Abstract
A model of a socialist economy is presented, incorporating bargaining over wages and employment in the socialized sector and shortages that are reflected in the black market. The model is used to analyze the implications of liberalization policies, including trade liberalization, an administered price increase, and provisions allowing for increased direct foreign investment. The results suggest that reforms may have different effects under different trade regimes, that small price reforms may have perverse effects, and that foreign investment in a shortage economy may be immiserizing. [JEL P21, P31, P33]
A model of a socialist economy is presented, incorporating bargaining over wages and employment in the socialized sector and shortages that are reflected in the black market. The model is used to analyze the implications of liberalization policies, including trade liberalization, an administered price increase, and provisions allowing for increased direct foreign investment. The results suggest that reforms may have different effects under different trade regimes, that small price reforms may have perverse effects, and that foreign investment in a shortage economy may be immiserizing. [JEL P21, P31, P33]
The economic transformation currently being undertaken by many countries in Eastern Europe, and initiated in the former Soviet Union, is often portrayed as a “leap to the market” (see, for example, Sachs (1990)). It is widely recognized, however, that this metaphor exaggerates the speed with which a switch to a full-fledged market economy can be made—building new institutions simply takes time. In many countries, including Hungary, Poland, and Yugoslavia in the 1980s, and the former Soviet Union in the early 1990s, reforms have been undertaken gradually, while the basic structures of a socialist economy have been preserved. As a result, in the interim there has existed a situation of “neither plan nor market,” in which no central economic plan is implemented but in which the state continues nominally to own a substantial part of state enterprises. A reforming socialist economy may also have a substantial nonsocialized sector, consisting of industries that were never nationalized to begin with, newly established private firms, and, in some cases, privatized formerly state-owned enterprises.1 The aim of this paper is to develop a model of such a reforming socialist economy and to explore the consequences of market-oriented policies in the context of such an economy.
In a reforming socialist economy the employees often dominate the enterprises’ management through worker-led enterprise councils; workers in such labor-dominated enterprises thus implicitly have some property rights over the enterprise that employs them. Despite the absence (or irrelevance) of a central plan, the state frequently continues to influence enterprises’ wage, employment, and output decisions through a variety of other channels. The vagueness of property rights over the state enterprise, together with the soft budget constraints that arise from the state’s propensity to tax away exceptional profits while accommodating any losses through subsidies and easy credit, as well as the substantial domestic market power enjoyed by many state enterprises, implies that the enterprise’s wage and employment decisions may be the outcome of bargaining between the government and the enterprise’s employees over their shares of the enterprise’s earnings. In most socialist economies, moreover, the importance of this bargaining is enhanced by the fact that the state enterprises are the primary source of revenues for the state budget (Tanzi (1991) and Lane and Dinopoulos (1991)).2
A transitional socialist economy may also be characterized by shortages. The government may continue to exert an influence over prices, and price controls may be associated with shortages, queues, and black market activity. In many socialist economies, the shadow economy is highly developed, A convenient, and probably not unrealistic, assumption is that black market activity exhausts the rents associated with the controlled price (see, for example, Barzel (1974) and Lipton and Sachs (1990)).
In this paper a model that combines these features of a socialist economy is presented in Section I, and the equilibrium of the model is characterized in Section II. In Section III the model is used to analyze the consequences of price reform and trade liberalization. Section IV explores the implications of permitting an increase in foreign direct investment. Section V offers conclusions.
I. A Model of a Reforming Socialist Economy
The simple model of a reforming socialist economy presented here is static and thus disregards the role of expectations and adjustment in the reform process. The labor market is central to the analysis; we examine the structure of wages and the allocation of labor between the socialized and nonsocialized sectors and the shadow economy or black market.
We assume that output in each sector uses labor and sector-specific capital. This assumption seems particularly appropriate, not only because of central allocation of capital, but especially because of the absence of well-functioning capital markets in socialist economies, which may limit the mobility of capital across sectors.
The socialized sector consists of a state enterprise. As discussed above, the wage, output, and employment decisions of the state enterprise are viewed as the outcome of bargaining between the enterprise’s management (dominated by its employees) and the state, which is the enterprise’s nominal owner. It sells its output at a price that is administratively fixed below the market-clearing level, which gives rise to excess demand. In this model the shortage is associated with a relative price imbalance, not an aggregate liquidity overhang. This assumption is made largely for the convenience of using a “real” model, but is also consistent with evidence adduced by Portes (1989) and others, which has cast doubt on the empirical relevance of a liquidity overhang as an explanation of shortages. The difference between official and market-clearing prices for socialized sector output gives rise to black market activity, which we model as directly unproductive profit-seeking (DUP) activity (Bhagwati (1982)). We assume that the rationing mechanism consists of queues formed by arbitrageurs who buy output at the official price and sell it at the black market price. Workers who cannot find a job either in the private sector or in the socialized sector become arbitrageurs; this implies that the income received by those engaging in black market activity (the “black market wage”) is the reservation wage.
The nonsocialized sector is perfectly competitive and produces an output that is different from that of the socialized sector. It has a neoclassical production function using a sector-specific input (say, capital) and labor.
The trade regime is modeled by assuming that the economy exports the good produced in the nonsocialized sector and imports the socialized sector good,3 The latter is subject to either a binding quantitative restriction or a tariff, such that the domestic market-clearing price exceeds both the world price and administered domestic price.
The next three subsections introduce the state enterprise, the black market, and the private sector, respectively.
