Economic Systems Analysis and Policies: Explaining Global Differences, Transitions and Developments

Economic Systems Analysis and Policies Also by S. I. Cohen PRODUCTION, MANPOWER AND SOCIAL PLANNING AGRARIAN STRUCTUR...

Author: Solomon I. Cohen

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Economic Systems Analysis and Policies

Also by S. I. Cohen PRODUCTION, MANPOWER AND SOCIAL PLANNING AGRARIAN STRUCTURES AND AGRARIAN REFORM PATTERNS OF ECONOMIC RESTRUCTURING FOR EASTERN EUROPE HUMAN RESOURCE DEVELOPMENT AND UTILIZATION MICRO ECONOMIC POLICY SOCIAL ACCOUNTING FOR INDUSTRIAL AND TRANSITION ECONOMIES SOCIAL ACCOUNTING AND ECONOMIC MODELLING FOR DEVELOPING COUNTRIES SISTEMA DE PLANEACION DE RECURSOS HUMANOS (In Spanish) (co-authored) INTRODUCTION TO MODERN ECONOMICS, PARTS I & II (In Russian) (co-authored) THE MODELLING OF SOCIO-ECONOMIC PLANNING PROCESSES (co-edited) POPULATION, HEALTH AND NUTRITION (co-edited)

Economic Systems Analysis and Policies Explaining Global Differences, Transitions and Developments

S. I. Cohen Professor, Erasmus School of Economics, Erasmus University, Rotterdam

© S. I. Cohen 2009 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2009 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN-13: 978–0–230–22382–0 hardback ISBN-10: 0–230–22382–6 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Cohen, Solomon I., 1941– Economic systems analysis and policies : explaining global differences, transitions and developments / Solomon I. Cohen. p. cm. Includes bibliographical references and index. ISBN 978–0–230–22382–0 1. Economics. 2. Economic development. 3. Economic policy. I. Title. HB171.C685 2009 330.1—dc22 10 9 8 7 6 5 4 3 2 1 18 17 16 15 14 13 12 11 10 09 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne

2008053797

To the memory of two teachers and colleagues Henk Bos and Jan Tinbergen

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Contents List of Illustrations

xii

List of Abbreviations

xix

Preface

xxi

1 Analytical Framework for Understanding Economic Systems 1.1 The study of economic systems 1.2 Behavioural types and behavioural settings 1.3 Distinct behavioural types determining different economic systems 1.4 Positioning countries along behaviourally different economic systems 1.5 Outline of the book 1.6 Summary and conclusions 2 Elaborations on the Analytical Framework and Its Application 2.1 Introduction 2.2 Micro and macro interactive processes in economic systems 2.3 A conceptual model of economic behavioural settings featuring the building blocks 2.4 Evolution of differing behavioural types into different economic systems 2.5 A conceptual model of the emergence and prevalence of behaviourally different economic systems 2.6 The structure, conduct, and economic performance of different economic systems 2.7 Dominance and diversification tendencies across countries and systems: Some applications 2.8 Summary and conclusions 3

The Firm Intensive System: Economic Challenges and Agent Responses in US, EU, Japan 3.1 Economic principles of a pure firm intensive economic system 3.2 Indivisibilities: Problems and firm-state responses 3.2.1 Problems 3.2.2 Natural monopoly and imperfect competition 3.2.3 Technology bias and growth limits 3.3 Uncertainties: Problems and firm-state responses 3.3.1 Problems 3.3.2 Incomplete information 3.3.3 Asymmetric information vii

1 1 3 6 12 16 19 21 21 21 28 30 33 37 46 52 54 54 60 60 61 72 74 74 75 75

viii

4

5

Contents

3.4 Externalities: Problems and firm-state responses 3.4.1 Problems 3.4.2 Positive externalities 3.4.3 Negative externalities 3.5 Collectivities: Problems and firm-state responses 3.5.1 Problems 3.5.2 Responses 3.6 Income distribution: Problems and firm-state responses 3.6.1 Problems 3.6.2 Responses 3.7 Summary and conclusions

81 81 84 88 93 93 94 95 95 100 105

The Firm Intensive System: Polity Functioning and National Accommodations in US, EU, Japan 4.1 Introduction 4.2 The political process as a political market 4.2.1 Overview 4.2.2 Voters 4.2.3 Political parties 4.2.4 Governing politicians 4.2.5 State bureaucrats 4.2.6 Public sector employees 4.2.7 Interest groups 4.2.8 Checks and balances: Country tendencies 4.3 Public regulation and national welfare 4.4 Public spending and national welfare 4.5 National accommodations to differing polities 4.6 Summary and conclusions

107 107 109 109 112 113 114 115 121 123 127 129 130 137 142

The State Intensive System: Past Polity of the Soviet Union and Allied Countries 5.1 Introduction 5.2 The state’s ideology 5.3 The state’s party 5.4 State ownership of property 5.5 The central planning system 5.6 Pursued allocation policies 5.7 The failing past performance 5.8 Causes of system rise and failure 5.9 Summary and conclusions

144 144 145 146 147 148 155 157 161 165

6 The State Intensive System: Economic Transitions 6.1 Alternative paths 6.2 Magnitudes, causes, and effects of the recession in transition countries 6.3 Overview of reforms and their phasing in transition countries

167 167 169 177

Contents ix

6.4 Short transition 6.4.1 Stabilization reforms 6.4.2 Liberalization reforms 6.5 Long transition 6.5.1 Competitive entrepreneurships 6.5.2 Market confidence 6.5.3 Internalizing externalities 6.5.4 Public goods provisions 6.5.5 Public income transfers 6.5.6 Size of the public sector in transition countries 6.6 Systemic inclinations of transition economies 6.7 Summary and conclusions

180 180 182 186 186 194 209 215 217 219 221 223

7 Economic Systems in the Developing World: Regional Differences 7.1 Introduction 7.2 Impacting development epochs 7.2.1 Political and economic epochs 7.2.2 Colonial rule 7.2.3 Nation building 7.2.4 Democratic reforms 7.2.5 Household-led demographic transition 7.2.6 State-led economic development 7.2.7 Firm-led global integration 7.3 Comparative development performance 7.4 Dualism in the economic system: Modern/traditional, rich/poor, in large/small developing countries 7.5 Macroeconomics of dualistic development 7.6 Microeconomics of dualistic development 7.7 Summary and conclusions

225 225 226 226 228 230 233 234 236 244 247

8 Economic Systems in the Developing World: Country Profiles 8.1 Introduction 8.2 East Asia Pacific (EAP) 8.2.1 Regional profile 8.2.2 Systemic change in China 8.3 South Asia (SA) 8.3.1 Regional profile 8.3.2 Systemic change in India 8.4 Middle East and North Africa (MENA) 8.4.1 Background 8.4.2 System development 8.4.3 System performance 8.5 Arab Gulf (GCC) 8.5.1 Background 8.5.2 System development 8.5.3 System performance

273 273 275 275 280 300 300 304 322 322 324 325 326 326 327 329

251 259 262 271

x

Contents

8.6

9

10

Sub Saharan Africa (SSA) 8.6.1 Background 8.6.2 System development 8.6.3 System performance 8.7 Latin America and Caribbean (LAC) 8.7.1 Background 8.7.2 System development 8.7.3 System performance 8.8 Summary and conclusions

330 330 332 335 336 336 338 339 340

Comparative Performance of Countries Relating to Different Economic Systems: A Social Accounting Approach 9.1 Introduction 9.2 Frameworks for analysing economic system performance 9.3 SAM applications to countries of Western and Eastern Europe 9.3.1 Introduction 9.3.2 The construction of comparative SAMs 9.3.3 Structural differences in the six SAMs 9.3.4 The comparative analysis of multiplier properties 9.3.5 Size and distribution of multipliers of sectoral injections 9.3.6 Size and distribution of multipliers of household transfers 9.4 SAM applications to Russia and China 9.4.1 Differences 9.4.2 The SAMs of Russia and China 9.4.3 Deriving SAM multipliers for Russia and China 9.4.4 Growth multipliers in Russia and China 9.4.5 Distribution impacts in Russia and China 9.5 Refuted limitations 9.6 Summary and conclusions

342 342 343 347 347 348 352 357 360 365 368 368 370 370 371 375 377 378

Long-Range Convergence and Displacements in Economic Development and Interactions between Economic Systems 10.1 Introduction 10.2 The convergence hypothesis: Supply side theory and evidence 10.3 The convergence hypothesis: Demand side theory and evidence 10.4 Empirical results 10.5 Demonstration 10.6 More convergence through transfer mechanisms 10.7 The displacement hypothesis: Future outlook for China and India 10.8 The displacement hypothesis: Implications for system competition and the relative dominance of alternative economic systems 10.9 Summary and concluding remarks

379 379 380 381 386 389 391 392

396 400

Contents xi

Appendices

402

Notes

406

References

424

Author Index

433

Subject Index

436

List of Illustrations Tables 2.1 2.2 2.3 2.4 3.1 3.2 4.1 4.2 4.3 5.1 5.2 5.3 5.4

Building blocks of the analytical framework Importance of household settings: Percentage of responses to varying ranks of importance of the family in one person’s life Importance of firm and state settings: Pro-firm and pro-state attitudes Indexes of Firms Competitiveness and State Appropriation (Rule of Law) for FIM and SIM related countries, respectively Problem areas leading to market failure, and the subsequent responses of firm and state A game theoretic presentation of the problem of collectivities Political power and political institutions in firm intensive systems: Country tendencies FIM related countries: Fiscal shares in the GDP, 1960–2000 FIM related countries: Public share and economic growth, various periods SIM planning: Demonstrative scheme of material balance for a major commodity, i.e. coal in 000s tonnes Average annual growth of GDP and GDP per capita in the SIM and FIM country groups Annual growth rates of output, inputs, and factor productivity for the SIM and FIM country groups Equity indictors for selected SIM and FIM countries

Required changes in agent behaviour accompanying transition from SIM to FIM 6.2 GDP performance in transition countries 6.3 Socio-economic performance in transition countries 6.4 Economic elements of system transformation 6.5 Transition sequencing 6.6 Proposed discussion in terms of short and long transition phases 6.7 Stabilization programmes and inflation performance in transition countries 6.8 Extent and pace of liberalization in transition countries 6.9 Privatization methods for medium and large state enterprises in six transition economies, by number and by value, per cent 6.10 Extent of privatization in transition countries as indicated by private sector share in GDP

23 47 50 52 59 94 128 131 135 149 158 159 160

6.1

xii

168 170 175 178 178 179 181 184 189 190

List of Illustrations xiii

6.11 Administrative corruption in transition countries: Share of time tax, share of firms paying bribes, and average bribe tax rate, 1999 and 2002, per cent 6.12 Capture corruption in transition countries: Share of firms affected by capture and share of captor firms, both regarding capture of laws and regulation, 1999 and 2002, per cent 6.13 Transition countries: Performance in extending global links, per cent 6.14 Transition countries: Performance relating to share of public spending in the GDP, per cent 6.15 Needs for and realization of public income transfers in transition countries 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12 7.13 7.14 7.15 7.16

7.17 7.18

7.19

Historical epochs and their effects on major settings in the development process War casualties in the developing countries Political regimes in the developing regions Developing regions: Population and urbanization trends Developing regions: Changing concentrations of agents and GDP Developing regions: Indicators of the relative dominance of agriculture/household settings versus industry/firm settings, 2000 Developing regions: Indicators of state influence, 2000 Foreign trade patterns: Shares of manufactured exports by developing region, 1970–2000 Foreign financial flows to developing countries, 1970–2000 Foreign financial flows: Shares of flow types by developing region, 1970–2000 Developing regions: GDP growth and GDP per capita growth, 1960–2005 Developing regions: Economic growth accounting Developing regions: GDP per capita in US$ and in ppp $, 2000 Developing regions: Poverty headcount at $1 a day ppp as per cent of total population, 1981–2004 Developing regions: Indicators of income distribution, 1980–2005 Developing regions: Indicators on distribution of the population by rural/urban, and the urban labour force by formal/informal/ unemployed status; and indicators of income distribution Summary of cross-section between informal/formal and poor/rich in a large developing country The impact of formal and informal sector injections and of transfers on output and the incomes of poorer and richer household groups. Demonstration of results for Indonesia The impact of formal and informal sector injections and of transfers on output and the incomes of poorer and richer household groups. Demonstration of results for Pakistan

200

203 214 217 220

227 233 234 236 241 242 243 244 245 246 247 248 249 249 250

253 255

260

261

xiv List of Illustrations

7.20 Indonesia: Average values of assets and profits in thousand rupiah, and profit rates 7.21 Pakistan: Average values of assets and profits in thousand rupees, and profit rates 7.22 Indonesia and Pakistan: Share of difficulties reported by surveyed establishments, grouped by informal and formal market segments; per cent 8.1 8.2

8.3 8.4 8.5 8.6 8.7 8.8

8.9 8.10 8.11 8.12 8.13 8.14 8.15 8.16 8.17 8.18

8.19

Population and GDP of EAP: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 Economic structure and conduct in China and EAP: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Comparative performances of the economies of China and the EAP, 1981–2005 China: Planned versus market components of agricultural procurements and retail sales China: Convergence towards market prices: Rice and wheat China: Distribution of output and employment by state and non-state ownership of industrial enterprises, per cent China: Profit/capital ratios for different types of industrial enterprises, per cent China: Distribution of the number of industrial enterprises above designated size and their gross output value, grouped by status of registration, per cent China: Foreign trade, foreign capital inflow, and foreign exchange reserves, US$100 million China: Economic cooperation with Rest of World US$ 100 million China: Trading Summary for Stocks, shares in 100 million shares, values in 100 million yuan China: Shares of total government revenue and expenditure in the GDP, and their allocation between central and local levels China: Composition of total government budget by revenue sources and expenditure functions China: Average annual growth rates of real gross industrial output and real GDP: Official and physical output based estimates China: Decomposition of sources of economic growth China: Economic growth and Gini index Population and GDP of SA: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 Economic structure and conduct in India and SA: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Comparative performance of the economies of India and SA, 1981–2005

266 268

270 277

278 280 284 284 286 287

288 290 291 292 293 294 295 295 298 301

302 303

List of Illustrations xv

8.20 India: Socio-economic structure under Moghul Empire and British Rule 8.21 India: Shares of the value added of industry and services in the GDP, per cent 8.22 Comparative sources of GDP growth in industry and services, China and India 8.23 India: Foreign trade and its composition, per cent 8.24 Comparative export growth in merchandise and services, China and India 8.25 India: Fiscal features of public revenue and expenditure. Central government and all union 8.26 India: Decomposition of sources of economic growth 8.27 India: Economic growth and Gini index 8.28 India: Distribution of GDP and labour on various population segments, 2000, per cent 8.29 Population and GDP of MENA: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 8.30 Economic structure and conduct in MENA: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent. 8.31 Comparative performance of the economies of MENA, 1981–2005 8.32 Population and GDP of GCC: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 8.33 Economic structure and conduct in GCC: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent 8.34 Comparative performance of the economies of GCC, 1981–2005 8.35 Population and GDP of SSA: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 8.36 Economic structure and conduct in SSA: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent 8.37 Comparative performances of the economies of SSA, 1981–2005 8.38 Population and GDP of LAC: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 8.39 Economic structure and conduct in LAC: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent 8.40 Comparative performance of the economies of LAC, 1981–2005 9.1 9.2 9.3 9.4 9.5

Entries in the aggregate SAM SAM for Germany SAM for Poland SAM structure for Germany SAM structure for Poland

308 315 315 316 316 317 318 318 319 323

324 326 327

329 330 332

334 335 338

339 340 349 351 351 352 352

xvi List of Illustrations

9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13 9.14

9.15 9.16 9.17 9.18 9.19 9.20 9.21 9.22 9.23 9.24 10.1 10.2 10.3 10.4

East and West Europe: Selected variables expressed as percentages of the matrix total East and West Europe: Components of the GDP from the expenditure side East and West Europe: Returns to labour and capital that go to households as a percentage of matrix total East and West Europe: Government incomings, total and by source, expressed as percentage of matrix total East and West Europe: Distribution of expenditure by want category and income by decile group, per cent East and West Europe: Sectoral shares in the total output and total value added, per cent SAM in the form of Ay x y Selected multipliers for further analysis East and West Europe: Income and output multipliers resulting from injections in alternative activities, exogenous shares, and other indicators East and West Europe: RDM analysis for activities resulting from an overall injection in activities East and West Europe: RDM analysis-s for households resulting from an overall injection in activities East and West Europe: Income and output multipliers resulting from transfers to different household groups East and West Europe: RDM analysis of households and activities resulting from an overall transfer to households China and Russia: GDP and Indices of GDP Output of major goods in China and Russia SAM multipliers for Russia 1991 SAM multipliers for China 1989 RDM analysis for Russia 1991 RDM analysis for China 1989

SAM features and GNP per capita of 16 countries Regression results of equations (4) and (5) Selected simulations: Initial runs for rich and poor countries Selected simulations: Alternative runs assuming different income levels 10.5 Future outlook: Country shares in the world population, and the world GDP 10.6 Future outlook: Country Index of Interactive Influenc

353 354 355 355 356 357 359 359

360 362 365 366 367 369 369 372 372 373 376 387 388 390 390 393 396

List of Illustrations xvii

Figures 1.1 Interactions of micro settings and the macro frame 7 1.2 (a,b,c) Configurations of three socio-economic systems: HIM, FIM, SIM 9 1.2 d Configuration of a multi-poles socio-economic system: MPM 11 1.3 Positioning of economies along axis of dominant systemic interactions 14 2.1 Importance of household settings: Country ranking of importance of family 48 2.2 Importance of firm and state settings: Pro-firm and pro-state attitudes 51 3.1 Firm decisions on use of factors 56 3.2 Firm decisions on production of goods 56 3.3 Deadweight loss from restricted output 67 3.4 Deadweight loss from managerial slack 67 3.5 Scheme for tracing the conditions under which a side effect can be identified as an externality and justify a policy measure 83 3.6 Deadweight loss from positive externalities 84 3.7 Deadweight loss from negative externalities 89 3.8 Lorenz curve and Gini index 96 3.9 The untouched normal distribution of abilities 98 3.10 The real world distribution of income 98 4.1 Upward budgetary bias I 117 4.2 Upward budgetary bias II 118 4.3 Upward budgetary bias III 119 4.4 Uniform taxation 126 4.5 Progressive taxation 126 4.6 Negative relationship between public share and GDP growth in FIM countries 135 4.7 Positioning of FIM countries 137 6.1 Transition countries: Time profile of GDP decline and recovery by country group 172 6.2 Transition countries: Relationship between percentage change in GDP 1989–2005 (y-axis), and change in the Gini index 1989–2005 (x-axis) 177 6.3 Transition countries: Average annual inflation rates and the loss and gain in real GDP 182 6.4 Transition countries: Extent of liberalizations as measured alternatively by World Bank Index of Liberalization (WBIL) and Heritage Index of Economic Freedom (HIEF) 185 6.5 Transition countries: Liberalization and cumulative GDP 185 6.6 Systemic inclinations of transition countries 222 7.1 Profit rates, profit values, and asset values of SSI in million rupiah, Indonesia 266

xviii

List of Illustrations

7.2

Profit rates, profit values, and asset values of SSI, in thousand rupees, Pakistan 8.1 Positioning of the world developing regions along axis of dominant systemic interactions 8.2 China: Annual living expenditure per capita in RMB: Rural overall, Urban overall, Urban Beijing, Urban Henan, 1997–2006 8.3 India: Index of GDP/labour for various segments of the population, 2000 (Value of index for Total India = 1.0) 9.1 The analytical framework for comparing performances 9.2 Circular flow 10.1 Relationship between the exogenous share in national income X/Y and income per capita Y/N 10.2 Relationship between multipliers m and exogenous share in national income X/Y

268 274 298 320 344 348 383 385

Boxes 3.1

Changing patterns of nationalization and privatization in FIM countries: 1980–2005 65 3.2 Firm intensity and open competition in FIM countries, 1995, 2000, 2005 71 3.3 Business and state resources in Research & Development in FIM countries, 1970–1980, 1990–2000 73 3.4 Corporate governance patterns in FIM countries, around 2000–2004 80 3.5 Response to liberalization initiatives of the World Trade Organization in FIM countries 88 3.6 Responses of FIM countries to the Kyoto Protocol 92 3.7 Recent trends in income inequality and poverty incidence in FIM countries 102 3.8 State spending on income transfers for the working age population in FIM countries 103 3.9 Social security spending and projected composition of the population in FIM countries 104 6.1 Privatization rush in transition countries 193 6.2 Undervaluation of assets in transition countries: The case of Russian companies 194 6.3 Transition countries: Consensus on subjective perceptions and objective indicators on the imposition of the rule of law.: Differences between country groups 207 6.4 Transition countries: Poll of polls corruption perception index, CPI 208 7.1 An accounting framework for informality and inequality in developing countries 257 10.1 The comeback of China and India 395

List of Abbreviations BCEE BEEPS BRIC CPI DRC DTM EAP ECB EMIS EXSR FIG FIM FMT FDI GATT GCC GDP HIEF HIM ICT III IMF KP LAC MENA MMC MPM NAFTA ODA OECD PHS RDM RPC ROW SA SAM SAP SARC SIM SOE

Baltic, Central and Eastern Europe WB/EBRD Environment and Enterprise Performance Survey Brazil, Russia, India and China Corruption Perception Index Real Domestic Resource Cost Demographic Transition Model East Asia and Pacific European Central Bank Emerging Market Information Service at http://www.securities.com/ Ex-Soviet Republics, except Baltic and Russia Financial-Industrial Group Firm Intensive System, also referred to as F-system Foreign Merchandise Trade Foreign Direct Investment General Agreement on Tariffs and Trade Arab Gulf (Gulf Cooperation Council) Gross Domestic Product Heritage Index of Economic Freedom Household Intensive System, also referred to as H-system Information Communication Technologies Index of Interactive Influence International Monetary Fund Kyoto Protocol Latin America and Caribbean Middle East and North Africa Monopolies and Merger Commission Multiple Pole System North American Free Trade Agreement Official Development Assistance Organization for Economic Cooperation and Development Poverty Headcounts Share in the population Relative Distributive Measure in SAM context Restrictive Practices Court Rest of World South Asia Social Accounting Matrix Structural Adjustment Package South Asian Regional Council State Intensive System, also referred to as S-system State Owned and state-holding Enterprises xix

xx

List of Abbreviations

SSA TVE VAT WB WBIL WTO WVS

Sub Saharan Africa Rural Township and Village Enterprises Value Added Tax World Bank World Bank Index of Liberalization World Trade Organization World Value Surveys

