs. This circular dependence in the presence of imperfect competition creates a pecuniary externality in the sense that a price increase or an output reduction by one industry raises other industries' costs and reduces their intermediate demands. Under central planning, the industries are fully integrated, allowing the state to internalize the externality. Big bang reform decentralizes the state monopolized industrial structure. Price or quantity competition among decentralized, concentrated, and circularly dependent industries leads, in a Nash equilibrium, to reduced output, lower profits, and higher prices. The controlled reform in China, however, 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 effect of the externality, the marginal liberalization encourages enterprises to produce beyond the quotas. Enterprise-level panel data from China are used to test the theory.