The Socialized Sector
The model of this sector is similar to that presented in Lane and Dinopoulos (1991). It is modeled as a labor-dominated firm whose objectives can be represented by a utility function that depends positively on the employment level and on the difference between the wage in the socialized sector and the workers’ reservation wage. We adopt a modifiedt one-Geary form for this utility function:4
where wx is the wage in the socialized sector; Lx is the employment level in the socialized sector; and wb is the reservation wage—that is, the income that may be earned by queuing for scarce goods, which are then resold at black market prices. The parameters θ and γ correspond to the excess wage and employment elasticities of U (.); we will use the term “wage (employment) oriented” if θ > γ (θ < γ); the intermediate case, in which θ = γ = 1, corresponds to maximization of excess labor income. For the sake of clarity, we will assume, unless stated otherwise, that the state enterprise is employment oriented.
Output is produced through a neoclassical production function:
where Kx is sector-specific capital, which is assumed to be fixed.5
The state enterprise is owned by the government, which is interested in maximizing total tax revenues collected from the enterprise. This formulation of the government’s objective is designed to capture the heavy dependence of government revenues on enterprise taxation, as discussed earlier. These tax revenues are equivalent to the enterprise’s profits:
where Px is the official price; rx is the opportunity cost of the governments’s capital, Kx; and wx is the wage in the socialized sector. All prices are expressed in units of the good produced in the nonsocialized sector, which is assumed to be the exportable.
The labor-dominated firm and the government bargain over the wage, wx, and employment, Lx, taking the centrally controlled price. Px, and the reservation wage as given. This is intended to capture the extensive bargaining over wages, taxes, and other aspects of enterprises’ decisions that characterizes reformed socialist economies. The fixed official price, Px, is consistent with the observation that many relative prices in socialist economies have been historically fixed below market-clearing levels. Bargaining is assumed to follow the generalized Nash bargaining model. The Nash solution is obtained by maximizing the generalized Nash product:
where 0 ≤ α ≤ 1 is a parameter capturing the relative bargaining power of the enterprise vis-à-vis the government. The threat points of the bargaining game correspond to a possible shutdown of production; this would imply that Lx would be zero, so that the government’s revenues would be –rxKx (because Kx is fixed), and the utility of the enterprise would be zero. The Nash bargaining solution implies, however, that agreement is reached at an efficient combination of wage and employment, so that these threats are not realized.
Maximizing H(.) with respect to the negotiated wage, wx, and employment, Lx, we obtain the following first-order conditions:6
These two equations determine the negotiated wage and employment in the socialized sector for a given price level, Px, and black market wage, wb. These conditions may further be expressed as follows:
where λ = α γ/(1 – α + α γ) with 0 ≤ λ ≤ 1. Equation (6a) defines the contract curve (CC) and expresses the negotiated wage, wx, as a function of employment in the socialized sector. The CC is the locus of tangencies between the state enterprise indifference curves and the isotax-revenue contours.7 The CC passes through the intersection of a wage line, wx = wb, and the value of the marginal product of labor, PxF1(Lx). The slope of the CC has the same sign as γ – θ: if the firm is employment oriented, the CC is positively sloped; if the firm is wage oriented the CC is negatively sloped; and if the firm cares equally for wages and employment, seeking to maximize its employees’ total excess wage income, the CC is vertical.
Equation (6b) defines the Nash bargaining curve (NBC) in wage-employment space. It is downward sloping and expresses the negotiated wage, wx, as a convex combination of sales revenue per worker, PxF(Lx)/Lx, and the value of the marginal product of labor, PxF1(Lx). The coefficient, λ, increases in the bargaining power of the firm, a. The NBC determines the fraction of labor-negotiated compensation for each level of employment.
Figure 1 illustrates the determination of the negotiated wage, wx, and employment, Lx, in the socialized sector, for a fixed price, Px, and reservation wage, wb. The top panel shows the case of an employment-oriented firm, and the bottom panel depicts that of a wage-oriented firm. The intersection at point E of the contract curve, CC, and the Nash bargaining curve, NBC, determines the negotiated wage, wx*, and the level of employment, Lx*. Figure 1 also depicts a typical isotax curve,
Wage and Employment Determination in the Socialized Sector
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Wage and Employment Determination in the Socialized Sector
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Wage and Employment Determination in the Socialized Sector
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
In Figure 1, total revenue of the state enterprise, PxF(Lx*), equals the area OLx*AG. This revenue is divided between the workers, who get
A useful comparative statics exercise is to trace the effects of an increase in the reservation wage, wb. It is obvious from Figure 1 that an increase in wb, reduces employment and output and increases the negotiated wage. It can be shown that the negotiated wage increases by less than the reservation wage, and the excess wage in the socialized sector is consequently a decreasing function of the reservation wage.
By eliminating the negotiated wage from equations (6a) and (6b), we can express the relationship between the reservation wage, wb, and the negotiated employment level, Lx:
where β = (γ – θ)α/(1 – α + α γ). Equation (7) can be thought of as the inverse demand for labor curve for the socialized sector (expressed as a function of the reservation wage, rather than the actual wage, which is negotiated simultaneously with employment). Notice that equation (7) implies that if the state enterprise does not have any bargaining power, (α = 0), then wb = PxF1(Lx, Kx); that is, the reservation wage equals the value of marginal product of labor. In general, equation (7) defines a downward-sloping curve in wage employment space, which will be used later to determine graphically the intersectoral allocation of labor.
The Nonsocialized Sector
In contrast to the socialized sector, the private sector is characterized by competition. The technology of the nonsocialized sector is described by a neoclassical production function:
where Lz is total labor used in the sector, and Kz is the sector-specific capital. A worker fired from the nonsocialized sector can enter the black market and earn the reservation wage, wb; thus the wage in the nonsocialized sector equals the reservation wage, wb8
The representative firm in the nonsocialized sector maximizes profits with respect to employment, Lz, given the reservation wage, wb. The first-order conditions for profit maximization imply the familiar result that the wage equals the marginal product of labor:
The result is that both employment and output in the nonsocialized sector are decreasing functions of the reservation wage.