Preface Research, teaching, and advisory work in the two areas of economic systems and development economics have gone through similar ups and downs in the past three to four decades. In the 1960s and 1970s, both areas attracted the positive attention of many scholars, students, and advisors. The 1980s and 1990s witnessed the empirical documentation of disappointments with the socio-economic performance of centrally planned economies and many developing countries, which are the main clients and subject matters of the two areas, respectively. Justified or unjustified, interest in both areas waned in the 1980s and 1990s, and much of the past academic work on economic systems and economic development was criticized on grounds of being remote from what happens in the real world, inability to foresee the disappointing socio-economic performances, and incompetence in advice on policy matters and reforms. The period of the downturn has been followed recently by a period of upturn in the twenty-first century. Interest in both areas has again flourished due to, on the one hand, the general success of many transition economies in reforming and redirecting their economic systems towards a more market–state mixed profile despite their past regime failures, and on the other hand, the reappearance of past state-wise rent seeking interests in some major transition countries. Furthermore, the success of some leading and big developing economies like China and India in likely overtaking rich countries in terms of the size of the GDP, industry, trade, and foreign exchange reserves, and the fall back of some other developing regions far behind, have contributed to the upturn in enthusiasm for the sub-disciplines. Moreover, the unexpected global financial meltdown of 2008, which is hurting free market economies more than others and is accompanied by calls for collective actions to stabilize the economic systems, are very likely to further enhance academic and policy interests in economic systems and economic development. The downturn and the upturn caused profound changes in topics and methods pursued by economists dealing with economic systems and economic development. The two areas have become closer to each other than ever before regarding topics and methods, without tarnishing basic differences between transition economies and developing countries. There is now more insight into, and appreciation of the subtleties of these two sets of countries, and how they differ and develop differently from the economic systems of the richer and predominantly Western countries. It is now again generally appreciated that because of the intrinsic differences in their functioning and future development, economic work on countries manifesting different economic systems need to be framed in distinctive ways. This book is a meeting point between economic systems and development economics. The scope is the worldwide economic dynamics of national economies that manifests itself in distinct economic systems. The book is directed to scholars xxi

xxii Preface

and readers, teachers and students, policy advisors and policy recipients, working on economic systems and development economics. If each book should state its focal point in one or two sentences, then ours will be the following. The future prospects are not those of a universalistic set of economic behaviours that countries would adopt worldwide some time in the future; instead, our contention is that there are behavioural differentiations of a higher order that separate the interacting agents from integrating and converging towards any one economic system. The behavioural differentiations emanate from different sociological, political, and economic behavioural orientations that characterize major settings (such as household, state and firms settings, respectively), and in which agents interact, and lead ultimately to distinguishable dominant behavioural types. I sketched in 1978, a model wherein the social and political domains dominated the economic domain and then applied the idea to study the prospects of land reform in India and Chile, in Cohen (1978). The idea of distinguishable dominant behavioural types in different systems/countries was bound to gain strength over time as it became increasingly supported by theoretical foundations and empirical evidence from various distanced sources. In time, and bolstered with this support from theory and empirics, it was possible to elaborate a theoretically founded analytical framework for explaining distinguishable dominant behaviours in economic systems, and demonstrating its validity and applicability to wider issues including the study of emerging systemic problems and subsequent policy responses, as is being done in this book. The theoretical foundations came with the development of convention theory, starting with David Lewis (1969), who provided the seminal work on common knowledge, and laid the foundations for formal approaches to the study of social conventions and social norms. The formal approaches which at one time consisted of game theory, soon extended to include folk theory, information cascades, evolutionary learning and social network formation, and allowed for the coexistence of multiple behavioural equilibria; thanks to works by Thomas Schelling (1978), Robert Frank (1988), Herbert Simon (1993), and many others. In all these works, typical behavioural patterns that make-up the system anatomies can be described as social conventions in the sense that they result somehow from the interdependency of individual actions subjected to some given initial conditions. While conventions change they tend to follow the down-laid paths of past events and responses, thus resulting in differentiated and sticky systems of joint social, political and economic behaviour. The empirical backing of the persistence of behavioural types and institutional set-ups that associate with such behavioural types in separated societies, whereby intentionally or unintentionally, the institutional set-ups are inclined to benefit specific groups of agents and disfavour others, is the second line of inspiration of the book. Some modern contributors who fit here and who have analysed different economic systems can be quoted as examples: Janos Kornai (1967), Gunnar Myrdal (1968), John Galbriath (1983), Douglas North (2006), and many others.

Preface

xxiii

The book starts with laying in the first two chapters the theoretical foundations for understanding different dominant behaviours in economic systems. The concept of dominant behavioural settings is crucial. I distinguish between household, state, and firm settings that are driven by social, political, and economic motivations, respectively. One motivation tends to dominate over the other motivations, and thus determine the shapes of conduct, structure, and performance. Which motivation prospers where depends on the initial situation, the external environment, and historical events. I introduce a fourth type of setting, calling it persuasive settings, which can play a crucial role in coordinating less integrated multipole social systems. Interactive behaviour of agents in all four types of settings shapes the development path of the economic system. After a motivated classification of world regions to behaviourally dominated prototypes of economic systems, the book examines the real world country counterparts of the prototypes. We devote two chapters for each of the rich industrialized countries, the transition economies, and the world developing regions. The chapters focus on an analysis of conduct, structure, and performance, as well as related policy. Chapters 9 and 10 are devoted to a retrospective comparative analysis between countries belonging to the differing economic systems, and their intercourse in the context of system competition. The book benefited from interactions in lecture courses on the topics treated to undergraduate and master degree students at Erasmus University Rotterdam and courses and visiting lectures delivered abroad in various countries. The deliberations in these courses convinced me that the ten chapters of the book fit together in a coherent whole that meets four goals: describes world economic systems fairly well; gives theoretically founded explanations to global differences, transitions, and developments; provides convincing grounds for using the developed framework for further fruitful analyses; and highlights policy considerations towards higher growth and more equity. If the book succeeds in contributing to any of the four goals, then it would have achieved its objective. Indebtedness goes for the forerunners mentioned above, and to Henk Bos and Jan Tinbergen, who introduced me on systems and development, and not least, have paved the way for a sober and humble academic life. Indebtedness goes also to course participants, and colleagues and reviewers who read and commented on isolated parts of the book. I am also thankful for the generous support and editorial work provided by Palgrave Macmillan. The book has made extensive use of several databanks for which I am gratefully indebted. The majority of computations and tables in the book have relied on these databanks that are generally accessible via the websites that we refer to. The use of these sources are hereby acknowledged, and they are listed below in alphabetic order: Beck’s database of political institutions; Centre for Systemic Peace, University of Maryland for its database on war causalities; Economic and Social Research Centre for Islamic Countries for its SESRTCIC Statistical Database; European Bank for Reconstruction and Development for The Business Environment and Enterprise Performance Survey (BEEPS) and for reports of the Bureau of Economic Analysis (BEA); W. Heinsz’s dataset on political constraints;

xxiv Preface

Heritage Foundation for the Index of Economic Freedom; International Monetary Fund for Government Finance Statistics and International Financial Statistics; ISI Emerging markets for the EMIS databank; OECD for Geographical Distribution of Financial Flows to Aid Recipients, and OECD Historical Statistics; Transparency International for the Corruption Perceptions Index, CPI; Unicef-icde for Transmonee database; UN Population Division for its World Urbanization prospects; UN Public Administration Programme for data on the public sector; World Bank for the World Bank Development Indicators Database, development gateway, query, and other related data; World Values Survey Association for World Value Survey; and World Trade Organization for International Trade Statistics. The author acknowledges also with thanks the permitted use, granted by copyright holding publishers, of material from Cohen (2001), Gregory and Stuart (1999), Maddison (1971), and Cohen (2002b), in Chapters 2, 5, 8, and 9, respectively. Every effort has been made to trace rights holders, but if any have been inadvertently overlooked the publishers would be pleased to make the necessary arrangements at the first opportunity. A symbolic dedication of this book to the next generation of grand children is in place: to Sophie, Nelson, Yasmine, and Midas. Perhaps some of them some time in the future will pick up from where I have stopped. (Solomon) Suleiman Ibrahim Cohen

1 Analytical Framework for Understanding Economic Systems

1.1

The study of economic systems

Although there exists no unique, commonly accepted definition of an ‘economic system’, nor is there an objective way of delineating that part of the total social experience to be described and analysed under this topic, yet economists recognize the existence of different economic systems in their study of economic phenomena. At the national level different groups of countries, and specific countries, are seen to have different economic systems. Why are economists interested in economic systems in spite of the difficulties they face in delineating the boundaries of economic systems? The rationale for the analysis of economic systems and their comparison can be seen gathered from answering one general question: What effect does the choice of the socio-economic system have on the socio-economic welfare of the people living in that system, and those in other systems? There is much in economic theory and policy that is intended to provide macroeconomic guidance to government and micro-economic guidance to firms, consumers, and other groups as they collectively or individually decide on the allocation of resources in the production of different goods and their allocation among various agents, and so on. The guidance targets high levels of economic welfare, albeit such outcomes are definable in various ways. Clearly, the particulars of the economic system are crucial factors influencing these decisions and their outcomes. Going beyond economic welfare, an economic system is essentially a means towards achieving some fundamental goals of society, such as freedom, egalitarianism, democracy, and ecological survival, next to satisfying material standards for the serving population. Although these goals cannot be valued objectively, the study of different socio-economic systems can throw light on the trade-offs between these goals. In addition to providing basic theoretical and applied foundations towards handling such as mentioned above, the study of comparative economic systems helps to acquaint agents in different economic systems and relating countries with and appreciate the understanding of economic systems of countries with which they live in and share one globe. A deeper understanding of one’s own system and other systems contributes to a peaceful and fostering whole, next to 1

2


sharpening the scientific basis for the mastery of economic tools as more insights are gained into formulating institutional assumptions that come closest to world realities. Notwithstanding, the study of economic systems, in itself, has gone through ups and downs from its very start, which can be said to coincide with Adam Smith, and economics in general. The traditional approach to the study of economic systems established a collection of prototypes corresponding to the major ‘isms’ – capitalism, socialism, and communism. The initial commitment to this approach was the product of conflicting political and social ideologies, a conflict that dates to the late nineteenth century when the systems of capitalism and socialism were debated and contrasted primarily (but not exclusively) on the relative merits of their social, economic, and political implications. An important corollary of the emphasis on the ideological content of the economic system was the emphasis placed on property relations as the key element in distinguishing systems. This emphasis was rooted in the classical economics of Adam Smith, David Ricardo, and John Stuart Mill and was elevated to an ideological standpoint by Karl Marx. The traditional framework developed for the analysis of economic systems in the twentieth century reflected the ideological divide and the cold war between the two opponent regimes of capitalism and communism. This preoccupation with ideology has distracted attention from fundamental research into the phenomena and foundations of economic systems. The result is that once the choice between capitalism and communism was no more relevant by mid-1980, the subdiscipline of economic systems came to face identification crises in the past two decades. The literature on economic systems in the twentieth century was in general interested in the descriptive analysis of capitalism and communism, as by Gregory Grossman, Janos Kornai, Egon Neuberger, Frederic Pryor, and others, their comparative evaluation as by Friedrich von Hayek, compromise regimes as by Oscar Lange, and convergence and the optimal economic order as by Jan Tinbergen. Over the years, workable alternatives to capitalism have appeared, and prototypes have evolved in response to changing political and economic realities. Various thinkers have debated variations on the same basic themes: capitalism has been subdivided into ‘competitive’, ‘regulated’, and ‘welfare’ capitalism; socialism into ‘liberal’, ‘command’, and ‘market’ socialism. In contrast, little attention went to theorizing on the formation, evolution, and differentiation of economic systems, with the exception of several basic contributions by Morris Bornstein, Leonid Hurwicz, Tjalling Koopmans, and John Montias.1 The study of economic systems is currently undergoing basic changes. New issues that ask for clarification are emerging, but the traditional framework has not been helpful in addressing them. The traditional framework for the study of economic systems, based on an ideological debate on capitalism and communism, diverted attention away from fundamental questions relating to the microand macro-interactions in economic systems. The current situation for the study of economic systems can be practically described as that of a new start. There is

Understanding Economic Systems 3

recently a renewed interest in related issues partly stimulated by the recognition that next to convergence tendencies in some areas there are significant institutional diversifications among in the Organization for Economic Cooperation and Development (OECD) countries Jackson and Deeg (2006); that behavioural traits of the communist regime are re-emerging in ex-Soviet countries, Beck and Laeven (2006); and the quest for a healthy relationship between economic and political participation and progress in the developing world, Barro (1996). There are now various calls and attempts to theorize on these matters, as found in Acemoglu and Robinson (2005), and North, Wallis and Weingast (2006). The treatment of these issues is a distinct departure from the traditional framework and is genuinely new. The purpose of this chapter is to contribute to theories on the formation, evolution, and differentiation of economic systems. It shares with the last two references the purpose of developing a conceptual framework for understanding long-range changes in the economy and polity, but the unit of analysis, methods, findings, and implications differ in all three works. Our framework emphasizes the location and interaction of agents in distinct behavioural settings as the clue for understanding how agents, and the economic system they form, become aligned with a particular behavioural setting, take over the typical behavioural type that associates with that behavioural setting, and spread it to other settings via various channels. The main components of the approach pursued will be displayed, and then combined to distinguish between basically different economic systems. Country examples are added in support of the arguments. We focus on three distinct behavioural settings and behavioural types, namely those typical of the traditional household, the modern firm, and the state. We treat economic transformations within these settings, as well as inter-transactions, intercommunications, and inter-mobility of agents between these settings. We derive three distinct social regimes that associate with these settings, display the mechanisms involved, and classify countries along these regimes and their intersections. In separate sections we answer why and how different regimes evolve from different external environments and from different combinations of personal and collective needs; illustrate main arguments using a conceptual model; and recapitulate on the comparative performance of settings and regimes. We also elaborate in a separate section on the micro- and macro- interactive processes in economic systems in general. A final section describes the outline of the book.

1.2

Behavioural types and behavioural settings

We start from behavioural settings, following Fox (1984). A behavioural setting g is a physical site populated by interacting persons that became members of the setting by accident and/or choice. Behavioural settings relevant for economic analysis are those that generate for their participants added value from the transformation of some activities. Agents inhabiting such a behavioural setting engage in a value added transformation of goods and services, subject to institutional rules, information flows, and physical and technological transformation boundaries. Agents fulfil

4


different roles within any setting. Some perform leader roles, the rest perform various subordinate roles. Furthermore, agents are endowed with, and acquire in the process, different attributes. A well functioning setting would allocate such roles to agents with attributes that fit most to those roles. The most common examples of behavioural settings of interest for economic analysis are household, firm, and state settings, to be denoted by g {h, f, s}. The most common examples of household settings are a domicile, an extended family, or a kinship network; firm settings include firms, shops, and markets; while state settings include legislative chambers, government offices, public lockets, and state enterprises.2 Many more behavioural settings are not engaged in economic transformations. Some of these, that we call persuasive settings, have significant bearings for economic transformations, as will become clear later. We shall focus below on the three settings of the household, firm, and state. A distinct behavioural type characterizes each of the three behavioural settings. Transformation processes in the household, firm, and state settings are driven by intrinsically distinct behavioural motives that are typical of the given environment that circumscribes the setting. In terms of motivation, social sharing and reciprocal exchanges are the underlying motives in the traditional household settings. Profit maximization is the intrinsic motive in firm and market settings. Political returns and rent seeking are the intrinsic motives in state and related settings. In terms of coordination, the coordination mechanism in traditional household settings is typically sociologic in character, in state settings coordination is politic, and in firm settings coordination is economic. Sociologic behaviour is the basis for coordinating communal relationships in the social group. The motto of the homo sociologic here is from whom according to his ability and to whom according to his needs, resulting in social sharing and committed reciprocity. The coordination of firm settings is economic in character. The homo economic makes choices in production and exchanges such that material benefits minus costs are maximized. From whom according to his abilities and efforts and to whom in accordance with his relative abilities and efforts is the motto that is typical of firm settings. The coordination of state settings is politic in character. The homo politic brokers a settlement among insecure and/or differing parties in ways that guarantee security and resolve conflict peacefully, and with simultaneously building institutions that achieve maximum power and protective rent for the broker. The motto in state settings is best described as from whom according to maximum negotiable ability and to whom according to minimum negotiable needs. The three distinct behavioural motives can be modelled as is done in equations 1, 2, and 3, below.3 In the traditional household setting, the agents lump together their benefits and costs in an effort to make total benefits exceed total costs. In equation 1, V h stands for the value added in the household setting and it is when benefits B and costs Q of agents i and i’ are lumped together and somehow shared among all i. V h Bi Bi’ Qi Qi’ 0.

(1)


The agents would thrive to distribute these benefits and costs between i and i’ in ways that contribute to a maximum value added or at least a positive result for the whole setting. The resulting income distribution among agents i and i’ can be affected by personal and relational circumstances. In the firm setting, equation 2, the value added in the firm is denoted by Vf. In the firm setting each agent i and i’ would like to realize the highest positive returns to oneself, and thereby allowing the firm to maximize its returns to capital beyond the rate of interest r at which it borrows capital. The returns to capital are defined as benefits less costs per unit of capital invested; the latter can be related to the total cost via a parameter π. Vf S (BiQi) / pS Qi r

(2)

The resulting income distribution among agents i and i’ is likely to show returns of one agent higher than the other. To model the state setting we attach to variables B, Q, V subscript s, as compared to the pre-state setting, subscript ps. We also employ k to represent agents with state authority. Equation 3 shows a higher value added in the state setting compared to the pre-state setting. This is due to a reorganized transformation with intervention of state agents k that results in S Bsi S Bpsi and/or S Qsi S Qsik S Q psi. Part of S Qsi is a privately incurred cost and the other part is the collectively invested expenditure that allows for the higher value added transformation. Vps S Bpsi S Q psi 0, Vs S Bsi S Qsi S Qsik 0

(3)

Agents in the state setting, k, acquire an authority to extract a remuneration from all other agents denoted by Qsik, such that the average remuneration for k is higher than the average level of net benefits left over for agents i. Distribution of incomes will manifest on the average a higher level for the authority agent k than for subordinate agents i. Given the above distinct behavioural patterns per distinct setting, the coordination mechanisms in the three settings are distinctly different. The coordination mechanism in households is typically sociologic in character, in firms coordination is economic, and in state settings coordination is political. Settings can relate to each other horizontally and vertically as organizations do. Proceeding to a higher level of organization, large numbers of comparable economic settings manifesting the same coordination mechanisms and organizational culture in resolving economic choices result in a macro frame that can be identified as a uniform economic system, denoted by m. Such a system is an integrated aggregation of a large number of similar settings. For example, an allhouseholds economic system is one in which each and all economic settings are of the household type. This is a hypothetical example, although primitive society and village communities in some developing countries resemble such cases. Other hypothetical examples are those of an all-firms economic system and an

6


all-state economic system, even though some real world counterparts are not unthinkable. What are the characteristic features of each of the three behavioural settings? In particular, how do the external environments that embody these settings differ? And how do the three types of settings differ with respect to structure and conduct? The external environment is a basic determinant of behavioural settings and of the behavioural type that characterizes the setting. Different external environments generate typical coordination structures that coincide and fit with typical behavioural settings. Agent interactions in the context of the given environment reinforce the conditioning of the settings to adapt to a dominant coordination structure, mechanisms, and cultures, leading usually to a coherent and predictable socio-politico-economic structure that can be recognized as such. External environments typical of the traditional household settings h are characterized by a closed world, homogeneous population, severe scarcity of resources, and low levels of material well-being. This external environment promotes sharing behaviour and solidarity structures coinciding with and taking place in household settings. Agents in these settings are conditioned towards adopting institutions of familial altruism, brotherhood attitudes, income sharing, and reciprocal exchanges at the group level. External environment typical of firm settings f are characterized by high mobility, and an open world with many options. The f setting promotes profit maximization and commercial exchange structures taking place in firms and markets. These settings would influence connected settings to adopt institutions of profit maximization, property rights, fair competition, and open markets. External environments typical of state settings s are characterized by highly skewed human endowments, esteem, and rank among differentiated population groups. The s setting supports restricted mobility, surplus creation, and makes exploitation feasible. It promotes politicized behaviour and command structures coinciding with and taking place in state settings interactions. These settings would influence connected settings towards adopting institutions of rent seeking, asymmetric, and overlapping property rights, forced subjection, and authoritarian rules.

1.3 Distinct behavioural types determining different economic systems The three configurations of economic systems, corresponding fully with three types of behavioural settings, are hypothetical. They represent extreme prototypes, since anywhere in the real world all three types of economic settings coexist and interact together in the macro-frame of the economic system. In any country, one finds households, firms, and state settings co-existing in large numbers side to side. The same agents can be members of more than one setting simultaneously. Agents communicate with agents within their own settings and other settings. The interactions are given shape in Figure 1.1.