Supply Shortage and Queues
We assume that at the official price, Px, there is an excess demand for good X, which needs to be rationed. We consider a very simple rationing mechanism that consists of waiting lines outside the official stores. In principle, the queue may consist of employed consumers, as well as professional middlemen who queue to purchase goods at the official price and resell at the black market price, Pb. In our model all queuing is done by persons who are otherwise unemployed and who queue for goods for purchase and resale. The conditions under which this would occur are characterized in the Appendix.
Black market services do not enter directly into either sector’s production function or into the social welfare function; this implies that queuing is modeled as a DUP activity, as characterized by Krueger (1974), Bhagwati and Srinivasan (1980), and others. We assume (as in Dinopoulos (1984)) that black market activity uses only labor and is characterized by constant returns to scale. We assume that all goods sold in the black market are produced in the socialized sector, and that all goods produced in the socialized sector are sold through the black market.
Free entry into the black market, together with the linerarity of the queuing technology, then implies the following zero-profit condition:
where Pb – Px is the difference between the black market and the official price, wb is the black market wage, and Lb is the amount of labor in the sector. Condition (10) simply states that net revenues from selling X units in the black market are equal to total labor costs.
Consumer Tastes and International Trade
We close the model by describing the behavior of consumers and the trade regime that determine the black market price, Pb. The black market price establishes equilibrium in the black market, and thus, by Walras’s law, clears the market for both goods. The price of imported goods must also equal Pb; with a quota, this occurs through an adjustment of the price, while with a tariff it results from an adjustment of the quantity of imports consistent with maintaining the black market price at the world price plus the tariff.
All consumers in the economy are identical and their tastes are represented by the following utility function:
where Dx and Dz are quantities consumed of the two goods, and l is leisure. The utility function, V(.), is increasing and concave in its three arguments, and separable in leisure. The function is assumed to be homothetic in Dx and Dz; and the marginal utility of leisure is positive and decreases in leisure (that is, ∂Φ/∂ l > 0, ∂2Φ/∂ l2 < 0).
The pattern of trade of this small open economy is, for analytical convenience, assumed to be such that the socialized sector imports and the private sector exports. Denoting with Px* the world relative price of the importable, the balanced trade condition is
where Qx is the quantity of imports of the good produced in the socialized sector, and Qz is the quantity of exports of the good produced by the nonsocialized sector. Under free trade, the black market price, Pb, and the official price, Px, must both be less than or equal to the international price,
II. Equilibrium in a Shortage Economy
In this section we analyze the equilibrium of the model. To determine the intersectoral labor allocation, we first need to express the amount of labor devoted to queuing as a function of the reservation wage, wb. The utility function, V(.), implies that the black market price, Pb, is a decreasing function of the ratio DX/Dz, because tastes are assumed to be homothetic. We can therefore write
where Dx = X + Qx is the consumption of the importable, and
where
and
Substituting (14) into the zero-profit condition (10), the amount of labor devoted to black market activity, Lb, can be expressed as a function of the reservation wage, wb, for any given quota level, Qx:
Labor employed in the black market, Lb, is thus not necessarily a monotonic function of wb over the relevant range. For instance, if there exists a reservation wage,
Intersectoral Labor Allocation Under a Quota
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Intersectoral Labor Allocation Under a Quota
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Intersectoral Labor Allocation Under a Quota
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Figure 2 shows the intersectoral allocation of labor and the determination of the reservation wage in a reforming socialist economy. The length of the horizontal segment, OxOz, measures the total endowment of labor in the economy,
Multiple Equilibria Under a Quota
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Multiple Equilibria Under a Quota
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Multiple Equilibria Under a Quota
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
The fact that the labor employed in the socialized sector and the black market may not be a monotonie function of the reservation wage introduces the possibility of multiple equilibria. Figure 3 shows the case of two equilibria, one of which involves a lower level of output for both sectors, a higher reservation wage, a higher level of black market employment, and a higher black market price than the other; this “bad” equilibrium, which is associated with point A, however, turns out to be stable, and the other one, which corresponds to point A’, is unstable.10
Once the reservation wage and the interseetoral labor allocation are determined, the remaining endogenous variables in the model are determined. In addition to the reservation wage, the labor market is characterized by sectoral wage differentials; the negotiated wage in the socialized sector, wx, exceeds the reservation wage, wb, because the socialized sector excess wage (wx – wb) is an argument in the enterprise’s utility function.11
III. Market Liberalization Policies
Market-oriented reform, beginning with the liberalization of trade and the adjustment of administered prices, has been particularly important in socialist economies in recent years.12 The model that has been developed in Sections I and II can readily be used to analyze the effects of two major types of market liberalization policy: liberalizing trade flows, and moving administered prices toward levels that would clear domestic markets. Both of these policies would alter the allocation of labor across the different sectors of the economy, including the resources devoted to DUP activity in the black market. They would also affect the structure of wages. The implications of each of these aspects of liberalization will be examined in turn.
Trade Liberalization
In the analysis so far, it has been assumed that trade is restricted to protect the socialized sector from import competition; since this is also the sector whose output is subject to a shortage, liberalizing trade would alleviate the shortage and thus reduce the distortionary effect of the DUP activity that arises in connection with this shortage.
Trade enters the model through the market for the socialized sector good in a way that depends on the instrument used to establish protection. We will start by discussing the implication of trade liberalization when the trade restriction takes the form of a quota.13
The implications of liberalizing an import quota are explored graphically in Figure 4, which depicts the effects of an increase in the fixed quota level, Qx. Equations (7) and (9) imply that the Lx and Lz curves remain unchanged. An increase in Qx reduces the black market price, Pb, and the black market employment, Lb, at each wage level, wb. Thus, the Lb curve shifts to the left, and so does the Lx + Lb curve. The new equilibrium is determined by point A’, which implies a lower reservation wage, w’b. The amount of labor devoted to the black market sector, Lb, decreases from
Trade Liberalization Under a Quota Regime
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Trade Liberalization Under a Quota Regime
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Trade Liberalization Under a Quota Regime
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
The analysis in the previous section allows us to follow the changes in the rest of the endogenous variables of the model. The discussion in Section I implies that a reduction in wb increases output, Z, and employment, Lz, in the nonsocialized sector.