Households

Firms

State

Figure 1.1

Interactions of micro settings and the macro frame

The squares, triangles, and circles refer to the three behavioural settings, each with its own members; the engagement lines linking them indicate transformation and mutual exchanges taking place among agents in or between the organizations, as well as communicated behaviours. Each engagement line can be interpreted as consisting of a large number of bits of exchanged transformations and communicated traits. Such an engagement line can be denoted by Eigi’g’. As these bits are not uniform in intensity in terms of time, effort, or effects, they can be normalized making use of some scale of the intensity of the engagement, N, in terms of time, effort or effect. The engagements weighted by intensities can be expressed by Sig (Eigi’g’. Nigi’g’). This term can be eventually divided by the sum of all engagements weighted by intensity in the whole economy to give a relative measure of the strength and dominance of the engagement lines. They can be drawn lightly or heavily to reflect relative strength, as shown in the figure. A setting generates outcomes that are distributed as rewards to its members. The distributed rewards in competing settings are crucial for an evaluation that participating agents regularly do, and which guides them in their decision to continue in the setting, voice, or exit and enter a more rewarding setting.4 The propensity to move and participate in alternative settings satiates when the marginal utility of the agent of shifting a unit of effort between settings is equal to the marginal cost of the shift. The engagement lines can accordingly be given an additional meaning: they contain agent mobility and express directions of reallocation of agents between alternative settings. Processes of exchanged transformations, communicated traits, and agent reallocations, if not obstructed by separation barriers, would lead over lengthy periods to greater concentrations of agents in related behavioural settings g than others g’, opening the way for the spread and dominance of the behavioural type G that coincides with behavioural setting g. Once a threshold is reached with regard to accepting a specific behavioural type G, this G can be expected to gain momentum in view of network externalities, and will spread further and subordinate other G’. The adoption and spread of a particular behavioural type among more agents has been studied in many contexts, and there are well-known related mechanisms in the literature.5

8


A conglomeration of interacting behavioural settings having a common dominant core is very likely to evolve into, and be identifiable as, a social system. The structure, conduct, and outcomes of the social system will tend to be relatively homogeneous and reasonably predictable. Each social system has its own integral economic aspects that describe together its economic system. Similarly, each social system has its own integral polity. It is logical to expect high degrees of consistency and correlation between the economy and polity of a specific social system.6 To recapitulate, agents adopt the behaviour of the setting that they inhabit most and in which they interact most, and spread it to other settings they communicate with, or partially inhabit.7 Several points relating to the above can be emphasized. (a) Coordination mechanisms in each of the three settings are distinct and different from each other, and stand for different prototypes of behaviour. (b) All three types of settings do coexist in large numbers side to side in any country; and agents may thus interact within and between all three settings. (c) Economic exchanges between the many settings, and presence of agents in more than one setting, are crucial factors in fostering communication, integration, and convergence among the settings. (d) In any one country and over many years, complex interactions take place between people cross-inhabiting and cross-dealing with settings; these result into integrative processes that have usually ended up in a domination of one of the three coordination mechanisms (or behavioural prototypes) over the others. (e) The complex interactions involve the external environment, initial cross-concentration of agents in settings, intensity of interactions, and mobility of agents in and between settings. (f) Notwithstanding, there are thresholds conditions under which domination of one coordination mechanism over the others cannot be realized, resulting into loosely linked economic systems. Sharing common external environments among related behavioural settings, communication in and between settings, mobility among settings, and network externalities, tend to end up in a social system, with an integral economic system allied to it that would manifest one dominant behavioural type G over others G’. The general tendencies of convergence towards a dominant behavioural type have, in principle, as outcomes three distinct economic systems. The first type, and the oldest, is the economic system that circles around traditional households and in which all settings have adapted to the traditional household behavioural traits. This can be called the household intensive system, HIM, as in Figure 1.2a. In the real world, many rural regions within developing countries would qualify as HIM. At the country level, there are limited examples that fully operate along the lines of HIM. The second type, depicted in Figure 1.2b, is the economic system where agents adopt a firm-like behavioural type, i.e. maximization of material returns at least material cost. The firm intensive system, FIM, has many copies in the real world; the best example is US. The third type, depicted in Figure 1.2c, is the economic system where agents have adapted to a state-like behavioural type that is guided by rent appropriation and political returns. In the real world, there are a good number of countries that operate along the state intensive system, SIM, one example is Russia.


(a) Households

Firms

State

(b) Households

Firms

State

(c) Households

Firms

State

Figure 1.2 (a,b,c)

Configurations of three socio-economic systems: HIM, FIM, SIM

In general, the ability to predict the structure and conduct of the economic system of a specific country depend on how uniform and integrated is the economic system in that country. For example, the modelling and analysis of the structure and conduct of the FIM along the lines of profit maximizing behaviour in

10 Economic Systems Analysis and Policies

a country like US; and similarly for the SIM along the lines of rent appropriating behaviour in a country like Russia, should be seen as workable approximations made possible by over majorities of agents behaving along these distinguished lines under the two systems in the two countries, respectively. Prediction is more difficult for loosely linked and less integrated systems that are characteristic of many developing countries. Specific conditions can exist that may delay convergence towards one dominant behavioural type. There can be barriers that separate specific groups of agents from interacting together intensively, and as a result the specific groups remain genuinely separated and convergence is substantially delayed or even not realized. Such barriers that separate agent groups can be based on significant differences in the religion, ethnic origin, or socio-economic status and living styles of the groups. A very skewed distribution of income and endowments tends to strengthen the perpetuation of upper and lower socio-economic strata in the population, create separation barriers, and hinder agent interaction and behavioural convergence. This phenomenon shows up in the context of some Latin American countries where there are significant differences in earnings and endowments by birth and origin, and high degrees of socio-economic stratification.8 In principle, convergence would occur once the separation barriers are relaxed. A more fundamental case in which convergence towards one dominant behaviour may not occur is where the absorption of agents from household into firm or state settings faces boundaries because of the sheer large numbers of agents to be absorbed, as, for example, in China or India. These countries have vast rural populations that are attached to household settings, and at the same time significant urban populations manifesting subcultures relating to firms and state. The distribution of agents on these settings has been historically stable, and given the magnitudes of agents involved the distribution may not change much in the future.9 The result is a loosely linked multipoles system that can be denoted by MPM. It can be asked how is such a system kept intact. The answer is that especially in such a system, there is a host of institutional settings that link the multiple. These include political congresses, judiciary courts, religious, and intellectual and media circles. A suited name for these settings is persuasive settings. Persuasive settings play a crucial role in the streamlining of developments among these segments. Persuasive settings are exclusive settings. Participating agents are highly talented leaders who are able to place themselves as leaders in various contexts: household, firm, state, religious, intellectual, and judiciary settings, as well as spatially, in rural and urban areas. They are the so-called ‘wise men’, and they are able to obtain the support of leaders that lead different settings. They have the natural authority to affirm the status quo and anticipated changes. Persuasive settings are usually much higher up in the hierarchy of settings. Occasionally leading persons from different settings would sit down together and forge crucial deals and endorsements that commit their fellow members in their settings, simultaneously and mutually. Such deals and endorsements can


be interpreted to contain value added transformations conceived as such by the leading persons representing their constituent settings and usually backed by their fellow members in the concerned settings. But persuasive settings do not constitute economic transformation settings in the conventional sense. However, they can be vital for rationalizing and endorsing multipolar behavioural patterns within the same borders, for binding loosely linked settings into one whole, and for the smooth operation of the economic system in a diversified country. To the extent that agent distribution among these segments in these countries will continue to keep a stable balance in the future it can be expected that persuasive settings will increase their leverage significantly in environments of such big countries as China and India.10 The introduction of behavioural settings suggests that there can be fourth configurations of economic systems as sketched in Figure 1.2d. This figure shows location of the population in two segments: rural and urban. Agents interacting in the rural segment do that in household settings with little interaction with firms and state settings. In situations where very large numbers of agents are rural, these village agents cannot be possibly absorbed into the urban segment for a long time to come, and hence it is unlikely that they would converge to either firm or state behavioural types typical of urban areas. The figure is a fair representation of big countries such as China, India, and some other Asian countries. Persuasive settings are introduced in the figure via stars. The dashed lines are indicative of the influence of persuasion settings on other settings. These influences are most effective when there are mutual feedbacks between the persuasive and the other settings.

Urban households

Firms

Urban/rural administration

Rural households

Figure 1.2d

Configuration of a multi-poles socio-economic system: MPM

12


1.4 Positioning countries along behaviourally different economic systems What makes a network of interactions comprehensible as a distinct system is the prevalence of common revealed preferences and typical coordination tracts, structures, and performances as can be observed in countries considered to have adapted to that system, as compared to other groups of countries with a different behavioural focus. How is the common formed? And how is the prevalence caused? We emphasize four factors, mentioned in passing in previous sections, and which are elaborated here and later: (a) Settings with relatively greater numbers of agents and greater economic transformations are likely to become more prevalent. Over time, agents observe the transformation outcomes in alternative settings, and move to the advantaged setting or copy its behaviour, thus resulting in the prospect that the typical behaviour of the advantaged setting becoming more prevalent; (b) Highly intensive and extensive interactions and outward communications of agents belonging to a particular setting and their participation in other and more settings allows the greater prevalence of this particular setting and its associated behavioural type; (c) Network externalities enforce further convergence towards the most prevalent setting and behavioural type. Finally, and of paramount importance; (d) sharing of common external environment and history fosters convergence towards a common behavioural type. Furthermore, there is the strong association between specific given environments, behavioural settings and behavioural types. When a behavioural setting g happens to stand higher than g’ in the hierarchy of settings, then g is also able to set rules that other settings g’ would follow. And in this way, the behavioural type associated with g’ is subjugated to that of g, allowing a further dominance of the behavioural type associated with g. Finally, if persuasive settings, being the highest, affirm the socio-economic order, then prevalence of stipulated behavioural type in the economic system is complete.11 To drive the point at the cost of some exaggeration, we maintain that in US the high concentration of agent interactions in firms pushes intrinsic motivations in the household and state settings aside and they are replaced over time by profit maximization typical of the firm settings. In contrast, the same processes oblige agents in household and firm settings in Russia to follow a politicized motive typical of state settings. As a result, all three settings in US behave in ways typical of firm settings, while in Russia they manifest behaviour typical of state settings. In the extreme, a comparison between the economic systems of US and Russia is a comparison of two contrasting behavioural types that involves the political, and the whole social, system. In US, the economic motive dominates, and the polity can be described to have adapted itself to the economic motive. Next to constitutional checks and balances, and an independent judiciary system, that keep state discourse in control, profit maximizing firms and agents have installed more institutions for controlling state conduct, and in some cases bending the polity to realize economic interests. In contrast, in Russia the polity can be seen as exogenous to the economy.12


Apart from the two examples above, it is not always easy to identify individual nations in the real world with prototype economic systems that we developed for gaining analytical insight. However, economists manage successfully to group countries that share several properties together. There are international mechanisms relating to sharing trade, politics, events, history, culture, religion, ideology, and distance that tend to attach together some countries away from others. In discussions on economic systems, economists have traditionally grouped Western industrial countries together under the labels of capitalist and/or free market economies, and the former Soviet Union and allied countries under the labels of communist and/or centrally planned economies. The rest of the world was then named the third world and/or developing countries. Our classification of countries and regions along economic systems is in terms of HIM, FIM, and SIM, and we assign individual countries and regions to these systems based on a variety of country indicators relating to structures and conducts that correspond a priori with the specific features of these systems. In the following chapters, a large number of country indicators on the structure and conduct of their economies will be displayed in support of the classification. Our classification is also more refined than traditional classifications by allowing a diversification between countries within FIM and SIM, and a varied positioning of regional groups among developing countries. In applying the classification, it is thought that it is more functional and purposeful to proceed from some established regional divisions such as those followed by the World Bank, and which are generally followed by the profession, than to introduce new regional terms and specifications with which readers are not acquainted. We add refinements on the World Bank regional divisions, by adding one more region, introducing relevant and significant subdivisions within the regional divisions and where the need arises, reflecting on specific conditions for a few special case countries. The World Bank regional divisions take the industrialized countries by their country names; these are mostly OECD countries. Then there are the former ex-Soviet republics and allied countries; commonly called transition countries. Within the industrialized countries we make a distinction between United States of America (US), Western Europe (WE), and Japan. Similarly, within the transition countries we make a distinction between Russia, the Baltic, Central and Eastern Europe (BCEE), and all other ex-Soviet Republics (EXSR). World Bank regionalizes developing countries into five groups: East Asia and Pacific (EAP), South Asia (SA), Middle East and North Africa (MENA), Sub-Saharan Africa (SSA), and Latin America and Caribbean (LAC). We follow these regional divisions too, and we add a sixth region of countries of the Arab Gulf (GCC). This region consists of six oil-rich countries.13 As a result, MENA excludes these six oil-rich countries.14 We shall elaborate also on subdivisions within developing regions in due course.15 The outcome of our positioning of the above countries and country regions in the world at large along the four economic systems is displayed in Figure 1.3. As will be apparent from Chapters 3 and 4, the analysis and ranking of a large

14


South Asia SA

East Asia Pacific EAP

Japan

HIM

US FIM

Latin America Caribbean LAC Sub Saharan Africa SSA

Western Europe WE

Middle East Nr. Af. MENA

Arab Gulf GCC SIM

Ex-Soviet republics EXSR

Figure 1.3

Russia

Baltic, Central, Eastern Europe CEEE

Positioning of economies along axis of dominant systemic interactions

number of empirical indicators relating to firm and state settings shows US to be most close to FIM,16 while Japan and West European countries, also identifiable as FIM, yet showing differing inclinations towards HIM and SIM, respectively. West European countries lie on the right of US and reflect a state control-inclined economy that is characteristic of SIM.17 In Figure 1.3, Japan lies to the left of US and reflects a household sharing-inclined economy that is characteristic of HIM.18 In Chapters 5 and 6, we examine indicators that show Russia to fit most to SIM, with the BCEE and EXSR country groups also manifesting SIM but showing differing inclinations to the HIM and FIM, respectively. The East European former satellites lean slightly more to firm settings. The EXSR lean slightly more to household settings.19 Chapters 7 and 8 are devoted to examining economic systems in developing countries; their positioning is shown in Figure 1.3. Geographically seen, we start with the EAP region and move eastwards to other regions. To start with, the positioning of the EAP, consisting of China, Indonesia, Philippines, Vietnam, Thailand, Malaysia, among others and Pacific Islands, close to HIM and along the HIM–FIM axis, reflects the facts that the majority of agents in the region are still in rural areas where household settings count, despite a sizable population living in urban areas, working in commercial firms, and manifesting the impact of firm settings. We show in Figure 1.3 a special position for China, given its characteristic multipolar economic system. The South Asian region, consisting of India, Bangladesh, Pakistan, Sri Lanka, among others, is placed in the HIM corner, which reflects the relatively higher dominance of household settings in this region. The SA region, like the EAP, is also positioned along the HIM–FIM axis; but SA is much closer to HIM than FIM, when compared to EAP. We refer also in Figure 1.3 to a special position for India, based on previously stated arguments regarding prevalent multipoles structure.


Practically speaking, the Arab countries, sharing common linguistic, historical, religious, and socio-cultural features, fall in the two regions of GCC and MENA. The oil-rich Arab Gulf countries, i.e. the GCC region, are traditionally known for a dominance of household settings. While household settings are dominant, due to various historical and cultural precedents, state authorities have a significant influence in these regions. More recently, oil exploitation, the oil booms, and the quick modernization of the GCC region resulted in the conversion of major segments of the GCC economies into firm oriented settings.20 The region is placed along the axis of HIM and SIM, and with a close distance to FIM in view of its modern segments. The Middle East and North African countries, i.e. MENA region, are placed halfway the HIM–SIM axis, in view of long histories and religious traditions by which households voluntarily entrust state leadership, whether it is led by royalty, president, military, or religious council, with authorized and extended rights and obligations. Notwithstanding, the state settings undergo other checks and balances instituted by history and tradition and are thus less intensive and dominant in MENA than in the ex-Soviet and allied countries. The Sub Sahara African countries are positioned along the axis HIM and SIM. As kinship and ethnic ties occupy a central role in agent interaction in most SSA countries, it is logical to position SSA closer to the traditional household settingsHIM corner. Because of the influential role of the state in African countries they are positioned along the HIM–SIM axis. But state institutions in SSA are not as strongly institutionalized as in the ex-Soviet and allied countries. Finally, the positioning of LAC, consisting of Latin American and Caribbean countries, is along the HIM–FIM axis, but closer to FIM than HIM, reflecting long periods of a significant impact of firm settings on the economic system, and a relatively higher degree of urbanization than other developing countries. However, separation barriers between population groups in LAC stand in the way of convergence towards a dominant behavioural type. Within the regions covering the developing countries there can be important variations. Some of these variations can be systematized by introducing subdivisions to gain more reality and comprehension. This will be done in Chapters 7 and 8. In Chapter 7, we make the basic and important distinction between small developing countries and large developing countries with large populations living and working in rural and informal settings. In Chapter 8, we attempt to accomplish a meaningful overview of regional subdivisions by developing an analytical strategy based on a few basic hypotheses that have been displayed in this chapter. We apply these hypotheses to identify leading countries within regional div isions. The basic hypotheses are as follows: Among alternative settings that setting which contains the largest number of agents and manages the largest economic transformation is more likely to dominate on other settings. Furthermore, the intensity and extensiveness of interactions of agents and their outward communication to other settings, network externalities, and a common external environment matter in the prevalence and domination of one type of setting over others. The noun country can be substituted for the noun setting in

16


the above hypothesis. If a few measurable indicators can be identified at the country level regarding the size of the agent population, the size of the economic transformation, and the outward orientation of both the population and the economic transformation, countries within a regional division can be ranked to give an indication of leading country(ies) within a regional division, as will be done in Chapter 8. These are countries whose economic systems are likely to dominate the economic systems of the regional divisions. Focusing on the economic systems of these leading countries and understanding them is a richer alternative than reviewing the complexities and differences within the regional divisions. An application of the above strategy results in focusing on ten major countries that constitute poles of attraction likely to dominate neighbouring countries in the identified regional group. These ten countries are also the focus of further treatment in Chapters 7 and 8. The countries are China and Indonesia (EAP), India and Pakistan (SA), United Arab Emirates (GCC), Egypt (MENA), Nigeria and South Africa (SSA), and Brazil and Mexico (LAC). Certain aspects in two countries, Indonesia and Pakistan, belonging to SA and EAP, respectively, will be treated at some length in Chapter 7, the other countries in Chapter 8. A closer look will detect that in some developing regions there are outliercountries that can be characterized as having a state intensive economic system, very close to the sense used for the ex-Soviet Union and present Russia.21 Notwithstanding these exceptions, the positioning of the six developing regions along the indicated planes of HIM–FIM and HIM–SIM meets global and average criteria and contributes to a rational and anticipated distinction between the developing regions and other world regions that distinctly lie in or along the axis of FIM and SIM.

1.5

Outline of the book

This first chapter gave the basic components of a conceptual framework for studying economic systems and went some way in applying it. The application gave a positioning of countries and country groups along four identified economic systems and their intersections, and relating motivations. Chapter 2 elaborates on the analytical framework. It elaborates on the micro behaviour of agents in the short run, and the convergence of agent behaviour into distinct economic systems in the long. We make use of simple conceptual models to illustrate the involved mechanisms in the short and long runs. The chapter then examines the structure, conduct, performance, and attitudes in different economic systems. Each system carries with it particular social attitudes. Making use of results from the World Values Surveys (WVS), the chapter checks on how attitudes with regard to household, firm, and state settings differ in countries that associate with HIM, FIM, and SIM, respectively. The check supports our specific positioning of countries and country groups along the axis of HIM, FIM, and SIM. Chapters 3 and 4 study the economic systems in FIM relating countries, in particular, US, Western Europe, and Japan. While Chapter 3 focuses on the economy, Chapter 4 treats the polity.


Chapter 3 reviews the economic principles of the pure firm intensive system. The optimal performance of the perfect market economy centred on firms depends on the fulfilment of four presumptions; that is absence of indivisibilities, uncertainties, externalities, and collectivities. Non-fulfilment of underlying presumptions in the real world results in inefficiencies that may be remedied by firms and market solutions and/or state interventions. A fifth presumption towards reaching highest welfare relates to income distribution. Market failures occur in the five areas. The chapter treats each of the five market failures by reviewing the problem, and examining and assessing the response of affected firms and state intervention in resolving the problems. We make use of FIM-related country data to illustrate the problems and illuminate country differences. Chapter 4 turns to the treatment of the polity in the FIM and relating countries. In a FIM economic system, profit maximization is the underlying common behavioural pattern of all actors, thus both firms and state. The political process in such a system can be described as an exchange process subject to instituted constraints that serve the FIM system. The functioning of state institutions, and state agents, i.e. voters, political parties, governing politicians, bureaucrats, interest groups, public sector employees, is equivalent to that of a marketplace. The chapter addresses several questions. Who are the main actors in this polity and how do they function and interact in the FIM nation state in relation to their two main activities in the economy: public regulation and public spending? What are the consequences of their functioning for the size of the public sector versus the private sector, and for the economic and social welfare of the nation as a whole? The chapter uses comparative country examples from US, EU, and Japan, among other FIM relating countries, to illustrate the extent and variety of the political influence of the executive branch on the economic system and its economic performance. Chapters 5 and 6 study the economic systems in SIM relating countries, in particular, Russia and the ex-Soviet republics and allied countries. Chapter 5 examines how the polity dictated its rules and policies on the economy in the past communist era. Chapter 6 turns to the transition period and studies the transitional problems, reforms and progress in the transition countries. Chapter 5 demonstrates the point that state settings in SIM are all-dominant and all-political in their behaviour, making the economy a by-product of the polity. The main features of the communist regime of the Soviet Union are reviewed with more attention given to the state as the sole coordinator and driver of the economy via a system of central planning and monitoring. We treat procedures, methods, forms, and the practical operation of central planning. System reforms and state policies will be reviewed and the failing results evaluated. The chapter looks at the past economic growth and distribution performances of the Soviet Union and its allies, and compares them with those of FIM relating countries to obtain a grasp into the missed opportunities of communist countries to achieve more. Not only did most of the reforms, policies, and performance fail, but the whole regime fall short of achieving the announced objectives which it promised for its people. The chapter reviews alternative explanations for the failure of the


communist regimes. The explanations rely, to different extents, on economic, social, and political theory. Chapter 6 starts from where the communist regime collapsed. A heavy recession, which endured from four to ten years depending on the SIM relating economy, wiped on average about 40 per cent of the GDP. The chapter examines the magnitudes and causes of the transitional recession in the ex-Soviet Union and European associates. It then gives a review of transitional reforms and their phasing into what is called short transition and long transition. A SIM relating country undergoing the long transition is confronted with economic failures that appear also in the FIM countries. These are economic imperfections due to the presence of indivisibilities, uncertainties, externalities, collectivities, and inequalities. The responses of firms and state settings to these economic challenges are different in the two systems. In contrast to FIM countries where firms orchestrated the remedies, the responses in most of the transition countries reflect a dominance of state agents, rent seeking practices, and disruptive consequences that are consistent with the assumptions of the state intensive economic system. The chapter displays separate empirical material on these disruptions for Russia, EXSR, and BCEE. The results show the disruptions to be highest in Russia, followed by EXSR and BCEE. Chapters 7 and 8 examine the economic systems of six developing regions. Chapter 7 discusses five to six decades of social, political, and economic developments across the six regions. Chapter 8 considers each region separately, giving more emphasis to China and India. Chapter 7 treats several groups of related questions on the changing economic systems in the six developing regions. Which mixtures of social, political, and economic structures were initially present in various parts of the developing world in roughly the eighteenth century? What are the major historical epochs, since then, through which developing countries passed and are still passing? How were the roles and significance of behavioural settings such as of the household, state, and firm affected? What can be said of the economic system in very large countries with substantial populations living apart in household settings, and in firm settings? Which macro and micro analytical and policy frameworks are able to catch multiple systemic prototypes in the same country? The chapter attempts to give region-wise differentiated answers to these questions and support the answers by empirical material from the six developing regions. Chapter 8 combines indicators of (a) country’s share in the regional agent population and (b) country’s share in the regional economic transformation, in determining countries whose economic systems are likely to dominate the economic systems of the concerned region. The analysis renders eight such countries across the third world, whose economies are studied further. The chapter devotes most attention to China and India. The chapter reviews for both countries the past background, the systemic changes accompanying economic development, and critical issues regarding system performance, future outlook, and coordination problems in multipolar social systems.


Chapters 9 and 10 elaborate on methods and applications for the comparative analysis of economic systems. Chapter 9 develops the Social Accounting Martrix, SAM, into a comparative model for evaluating the structure and performance of countries manifesting different economic systems. The chapter explores the growth and distribution effects of state and external injections in the economy. It does this for a selection of FIM and SIM relating countries: Italy, Germany, Netherlands, and Spain as representatives of Western Europe; and Hungary and Poland for Eastern Europe. Furthermore, the chapter adds a few refinements to the SAM analysis in an applied comparative evaluation of the SAMs of Russia and China. Chapter 10 investigates long-term tendencies in the income per capita gap between rich and poor countries, and catch-up tendencies in both income per capita and the GDP. First, while most studies have relied mainly on supply side models of economic growth, this chapter offers a demand side model, based on the social accounting matrix. The SAM model, applied to 16 countries belonging to different economic systems and economic development levels predicts, after adjusting for peculiarities of economic systems, higher economic growth at lower as compared to higher levels of income per capita, which is indicative of a convergent tendency. Main causes behind this convergent tendency are dispelled. Second, taking a longer time perspective, for instance 2040, the chapter examines displacement tendencies between countries, and their associated economic systems, with respect to the country’s size of the GDP. If current trends in economic growth are prolonged some of today’s developing countries, i.e. China and India, are projected to have larger shares of the world’s GDP than today’s developed countries, i.e. US and EU. The chapter speculates on the future profile of dominant economic systems in the world at large, and the place therein of household, firm and state settings, and the related behavioural types to these settings.

1.6 Summary and conclusions The first chapter laid down basic elements in a foundational analysis of economic systems that emphasizes the prominence of distinct behavioural types in driving economic systems. Individuals behave in accordance with the settings in which they live and interact. The joint presence of individuals in several roles, and in complimentary behavioural settings, intensifies the likelihood of agents facing similar environments, develop mutual expectations, and produce a unified behavioural pattern. Interdependent behaviour and mutual influences among agents in typical behavioural settings result in typical behaviours and revealed preferences that characterize different societal orders. Our foundational analysis of economic systems distinguishes between three behavioural settings that associate with distinct behavioural motives. We focus on household, firm, and state settings. Intensive interactions of agents in such settings lead to the evolvement in the long run of the household intensive system, HIM, the firm intensive system, FIM, and the state intensive system, SIM.

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The structure, conduct, and performance of the economic system in the HIM, FIM and SIM are basically different. Individuals who spend most of their day in household settings and are frequently in interaction with persons in similar behavioural settings, as is typical of village economies, develop a group and individual behaviour that is characterized by fraternity motives, group allegiance, mutual help, and sharing rights and obligations. When individuals, who strongly associate with household settings, perform ‘economic’ exchanges, these exchanges are socially coloured. Large portions of agent interaction in rural surroundings in developing countries can be described to associate with the HIM. A very different setting is that where individuals spend a great portion of their days in business settings where economic choices take place regularly, profit maximization and cost minimization hold, and entry and exit are commonplace. The interdependent behaviour between and among individuals living in the same commercially oriented settings results in a dominant economic behaviour that is typical of the business firm and the marketplace. Exchange between individuals tends to have the pure economic motivation behind it. US and many European countries associate most with the FIM. Another very different setting is that where the behaviour of individuals is coordinated for a large part via, by, and for state authorities. Political behaviour of individuals evolves over time towards taking the forms of strategic responses to use of opportunities and threat, more likelihood of rent seeking, and the accumulation of subordinating power. When individuals perform economic exchanges, these tend to be politically tainted economic exchanges. Significant portions of the populations in communist-like regimes in Russia and elsewhere lived and many are still living in politically dominated behavioural settings, characteristic of the SIM. We attempted to position major countries and regions along the axis of HIM, FIM, and SIM. The vast and highly dualistic countries of China and India would not fit in these configurations for now and for the near future. This is due to their densely populated multipolar orientation and the low prospects of absorption of these populations in any one setting. The remarkably big sizes of the segments relating to rural households, urban households, commercial enterprises, and state settings in such big countries stand in the way of an evolution of the social system towards a unified system that behaves along one dominant behavioural pattern. As a result, persuasive settings and persuasive institutions are bound to play a greater crucial role in coordinating the economic and political systems in these two countries, than elsewhere.

2 Elaborations on the Analytical Framework and Its Application

2.1

Introduction

In this chapter we elaborate on the analytical framework and its applications. Sections 2.2 and 2.3 develop a theory of changing economic systems that is based on interaction of agents in economic behavioural settings. Section 2.2 develops the premises of the theory in the process of answering several questions. Section 2.3 sketches a simple model of interacting economic behavioural settings that captures salient features. Sections 2.4 and 2.5 treat the emergence, evolution, and prevalence of specific behavioural types and economic systems over time. Section 2.4 lays out the principles. Section 2.5 makes use of a simple model to demonstrate the operation of the principles. Section 2.6 examines aspects of structure, conduct, and performance of economic systems; and it reflects on the comparative performances of economic system related country groups. Section 2.7 examines the diversification tendencies between countries that relate to different economic systems, as well as among countries that relate to the same economic system. Section 2.8 gives a summary and conclusions.

2.2

Micro and macro interactive processes in economic systems

Generally speaking, the function of positive economics in the context of economic systems is to uncover the static and dynamic properties of the (national) economic system and anticipate changes due to external and internal forces. Somehow, a system has to be assumed or identified as a well-behaving and predictable system to be studied at all, and be usefully employed. In doing that, four sets of questions are raised, which we display below. Our answers to these questions will explain our approach. The approach followed in building a theory of economic systems focuses on the interaction of agents in interactive economic behavioural settings. The building blocks of the theory will be grouped under the headings of external environment, internal structures, outcome performances, response processes, 21

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and systemic integration. Table 2.1 is a schematic presentation of these building blocks and is helpful for a quick review. The table gives the constituent elements in the left column and adds remarks on mechanisms in the right column. Let us start with listing the four sets of questions and our answers to them. First, what is the unit of analysis? What is the smallest (economic behavioural) setting that can be identified as an (economic behavioural) setting? What are the constituents of the external constraints, i.e. the external environment, which circumscribes the setting and determine its behavioural type? What are the constituents of the internal structures that allow the setting to function? Second, how do settings organize their agents in pursuing their aim, how do settings reward their agents for their efforts? Third, how do comparative rewards between alternative settings drive the agents to move from one setting to another? And what are the implications of this mobility, reshuffling, and response processes? Fourth, in which way does participation of agents in overlapping settings produce an identifiable (national) economic system and lead to systemic integration? To start with, in dealing with the first question regarding the unit of analysis, it is helpful to adopt the idea of a behavioural setting as described in K.A. Fox (1984). This is a physical site where participating agents mutually interact and generate some valued outcomes as perceived by those agents. Those behavioural settings, which have the objective of generating a valued transformation of artefacts to their participating members, would qualify as economic settings. Our focus is on economic behavioural settings, to which we refer henceforth as settings, and sometimes as organizations. We have distinguished between three main settings of relevance for the study of economic systems: household settings, firm settings, and state setting. All three settings involve economic transformations in which the values of the transformed products increase. Besides the primary forms of economic organizations at the micro-level such as households, firms, and state settings there are related types of settings at the meso-level such as cooperative organizations of households, business associations, interest groups, political parties, and various types of state governing bodies, and a vast number of different transforming markets. Each type of setting is circumscribed by distinct externally imposed constraints constituting the external environment and is characterized internally by different and distinct structural features, conducts, and outcomes. A behavioural setting is thus subjected to exogenously given external constraints, which affect and condition the internal structures of the setting. As a result, over a long period of time the external environment shapes the structural features of the setting, its conduct, and outcomes. The internal structures of an economic behavioural setting can be described to fall into four structures that can be briefly denoted by the following shortcuts: (1) the physical-technological transformation structure, (2) the transacting agent structure, (3) the institutional rules, and (4) the information structure. The following can be elaborated on each. (1) The transformation operates along physical-technological laws and restrictions, with the objective of increasing the

Elaborations on the Analytical Framework Table 2.1

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Building blocks of the analytical framework

External constraints (external environment) An economic behavioural setting is subjected to external constraints that shape the setting’s behaviour, structural features, and outcomes.

External environment constraints are given data for the referred setting. Different external environments lead to different behavioural types.

Internal structures (four structures) within the setting (i) The physical-technological transformation structure is the transformation process of an economic activity, T.

The transformation process is guided by given technologies and physical restrictions.

(ii) The structure of participating agents, p 1, ... ,#, manages the transformation process.

Each participating agent has his/her own role to play in the transformation process; next to goals, endowments, and attributes. These can be denoted by indicators q, collected together in a set of personal attributes Q. So there are Q p for p 1, ... ,#.

(iii) The structure of institutional rules, I, regulates interactions among agents. Institutional rules define obligations, rights, and decision-making responsibilities for each agent based on their roles in the setting and the transformation process.

The institutional rules are driven by behavioural motives that are tied to the type of setting. Sharing oriented rules are typical of household settings. Commerce oriented rules characterize firm settings. Polity oriented rules characterize state settings.

(iv) The structure of information signals, N, which agents use communicate to each other, drives the transformation process into motion.

Information can be some times incomplete and asymmetric, involving situations with adverse selection and moral hazard.

As interactions among members of an economic setting intensify and converge over many periods, the four internal structures will tend to adjust to each other, and integrate towards a homogeneous whole.

The four internal structures will undergo unified shaping towards a homogeneous whole that reflects the conditioning influences of the constraining external environment, and the behavioural type that is typical of the setting.

Outcome performance Periodically, each setting generates outcomes, i.e. transformed value added, which are distributed on participating agents. The effort of each agent is compensated with material and immaterial rewards.

Outcomes are signalled to agents in other settings. If freely signalled, agents will know the outcome performances of comparable agents in competing settings, allowing agents to appraise alternative allocations of their efforts on competing settings. Continued

24 Economic Systems Analysis and Policies Table 2.1

Continued

Response process The dynamics within a setting are set into motion by [c] leading to potential changes in institutional rules. A setting gaining members, set into motion by [d], adapts its institutional rules to newcomers.

Agents with an overweight of socialization motives are likely to opt for [a] and [b]. Agents with an overweight of self-identity motives are likely to opt for [c] and [d].

The end configuration between competing settings is that of growing and shrinking settings, as well as a hierarchy of settings.

The power of a setting is directly measurable by number of participating agents and size of transformed value added. In case of hierarchy, an indirect measure is the extent of authority that a higher setting has in laying external constraints on the conduct of agents of lower settings.

Systemic integration Agents carry with them the behaviour typical of their setting and manifest such behaviour in interactions with other agents in other settings in which they participate, transact, or communicate with. This results in a spread of the behavioural trait, and its institutionalization on a larger scale.

Degree of systemic integration depends on agent distribution and participation across settings, interaction intensities of agents within and between settings, network externalities, and extent to which settings share the same external environment.

value of the transformed good. (2) The transformation is operated by a population of agents with varying attributes and values, whereby each agent searches for a satisfactory combination between use of his endowments (means) and fulfilment of his preferences (aims). (3) The transformation is governed by institutions, which delineate rules on the transformation, and on the behaviour, rights, and obligations of agents engaged in the transformation. (4) The transformation process is set into motion by a complex of information flows communicated by the agents on (1), (2), and (3). When taken together it can be stated that an economic behavioural setting is engaged in an economic transformation; it has its own members, who are mobile agents with varying attributes and converging values. The transformation is carried under physical and technological restrictions; the transformation takes place under a set of institutions containing behavioural rules on the conduct of the interacting members, such rules were formed in earlier periods, and they undergo changes as a result of changes in technicalities, information and profiles; and the transformation is set into motion by information flows between the members. In general, the components of the internal structure will adjust to each other to produce a consistent whole that converges with the external environment.

Elaborations on the Analytical Framework

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The structural features that characterise a setting will undergo changes that can be secondary or primary in nature. Several examples of secondary changes include the following. (a) The transformation of artefacts may undergo upgrading through technological change, investment, and scrapping. (b) The profile of the agents changes over time due to internally induced changes such as when the profile of members in different behavioural settings change in more or less predictable ways: ageing, or when endowments and preferences of members in different behavioural settings change with the phase of development. (c) The institutional rules may undergo changes through mutual acceptance by members of the setting. (d) Through contacts with other systems, new perceived information signals on alternative transformation details, institutional rules, and opportunity costs become available, or can be increased by conscious search. Primary changes are put into motion by a comparative evaluation by agents of outcome in alternative settings, a search by agents for settings in which individual agents can combine endowments and preferences to their satisfaction, and consequently, the reallocation of agents between settings. As a result, the distribution of persons among settings is adjusted and new configurations of settings and their populations are reached, which in turn make possible further major changes in the transformation structure, agent composition, institutional rules, and the information structure. The aspects of the comparative evaluation of outcomes, and the consecutive response processes belong to the second and third sets of questions. Second, how do settings organize their agents in pursuing their aim, how do settings reward their agents for their efforts? Each setting organizes itself by assigning roles to its member agents. The agents are expected to implement these roles within given physical-technological transformation boundaries, institutional rules, and information flows. The fulfilment of the transformation process allows the setting to generate outcomes, i.e. value added-s, which are then distributed as rewards to each member agent. The received rewards have material as well as immaterial contents. Knowledge about the received material and immaterial rewards of competing settings are crucial for an evaluation that participating agents regularly do, and which guides them in their decision to continue in the setting or move to another setting. Third, how do comparative rewards between alternative settings drive the agents to move from one economic behavioural setting to another? And what are the implications of this mobility, reshuffling, and response processes? A review of the situation at any moment will show that (i) some members are content with their setting vis a vis other settings and they continue with the same effort as in the past or more, there is full conformity between the values of these members and the governing institutions (ii) some have voiced objections, got no response, have reassessed alternative benefits and costs and chose to cling to the setting but lower their effort in it causing X-technical inefficiency (iii) still others have voiced, found that they are better off elsewhere and have exited, and (iv) they may have entered other settings or are searching for one. Hirschman (1970) was among the first to emphasize the notions of loyalty, voice, exit, and entry.


Agents move from one setting to another. The movement continues until the agent reaches equilibrium, i.e. marginal benefit and costs of changing positions between alternative settings becomes the same for the participant. In other words, the mobility continues up to the point where the propensity to move satiates in the sense that the marginal utility for an individual of shifting a unit of effort between settings is equal to the marginal cost of the shift. The moment situation in which each and all agents find themselves is interpretable in terms of the concept of general equilibrium, but with focus on reshuffling of agents. The distribution of agents on settings can be seen as Pareto optimal. It is understood that the equilibrium referred to here is meant to consider both material and immaterial rewards. The specific harmonization between the two types of rewards would depend on the specific agent, and it is outside our immediate scope here. However, in household settings the immaterial may weigh more than the material rewards, while in firm settings the material may weigh more than the immaterial rewards. What is observed and measured at a time period is a search and response process. A few remarks on the implications of this response process are in place. Voice and exit in some settings lead to the relative decline of these settings in relation to competing settings. An organization that manifests such voice, little restructuring of rules and little exit possibilities for its members is doomed to decline in terms of effective outcome. It may retain members for a long time. These members will consciously minimize their utility by minimizing their effort, thus resulting in X-inefficiencies that would undermine the outcome performance for the setting and its members.1 Entry to, and loyalty within settings, lead to the relative growth of these settings. The movement of agents leads to a reallocation of the effort of individuals within and between behavioural settings to the advantage of those settings that gain in retaining their members or attracting new entrants. Fourth, in which way does participation of agents in overlapping settings produce an identifiable (national) economic system and lead to systemic integration? There is a problem here. How can the national economic system be identified as an economic system as such when it is viewed as a conglomeration of interacting and overlapping agents participating in many organizations with each having its own dimensions in terms of transformation of artefacts, rules, members, and information? How to identify a common core in the vast collection of behavioural settings? In which sense do interactions of mobile agents in and between non-symmetric behavioural settings form a distinct observable system at all? The answer is sought along the following lines. What makes a network of interactions observable as a typical system is prevalence of mutual behaviour, common revealed preferences, and typical coordination tracts among the population for a nation as compared to other nation states. How is the ‘typical’ formed? And how is the ‘prevalence’ caused? We emphasize several factors. (a) Settings with more agents and greater value added transformations have a greater prospect of their typical behaviour becoming more prevalent. (b) Greater intensive and extensive interactions and greater outward communications of agents belonging to setting g and a greater outward communication with and participation in


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other settings g’ will extend the prevalence of the behavioural type associated with g, call this behavioural type G. (c) Once some thresholds of prevalence are achieved for setting g, network externalities enforce more convergence towards and extended prevalence of settings and behavioural type G. Last and not least (d) there is horizontal and vertical interaction among settings. In the horizontal interaction between settings, the sharing of a common external environment causes convergence and if the external environment is characteristic of a setting type g, it is more likely that behaviour characteristic of setting g prevails. In the vertical interaction, if setting g is higher in the hierarchy of settings, it may be able to set rules that other settings g’ would follow; and thus influence the other settings to follow behavioural type G. If persuasive settings, being the highest setting, affirm the existing order, then the prevalent behavioural type G, its structures and outcomes are strengthened furthermore. The above lines can be elaborated further. To start with, (a) the relative size of agents and the relative size of economic transformations that characterize a setting are major determinants of the relative influence of a setting. Agents move from what they see as a less attractive setting to a more attractive setting. The direction and extent of this mobility depends on the information they get and collect, and on mobility restrictions. If in settings g and g’, outcome performance of g outcome performance of g’, this leads to tension in g’ (voice and exit) and pressure on g (entry). As more agents move from the g’ settings to the g settings, the behavioural type associated with the g settings gains more followers at the cost of g’. Ultimately, the relative sizes of settings in terms of the number of agents and of the value added transformations become basic determinants of the relative dominance of competing settings. (b) Communication between agents matters. In spite of the vast variations among organizational settings, it is the joint presence of agents in several roles in various organizational settings intensifies the likelihood of agents facing similar environments, and developing mutual expectations and realizations in linked organizational settings. Interdependent communications and mutual influences between agents normally result in synergetic profiles and revealed preferences that characterize the system as a whole and its development over time as a separate entity. Such synchronization mechanisms are sometimes termed socioeconomic conditioning. The importance of communication was illustrated with the help of Figures 1.1 and 1.2 in Chapter 1, which described in general terms the communication and transaction lines within and between the three most frequently encountered forms of economic organizations: households, government, firms, and markets. (c) Once a threshold is reached with regard to the acceptance of a specific behavioural type, this behavioural type can be expected to gain momentum in view of network externalities. Besides intensively experiencing a particular behavioural type, adopting it and spreading it to others, there are related mechanisms that lead to the same convergence and concentration around specific behavioural types. These mechanisms may overlap but we mention them as additional forces that cause the spread and dominance of particular behavioural types. These

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mechanisms include imitation, convention, focal points, information cascades, reciprocal behaviour, group learning, Markov chain inversions, melting pot, and power of dominant shares, among others.2 The contribution of social networking to the formation of uniform norms and commonly expected behavioural rules has associations with the notion of small world phenomena, where interconnections between a minimal number of persons are sufficient to secure interconnectivity for a much larger population. 3 (d) Finally, a typical behavioural pattern among the members of many organized settings is the result of the sharing a common external environment over many years. The operation of an organization is constrained by the environment external to it. Participating members in an organizational setting tend to mutually adjust their behaviour, technology, institutions, and information to the external environment that they commonly face. Organizations subjected to the same external environment will ultimately converge in their behavioural patterns. A shared external environment integrates settings in more subtle ways too. Tendencies towards a unified culture, associated with one dominant setting, are bolstered by the presence of external constraints enforced by the dominant setting, higher up in the hierarchy, on other settings lower down. The external constraints imposed by one setting on other settings are often in the form of checks and balances. While many institutional rules that agents observe in setting g’ are endogenously created by agents themselves to assure the well functioning of the agents collectively in setting g’, there are usually other checks and balances on agents inhabiting setting g’ that are exogenously imposed by agents of setting g higher up in the hierarchy. The extent and intensity of these exogenously imposed checks and balances, and how heavy they are, are indications of the degrees of dominance of agents of g on agents of g’.4 Persuasive settings, see Chapter 1, can be seen as belonging to the highest level in the hierarchy of settings. The consensus that is reached, proclaimed, and disseminated from these persuasive settings usually play an important cementing role in endorsing and propagating the dominant features of the socio-economic system.