The socialized sector’s response to trade liberalization reflects the special structural elements of the model. The increase in employment results in an increase in output, X, because the official price, Px, is fixed. In addition, the reduction in the reservation wage lowers the negotiated wage, wx, by less than the reduction in wb. Consequently, the wage differential, wx – wb, increases. Higher output and a lower negotiated wage imply that the tax revenues from the state enterprise increase. Finally, note that shortages are reduced because an increase in imports and domestic production reduces the black market price and the profitability of DUP activities.
Is the small reforming socialist economy better off as a result of trade liberalization? In this simple framework, since consumption of the two goods, X and Z, both increase, the answer is yes.
The effects of trade liberalization under a tariff regime are qualitatively the same as those resulting from an increase in the quota. Consider Figure 5, which illustrates the employment effects of a reduction in an ad valorem tariff, τ. The black market price is
Trade Liberalization Under a Tariff Regime
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Trade Liberalization Under a Tariff Regime
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Trade Liberalization Under a Tariff Regime
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
so that the amount of labor employed in the black market is a monotonically decreasing function of the reservation wage.14 Figure 5 shows the initial equilibrium, which is given by the intersection of curves Lx + Lb and Lz at point A, Trade liberalization in the form of a tariff reduction lowers black market employment, Lb, for every level of the reservation wage, wb, and results in a leftward rotation of curve
These results, which predict that trade liberalization—be it a reduction of a tariff or an increase in a quota—leads to an expansion of both sectors, appears counterfactual in the light of recent experience in Central and Eastern Europe. In Poland and in east Germany, to give two examples, trade liberalization was followed by a sharp decline in output of the socialist sector. This is not inconsistent with the model, however; the results presented in this section are local ones, pertaining to a small liberalization of trade in the presence of shortages. Once trade liberalization brings the market price down to the point at which Pb = Px, the shortage is eliminated, and the model reverts to the standard sector-specific model: any further liberalization leads to a decline in output and employment in the socialized sector—as has been observed in Poland and east Germany.
Price Reform
Adjustments of administered prices and price liberalization have played an important part in reforming socialist economies. In some cases prices have simply been freed and allowed to adjust to market-clearing levels.15 In other cases the authorities have adjusted administered prices while maintaining some degree of control or restriction over these prices.16
Price reforms have typically been undertaken for several purposes: to alleviate shortages associated with queues, to correct relative price imbalances that lead to a less efficient allocation of resources, and to eliminate or reduce commodity subsidies. The model that has been developed in this paper permits an analysis of all these issues: the effects of price adjustments on the queues, on government revenues, on output in the two sectors, and on real wages.
Consider the effect of a small increase in the administered price of the good produced in the socialized sector. Px. This increase will, in general, induce the state enterprise to expand its output for a given reservation wage. The reservation wage will also change, however, since price liberalization affects the black market in four ways. First, the rise in administered price squeezes the margin between the official and black market price (Pb – Px), tending to lower black market revenues. Second, the rise in output of good X increases the volume of sales on which the black marketeers earn this margin. Third, if imports are limited by a quota, the increased output of good X depresses that good’s price in the black market, Pb; under a tariff, increased domestic output is reflected in a pari passu reduction in imports. Fourth, labor absorbed by the socialized sector may come from the black market. The net effect on the reservation wage is
where
Here, we make use of the following elasticities:
and
the inverse elasticities of labor demand in the socialized and nonsocialized sectors, respectively, and
the inverse elasticity of demand in the black market.17 The determinant, A, can be signed using the stability condition: it is positive if and only if the initial equilibrium is stable (which implies that an increase in the reservation wage generates an excess supply of labor in the economy),18
The overall expression given in equation (17) is ambiguous in sign. It is unambiguously negative when prices are close to their equilibrium levels, since then wb and (Pb – Px) are close to zero, leaving the two negative terms: –PbϵF1Lx/Pxηx, reflecting the effect of additional output in depressing the black market price; and – X, reflecting the direct effect of price adjustment in reducing the black market’s buy-sell spread. Price reform is more likely to lower the reservation wage under a quota than under a tariff, since under a quota, ϵ > 0, and price reform lowers the black market price; under a tariff, ϵ = 0, so price reform leaves the black market price unaffected.
The ambiguity of the effect of price reform on the reservation wage is mirrored in the ambiguities of its effects on the labor force devoted to black market activity:
Expression (19) has four terms. The first three are positive in sign, while the fourth is ambiguous, making the whole expression ambiguous. The fourth term again reflects the mutually opposing effects of increased output being channeled through the black market but at a reduced price. When the official price is close to its equilibrium level, the expression is unambiguously negative, indicating that adjusting official prices reduces the distortion due to shortages—that is, reduces the labor that is “wasted” in the black market. But when prices are far from market-clearing levels, one cannot rule out the possibility that a small price adjustment would actually increase the impact of the shortages—that is increase the amount of black market activity.19 However, as can be seen by comparing equations (17) and (19), the conditions required for black market employment to increase are more restrictive than those needed for the black market wage to rise.
The change in the reservation wage affects the level of employment in both the socialized and nonsocialized sectors. In the nonsocialized sector the result is
The sign of (20) is the same as that of ∂wb/∂Px. Thus, if price reform lowers the reservation wage, it allows an expansion of employment in the nonsocialized sector, and conversely, if it raises the reservation wage it squeezes employment in the nonsocialized sector.
The effect of a price increase on state enterprise employment is the following:
Thus, even if price liberalization raises the reservation wage, the direct effect of the official price increase dominates: the level of employment and output in the socialized sector increases. The intuition for this result is simply that any rise in the reservation wage in general equilibrium itself depends, through equation (17), on a rise in output of good X: this rise in the reservation wage cannot then itself be associated with a decline in output (assuming, as always, that the initial equilibrium is stable).
Let us now put the picture together. Price reform has two possible results. If the initial price distortion is small, an increase in the administered price reduces both the reservation wage and the labor force employed in the black market. In this case there is an expansion of output and employment in both productive sectors, and an increase in national income evaluated at world prices.
However, if the initial price distortion is large, an alternative result is possible. Because the increased output of the socialized sector increases the volume of black market sales on which traders earn the spread (Pb – Px), the income of black market participants—that is, the reservation wage—actually increases; the number of participants in the black market may even increase. In this case, although the price adjustment increases the output of the good that is in short supply, it does so at least partly at the expense of output of the other good; the higher reservation wage resulting from the improved black market opportunities reduces employment and output in the nonsocialized sector. In the case in which ∂Lb/∂Px > 0, a small administered price adjustment actually increases the resources “wasted” on queuing; national income evaluated at world prices may actually fall.
The moral of this story is that small administered price increases are only appropriate if the initial distortion is small. If the distortions are large—as in many of the Eastern European countries before the reforms of 1990,20 and more recently in the states of the former Soviet Union—a small price adjustment may even draw more labor out of the productive sectors into the black market.21 This argument strengthens the case for a “big bang” price adjustment, which allows prices to adjust immediately to their market-clearing levels and thus immediately eliminates the associated black market activity.
IV. Direct Foreign Investment
Direct foreign investment is widely believed to have an important role to play in accelerating the market-oriented restructuring of Eastern European countries and the former Soviet Union. Capital flows are typically limited by restrictions on the repatriation of investment income, and the liberalization of such restrictions is an important aspect of market-oriented reform. Capital inflows are viewed both as a way of augmenting these economies’ productive resources and as vehicles of technology transfer. In this section we will focus on the former consideration, examining the impact of direct foreign investment whose productivity is the same as that of the existing sector-specific capital of a reforming socialist economy.
In practice, direct foreign investment has in most cases entered the socialized sector in the form of joint ventures between Western corporations and state enterprises. Other direct foreign investment has taken the form of purchase of shares of privatized enterprises or the establishment of new facilities, and encouraging this type of foreign investment is often regarded as a desirable aim of policy. Joint ventures typically involve a complex set of bargaining rounds between investors and host government, which is beyond the scope of this paper; we will therefore focus on examining the effect of a small inflow of direct foreign investment to the nonsocialized sector. As is common in the literature on direct foreign investment, we ignore the transitory effect of the inflow itself on the balance of payments; this is dictated by the static nature of the model.
Figure 6 shows the employment effects of an inflow, K*, of foreign capital into the nonsocialized sector under a tariff regime. An increase in capital increases employment, Lz, at every level of the wage, wb. Curve Lz shifts upward, and the equilibrium shifts along curve Lx + Lb, from point A to point A’. Note that curves Lx and Lx + Lb do not depend on Kz and do not shift. The new equilibrium is associated with a higher reservation wage, higher employment in sector Z, and lower employment levels in the black market and the socialized sector. Finally, because direct foreign investment lowers the marginal product of capital, it reduces rz, the rental rate of (sector-specific) capital, for a given level of the reservation wage.
Effects of Direct Foreign Investment in the Nonsocialized Sector Under a Tariff
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Effects of Direct Foreign Investment in the Nonsocialized Sector Under a Tariff
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Effects of Direct Foreign Investment in the Nonsocialized Sector Under a Tariff
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
The increase in the reservation wage induced by direct foreign investment reduces employment and output in the socialized sector. The negotiated wage increases but the wage differential in the socialized sector decreases. The increase in the negotiated wage, coupled with the output decrease, reduces the tax revenue for the state enterprise. Because the black market price is fixed (due to the tariff regime), imports, exports, and tariff revenues increase. The increase in the reservation wage results in a reduction in black market activity. Many arbitrageurs move to the nonsocialized sector, and shortages are reduced because the supply of imports increases.
The influx of direct foreign investment into the nonsocialized sector increases the economy’s national income evaluated at world (and domestic) prices. To see this result, define the index of national income as
where Kx, Kz is sector-specific capital in the socialized and nonsocialized sectors, respectively; K* is foreign capital; and rz is the return to capital in sector Z. Equation (22) states that national income equals gross domestic product minus the return to foreign capital, rzK*. Differentiating expression (22) totally, we obtain
To obtain (23) we have used the following equations: rz = Z2(E, Kz + K*), which is the condition that the marginal product of capital equals its rental rate in the nonsocialized sector; and dLz –dLx – dLb, because the net change in labor reallocation is zero. All terms on the right-hand side of (23) are positive. Note that P*F1 < Px F1 < wb < wz for an employment-oriented firm. Moreover, dLx/dK* are both negative because direct foreign investment reduces employment in both the black market and the socialized sector. As a matter of fact, (23) decomposes the change in national income into three sources. The first term is positive and reflects the gain in I due to a transfer of labor from the socialized to the nonsocialized sector. The second term reflects the increase in I due to a decrease in employment in the black market sector. Finally, the last term reflects the standard result that direct foreign investment decreases the rental of capital and reduces producer surplus because the inframarginal units of K* receive less than their marginal product.