2.3 A conceptual model of economic behavioural settings featuring the building blocks A model of participating persons p 1, ... ,# in setting g can be written in three sets of equations using the following notations. Notations Eg Tg Ig Ng Qp

Exogenously given external environment Transformation structure Institutional structure Information structure Set of personal attributes q belonging to person p


Vpg Dpg

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Value added received by person p from participation in setting g Decision of p to move, or not, from setting g to g’

Equations (T,I,N,Q p)g,t ø{d(T,I,N,Q p)g,t 1; Eg,t} Vpg s (T,I,N,Qp)g Dpg m(Vpg:Vpg’)

for g 1,2 p 1, ... ,# for g 1,2 for p

(1) (2) (3)

Equation 1 shows the changing profile of the four structures in setting g as dependent on the exogenously changed environment circumscribing setting g, and similarly for g’. Equation 2 shows the value added in utility accruing to the agent in setting g as dependent on the four structures of setting g, and similarly for setting g’. Equation 3 is a general function that determines the decision of the agent p to stay in g or move to g’. Among the arguments in this decision is the relative relation between the value added utility in g and that expected in g’. Equation 3 allows the decision Dpg to be conditioned by the behavioural features that are typical of behavioural setting g. ‘Value added utility’ is differently conceived in the behavioural settings of the household, the firm, and the state. In firm settings, Dpg is guided by the following: p continues to participate in g if Vpg defined in terms of material benefits opportunity cost of p in g’. In firm settings p leaves g and participates in g’ if the material benefit Vpg is below opportunity cost, thus causing the movement of agents, and hence resulting in changes in the profile compositions in settings dQ pg.5 In household or state settings agents are less motivated by material benefits. The arguments in the decision functions in the household and state settings take other forms. For the sake of simplicity, taking for the moment the variables T, I, N, and Q as given, the model is reduced to 2 times equation 2 and 1 time equation 3, in total three equations; and three unknowns of Vpg, Vpg’ and Dpg ; giving thus a determinate model that solves for the three unknowns. The model can be extended to make the four structures fully endogenous over time. The model can also be extended to solve for the optimal allocation of effort in terms of the agent’s participation between two settings. The greater the degree of integration between T, I, N, and Q p in setting g, the greater is the transformation surplus and the value added accruing to the person Vp, and the attractiveness for the person to allocate more effort (participate) in the particular setting at the cost of the other setting. Once the participation and integration between T, I, N, and Q p in setting g, have reached certain levels, one can then speak of the setting as an integrated economic system with predictable economic behaviours and outcomes. A behavioural setting, which is purely economic in nature such as a pure commercially operating firm, will produce an economic system which behaves in purely economic terms, indeed the more so if T, I, N, Q are fully integrated and adapted to each other. In contrast, a predominantly social or political setting is bound to produce a diluted economic system.


In summary, and turning to the applied side of contemporary economic systems, it has been stated that when agents share common external environments, are unrestricted in their mobility between settings, and when there is direct and indirect communication between agents in different settings that take place frequently and over long periods of time there is a tendency for the structures of technology, rules, information, and agent profile at the micro behavioural settings to be extrapolated to all settings and create common traits at the macro national level. There is also the tendency for these structures to converge into each other at a macro level so that technology, institutions, information, and agent preference reflect each other. It has been stated furthermore that over long periods of mobility and interactions several distinct economic systems are likely to emerge reflecting the features of distinct settings and the associated distinct behavioural types with them. We have distinguished between three such distinct prototypes: (a) HIM, the traditional household intensive system that takes place in and among households, and which is characterized by familial solidarity; (b) FIM, the firm intensive economic system, which is allied to commercial firms that buy and sell their inputs and outputs in open markets, driven by monetized commercial motives; and (c) SIM, the state intensive economic system, which takes place in governmental circles, and which is characterized by seizure of political opportunities and rent appropriation. Each of the three economic systems display distinct and alternative patterns of institutions, preferences and information backups, which fit into each other, as was demonstrated in Chapter 1, Figure 1.2 (a, b, c), respectively. The above assumes convergence of behaviour towards the behavioural type of the dominant setting. Notwithstanding, it was also concluded earlier that there are some large developing countries, such as China and India among others, where the process of convergence is far from reaching any conclusive end, and that their socio-economic system would suggest the treatment of a fourth prototype of socio-economic systems which we called MPM, for multi-poles system. It was also concluded that persuasive settings play a crucial coordination role in the context of the MPM.

2.4 Evolution of differing behavioural types into different economic systems It is helpful to postulate the development of the three prototypes of economic systems as an outgrowth from some common origin, which is by definition the household setting. If at the end of the road three, or four, broadly defined economic systems show up, then how did each start at all at the very beginning and developed further? The external environment is a basic determinant of behavioural settings and the behavioural type that characterizes the setting. Different external environments generate typical coordination structures that coincide and fit with typical behavioural settings. A closed world, homogeneous population, strong kinship, severe


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scarcity of resources, and low levels of material welfare characterize the external environments of household settings described here. This external environment promotes sharing behaviour and solidarity structures. Agents in these settings are conditioned towards adopting institutions of familial altruism, brotherhood attitudes, income sharing among households linked by kinship and location. Similarly, households unrelated by kinship or locations tend to be excluded from the sharing tradition. Group altruism is double edged, with inclusive and exclusive dimensions. The external environment typical of value maximizing settings is materially better off, and is characterized by an open world with frequent changes, product discoveries, and choice opportunities, and a high mobility of agents. The external environment typical of state settings is also materially better off, but is characterized by highly skewed endowments and rank among differentiated population groups, often generating conflicting interests and requiring authoritarian rules to resolve them. The external environment contains also barriers that obstruct openness, choice, and mobility. The starting point is conveniently the situation where household settings are already there. It can then be asked which settings followed: firm settings or state settings? Hicks (1969) is among the many economists who contend that tribal, feudal, army and state settings historically preceded firm and market settings. Most anthropologists, like Firth (1967), maintain that economic organization and the transformation and exchange of products within and between neighbouring primitive societies came first and preceded political organization. There is documented history that can be used to support both views in different regions in the very past. The way we shall model the introduction of a new setting would make both scenarios possible, next to the simultaneous emergence of economic and political organization in a predominantly household intensive system. The model is basically microeconomic, and it is based on several premises. (1) Agents inhabiting household settings, and interacting with each other in a communal environment, experience specific needs, or can be attended to uncovered needs, and they are ready to embrace these needs. Agents are also innovative and capable of finding solutions and creating new transformation settings that satisfy these needs. (2) The needs of an agent can be personal or collective. Personal needs of one agent can be directly satisfied by the innovative and responsive transformation offered by another agent; opening ways for exchange and firm settings. Collective needs are indivisible and their satisfaction would require a joint effort of agents and a third party intervention to coordinate the task at a higher level; which opens ways for authority and state settings. (3) In communities where personal needs happen to have overweight, firm settings will emerge and prosper. In communities with an overweight of collective needs, state settings will emerge and prosper. (4) The above premises assume other things remaining the same; in particular, the external environment is kept constant.6 Communities where personal needs had overweight would push the economic system towards adopting a firm-like behaviour. These communities happen to be


more of the open type. In an open economy, agents search more frequently for new personal products. Eventually, these demands for new products are matched with talented and skilled agents who are capable of innovating and achieving a value added transformation in the form of a new product that satisfies some felt personal need. The newly introduced transformation is by itself a new setting in formation. The larger the community and the more open it is, the greater is the probability that more personal needs, talented transforming agents, and new transformation settings emerge in the form of firms and markets. As demand for personal goods diversifies and increases, more agents reallocate from households to transforming firms and markets. The income sharing behavioural type would tend to decline in favour of the profit maximization behavioural type. In contrast, communities where collective needs had overweight over personal needs would promote the emergence and prevalence of state settings. The development can be displayed along the following lines. Collective needs consist of urges to curb uncertainties and externalities that the agents experience. Unable to resolve their uncertainties and externalized divisions agents i and i’ call on a ruling agent k to organize security and to execute public actions to satisfy collective needs. In all societies there are talented agents who are well equipped to take the role of ruler k, lead politically, find compromising solutions to collective needs, and govern effectively towards realizing these solutions. Having a governing monopoly, agents k pursue an economy of measured exploitation in fixing their compensation for the services they provide to agents i, i’. If all the counteracting i,i’ agents calling for collective action count I and each produces y, and the production is liable to fall down to x if no collective action is taken, but may increase to z if the state intervenes, whereby x y z, then I (z x) represents the maximum amount that agent k can collect from agents i, i’ for the collective actions rendered, including the bureaucratic apparatus required to implement these actions. If the number of agents involved in the collective actions is K, then their average reward per agent k is I (z x)/K. Under crude but realistic assumptions agent k can be shown to end with about double the income of agent i, i’ or more.7 Under leadership of politicians and bureaucrats, governments have evolved overtime into natural monopolies.8 Anywhere, there is only one government to run state affairs. This monopoly position is likely to seduce state officials to appropriate rent in the process of organizing and executing collective actions in the future. State officials are also politically motivated to create and expand community needs for collective goods. In this way, the received rent is extended to more activity areas, and the monopoly is sustained and broadened. To create community needs for collective actions, political man would take measures to discourage private solutions to emerging needs. The above does not mean that all state agents behave along rent appropriating motives. Many, or most, state agents will pursue benevolent motives as when the state is embedded in a household intensive system, HIM; since they are conditioned to behave accordingly in a HIM environment. Similarly, many or most state agents will seek no more than their opportunity cost if they are embedded in a firm intensive system, FIM; since they are conditioned to behave accordingly in the FIM environment. But


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if they function within a system that is intensively dominated by the state, SIM, then state agents will excel in rent appropriation and political behaviour, and cause this behavioural type to spread to other settings in the context of a SIM environment.9 Finally, persuasive settings play an important role in affirming the principles of a newly installed socio-economic order, whether it is one where firm settings dominate or one where state settings dominate. If persuasive settings, being the highest, affirm the socio-economic order, then prevalence of stipulated behavioural type in the economic system is complete.10 To summarize, alternative scenarios are feasible regarding sequence of regimes. It follows therefore that it is perfectly plausible that the state (firm) settings emerge first and firm (state) settings follow later if collective (personal) needs were felt to be more urgent than personal (collective) needs. Therefore, both routes are possible, and these can vary over time and place. The breakthrough towards a predominance of the firm or state settings would then depend on the cumulative relative weights of personal vis a vis collective needs. We have abstained in the above from various complications. In the real world, the external environment undergoes basic changes that particularly promote FIM or SIM. A few examples suffice: (a) the age of discovery has allowed a major diversification in demanded products at the personal level, a huge jump in personal needs of the newly settling migrating populations and a push for firm settings, and (b) technological advances enhance demand for new personal products and their divisible production encourages firm settings. Both examples can explain the early inclination of US and Europe towards FIM. On the other hand (c) military conflicts with neighbouring countries promote growth of state settings, while (d) frustration with the social order leads to calls for authoritarian rule. Both examples explain the inclination of Russia to SIM after WWI, and a stronger state in Germany between WWI and WWII, and in WWII. In principle, there are conceivable conditions under which the two orders can temporarily (or permanently) reverse. If in specific circumstances, collective needs overshadow personal needs there will be a strong demand for state settings. Similarly, disappointment with achievements of state settings and rising demand expectations based on better attainments in firm settings can shift the overweight from collective to personal needs, giving some push towards firm settings. A pronounced example is that of Russia that experienced both reversals in the twentieth century. Other examples of modest realignments between the two orders are inherent in deregulation and regulation waves in US and other FIM related countries: deregulation of the utilities and communication sectors in the 1990s, and regulation of the finance and banking sectors following the financial meltdown of 2008.

2.5 A conceptual model of the emergence and prevalence of behaviourally different economic systems With the above as background, the emergence and prevalence of specific behavioural types in response to satisfaction of personal and collective needs can be

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conceptually modelled. This is a specific model of social interactions, inspired by the more general models of social interaction in social groups such as by Becker (1974) and Simon (1952). The probability that a behavioural type identifiable with setting Vg prevails over all other Vg’ can be expressed as in equation 4. Vg prevails if (v1 Ag v2 Cg) v

(4)

In this equation, two share parameters affect prevalence. Ag is the share of agents in setting g, with respect to all agents in all settings. Cg is the share of goods and services, say commodities, demanded that are most suitably transformed in setting g, with respect to all demanded commodities. The personal commodities are most suitably transformed in firm settings. The collective needs are most suitably transformed in state settings. The greater the shares of those agents and commodities associated with a particular setting the greater is the probability that the behavioural type underlying this setting prevails over other behavioural types. v1 and v2 are weights applying to these two shares, whereby v1 v2 1.11 In this equation, n is a proportion, this represents a critical mass. Once the practice of a particular behavioural type reaches this critical mass, this behavioural type can be expected to benefit from network externalities and to extend its maintenance to practically the whole population. There are different views concerning the likely value of the critical mass. Values of 2/3rd and 3/4th are among the most quoted in the literature relating to a critical mass.12 There is thus justification for fixing the value of n at around 0.7. The network externalities can be interpreted by adding to the term of the direct effects of the agent shares in equation (4), a term for the indirect externality effects. This latter can be conceptualized by introducing a squared term that is meant to emphasize a scale effect in this process of induced interactions and spin offs. For example: (v1 Ag v2 Cg) vo (v1 Ag v2 Cg)2 . In this expression, giving thus the direct and indirect effects of relative agent participation on behavioural prevalence, the squared term should have a lesser weight, than the non-squared term, 0 vo 1. If (v1 Ag v2 Cg) reaches the value of v, say, 0.7, and if vo is set at say ½, then the direct and indirect effects would result in a full-fledged prevalence tending towards 1.0. The shares of agents and transformations by setting, Ag and Cg, as combined in equation 4, form an Index of Interactive Influence, which is indicative of the relative assertive power of setting g over the other settings. Quantification of this index for types of settings for individual countries would give the systemic orientation of the individual country as to which setting is most dominant. A value of the index for a setting type g of around and above 0.7 is a strong indication of the dominance of that setting type. We shall apply the index in Chapter 7 to that end, and later on in Chapters 8 and 10 to explore, respectively for the world regions and the world at large, the relative dominance of prospective economic systems that associate with leading countries.


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Attention can now be directed to examining the likely paths of the share of demand for commodities, Cg, and the shares of agents Ag for each setting g. To start with concentration of commodities, define Cg as the proportion of demanded commodities D most suited to be transformed in setting g, in the total demand for commodities, Cg Dg / D. Applied to the three settings we have the share of demanded personal commodities that happen to be most suitably transformed in firm settings Cf Df / D, and the share of demanded collective commodities that happen to be most suitably transformed in state settings Cs Ds / D, so that the share of demanded domiciled commodities that happen to be most suitably transformed in household settings becomes Ch 1 – Cf – Cs. For the evolution of the shares of commodity types transformed in alternative settings, Cg, introduce Dho, Dfo, Dso for the initial demand for goods whose transformation is related to the domicile, personal and collective types h, f, and s, respectively. In equations 5.1 and 5.2, the evolution of the commodity shares of Cft and Cst over time t is described in terms of the initial Dho, Dfo, and Dso, and the growth rates of per capita demand for the f and s commodities: gf and gs; which are assumed for convenience of presentation to grow at constant rates but this is not a necessary assumption. As we stated earlier the shares can shift abruptly due to exogenous changes in the external environment. In equation 5.3, commodity share Cht becomes a residual in terms of the initial values of goods by the three types and the growth rates gf and gs. Cft Dfo (1 gf )t / {Dho Dfo (1 gf )t Dso (1 gs)t} Cst Dso (1 gs)t / {Dho Dfo (1 gf )t Dso (1 gs)t} Cht Dho / {Dho Dfo (1 gf )t Dso (1 gs)t}

(5.1) (5.2) (5.3)

The following can be noted on the evolution of the commodity shares. Ch tends to fall over time in favour of Cf and Cs. However, these effects are tempered if the per capita growth rates of demand for commodities gf and gs are low, due to a high population growth and/or low economic growth. Next, considering the concentration of agents, define Ag as the proportion of the population L in setting g, in the total population, Ag Lg / L. Applied to the three settings we have therefore the share of agents in firm settings Af Lf / L, and the share of agents in state settings As Ls / L, so that the share of agents in household settings becomes Ah 1 – Af – As. For the evolution of the agent shares in alternative settings, take first the case of firm settings f. In equation 6.1*, future agents in firms Lft are determined by the initial labour input/demand output ratio Lfo / Dfo, and the evolution of this ratio as depicted by the future growth of labour productivity lf ; and the future level of the demand for commodity f. This is the initial demand Dfo multiplied by the future growth rate of per capita demand for this commodity (1 gf )t. The result of the above gives Lft. This is divided by the future total number of agents Lt to give the share Af, where Lt is the initial Lo multiplied by the future growth of the labour force, or the population at large, (1 p)t. By substitution and elimination, equation 6.1* is simplified to its final form in equation 6.1. Similar results are shown for the case of state


settings s, in equation 6.2. In equations 6.1 and 6.2, the evolution of shares of agents in firm and state settings Aft and Ast over time t is described in terms of their initial values of Afo and Aso; the growth rates of labour productivity in firm and state settings lf, ls; the growth rates of per capita demand for commodities that relate to personal and collective needs and that are most suited to be transformed by firm settings and state settings, gf , gs, respectively; and the growth of the labour force. In equation 6.3, the share of agents in household settings Aht becomes a residual. Aft Lft / Lt [(Lfo / Dfo) (Dfo (1 gf )t (1 l)t)] / Lo (1 p)t Aft Afo (1 lf )t (1 gf )t / (1 p)t Ast Aso (1 ls)t (1 gs)t / (1 p)t Aht 1 Af As

(6.1)* (6.1) (6.2) (6.3)

The following can be noted on the evolution of the agent shares Ag. (a) The effective share of agents in household settings Ah tends to decline, and those of Af and As tend to increase. However, if the per capita growth rates of demand for commodities gf and gs are low, due to a high population growth and/or low economic growth, then the effects just mentioned are tempered. Thus, high population growth and/or low economic growth sustain the prevalence of Ah, while low population growth enhances the shares of Af and As.13 (b) There is disputed evidence that gf gs. To the extent that this is true then firm settings have a greater probability to spread than state settings. However, these growth paths are frequently interrupted and there are periods when collective needs dominate personal needs, and other periods manifest the contrary. (c) It is generally established that the growth rate of labour productivity is higher in the transformation of personal goods as compared to collective goods lf ls; this tendency favours a relative rise in the agent share of state settings as compared to firm settings. Finally (d) a high population growth rate p sustains the prevalence of Ah, while low population growth enhances the shares of Af and As. The conceptual model in this section can be elaborated further to consider additional interactions between settings. A behavioural type associated with a setting type g can extend to and determine behaviour in setting type g’ via two channels that can be called (1) horizontal, and (2) vertical. (1) In the horizontal channel, agents in setting g are many and have a high intensity of interaction. These agents participate as well in setting g’ and interact with agents in g’, and thus transfer their behavioural type to g’, so that in time agents in setting g’ take over the behavioural type characteristic of setting g. The conceptual model in this section treated the horizontal channel. The model identified two key variables in the transfer of behaviour: the relative share of agents in g and g’, and the relative share of transactions in g and g’. (2) In the vertical channel setting g stand higher up than g’ in a relational hierarchy. Binding rules of conduct are imposed by setting g that setting g’ should observe, resulting in behaviours and outcomes of g’ that are consistent with those of g. The conceptual model in this section does not incorporate binding rules of conduct by g on g’, though they can be readily introduced.


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Channel (1) is direct. It can be more enduring in its effect as it is generated via experiencing, learning, and adoption. Channel (2) is indirect. The origin of the vertical channel lies in the ability of higher settings (usually state allied agencies) to impose binding rules of conduct on the lower settings. Such binding restrictions belong to the control sphere. The effect of vertical channels of interaction on the distribution of power and decision-making between settings can be very significant. For instance, the accumulated strong power of state authorities over centuries of agent interactions in SIM related countries have been acquired through vertical and not horizontal interactions. In contrast, FIM related countries have relied in their adoption and evolution of the FIM system more on horizontal than on vertical channels of assimilation. It is sometimes observed that the contribution of vertical channels of interaction towards unified behavioural formation across settings is less permanent than that of horizontal channels of interaction. In the case of vertically acquired behavioural attitudes, these can terminate after some time if the control mechanisms become too demanding due to technological loopholes, or the rationale for the binding restrictions disappears, or the balance of power between g and g’ reverses. On the other hand, the appreciation of how vertical channels of interaction determine the balance of power between settings and how behavioural conduct is transferred from higher to lower settings is important for understanding the management structure of the socio-economic system in a specific country, as well as the emergence of international institutions and binding restrictions for interacting firms and states of different countries. The role of vertical channels in the context of persuasion settings is of special relevance. Vertical channels and persuasion settings are vital for the streamlining and coordination of differing attitudes and interests in multipolar social systems.