Figure 7 shows the employment effects of direct foreign investment in the nonsocialized sector under a quota regime. The initial equilibrium is given by point A, and the final one, by point A’. The reservation wage increases, and because the Lx curve is negatively sloped, output and employment in the socialized sector are reduced. If the initial equilibrium occurs to the left of point M, then the employment effects of direct foreign investment under a quota are identical to those under a tariff. However, if points A and A’ lie to the right of point M, many of the previous results could be reversed. Figure 7 illustrates the case where the Lx + Lb curve is negatively sloped. An increase in direct foreign investment reduces Lx but increases Lb. Employment in the socialized sector is reduced by more than the increase in employment in the black market; this suffices to increase output in the nonsocialized sector. A reduction in output in the socialized sector increases the black market price and the length of queues. Expression (23) becomes ambiguous, however, because dLb/dK* > 0, More direct foreign investment increases the intensity of DUP activity in this case and drains resources from the socialized sector. If the Lx + Lb curve is positively sloped, then direct foreign investment decreases employment in both productive sectors and increases the possibility of a reduction in national income.
Effects of Direct Foreign Investment in the Nonsocialized Sector Under a Quota
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Effects of Direct Foreign Investment in the Nonsocialized Sector Under a Quota
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Effects of Direct Foreign Investment in the Nonsocialized Sector Under a Quota
Citation: IMF Staff Papers 1992, 003; 10.5089/9781451973174.024.A001
Effects of Market Liberalization Policies Under Quota and Tariff Regimes
National income is evaluated at international prices. It is equal to gross national product in the absence of foreign investment.
Effects of Market Liberalization Policies Under Quota and Tariff Regimes
| Policy | Queues/Black Market Employment | Reservation Wage | Output/Employment | |||||
|---|---|---|---|---|---|---|---|---|
| Nonsocialized sector | Socialized sector | National Income a | Black Market Price | |||||
| Trade liberalization | ||||||||
| Quota | Declines | Declines | Increases | Increases | Increases | Declines | ||
| Tariff | Declines | Declines | Increases | Increases | Increases | Declines | ||
| Price liberalization | ||||||||
| Quota/tariff | ||||||||
| Small (Pb – Px) | Declines | Declines | Increases | Increases | Increases | Declines | ||
| Large (Pb – Px) | Ambiguous | Ambiguous | Ambiguous | Increases | Ambiguous | Declines | ||
| Foreign investment in | ||||||||
| nonsocialized sector | ||||||||
| Quota | Ambiguous | Increases | Increases | Declines | Ambiguous | Increases | ||
| Tariff | Declines | Increases | Increases | Declines | Increases | Unchanged | ||
National income is evaluated at international prices. It is equal to gross national product in the absence of foreign investment.
Effects of Market Liberalization Policies Under Quota and Tariff Regimes
| Policy | Queues/Black Market Employment | Reservation Wage | Output/Employment | |||||
|---|---|---|---|---|---|---|---|---|
| Nonsocialized sector | Socialized sector | National Income a | Black Market Price | |||||
| Trade liberalization | ||||||||
| Quota | Declines | Declines | Increases | Increases | Increases | Declines | ||
| Tariff | Declines | Declines | Increases | Increases | Increases | Declines | ||
| Price liberalization | ||||||||
| Quota/tariff | ||||||||
| Small (Pb – Px) | Declines | Declines | Increases | Increases | Increases | Declines | ||
| Large (Pb – Px) | Ambiguous | Ambiguous | Ambiguous | Increases | Ambiguous | Declines | ||
| Foreign investment in | ||||||||
| nonsocialized sector | ||||||||
| Quota | Ambiguous | Increases | Increases | Declines | Ambiguous | Increases | ||
| Tariff | Declines | Increases | Increases | Declines | Increases | Unchanged | ||
National income is evaluated at international prices. It is equal to gross national product in the absence of foreign investment.
The analysis of this section suggests that in a reforming socialist economy, foreign capital is more beneficial under a tariff than under a quota regime. Under a tariff, direct foreign investment necessarily increases national income and reduces shortages. However, under a quota, perverse efforts may occur; direct foreign investment might lengthen the waiting lines, thus reducing productive employment and national income.
V. Conclusions
The framework developed in this paper incorporates many important features of a socialist economy in transition, providing a structure within which the effects of market liberalization policies can be traced. The results of the policies analyzed are summarized in Table 1. Trade liberalization, whether through the expansion of a quota or the reduction of a tariff, leads to an expansion of output and employment in both productive sectors, and thus increases national income evaluated at world prices.
Price reform has different consequences. Raising the administered price of the product produced by the state enterprise stimulates expansion of that enterprise’s output. However, if the official price is initially far from a market-clearing level, a small upward adjustment of the administered price of the good that is in short supply may exacerbate the shortage. It may actually increase the revenue earned in the black market, thus drawing labor out of the nonsocialized sector, possibly even leading to an increase in the number of (ostensibly unemployed) workers engaged in black market activity. As a result, if there are substantial initial price distortions, a small administered price increase may actually lead to a decline in national income measured at world prices. These results are consistent with the experience of Eastern European countries in the late 1980s and of the former Soviet Union in the early 1990s: as prices were timidly being adjusted upward, shortages grew worse. The results tend to support the big bang approach, which (in our model) must lead to a reduction in black market activity and a consequent movement of labor into the productive sectors. They also tend to support the strategy followed in several Eastern European countries of liberalizing trade in order to alleviate domestic imbalances.
The effects of foreign investment in the private sector are also analyzed; it is shown that under a quota regime such investment may exacerbate the shortage of the good produced by the socialized sector, although it does alleviate the distortion associated with import protection. The lesson is that the completion of domestic price liberalization or the abolition of quantitative import restrictions may be a precondition for foreign investment to benefit a reforming socialist economy.
The framework developed in this paper provides an analytically tractable treatment of an economy with many of the features that are common to reforming socialist economies. It therefore offers the potential of answering many questions concerning the effects of economic policies during this transitional stage.
APPENDIX Consumer Choice and Shortages
In the model presented in Section I, it is assumed that all rents associated with the controlled price are dissipated, and that the price that is relevant from the standpoint of consumers is the black market price, Pb We also assume that all DUP activity associated with the controlled price is carried out by individuals who are not otherwise employed and who specialize in standing in the queues to purchase goods for resale in the black market. This assumption is in contrast to models such as those of Weitzman (1991) and Boycko (1991), in which queuing is done by the representative consumer, and in which no resale takes place; it is closer to the simple model presented in Lipton and Sachs (1990). In this appendix, we derive the circumstances under which there is specialization in queueing.
Consider the following simple framework, similar to Boycko (1991), in which the individual chooses the allocation of time and money. Individual i’s utility function is
where xi zi, and li denote the individual’s consumption of the two goods and leisure, respectively. The budget constraint is
indicating that wage income must equal the sum of expenditures in the official shops and in the black market (where the latter would be negative for a specialist arbitrageur).
The individual’s time constraint is
where hi denotes the individual’s hours of work in his or her place of employment (if any), li the hours of leisure, and t the time required to purchase one unit of the good; the total amount of time available is normalized to unity. This assumes, as in Boycko (1991) but unlike in Weitzman (1991), that purchasing each unit of the good requires a fixed waiting time, as with a “one to a customer” limit; this assumption is needed, because when resale is permitted, the first customer in line would otherwise buy the entire available stock.
Finally, there is a nonnegativity condition on the amount the individual purchases in the official shops:
The first-order conditions for this problem give rise to the following results. First, there is the familiar result that
that is, the marginal rate of substitution between the two goods equals the black market price. This confirms the assumption in the main text of the paper that it is the black market price that is relevant for consumer demand. Next, there is a condition for time spent queueing:
where λ is the multiplier on condition (27); the Kuhn-Tucker conditions state that
Note also that one can define the black market wage (per unit of time) as the return per unit purchased and resold times the number of units that can be purchased per unit of time, or
Thus, a household that participates in the queue (xci = 0), using equations (30) and (31) in (29), is seen to queue up to the point at which
that is, the black market wage equals the marginal rate of substitution between leisure and the numeraire good.
Another result follows directly from definition (31): if it is assumed that the average time required to purchase a unit of the good is equal to the total number of people queuing divided by the goods available—that is, t = Lb/x—then equation (10), the zero-profit condition for the black market, follows immediately.
For the household that does not participate in the queue, equations (29), (30), and (31) imply that
that is, the additional consumption to be earned by participating in the black market is less than the marginal evaluation of the leisure that would be lost.
Now in equations (32) and (32’), both Φ1, and S2 will, in general, be different for households that are otherwise unemployed than for those employed in the productive sectors. First, employed workers generally have less leisure—li = 1 – hi—txci— where h’ > 0; for unemployed workers, li = 1 – txci. This implies that (if all workers are otherwise identical) Φ1 is higher for employed than for unemployed workers. In addition, the marginal utility of consumption of the numeraire good may be lower for employed workers (if the subutility function, S(x,z), is strictly concave), since they have higher incomes if wx,wz ≥ wb. We can write the marginal utility of the numeraire good as a function of the consumer’s wage and the black market price, S2 (w, Pb).
Then complete specialization in the DUP activity requires that
that is, the black market wage, which is equal to the marginal rate of substitution for leisure of individuals who specialize only in black market activity, must be less than the marginal rate of substitution of goods for leisure for workers employed in either of the two productive sectors.
If workers in the two productive sectors could voluntarily choose their hours of work for a given wage, condition (33) would become simply
Condition (34) may or may not be satisfied; the bargaining structure for wage determination in the socialized sector presented in Section I implies that wx > wb, provided that the enterprise has any bargaining power, but in the nonsocialized sector, wz = wb. In a previous version of this paper, however, a model of efficiency wages was presented, in which workers were paid more than their reservation wage in order to motivate greater effort, implying that wz > wb.
However, the assumption that workers can choose their hours of work for a given wage is not necessarily appropriate. In the nonsocialized sector an efficiency wage mechanism would imply a distortion in hours if the worker can choose hours voluntarily; some restriction on hours would be a feature of a cost-minimizing contract, a general feature of agency models as examined by Lazear (1980). Efficiency wage models imply economies of scale in deterring shirking, so there is a tendency for hours to be longer than would be implied by equality of the reservation wage with the marginal rate of substitution of leisure for consumption, Φ1>,/S2; this implies that condition (33) will generally be met for the non-socialized sector. In the socialized sector hours could be made an additional subject of bargaining between enterprise and government; an employment-oriented enterprise might engage in “feather-bedding,” reducing (effective) hours of work in return for higher employment, which would imply that the individual worker would be subject to restrictions on hours, possibly implying Φ1/S2 < wb—in effect, “forced leisure.” If that were the case, some workers in the socialized sector would participate in queues after (or during) normal working hours.22
It has been demonstrated that the assumption of complete specialization in queueing can be the result of optimal behavior by otherwise identical consumers who differ only in whether they happen to find employment in the socialized, or nonsocialized sector, or nowhere. It has also been argued, however, that the conditions for complete specialization may or may not be met, even if, as is assumed, wages in the two productive sectors exceed the income that can be earned in the black market. The possibility that workers in the socialized sector have “forced leisure” implies that some of them may participate in queues; this would be consistent with the observation that in socialist economies some (although not all) of the queueing is in fact done by people who are also employed elsewhere.23
In the main text of the paper it is assumed that complete specialization does occur. It is also assumed that hours of work are fixed in both productive sectors and in the black market (the latter being equivalent to assuming, not unrealistically, that the official shops are only open for a limited number of hours).