2.6 The structure, conduct, and economic performance of different economic systems In this section we examine the structure, conduct, and performance of the HIM, FIM, and SIM economic systems. We start with the HIM. The work by Becker (1981) on a treatise on the family is a major breakthrough. It deals with modern household in a firm intensive system. It explains family behaviour in terms of the principles of the FIM, i.e. profit maximization and cost minimization. The intrinsic principles that hold for the household family before intrusion of the FIM, often called traditional, peasant, or primitive households, constitute a different set of principles than that which operates in the household family after its integration in the FIM setup. In the context of the HIM, the traditional household is the relevant unit of analysis. With a few exceptions, notably advances in prospect theory and neighbourhood economics, economists give little attention to the study of structure and conduct in the traditional household intensive system.14 This is understandable in view of the diminishing role of traditional household settings as compared to

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firm and state settings, and is furthermore to be expected since traditional households behave along sociological rules that are far fetched from economics rules and the economics discipline. In contrast, the social anthropology literature of primitive economies deals at great length with the economic structure and conduct of societies centred on traditional households, kinship relations, and social groups.15 There are several salient economic features of the household intensive system that are worth mentioning. (i) The household units are engaged in the process of production with the aim of ensuring the reproduction of their customary consumption levels and the stability of their living and working conditions from one cycle to another. The household unit is always a part of a larger social grouping of households that are related by kinship, obligations, or land tenancy arrangements. Household behaviour is accommodated to the larger social grouping to which it belongs. The reference base of utility is the social grouping, as prospect theory asserts. (ii) Household behaviour is non-economic: it is guided by a survival algorithm and would avoid risk even if it is profitable, it would go for maximum total product commensurate with the customary consumption levels even when average productivity falls and costs rise. (iii) Products are transacted within and between households via reciprocity and redistribution. The guiding rule is from each according to his status obligations in the social system and to each according to his status rights in the system. (iv) Exchange between households at the market place is restricted to essential products and the feedback that links market values to production decisions is absent because factors of production are not marketed. (v) The economy in the HIM is embedded in social relations in the sense that the economic system functions as a by-product of social institutions. Economic relations can be understood only as part of a scheme of social relations.16 We turn now to examining the FIM and SIM economic systems. In contrast to the HIM, there is a vast economic literature on the structures and conduct of free market and state controlled regimes. A discussion of the structure and conduct of FIM and SIM would come close to a traditional review of the economics of free market and state controlled regimes, though with a different focus. We shall save the reader such a review and focus instead on how the underlying behavioural principles of SIM and FIM, these are respectively rent appropriation and profit maximization, tend to shape the structure and conduct of the respective systems. It is important to underline that while rent appropriation and related political motives are central in the behavioural patterns of the state intensive economic systems, profit maximization and economic motives are central in the behavioural patterns of the firm intensive economic system. This contention is valid when the reference points are the whole systems of SIM and FIM. Of course, these two associations cannot be all inclusive for all instances of state agents in all state settings, and respectively all firm agents in all firm settings, in all places and all times. There are instances where firms are engaged in rent seeking, as well


39

as many instances where states are performing their transformation tasks with opportunity cost as the purpose in mind. In the light of the above, it is important that the border lines between the two motives of rent appropriation and profit maximization be carefully delineated to avoid overlapping and allow for distinct behavioural types that identify distinct economic systems; without denying an apparent co-existence of both motives in the distinct systems. We shall examine below the differences between rent seeking and profit maximization and expand on their application in institutionalized socio-economic systems such as the SIM and FIM, as well as to their application to individual instances of state settings and firm settings. We shall then make a conceptual review of the comparative outcome performances of the rent appropriation based SIM and the profit maximization based FIM. Rent seeking is a premium an agent appropriates due to the agent’s monopolistic advantage. Rent is receipt in excess of opportunity cost in a competitive setting. Rent seeking, therefore, covers calculated and institutionalized acts by the agent towards realizing such an appropriation now and later. Rent seeking contains political coercion. In profit maximization the agents seek to extract the highest economic value by engaging in mutually beneficial transactions. Critics point out that in practice, there may be difficulties distinguishing between beneficial profit seeking and detrimental rent seeking. J.M. Buchanan (1980) postulates that the difference between profit maximization and rent seeking can be only determined ex-post. Where there is monopoly the result is described as the outcome of a rent seeking behaviour. Where there is competition the result is described as the outcome of profit maximization. So formulated, the impression is created that there is no genuine difference between the two motivations. The difference is shifted towards the circumstances in which the two motivations take place. This point of view does not go far enough since it does not answer the question why monopoly would exist in one setting while competition would come about in the other setting. However, the point of view suggests as well that one can speak ex-ante of rent appropriation in societies and socio-economic systems where monopoly of power is strongly rooted, i.e. SIM, and rather of profit maximization in societies and socio-economic systems that are more competition oriented, i.e. FIM. Our standpoint sees the significance of the difference between the two motives to lie in their applied integration into distinct whole systems with different institutional set-ups. Intensive interaction of agents within state settings and ruled-ruler like settings broil rent seeking behaviour, and generates monopolistic outcomes as contrasted with intensive interaction within firm settings that promotes profit maximization behaviour and bring about competitive outcomes. The standpoint can be elaborated further. Strictly speaking, the basic feature of the rent appropriating behaviour is in drawing out rules and erecting institutions that bind the ruled to the rulers, and thus constrain the mobility of the ruled to other options than those offered by the ruler. In this way, an institutional monopoly is artificially created in the first round, and is substantiated by


practice, custom, and acceptance in subsequent rounds. In an insecure society facing significant collective needs, and where most agents are least enabled and a few are highly enabled a ruled-ruler regime is very likely to emerge in which counter expectations and obligations between ruled and ruler are prescribed, and regularly revised to assure continued rent appropriation. These often go together with modes and boundaries of interaction between the common and the elites. State settings, if they are unchallenged in their growth, are able to transform the social system into a state intensive socio-economic system with an institutionalized monopoly of the state, a ruled-ruler regime with a maintained rent appropriation. As state agents, in a SIM context, have an unchallenged monopolistic advantage in running state affairs and related economic transformations, they are in a position to purse appropriating rents with success. The rent seeking act takes different calculated forms: for example, extending the authority of government and size of the public sector, political campaigning to govern and job queuing by aspiring candidates for state positions. The rents appropriated can be monetary payoffs, legal as well as illegal, job amenities, executive power, and prestigious status. Given their monopoly in running state affairs, state settings in SIM are natural breeders of the rent appropriation motive. More generally speaking, state agents in state settings are politically motivated to create and expand community needs for collective actions. In this way, the received rent is extended to more activity areas, and the natural monopoly is sustained and broadened. To create community needs for collective actions, political man would take measures to discourage private solutions to emerging needs. The measures used are subtle. They include restrictive rules, distorted information, and strategic policies with the objective of increasing indivisibilities, uncertainties, and externalities. It is in the interest of the politician to display a greater disagreement between opponent private actors than genuinely is, this raises the private demand for state intervention. It will be incorrect to assume that all states in all SIMs at all places and times were or are of the rent appropriating type. History contains benevolent state leaderships in SIMs that were exemplary in terms of ideal governance and away from self-enriching. The same history shows that such benevolent episodes were followed by rent appropriating regimes that are institutionally built-in in a SIM with an absolute monopoly for the ruler on the ruled. Power spoils. In contrast, in a firm intensive economic system, FIM, agents take over the profit maximization behaviour typical of a firm. It is in the interest of each and all agents to secure free entry and exit, and to create and maintain institutions that promote competitive outcomes. The more competitive agents are in relation to each other the greater is the probability of having fairly distributed opportunities and equitably distributed endowments. In turn, pursuing profit maximization by all agents reinforces institutions that promote competitive practice and profit maximization. It will be also incorrect to state that all firms at all places and times behave competitively throughout. Innovative firms come with their products as first in


41

the market and naturally obtain some surplus profit, as a reward for their innovative investments; but the surplus disappears gradually as more firms enter and compete. There are also bigger firms that are engaged in erecting entry barriers and spending resources towards excluding competitors. These firms try to build artificial monopolist positions and appropriate a monopoly rent, and are as such seeking rent, in the sense of the short term; but they do not have the authority or capacity to institutionalize this rent seeking permanently; which is the crucial feature of what constitutes rent appropriation. It is commonly agreed upon that profit maximization in the presence of many competing firms excludes in the longer run the presence of surplus or abnormal profits due to monopolistic positions. Given the large number of competing firms in a market economy, most firms are eventually inclined to behave competitively; and in the long run, tend towards making normal profits, and thus, no rents. Firms have an economic motive and not a political motive, and this makes firm settings distinctly different from state settings. A few more questions remain to be answered on many instances of rent seeking firms in the context of SIM-countries, say Russia, in spite of the intrinsic orientation of firm settings towards profit maximization. Similarly, there are many observed instances of benevolent state settings in the context of FIM-countries, say US or EU, in spite of the intrinsic orientation of state settings towards rent seeking. In explaining this phenomenon, we refer back to the external environment, including the hierarchy of higher settings that circumscribe specific settings. In general, while any transforming setting A has its own regulating institutions to assure the well functioning of agents A collectively, there are other checks and balances on agents A that are externally imposed by agents of a higher setting B, call them agents B. The extent and intensity of these exogenously imposed checks and balances, how heavy they are, is an indication of the degree of dominance of agents B on agents A. How extensive are rent seeking and political behaviour, or how extensive are profit maximization and economic behaviour in contrast in a specific system/ country, depends on checks and balances that constrain state power relative to those constraining firm power. It can be reasoned that systems/countries where the checks and balances on the conduct of firms are heavier than those on the state can be described to have a quasi form of state dominance. The state is thus able to impose more and heavier checks and balances on firm behaviour than is feasible the other way round. In other words, the institutional structure that the state settings have established is at a higher level of authority than the institutional structure that the firm settings have established. Contemporary Russia is an example of a quasi form of state dominance. In the past Russia, firms were public enterprises and had operated as such in the full realm of state settings. In the present Russia, most firms are privately owned. Although intrinsically these private firms can be expected to pursue profit maximization behaviour, yet the mix of past and present state checks and balances that circumscribe all firms in Russia drives most of the firms to pursue a rent seeking behaviour in their strategic operations.17

42


In contrast, countries that are characterized by heavier checks and balances on state agents and relatively lighter checks and balances on firm agents can be described as having quasi-firm dominance. In these countries, firm agents, and citizens at large, are able to institute checks and balances on the functioning of the state that make state conduct accountable to these agents. In other words, the state is subjected to institutional structures that are meant to limit the authority of the state. Contemporary western democracies can be sited here. Take the firm focused system of the US. Checks and balances keep the rent seeking and political behaviour of state settings within very limited boundaries. Behaviour of agents in state settings is commonly analysed in terms of income maximization, very much similar to the economic behaviour in firm settings. The acclimatization of agent behaviour in state settings towards that of firm settings is the result of many years of interactions with dominant firm settings and strong checks and balances that are externally imposed on the functioning of state settings. The quasi dominance of firms in US has been highlighted by Stigler (1971), who was first to maintain that state regulation of business activities and related state legislations were initiated in the first place by strong firms and interest group lobbies to allow these groups to earn a rent. Government, it is argued, is an instrument in the hands of firm lobby, to legitimize and channel the rent to the interest groups. This does substantiate the standpoint that the US is a firm intensive and firm dominated economic system. Stigler interprets the regulations as evidence of short run rent seeking behaviour of the regulations initiating firms, yet given the operation of the FIM in the longer run; the interpretation of Hayek (1971) is more consistent with the functioning of the FIM. Hayek sees the regulations as driven more by competing firms, and they are meant to enhance competition, earn a normal profit, and minimize rent. Firms in a FIM succeed ultimately in endogenously installing checks and balances on their own functioning and that of the state, to support sustainable exchanges and competition between firms with a minimum intervention of the state.18 Next to discuss is the economic performance of economic systems. It was mentioned earlier that a household intensive economic system is less capable than firm centred or state centred economic systems in producing larger valued transformations. The main reason for that is that the traditional range of household products is much smaller than modern personal and modern collective needs and products (that satisfy these needs). The question whether the economy in a firm intensive system or in a state intensive system would perform better in the above sense has been controversial for more than a century. There is the abstracting view that if the two systems would operate under the right conditions there is no reason to expect one system to perform better than the other. Under optimal conditions, firms in the firm centred economy would maximize their profits to the point where inefficient profits would be eliminated by more entry and exit of firms; and if this is realized the maximum economic welfare will be obtained. The state in a state centred economy can achieve the same maximum economic welfare, if it succeeds in obtaining the right information flows and coordinating them; very crucial here


43

is the ability of the state to calculate its exploitation margin right: that is to say, it will not impose a too high inefficient margin that, to say, may reduce the size of the cake and the ultimate margin as well. Apart from the difficult task of underpinning and coordinating decentralized information flows at a highly centralized level, there is the crucial question of deciding on the right exploitation margin. In the real world there are no pure forms of FIM or SIM, and the two systems are confronted by market failures and polity failures, respectively. The validity of either of the two standpoints depends on the conditions that market failures due to indivisibilities, uncertainties, externalities, and mal-distribution are collectively remedied under FIM, and the conditions that polity failures due to uninformed or exploitative rulers are collectively avoided under SIM. Both sets of conditions are violated. There are more pragmatic views that base the evaluation of economic systems on the opposite motives of rent appropriation versus profit maximization. These views would argue that economic outcomes of a system dominated by rent appropriation, political motives, and state settings can be expected to be inferior to that of a system dominated by profit maximization, economic motives, and firm settings. Six arguments are put forward. First, when artificial scarcities are created, thereby opening the way for rent seeking, the efficient allocation of resources is distorted. Second, when there is a rent to be captured, contenders often over invest in material resources and human efforts in seeking the rent. The competition involves a social waste of resources. Rent avoidance causes similar wastages. Third, incapable contenders for state positions may gain the rent seeking competition and obtain a payback and more for the investment they incurred; and if they were incapable they would strive to collect the rent and leave, in search of the next rent seeking activity. Fourth, although officials come and go in state settings, the accumulated authority and activity areas of the state are maintained and expanded in state settings. The effort of bureaucrats to expand the government share of economic activities is likely to have negative effects on economic growth. Fifth, If the powerful persons are privileged with rent seeking and realization, whereas subdued agents are excluded, people’s perception of the economic system, and their actions, are negatively affected.19 They are likely to follow and practise rent seeking and political tactics at lower levels, call for greater state interventions, and therefore lead to a spread of rent seeking behaviour at all levels. A political vicious circle often develops causing greater uncertainty overall, and hidden transactions and corruption among some, and passiveness and distrust among others. These effects hinder social progress and economic growth. Sixth, any economic system faces economic limitations that reduce its economic performance. These limitations relate to indivisibilities, uncertainties, and externalities.20 The state tends to intensify these limitations in an initial round to enhance the role of governments in resolving such conflicts in later rounds. Political gains involve economic losses. This is the opposite of the response in firm dominant systems. Firms here attempt to find least cost economic solutions to the limitations. Where feasible they cooperate in fixing new structures of technology


and governance that reduce indivisibility, uncertainty, and externality, or enlist minimal state interventions as a last resort. There is one systemic feature of the FIM that can be at times a major drawback for the FIM performance. This is the greater uncertainty characterizing financial markets in contrast to real markets in the FIM economy. A financial market failure in a FIM can cause loss of confidence and a financial meltdown that wipes accumulated economic gains and cause recession. The financial meltdown of 2008 is such a case. SIM is less prone to such financial risks. While financial institutions and risk-taking markets are indispensable for economic growth, the response of the market system and state intervention falls short in periods of financial uncertainties and instabilities. Taking the above arguments into consideration it can be maintained that there is a conditional edge for FIM related economies to perform better than SIM related economies over longer periods of financial stability and sustained growth. The empirical evidence on economic growth for the years 1950 to 1990 for FIM and SIM related countries does show that the growth in FIM countries was higher than in SIM countries, with the exception of the first ten years. Chapter 5, Section 5.7 will examine these trends. The empirics do not allow supporting the same judgement that favours FIM over SIM when periods of heavy financial turmoil are involved. The contrary judgement is in place in periods of heavy financial turmoil. The empirical analysis of issues of catching up, convergence, and displacements will be treated at some length in Chapter 10. Notwithstanding, it can be stated here that the contributions of empirical analysis to the debate on the relative economic performance of alternative economic systems have been limited. Empirical observation may not always establish superiority of system related country examples on others due to a host of intervening changes and related external and internal disruptions that affect the country examples. The impact of these disruptions is empirically not easy to isolate. There are significant non-systemic factors that affect economic performance and the catching-up tendencies of countries with different economic systems. These factors are often interrelated, and thus make it difficult to establish with rigour which system would realize a higher economic performance. For instance, if for one reason or the other, FIM related countries have become richer, and more expensive than others, the ensuing income and price effects in a trading world would favour higher growth in the lower income countries, which are mostly non-FIM. And, as high levels of richness are reached in FIM related countries, the scarcity problem tends to give way to an abundance phenomenon, the economic motivation loses gear and economic performance in FIM related countries could slow down. The ageing composition of the population is a reinforcing consideration. In a non-FIM country at a lower level of economic development, the economic motivation works in the opposite direction, and favours economic growth. Because economic systems cannot be isolated from the countries that adopt them, and because there are frequent disruptions at the country levels unrelated


45

to the economic system, these disruptions distort the comparative performance of alternative systems as they prevent agents from making a rational choice between genuine alternatives, discourage agent mobility across settings, systems and countries, and tend to reduce convergence between countries featuring different systemic behaviour. Where nationalist sentiments are high, the real gaps in comparative performances between competing systems related countries tend to be ridiculed if the gaps appear unfavourable to own nation. This instinctive attitude to defend one’s own distorts the transparency of comparative system performance. In principle, if performances of competing systems were fully transparent and agent mobility is assured between fully interacting competing systems, then this would permit convergence of the systems over time. But as noted above, various complexities intervene, disrupt genuine evaluations and choice, and prevent convergence. Moreover, there are indications21 that while interacting systems contain some general dimensions that tend to and can be predicted to converge, the same systems contain also other beholding specific dimensions that accentuate identity and divergence. One other question that remains to be raised is what are the future prospects of what can be called a synthesis-system? The historical development of the three societal systems of HIM, FIM and SIM can be interpreted in terms of an original, a thesis, and an antithesis, respectively. HIM is the original state. FIM can be viewed to constitute the thesis in which the individual agent strives towards his/ her individual maximum economic welfare. This thesis supports the free mobility of goods and factors of production in space and time. SIM can be viewed as the reaction to a privatized economy, as the antithesis where the individual’s self-interest is substituted by a collective satisfaction of needs that is defined and ruled by state authorities. In this context, regulations on the free movement of goods and factors of production and aspirations of nationhood and protectionism are likely to prosper. Are there grounds for expecting an evolvement towards a synthesis of the three systems? Or would there be new elements entering in a synthesis-system? The answer to this question is not independent from the future economic outlook for the countries that embody the alternative economic systems. In particular, the future outlook for economic systems may be significantly influenced by the expected larger sizes of the economies of China and India compared to US or Russia. Because all countries interact in an increasingly globalizing world, the rapidly expanding economies of China and India would raise the relative influence of their economic systems in relation to the FIM and SIM economic systems of today. If the contemplated future outlook were realized, some of the new elements in a synthesis system would come forth from the social systems of China and India. Both countries have configurations of behavioural settings that lean more towards household settings, i.e. the traditional and sharing behavioural type, than firm settings, i.e. the modern and maximizing behavioural type when compared to US. Their version of state settings is also different from that in Russia. Furthermore, and more important, persuasion settings in China and India are

46


much more active in coordinating and streamlining the social system than elsewhere, which is justified given the demographic dynamics and the multi polar differentiation of the social system in these two giant countries. It is likely that a synthesis system would manifest a more frequent and substantial occurrence of persuasive settings.22 More on these aspects will be treated in Chapter 10.

2.7 Dominance and diversification tendencies across countries and systems: Some applications We have emphasized in this chapter systemic tendencies towards dominance of one type of settings over others, but we gave also attention to the occurrence of disruptions at the country level that obstruct the systemic tendencies towards dominance from taking place fully. Instead, the disruptions show up in diversification tendencies across countries, within broadly defined economic systems that apply for country groups. This section reflects on the fabric of dominance and diversification in our economic systems and the various country groups that associate with these systems. We have already positioned countries along the three axes of economic systems: HIM, FIM, and SIM, in Chapter 1, Figure 1.3. How does this positioning of countries across systems fare with the observed dominance and diversification tendencies among the countries? In other words, how do agents in the various countries perceive their systems and the positioning of their countries in these systems? The answer to these questions requires an investigation of the variance in attitudes of agents towards the three distinguished settings: the family-household settings, business settings, and the state; and the implications of these attitudes for the system. It can be expected that in countries close to the household intensive economic system, HIM, agents would show preference for strong family ties and a greater role of the family in the agent’s life. Likewise, in a country leaning towards the FIM system, agents are likely to have more trust in business firms in conducting activities, and hence give preference for firms over state in managing the economy. Along the same reasoning, in countries leaning towards the SIM system, agents are likely to have relatively more collective than private needs. They would prefer a greater role for state bodies and a lesser role for business firms in managing the economy and producing the required goods. Of course, due to the diversification tendencies, it can be expected that not all agents will have the same systemic focal point no matter how integrated that system may be. An important source on agent attitudes is the World Value Surveys (WVS). The survey is a compilation of national surveys on values and norms on a wide variety of topics. It started in 1981 and was carried out in 1981–84, 1990–93, 1995–97 and 1999–2004.23 We use the last survey, and where necessary compliment it with the previous survey for missing country data. The WVS contains relevant information relating to the importance of the household family in an agent’s life, as well as information on preferences for business firms contra preferences for state bodies in managing the economy. The concerned question on the household family asks how important is the family, and the answers are ranked into ‘very important’, ‘rather important’ and


47

decreasingly down to ‘not important’. Table 2.2 and Figure 2.1 display the percentage results of the above alternatives for the reported countries; and the results are in conformity with our positioning of countries along the HIM axis. It is recalled that we placed the OECD countries in the FIM corner and the transition

Table 2.2 Importance of household settings: Percentage of responses to varying ranks of importance of the family in one person’s life FIM related countries

Country

SIM related countries

Very Rather important important Country

FIM US+ US Australia Canada

87.7 93.1 95.3 90.2 93.9

10.4 5.7 3.8 8.0 5.3

WE Austria Belgium Denmark Finland France Germany Greece Ireland Italy Norway Portugal Spain Sweden Switzerland UK

85.9 88.5 86.5 87.0 79.6 87.5 81.0 82.3 90.6 89.8 87.8 84.1 85.4 89.4 80.9 88.2

11.8 9.2 9.7 11.1 16.2 10.6 15.4 15.3 7.7 8.6 10.6 14.4 13.4 8.5 16.2 9.6

Japan+ Japan Korea Singapore

90.9 91.3 89.6 91.8

8.0 6.4 10.0 7.7

Developing countries and regions

Very Rather important important Country

SIM Russia

67.9 75.0

13.4 19.0

CSEE Czech Rep. Estonia Latvia Lithuania Hungary Poland Slovakia Slovenia Albania Bosnia Bulgaria Croatia Macedonia Romania

76.9 84.5 67.5 70.5 64.7 88.6 91.5 87.3 81.9 95.9 98.7 82.3 78.4 97.5 84.5

13.5 13.5 27.9 22.1 30.1 9.1 7.8 10.5 14.9 3.1 1.2 14.5 20.3 1.8 12.7

EXSR Armenia Azerbaijan Belarus Georgia Kyrgyzstan Moldova Ukraine

85.2 86.0 84.7 77.7 94.6 87.2 85.0 81.4

12.3 12.0 13.2 18.2 4.3 12.1 12.1 14.4

Very Rather important important

EAP China Indonesia Philippines Vietnam

89.0 76.5 98.6 98.6 82.2

10.5 22.5 1.0 1.3 17.0

SA India Bangladesh Pakistan

93.7 91.9 96.7 92.6

5.2 6.0 3.3 6.4

MENA Egypt Algeria Iran Jordan Morocco

95.0 96.4 94.4 94.1 96.6 93.4

4.2 3.3 4.7 4.5 3.1 5.4

GCC S. Arabia

94.7 94.7

4.8 4.8

SSA S. Africa Nigeria Uganda Tanzania Zimbabwe

94.4 95.2 98.9 91.0 89.6 97.3

3.8 3.0 0.9 6.9 5.6 2.6

LAC Brazil Mexico Argentina Chile Colombia Dominican El Salvador Peru Uruguay Venezuela

90.6 92.6 90.6 90.2 96.4 84.0 85.1 96.6 96.6 82.4 91.3

8.5 6.6 8.5 8.4 2.8 15.5 14.4 2.5 2.2 16.7 7.1

Source, note: Compiled from World Value Survey 1999–2000, at http://www.worldvaluessurvey.org. Results are for national sample surveys, around 2000. The figures for China refer to 1995. The table gives percentage of the responses ‘very important’ and ‘rather important’. The reply ‘not important’ accounts for the residual of a 100 percent. Figure 2.1 displays results for the reply ‘very important’ at the country group level. The country groups average is 89.1, and is indicated by the average line in Figure 2.1.

48


FIM

87.7 67.9

SIM EAP

88.9 93.7

SA MENA

95.0

GCC

94.7

SSA

94.4

LAC 0.0

90.6 10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

Percentage respondents reporting family as very important, average dashed line = 89.1 %

Figure 2.1

Importance of household settings: Country ranking of importance of family

Source: Table 2.2.

countries around the SIM corner. In contrast, we placed the six developing regions along the intersecting axis between household and firm intensive economic systems, HIM and FIM, and household and state intensive economic systems, HIM and SIM. This means that there is a greater alignment of the developing regions with household settings. This is not surprising since the development of the three prototypes of economic systems can be postulated as an outgrowth from some common origin, which is by definition the household setting; and in terms of economic development the developing regions are closest to the common origin. Table 2.2 confirms that the developing regions rating of household settings, the family and kinship as very important is higher than the FIM or SIM related countries. Figure 2.1 shows the average line for all countries for this question at 89.1%, with the developing regions above the average and FIM and SIM related countries below.24 The table shows a higher prominence of family settings and family related attitudes in the FIM related industrial economies than the SIM related transition countries, suggesting that firm settings are more accommodative to familial institutions than state settings. Especially in the context of the ex-communist rule in transition countries, the state appears to have specially undermined household settings.25 What are the implications of a strong preference for familial institutions? Alesina and Giuliano (2007) studied the influence of the above indicator of the family importance and related indicators on economic behaviour in a crosssection of 70 countries. They found strong family ties to associate with greater reliance on the family as an economic unit for production and exchange and less reliance on the market and the state as income providers. Furthermore, strong family ties go together with a higher home production reduced labour participation, less geographical mobility, and a larger size of the household. An interesting point of discussion is whether attitudes of agents determine the orientation of the


49

socio-economic system, or that such attitudes are accommodated to the existing socio-economic system. It is likely that both causality chains exist, representing active and passive behaviours of actively oriented agents and passively oriented agents, respectively. The agent mix of the actively oriented agents and the passively oriented agents would then determine the degree of dominance of new attitudes on new facts, and the pace of change. The World Value Survey is relevant in the context of economic systems in another respect. It gives national results around 2000 on attitudes towards the FIM and SIM axes. The set of questions asked that is of specific concern here was the following: {‘How would you place your views regarding the following statements on the following scale?’ The respondent is requested to mark the statements with which he/ she completely agree. There are ten statements numbered 1 to 10 that range from one extreme to the other. For example, 1 Private ownership of business should be increased; 2 ....; 3 .... ; etc ....; 9 ....; 10 Government ownership of business should be increased.} Table 2.3 sums the results of the responses from 1 to 5 as favouring private ownership, and responses from 6 to 10 as favouring government ownership. In countries that we classified as being oriented towards the firm intensive economic system, the dominant response is that favouring private ownership of business. The score for US is 83 per cent, with Western Europe and Japan at 76 per cent and 70 per cent, respectively. In the transition countries, which we indicated as relatively close to the state intensive economic system, the response becomes less favourable to private ownership. In the BCEE group, the preference towards private ownership dwindles to 64 per cent. Countries that were part of the ex-Soviet Union, the EXSR group show an equal preference for public and private ownership at 50 per cent. The majority of responses in Russia are seen to reverse, and favour government ownership, i.e. 55 per cent. Figure 2.2 shows a pattern of diminished preference for firm settings and a rising preference for management of the economy by state settings as one moves from US to Russia. The developing regions show a mixed picture with SSA as the region that favours private ownership of business most, followed closely by SA, MENA and GCC. On the other hand, the majority of responses in EAP and LAC favour state ownership over private ownership. These outcomes can be interpreted in various ways. One way of interpretation is that the private versus public attitude in a specific region is consistent with the respectively dominant FIM or SIM regime in the specific region, as was argued with respect to the developed and transition countries. This is a weak interpretation since the developing regions are undergoing processes of extensive socio-economic change and there is as yet no one economic system type that can be assigned as the dominant regime. This point is explored further in Chapter 6. The other way of interpreting the outcomes is to look at the private versus public attitude as a short-term reaction to disappointments with the occurring

50 Economic Systems Analysis and Policies Table 2.3 Importance of firm and state settings: Pro-firm and pro-state attitudes

FIM related countries Country

% for % for private public Country

FIM US+ US Australia Canada

76 82 83 82 80

24 18 17 18 20

WE Austria Finland France Germany Ireland Italy Norway Portugal Spain Sweden Switzerland UK

76 89 78 83 80 76 78 77 67 54 76 86 71

24 11 22 17 20 24 22 23 33 46 24 14 29

Japan+ Japan Korea Singapore

SIM related countries

70 76 67 68

30 24 33 32

Developing countries and regions

% for % for private public Country

SIM Russia

59 45

41 55

CEEE Czech Rep. Estonia Latvia Lithuania Hungary Poland Slovakia Slovenia Albania Bosnia Bulgaria Croatia Macedonia Romania

64 67 47 58 65 57 55 39 75 79 72 59 70 78 68

36 33 53 42 35 43 45 61 25 21 28 41 30 22 32

EXSR Azerbaijan Armenia Belarus Georgia Kyrgyzstan Moldova Ukraine

50 56 44 62 51 46 37 55

50 44 56 38 49 54 63 45

% for % for private public

EAP China Indonesia Philippines Vietnam

43 34 41 39 57

57 66 59 61 43

SA India Bangladesh Pakistan

60 49 60 72

40 51 40 28

MENA Egypt Algeria Iran Jordan Morocco

55 36 57 56 53 71

45 64 43 44 47 29

GCC S. Arabia

49 49

51 51

SSA S. Africa Nigeria Uganda Tanzania Zimbabwe

62 56 49 76 59 70

38 44 51 24 41 30

LAC Brazil Mexico Argentina Chile Colombia Dominican El Salvador Peru Uruguay Venezuela

47 58 52 52 45 36 42 42 40 56 47

53 42 48 48 55 64 58 58 60 44 53

Source, note: Compiled from World Value Survey 1999–2000, at http://www.worldvaluessurvey.org. Results are for national sample surveys, around 2000. The following definitions hold: (% for private) accumulated percentage of respondents in the interviewed sample that believes private ownership of business should be increased. Results of responses ranked in terms of five degrees of conviction are summed. (% for public) accumulated percentage of respondents in the interviewed sample that believes government ownership of business should be increased. Results of responses ranked in terms of five degrees of conviction are summed.


82%

US+

30%

64%

CEEE

36%

50%

EXSR

50%

45%

Russia

55%

43%

EAP

57% 60%

SA

40%

55%

MENA

45%

49%

GCC

51% 62%

SSA

38%

47%

LAC

Figure 2.2

24%

70%

Japan+

0%

18%

76%

WE

10%

51

20% 30% % for private

53% 40%

50%

60%

70% 80% % for public

90%

100%

Importance of firm and state settings: Pro-firm and pro-state attitudes

Source: Table 2.3.

socio-economic changes. For example, in Sub Saharan Africa, South Asia and the Arab countries, a pro-private attitude can be seen as a logical reaction to dissatisfaction with the increasing role and the development performance of the state. In contrast, in EAP and LAC, i.e. China and Brazil among others, the pro-state attitude can be seen as a logical reaction to dissatisfaction with firms and markets in rapidly changing economies with significant displacements. There is another plausible interpretation with a more endurable character. Country groups that tend to have pro-business attitudes were shown to assign a very high importance to familial institutions and household settings, while country groups that favour pro-state attitudes tend to assign low priority to familial institutions. This is generally true for the industrial and transition country groups, and applies also to the developing countries.26 The association at the country group level suggests the presence of a synergy between pro family and pro business attitudes; and an affinity between indifference to familial sentiments and support of pro-state attitudes. Finally, our positioning of countries along the systemic axis recognizes diversification within the dominance tendencies, with respect to FIM and SIM related countries. This is present in out positioning of US closest to the firm intensive economic system, and Japan and Western Europe to the left and right, respectively. This reflects the sharing-inclined economy in Japan, and a control-inclined economy in Europe. Taking an index for 2006 based on ten indicators of firm competitiveness, Table 2.4, left part, shows a greater ability of agents to compete in the US than in Europe, which can be seen as evidence of a more firm intensive economic system in US than in Europe. The indexes show Japan to be closer to

52 Economic Systems Analysis and Policies Table 2.4 Indexes of Firms Competitiveness and State Appropriation (Rule of Law) for FIM and SIM related countries, respectively Firm competitiveness in FIM related countries (a) US 82.4

Rule of law in SIM related countries (b) (10 = best, 0 = worst)

EU

Japan

Russia

BCEE

EXSR

70.9

74.5

3.7

7.2

4.4

Sources: (a) The Heritage Foundation (2000): Index of Economic Freedom, published by The Wall Street Journal and The Heritage Foundation, New York. See also Chapter 3 Table 3.3. (b) Wall Street Journal. The figures are also quoted in Hoff and Stiglitz (2002). See also Chapter 6, Box 6.3.

US than Europe. Chapters 3 and 4 will elaborate more on the diversification tendencies in the FIM country group. Among SIM related countries, Russia was positioned at the core, with former European satellites leaning to firm settings, and the other ex-Soviet republics, especially some Asian, leaning to household settings. This orientation is shown in Table 2.4, right part, which reflects on the extent of institutionalization of the rule of law versus state discretion, or in popular terms, rent appropriation by the state. The Rule of Law Index shows Russia as closest to state appropriation, with the Baltic, Central and Eastern European countries (BCEE) and the Ex-Soviet Republics (EXSR), as more free from state appropriation. The topic is revisited in Chapters 5 and 6.

2.8 Summary and conclusions The distribution of agents in contrasting behavioural settings, such as household, firms, and state settings, and their interactive participation, produce over long periods highly contrasting economic and political systems that coincide with distinct behavioural types. The three systems associate with dominance of households, firms, or the state and are identified as HIM, FIM and SIM. The chapter laid down a micro-macro conceptual framework that is useful for tracing the evolution and the internal consistency of the economic system and the polity towards focal behavioural types and settings. Making use of differing compositions of personal and collective needs, and a conceptual model to trace the mix of needs, the chapter explored the paths of different economic systems since early development that associate with satisfaction of personal and collective needs. The economy–polity configurations of countries like US and Russia are outcomes of firm-intensive and state-intensive economic and political transformations, with overweight of personal and collective needs, respectively. The chapter compared the structure, conduct, and performance of the three economic systems. Economic performance in the state intensive system, SIM,


53

being subjugated to the state polity, is likely to be inferior to economic performance of the FIM, which is oriented towards economic objectives, granted that firm competition is not hindered by monopoly power. However, in FIM the financial market is inherently less transparent than the real market and is a cause of uncertainties and instabilities that cut in the economic performance of FIM. Financial turmoil is less common in SIM. A preliminary discussion of the future configuration of economic systems pointed out to the inevitability of assigning greater roles for sharing and persuasion mechanisms in coordinating future systems. Finally, the chapter reviewed agent attitudes on economic systems by country groups. The World Values Surveys gives results on affiliation to households that are consistent with the positioning of country groups along the HIM axis. Differences among countries in attitudes towards business (personal) versus state (collective) solutions in the provision of goods and management of the economy are shown to support our positioning of countries between the firm intensive system, FIM, and the state intensive system, SIM.

3 The Firm Intensive System: Economic Challenges and Agent Responses in US, EU, Japan

3.1 Economic principles of a pure firm intensive economic system Historically, the rise of economics as a science about two and a half centuries ago in Europe coincided with the beginning of the firm intensive economic system (FIM). This coincidence is not an accident. It is a natural outcome of scientific reflection on emerging realities. While economics started as, and continues to be, the study of transformation processes that result in a value added at a lower cost, economic thought usually focuses on profit maximizing firms and allied markets as the main behavioural economic settings. It is in these firms and markets, where most transformation processes take place, where economic agents inhabit most and where economic behaviour is displayed, learned and spread by the agents to other settings. The industrial revolution in Europe made an end to home production as a major economic setting and opened the way for firms and markets to dominate the economic system. The firm intensive system can be described as one in which profit maximizing firm settings are the focal points. Firms, led by entrepreneurs, invest capital, hire labour and transform goods into higher values at lower cost, and exchange the goods in allied markets for real money – that is used to realize more exchanges. Firms strive towards maximization of profits, and agents labouring in the firms take over this economic behaviour and follow suit by maximizing their utility in their role as consumers. About a century ago, European and American economists started theorizing on the properties of this economic system in its purest form. They specified the conditions and presumptions, which must be satisfied by producers/firms and consumers/households in a model of the perfect market economy to achieve economic efficiency in the sense of Pareto optimality.1 Where there is a deviation from Pareto optimality, and given their goals, firms (and other agents), will reallocate and act to remedy the situation, and achieve more gain at lower cost. If for various reasons, firms (and other agents) cannot coordinate their actions purposely, they may call on collective action in the form of state intervention, which will mean that the government enters the stage as an explicit outsider. 54

Firm Intensive System: Economic Challenges 55

Economists have studied (a) ways in which real market economies deviate from the model of the perfect market economy, the response of firms, households and government to these deviations; and (b) how state intervention take place and the consequences of these state interventions for the economic system. This and the next chapter are guided by the insights gained in (a) and (b). This chapter will focus on issues relating to (a), the next chapter will deal with (b). Together, the two chapters aim at displaying the mechanisms and outcomes of the firm intensive economic system and the accommodation of the state in such a system. Our approach to examining the firm intensive economic system and its evolution is best done along the lines of considering the firm intensive system in its pure form and proceed to examine market failures and subsequent state interventions. We shall assess the FIM in terms of these issues, and in that order. Such an assessment is helpful in determining how responses of firms and government combine and evolve to the mixed forms observable in industrialized countries. We shall use examples from national economic systems that are closest to representing the firm intensive economic system; these are the US, the EU and Japan. We recall that while there are major differences between the three national economic systems they share together a primary role of the modern firm in shaping their economic systems. In relative terms, the US stands for the context where the role of the modern firm and free markets are paramount in determining the character of the economic system. In comparison, the EU allows for a greater influence of collective features typical of state settings, while the Japanese economic systems manifest elements of sharing typical of kinship settings. In this section, we review the economic principles of the pure firm intensive economic system. The firm intensive system can be seen to consist of firms (and individuals) who are motivated by commercial self-interest. The firms maximize profits subject to technological and budget constraints. Individuals follow suit and maximize their utility subject to budget constraints, which are the incomes the individuals earn from the firms for work done in these firms. The firm intensive system relies on the competitive price mechanism, which is characterized by indirect exchanges between many independent sellers and many independent buyers. The firms are sellers and buyers of output and input, respectively. The individuals can be owners and hired labour of firms (these being the input of firms), and buyers of consumption goods (this being an output of firms), respectively. All agents take note of the relative prices at which the market settles for competing goods, and agents react by buying or selling, without getting involved in a direct exchange. There are no exchange costs in place or time. If all agents (firms and individuals) behave competitively, there will be free entry and exit, there will be no barriers whatsoever to exchange, all agents will be price takers at the same price for the same commodity, and a simultaneous equilibrium will be obtained by all agents in all markets – hence the term general equilibrium. For example, Figure 3.1 shows how the maximizing firm x decides on uses of labour l in the production of commodity i (or j). The firm employs labour to the


Pi MPi1 (marginal value)

wage rate w0

l0 Figure 3.1

labour input

Firm decisions on use of factors

x3 Quantity i

x2 x1

Qi Pj Pi Qj Figure 3.2

Quantity j

Firm decisions on production of goods

point where the value of marginal productivity of the worker MP equals the wage rate he faces.2 Equation (1) obtains when all firms, x and y, so that x

y

MP i l = MP i l =

Pl Pi

(1)

Figure 3.2 deals with the choice of firm x between production of commodities i and j. Firm x faces profit lines x1, x2, x3 in an increasing order. The slope of these lines is given by the relative market prices for the two commodities. Firm x will choose an allocation between commodity i and j where the highest point is attained. The firm will equalize the marginal rate of transformation MRTij to the relative prices P of competing commodities i and j he faces, giving equation (2). The same applies to firm y. y x MRT i j = MRT i j =

Pj Pi

(2)


Similar figures can be drawn for individual consumers, making use of their marginal rates of substitution MRS, to demonstrate how they determine efficient choices in consumption between commodities i and j, and between consumption and work, all occurring under the same prices mentioned above. It can be shown that under perfect market conditions the marginal rates of transformations within and among firms and the marginal rates of substitution within and among households will coincide to give equation (3).

MRSija

MRSijb

...

MRTijx

MRTijy ....

(3)

In the prefect market economy, market prices carry significant information. Each commodity price would reflect the buyer’s marginal valuation relative to other commodities. Moreover, the price of a commodity must be equal to its marginal costs. Each price, therefore, expresses the lowest possible costs that society is ready to sacrifice for the commodity concerned. Furthermore, the market prices are equilibrium prices which go with an equilibrium position from where it is impossible to make a change without making someone worse off, hence competitive markets are Pareto optimal. The First Theorem of Welfare Economics thus states that if the marginal conditions in equation (3) will hold then the resulting competitive market equilibrium is Pareto optimal. Guided by equilibrium prices the self-interested decision of the economic agents lead to a social optimum in the Paretian sense. This is another way of viewing Adam Smith’s notion of the invisible hand mechanism. The optimal performance of the perfect market economy centred on firms depends on the fulfilment of four presumptions; that is, absence of indivisibilities, uncertainties, externalities and collectivities. There are technical and behavioural dimensions to these presumptions. The optimal performance of the market economy would require fulfilment of the technical presumptions as well as absence of behavioural bias in the four directions. The presumptions can be stated as follows. (1) Consumers’ preference ordering should satisfy non-satiation, continuity and strict convexity. Producer’s technology sets should satisfy boundedness, regularity and strict convexity. Factors of production, labour and capital are homogeneous and divisible. Commodities produced are homogeneous and divisible. Hence, there are no indivisibilities. (2) Perfect and same information given to all consumers and producers; no uncertainties. (3) The economy does not encounter external economies or diseconomies in consumption or production. Preferences and utilities of agents are independent of each other; no externalities. (4) All potential production of commodities and use of factors have been considered in the optimal allocation. Preferences and utilities of agents are genuinely revealed in market transactions; no collectivities. Non-fulfilment of underlying presumptions in the real world results in inefficiencies that may be remedied by firms and market solutions and/or state interventions. The model of the perfect market economy contains presumptions that are mostly difficult to maintain in the present-day market economies. Such situations are often called market failures, which possibly call for corrective market


responses and/or state interventions. Table 3.1 is a summary presentation of failures and responses. Because of technical barriers the four presumptions stated above fail to be realized in all real economic systems; hence, the label of market failure used by many, exaggerates the market context of the failure. Notwithstanding, imperfections in the profit maximizing behaviour of firms may aggravate the technical barriers. For example, not only does non-convexity create barriers and pave the way towards monopoly, but also monopolistic behaviour of firms may lead to intensifying indivisibilities in the production function. Similarly, while uncertainty exists on technical grounds in any economic system, asymmetric informational behaviour of firms in a market economy increases uncertainty faced by other firms. Again, while externalities exist on technical grounds in any economic system, it is likely that the emphasis on private benefits and costs in the market economy aggravates the gap between social and private benefits and costs and, with the presence of interdependent behavioural patterns among agents, will moreover strengthen the recurrence of externalities. Finally, the problem of collectivities is aggravated by non-revealed and intentionally distorted preferences in the context of free-riding behaviour. There is a Second Theorem of Welfare Economics that states that any Pareto optimal state is equilibrium for some initial distribution of endowments. It was thought at one time that if the initial distribution is sub-optimal, this could be easily reset ex-ante by lump-sum transfers without distorting work incentives. Mirrlees showed that this is not feasible. Then Kaldor-Hicks introduced the compensation principle, by which gainers compensate the losers from a gain made by the gainers. However, this compensation mechanism, which is ex-ante, is not operational. Arrow and Sen have shown furthermore the impossibility of the Paretian liberal. Bergson has shown, at the other end, the necessity of assuming the benevolent ruler in a discretionary regime as the way out. 3 In which ways can the actual working of the firm intensive economic system be interpreted to resolve the public choice dilemma in such a system? The economist’s rationalization of the system’s consistency tends to see the real world as consisting of a benevolent ruler who reviews the income distribution situation at the end of the year and resets this ex-post, giving due consideration to the perception of a desirable initial distribution and unintended differential outcomes during the year. Transfers are then affected in consistency with the resetting. If the resetting is well-done and duly implemented, then the outcomes of the firm intensive economic system can be described to be in harmony with the desired equity perspectives, even though this happens with a lag in time. And should the ruler be non-benevolent, it can be argued that via the parliamentary process his replacement by a benevolent ruler who could correct the distribution ex-post, and perhaps also in real terms, is again a matter of more time lags. Reasoning along the above lines, the regular and lagged implementation of ex-post redistribution policies in industrialized market economies can be seen as remedies that fit well within a general framework of applied welfare economics

Firm Intensive System: Economic Challenges 59 Table 3.1

Problem areas leading to market failure, and the subsequent responses of firm and state

Problem areas

Manifestations

Resulting market failures

Firm responses

State responses

Monopoly and imperfect competitive behaviour in a static context

Increasing returns to scale show up in indivisibilities in production, non-competitive behaviour of producers, market power taking, price setting, entry barriers etc.

Natural monopoly and imperfect competition: deadweight loss managerial slack rent seeking like practices

Contestable markets

Nationalization, privatization, regulation, and deregulation. Legislation on dominant position and restrictive practices

Monopoly and imperfect competitive behaviour in a dynamic context

Weak incentives for firms to invest in technology when benefits are nonexcludable.