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Portes, Richard, “The Theory and Measurement of Macroeconomic Disequilibrium in Centrally Planned Economies,” in Models of Disequilibrium and Shortage in Centrally Planned Economies, ed. by Christopher Davis and Wojciech Charemza (London; New York: Chapman and Hall, Ltd., 1989).
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Tarr, David G., “When Does Rent Seeking Augment the Benefits of Price and Trade Reform on Rationed Commodities?” (unpublished; Washington: World Bank, July 1991).
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Elias Dinopoulos, who is an Associate Professor at the University of Florida, received his doctorate from Columbia University. He was a consultant in the Research Department when this paper was written.
Timothy D. Lane is an Economist in the Research Department. He received his doctorate from the University of Western Ontario.
The authors wish to thank John Beghin, Patrick Conway, Peter hard, Kent Osband, and other participants in seminars at the IMF, the World Bank, the University of Florida, the Southeastern International Economics Meetings, and the University of Cincinnati for helpful comments.
For example, in Poland in the late 1980s the officially recognized private sector accounted for about 25 percent of total output; this is likely to be an underestimate, since it omits production in the “shadow economy” (Kalicki (1989)).
For instance, in Poland in 1989 taxes and dividends on socialized enterprises constituted 80 percent of the total revenues of the state budget, and transfers from financial institutions (also state owned), another 10 percent; only 5 percent of total revenues came from taxation of nonsocialized enterprises.
In practice, this assumption may not be realistic; many of the exports of Eastern European countries are produced by state enterprises. However, the alternative—to have the socialized sector exporting—would be less satisfactory, since it would imply that goods were being exported in the face of domestic shortages; this would require a more complex explanation (or an arbitrary assumption) to determine the level of exports. The alternative would be to disaggregate the socialized sector into exporting and import-competing subsectors, but that would make the model intractable.
This utility function has been used extensively in the literature to represent the objectives of labor unions; see McDonald and Solow (1981), Brander and Spencer (1988), Mezzetti and Dinopoulos (1991), Pemberton (1988), and Lane and Dinopoulos (1991), among others. The excess wage is defined in terms of the black market wage, because the latter represents the opportunity cost of labor.
In Lane and Dinopoulos (1991) we assumed a linear production function, such that X = Lx.
Numerical subscripts denote derivatives of a function with respect to the relevant argument; for example
and
In order to see this property, consider the slope of an isotax curve, dwx/dLx = – [wx – PXF1(LX)]/LX, and the slope of an indifference curve, dwx/dLx = – y(wx – wb)/θ Lx. Equation (6a) represents the result of setting these two expressions equal to each other.
In an earlier version of the paper, available from the authors on request, we assumed that firms in the nonsocialized sector could pay efficiency wages—that is, elicit more effort from their workers by paying them more than their reservation wage (see. for example, Brecher (1992)). The results are qualitatively similar, but the efficiency wage framework implies that wages in the nonsocialized sector need not be lower than those in state enterprises.
If imports were restrained by a tariff instead, the difference between the black market and official price would depend only on the tariff; in that case, the amount of labor, Lb, would necessarily be a decreasing function of the reservation wage, wb. The difference between the two trade regimes is developed in the next section.
The possibility of nonuniqueness of equilibrium is explored further in an appendix, available from the authors on request
In a previous version, incorporating efficiency wages, the wages in the socialized and nonsocialized sectors could not be ranked.
Some Eastern European countries, notably Hungary, Yugoslavia, and Poland, undertook market liberalization measures during the 1970s and 1980s; these efforts were greatly intensified in the radical reform programs initiated in 1989 and 1990 (see, for example, Lane (1991) and Boote and Somogyi (1991)), and similar programs were pursued by other countries in the region. By early 1992, some states of the former Soviet Union had yet to decide whether, and at what pace, to undertake extensive market liberalization in order to alleviate shortages and provide the basis for a move toward a market economy.
The case of quotas is particularly relevant due to the prevalence of nontariff barriers in socialist economies, including not only formal quantitative restrictions but also the implicit restrictions that have historically been associated with the dominant role of government-owned foreign trade organizations and with the centralization of the distribution system. Tariffs have replaced such quantitative restrictions in the countries that have proceeded furthest with market-oriented reforms.
Notice that this property excludes the possibility of multiple equilibria, as discussed in an appendix available from the authors.
An example is the freeing of agricultural prices in Poland in August 1989.
An example is the Polish authorities’ decision to raise coal prices by 400 percent for industrial users (and 600 percent for households) in January 1990, which still left these prices below world levels.
Geometric analysis is inadequate for examining the effects of a change in Px, since the direction and magnitude of the shift in the Lx + Lb curve are ambiguous.
This result, and the possibility of multiple equilibria, is examined in an appendix, which is available from the authors on request.
It should be emphasized that this refers to a small change in prices; even if official prices are initially far below their market-clearing levels, full price adjustment in this model must reduce black market activity (to zero).
For instance, Tarr (1991) reports that in Poland in 1979, the black market price of color televisions was twice the official price, and the black market price of automobiles, three times the official price.
In practice, gradual price adjustment may also be vitiated by the effect of expectations, as anticipated price increases may create increased incentives for hoarding and thereby exacerbate the shortages. Such dynamic effects cannot, of course, be analyzed in our static model.
The analysis has assumed that an employed individual must stay at the workplace for the stipulated hours of work. Anecdotal evidence suggests that this is far from the case in many reforming socialist countries; on the contrary, many workers spend time during which they are ostensibly employed to work at other jobs and to stand in line for goods.
This also abstracts from the possibility of specialization within the family—that is, the possibility that some members of a family who are unemployed or work shorter hours may do more of the queueing. Anecdotal evidence suggests that this may be an important phenomenon.