Retarded growth

Joint ventures

Technology policy with focus on innovating firm and/or on perspective technology

Imperfect information

Markets do not clear over time because of coordination failure, mobility costs etc.

Coordination weak under uncertainty Discouraged exchange Deadweight loss

Future markets

State legislation and information banks to clear markets and stimulate exchange

Distorted information

Asymmetric informational behaviour

Adverse selection, moral hazard, market barriers

Signalling

Governance policy: transaction restructuring

Interdependence of individual utilities

Diverging private interest behaviour avoids realization of positive externalities

Social and private benefits diverge leading to deadweight loss

unitization

Example of positive externality: industrial policy

Interdependence of individual utilities

Diverging private interest behaviour accentuates negative externalities

Social and private costs diverge leading to deadweight loss

unitization

Example of negative externality: environmental policy

– Non-rivalry and non-excludability – Free riding

Unattended public goods and merit goods

Cooperative provisions

Social provisions insurance schemes

No consensus Compensation principle not operational, not neutral

Trade-off efficiency and equity unresolved

Fair pay and provisions for income maintenance

Ex-post distributional policies Continuous necessity to revise distribution of income and wealth

Indivisibilities

Uncertainties

Externalities

Collectivities Genuinely revealed preferences Distribution No consensus over socially desirable initial distribution of endowments

60


for the firm intensive economic system. The presumption of a benevolent ruler, which may not materialize in the short run but is more certain through democratic processes and substitution of governments in the long run, is a basic condition for resolving the dilemma of public choice in these economic systems. A stylization of market failures showing unfulfilled assumptions, resulting manifestations and problems as well as areas of self-regulated market corrections and areas of public policy are found in Table 3.1. Of course, these aspects are not always symmetrically encountered in real life as the table may suggest. For example, competition policy is in reaction to imperfect competition and imperfect information, but overlaps with policies relating to monopoly, technology and industry. Even though the main thrust of industry policy lies in externalities, it involves other market failures. Environmental policy is mostly related to externalities, but contains collectivities as well. While health and education sector policies are responses to imperfections in competition, information and externalities, they represent collectivities. It is also important to note that while the table may give the impression that firm responses and state intervention stand opposite to each other as competing alternatives in remedying market failures, the usual case in FIM is that of a cooperation in which firms and state act in concert. In this cooperation, behavioural expectations consistent with intrinsic firm settings dominate over those typical of intrinsic state settings. Furthermore, as will be shown later, in most cases of market failure firm responses have overshadowed state interventions. In FIM, state interventions in firm economics are constrained to a minimum and subjected to various juridical and parliamentary controls. The following sections will treat each of the five market failures in Table 3.1: indivisibilities, uncertainties, externalities, collectivities and distribution, Sections 3.2 to 3.6, respectively. In each section we review the problem, and examine and assess the response of firms in remedying the problems and state intervention to resolve the problems. We make use of FIM related country data to illustrate the problems and illuminate country differences. The chapter ends with summary and conclusions.

3.2 Indivisibilities: Problems and firm-state responses 3.2.1 Problems Conditions of perfect competition require free entry and exit of firms leading to a large number of companies producing competitive goods. Through free entry and exit, a situation is created in the long run where price of a good is equal to the average total cost, so that monopoly profit is eliminated. In the real world, technological indivisibilities in some vital industries persist and translate in increasing returns to scale (or decreasing costs) so that average total costs of the firm are decreasing over a large output interval. If demand is small in relation to the output volume produced by the firm the activity will end up with one single firm offering the minimum costs for each desirable output volume. Even if a natural monopoly does not arise, the presence of indivisibilities


gives an advantage to incumbent firms, which could restrict entry, promote noncompetitive practices and result in imperfect competition. Because of indivisibilities the incumbent firm is able to fix a high price and receive a monopoly profit. Aspiring firms cannot enter because there is little space for more producers. This creates tension between incumbent and aspiring firms. Also existing firms that deliver or receive inputs from the monopolistic firm may not be content with lack of competition. Moreover, monopolistic practices have deadweight loss next to technical inefficiencies. Hence, there is mounting pressure to restrain monopoly power not only from business but also from the whole community. Because of the inability of the participating agents to act collectively towards that end, the government is called upon to render regulatory and monitoring services towards promoting competitive practices. The discussion below treats the static and dynamic consequences arising from indivisibilities, namely, natural monopoly and imperfect competition in the static context; and technological bias and growth limits in the dynamic context. We shall examine firm responses and state interventions relating to these contexts. 3.2.2 Natural monopoly and imperfect competition 3.2.2.1 Natural monopoly Natural monopoly appears when economies of scale are important. With huge economies of scale there is only one single producer. Familiar examples of monopolistic industries with a significant degree of economies of scale are telephone, postal and railway services, and public utilities such as water, gas and electricity. This is also true in particular for certain services sold on a limited local market. In the case of natural monopoly, the very nature of the decreasing cost of technology precludes perfect competition. With a natural monopoly, average costs are declining, and marginal costs are below average costs. Hence, if price were set equal to marginal cost, as in the case of perfect competition, it would be less than average costs and the firm would be losing money. If the community wanted a natural monopoly to produce at the point where marginal cost equals price, it would have to somehow support the industry to offset these losses up to the point of nationalizing the industry and fully regulating it. The opposite alternative is that the industry is privately owned and run but that the production and price of the product are regulated in some degrees. These two alternatives, nationalization versus regulation, are found in various combinations in FIM countries. The nationalized industries are basically the part of government production that covers the provision of private goods for sale through the market. Thus the nationalized industries in a typical country include railways and electricity, but not the army or the provision of education or housing, which are not sold commercially. There are several reasons why nationalized industries were entrusted to state ownership in the past. As was stated above, the first and foremost is the natural monopoly problem emanating from indivisibilities. The presence of large capital costs and economies of scale turn some industries into natural monopolies such


as electricity and railways. As in these industries marginal cost lies below average cost, they cannot meet the social efficiency criterion that requires that prices be close to marginal cost for otherwise they will incur losses. Private investors are furthermore discouraged to enter these industries. An entrant would have to enter on a large scale and incur costs comparable with those of the existing firm, and this is unlikely. The entrant worries too that should it enter, the existing firm will compete sufficiently keenly so that what promised to be high profits will disappear. Entry is even less inviting when there are large sunk costs: if the existing firm does compete and the entrant is forced to exit, the entrant will be unable to recoup much of its investment. Since private shareholders cannot be expected to initiate such enterprises, public ownership and/or public management may then become inevitable, and they are eventually endorsed by existing and aspiring firms. Nationalization has been supported for other reasons than indivisibility, such as externality. This is the case when the social gains from an economic transformation, i.e. air, road or rail network exceed the private benefit for which direct users are prepared to pay. Furthermore, some public services can be seen as merit goods that should be made available to all.4 Even though inescapable, state ownership of monopolistic industries is looked upon with scepticism in FIM. Several problems accompany nationalized industries. It is hard to ensure that the industry does minimize costs. The regulatory public body has the difficult task of trying to ensure that the management of the natural monopoly is as efficient as possible. This is a problem of information access and mechanism design between agent (management) and principal (ministry). The managers of nationalized industries often lack adequate incentives to cut costs and modernize vigorously, particularly given the fact that government is frequently willing to subsidize the industry when it loses money. In addition, the nationalization of natural monopolies subjects them to a number of political pressures and employment interests from regional and central politicians. Innovating firms, driven by a genuine demand by the business community to eliminate indivisibilities and minimize state responses, have responded in the past two decades with introducing new advances in production divisibility and distribution technology. The innovations succeeded in introducing contestable markets and enhanced potential competition. Transport and communication are typical examples of contestable markets where entry and exit is relatively cheap. In many case of contestable markets, the threat of entry is sufficient to keep prices from rising above average costs. Thus, potential competition is all that is required for FIM to operate efficiently, not actual competition. The technological innovations, directed towards reducing indivisibilities, have led in FIM countries to a gradual withdrawal of state ownership, management and regulation of economic activity, and the further enhancement of deregulation, privatization and competition. In addition, recent technological advances in telecommunications and energy supplies demonstrate that the national markets for any of these services are linked worldwide and are sufficiently large enough for three or more suppliers. This has


lead to more drives in the past two decades towards privatization of nationalized industries, and the greater enforcement of the FIM regime. In countries where privatization programme of nationalized industries were launched, and firms were tendered to take over the natural monopolies from the state, both parties have collaborated in developing a consistent and phased privatization strategy, followed by liberalization and greater competition within the national market and across the border, as well as adequate incentives and monitoring provided by regulatory public agencies.5 This was and is necessary in view of the diverse objectives, conflicting interests and specific restrictions involved. It is worth mentioning that there are empirical investigations regarding the choice between nationalization and privatization. These focus on determining whether public or private sector firms are more likely to attain the lowest possible cost curve. An evaluation of the results of 30 studies conducted in different industries in different countries by Yarrow (1985) lead to the general conclusion that there is not much difference in cost between government enterprises and large private corporations, particularly when both are subjected to the same degrees of competition and regulation. For particular cases, it is difficult to determine empirically how much more or less efficient the government is as a producer than if the same company is run by a private corporation. Many economists agree that the key issue is not the difference in ownership but rather how effective the monitoring of management and the forces of market competition. It is generally known that privatization leads to a better performance if it drives managers to act in more transparent and competitive ways. In the regulation alternative the dominant firm persuades other firms, and the community at large, to accept the firm as the sole owner of the natural monopoly, with the condition of entrusting the government with the role of ensuring that price is kept at the lowest possible level, commensurate with the monopolist’s obtaining an adequate return on its investment. In other words, the regulator tries to keep price equal to average costs – where average costs include a ‘normal return’ on the firm’s capital, on what the firms owners have invested in the firm. If the regulators are successful, the natural monopoly will earn no monopoly profits. From the start, prospects for the regulatory system in FIM were constrained by two levelled objections. The first objection is that regulations often result in inefficient practices. For instance, prices are set so that firms obtain a ‘fair’ return on their capital. For the firms to make the highest possible level of profit under the circumstance, firms respond by increasing their amount of capital as much as possible, which can lead to too much or too costly investment. Or, the structure of prices is set so that some groups, often businesses, may be charged extra-high prices to make it possible to subsidize other groups. Furthermore, firms’ incentives to innovate are greatly attenuated if every time they succeed in lowering costs, the regulators quickly force them to lower their prices as well, giving all or even most of the benefits to consumers. This problem is exacerbated when regulators require the shareholders to absorb all the costs of unsuccessful attempts at

64


cost reduction. More recently, the problem has gained recognition and utilities are increasingly permitted to retain much of the increased profits they obtain from improved efficiency, at least for a period of a few years. The second objection relates to regulatory capture, which implies that the regulator gradually comes to identify with the interests of the company it regulates. Regulators tend to be pulled into the camps of those they regulate, so that they give way to bribery, corruption and lobbying. Regulators depend on executives of the regulated industry for the information necessary to regulate the industry, and tend to develop personal friendships with them. Regulatory agencies – the principal – come to rely more and more on the experts, expertise and judgement of the regulated industries – the agent. Furthermore, there are instances in which regulators who show enthusiasm towards a particular industry are promised and get good jobs in that industry after leaving government service. The two objections on the regulation alternative gained momentum in US, EU and Japan in the past three decades, paving the way for a deregulation process. Deregulation focused on industries such as airlines, railroads and trucking, where there were thought to be, at most, limited increasing returns to scale. It sought to distinguish between parts of an industry where competition might work and parts where competition was unlikely to be effective. More recently the telecommunications industry has undergone the same fate and the sectors of railways, electricity and water are under discussion. What is the country experience in the FIM context? Whereas European countries tended to acquire public ownership of assets of natural monopolies, US handled the same problems through public regulation of industries whose assets were left in private ownership. Regulatory agencies set prices and specify quality and quantity of output. Hence, when countries concluded that the public sector was too involved in the economy, the initial policy priorities differed in Europe and US. In Europe, privatization came first and deregulation later. Having few nationalized industries, the US emphasis was on deregulation, starting with airlines in 1978. Empirical investigations of the economic effects of regulation preceded those of deregulation reflecting the historical path of policy orientations in most countries. Joskow and Rose (1989) offer a comprehensive review of the methods used and results obtained on the economic effects of regulation. As the term economic regulation covers many different types of control with a variety of objectives, they found the nature and magnitude of regulatory effects to vary substantially depending on the structure of the regulatory process, the industry examined and the economic environment. Several common themes emerge, nevertheless. The ‘public interest’ model is not borne by the regulation effects, but ‘producer capture’ models are seen to be too simplistic to account for the obtained picture. The structure of prices and revenue in public utilities reflect more political than economic efficiencies. And, regulation tends to increase costs and lower service quality. Winston (1993) provided empirical evidence on the economic effects of deregulation in US. Winston found for nine sectors in US mainly over the 1980s, and in


Box 3.1 Changing patterns of nationalization and privatization in FIM countries: 1980–2005 US policy tended to keep ownership of infrastructural activities in the hands of the private sector, but regulate it. In US local utilities, for instance, remain private, but their rates are regulated by the individual states. At the national level, federal agencies regulate interstate telephone services and prices charged for the interstate transport of natural gas and oil. In contrast, European countries were more for nationalization of infrastructural activities. The following figures show for 1980 the scores of the extent of nationalization/privatization for 11 infrastructural industries that are characterized by high indivisibilities. The figures show also the changes in these scores by 1990 and around 2000. An average score is calculated in the last column. The average for US in 1980 was .14, falling down in 1990 to .09, and in 2000 to practically zero. Canada follows US closely. The average score for European countries in 1980 was about .74, and falling down in 1990 to .61 and in 2000 to .28. UK was the most forthcoming in terms of privatization Japan scores closer to US than Europe. Korea is inclined to follow a similar course as Japan. At the other extreme end by way of comparing, scores for non-FIM related countries such as Russia, China, or India for the reported infrastructural activities are often between 3/4 and 1.0. Telecommunication

Electricity

1.0 3/4 1/2

0

1/4

1.0

1/4

1.0

3/4

0

3/4

France 1980 Changed by 1990 Changed by 2005

1.0

1.0 1/2 0

Germany 1980 Changed by 1990 Changed by 2005

1.0

Italy 1980 Changed by 1990 Changed by 2005 Netherlands 1980 Changed by 1990 Changed by 2005

1.0 0

0

Sweden 1980 Changed by 1990 Changed by 2005

1.0

1.0

UK 1980 Changed by 1990 Changed by 2005

1.0

1.0 0

Japan 1980 Changed by 1990 Changed by 2005

1.0

Korea 1980 Changed by 1990 Changed by 2005

1.0

Country/year

Post

US 1980 Changed by 1990 Changed by 2005 Canada 1980 Changed by 1990 Changed by 2005

Gas & Rail- AirShip water Oil Coal ways lines Motors Steel Building Average 0

0

0

1/4 0

0

0

0

0

.14 .09 .05

0

0

0

3/4 1/2 0

3/4 1/2 0

0

0

0

.34 .30 .14

1.0 3/4 1/2

nr

1.0

1.0

3/4

1/2

3/4

0

3/4

0

1/4

0

.80 .67 .35

1.0

3/4

1/2

1/4

1/4 0

0

1/4

0

0

1/4

1/4

.59 .55 .14

1.0

1.0

3/4

1.0

3/4 1/2 0

3/4

.83 .80 .50

0

1.0

0 1.0

0 1.0

1.0

0

1/2 1/4 0

nr

nr

1.0

1.0

1/4

1/2

0

1/4 0

0

.67 .61 .25

0

1/2

0

3/4

3/4

nr

nr

1.0

3/4 0

1/2 1/4 0

1/2

1.0

nr

nr

1.0

1/2

0

3/4 1/2 0

3/4 0

.72 .69 .33

1/4 0

1.0 1/4 0

1.0

3/4 0

1/2 1/4 0

3/4 1/4 0

1.0 1/2 0

.84 .32 .09

0

1/2

0

1.0 1/4 0

1.0 0

1.0 0

0

0

nr

0

3/4 1/4 0

1/4 0

0

0

0

.30 .12 .10

1.0

3/4

0

nr

1/4 0

1.0

0

0

3/4 0

0

.48 .38 .28

0

0

Source, note: Figures for 1980 are from The Economist Intelligence Unit (EIU). Figures for 1990 and 2005 are the result of updating done by I. Gurkov and S. I. Cohen undertaken in 1996 and 2007 at Foundation for Economic Rotterdam and Erasmus University Rotterdam, on the basis of data from EU, OECD, World Bank, and industry study reports from EIU. Extent of nationalization 1.0, ¾, ½, ¼. Fully privatized 0. nr not reported.

66


conformity with economic theory, lower prices and significant gains to consumer welfare as a result of deregulation. Other results are price variations that arise from cost and competitive considerations. Several important improvements in provided services also occurred, especially in airline, road and motor travel; and in telecommunications. 3.2.2.2 Imperfect competition Although imperfect competition can take different forms in different markets, the origin of imperfect competition lies in the first place in the possibility of reaping an advantage from production indivisibilities; i.e., the presence of some economies of scale or scope. As most industries operate under less than full capacity they are able to set a market price that is higher than marginal costs. The advantage will not be as permanent as in the case of the monopolist but may be just sufficient to serve as a barrier for entry, which can be further substantiated by non-competitive behavioural practices such as predatory pricing or cartel formation. Seen from the point of view of competing firms non-competitive practices by monopolistic firms limit the gains and perspectives of the competing firms. Seen from the community viewpoint the results are a restricted output with a higher price, managerial slack, and rent seeking like practices. Therefore, many participating agents have an interest in mobilizing the state to restrict imperfect competition. This section reviews the effects and the remedies. We shall examine first the restricted output effect. A perfect competitor will accept market price equal marginal cost and the result will be Q0 of output in Figure 3.3. A monopoly that maximizes profits produces and sells a volume of output at which marginal costs and marginal revenue coincide, leading to a market price above marginal costs. This means that the output Q1 will be less than optimal in a competitive market. The shaded area in Figure 3.3 will then express the deadweight loss. The reduction in output and the consequent higher prices makes the owner of the monopoly better off (than he would otherwise be) and makes consumers worse off. Consumer surplus is cut down and producer surplus is increased. There can thus be a large transfer bias of purchasing power from consumer to the producer.6 It is difficult to quantify precisely how much worse off society as a whole is as a result of the deadweight loss and the transfer bias. Lower production levels mean less use of society’s resources within an industry. Thus resources that the monopoly might have used are deployed elsewhere and production of other goods increases. From society’s point of view the cost of the monopoly’s reduced output is only the net difference in the value of how these resources are used. There may be as a consequence a significant production shift from one sector to another with unknown transfer effects. Managerial slack refers to the situation where monopolistic firms are insulated from the pressures of competition there is a lack of incentives to economize resulting in a loss of efficiency. In the absence of the discipline provided by


Price MC

a P1

b

c e

P2 d

D MR Q0

Q1 Figure 3.3

Quantity

Deadweight loss from restricted output

Price

MC0 MC1

D MR Q1 Figure 3.4

Q0 Q2

Quantity

Deadweight loss from managerial slack

competition, resources are often not utilized efficiently. The discipline provided by competition limits the extent of managerial slack. High profits and other consequences of limited competition can be expected to give rise to a wasteful use of available resources and hence to an unnecessarily high level of production costs. The result is that the marginal costs curve MC0 in Figure 3.4 may turn out to be too high. On the contrary, in a situation of active competition the marginal costs might be reduced to the level indicated by the MC1 curve. The monopoly would thus lead to a second form of efficiency loss as shown by the shaded area in Figure 3.4 (reduced by the costs, if any, for reorganizing production). Figures 3.3 and 3.4 imply that the total efficiency loss from monopoly behaviour will equal the sum of the shaded areas in both figures. The empirical evidence of the size of the efficiency losses from restricted output with higher price and managerial slack is both fragmentary and open to criticism. It is sometimes argued that the first effect - underproduction due to monopolistic pricing policy – is of no practical importance. The efficiency loss that stems from this effect, it is suggested, amounts to much less than one percent of the value of the GNP. It is clear, however, that even small percentages of the GNP in a long

68


run context might be important from a policy point of view. It is often assumed, however, that the loss from limited competition is due primarily to the second effect of the managerial slack. The association between monopolistic practices and low growth is not fully established, however. While competition motivates firms to develop new products and less expensive ways of producing goods, a monopolistic firm, by contrast, may let the profits roll in, without aggressively encouraging technological progress. Nevertheless, there are cases where monopolists have pushed hard for technological progress. The issue is controversial in the sense that a large firm may be more able than a small one to invest in R&D, build up cost advantages of economies of scale and end up with a lower MC curve than otherwise in a competitive market. Rent seeking like practices are situations where competing firms take various measures to improve their chances of winning the contest for the monopoly position.7 The cost of these measures might be quite large. For example, the individual company would obviously be willing to accept costs, if necessary, all the way up to the level of the expected value of future monopoly profits, if measures taken would guarantee victory over its competitors. In particular, society loses when monopolistic firms devote resources to obtaining or maintaining their monopoly position or deterring entry. In competitive markets, the profits earned by a company would ordinarily serve to encourage competitors to enter the business. However, in a non-competitive setting, rent seeking firms can use entry-deterring devices to discourage such entry, and make payments to lobbyists and politicians to maintain regulations that restrict competition so that they can keep their profits high. These lobbying and political activities are, for the most part, socially wasteful. The waste from rent seeking like practices can be much larger than the loss from the restricted output and managerial slack. While technological indivisibilities are a primary cause of failures of competition in the economy, other imperfections are the result of sharp business practices that deter the entry of competitors and promote collusive behaviour among the firms in the industry. Just as with natural monopolies, it was seen above that this restricted competition results in higher prices and lower output than would prevail under monopolistic competition, managerial slack and rent seeking like practices. Competing firms, as well as the community as a whole, would gain if dominant position legislation and restrictive practice legislation were monitored by the state. We review below these two state interventions. Dominant position legislation becomes applicable when one firm or group of firms controls, say, one-third or one-quarter or more of a market. A monopolies and merger commission, MMC, is asked whether the monopoly or merger at hand is acting against public interest, i.e. is not against (a) promoting effective competition, (b) interests of consumers and users, (c) reducing costs and (d) raising quality. If it does and is accepted as such by parties concerned, then negotiations are started which would lead to actions to curb the monopoly. In general, dominant position laws are particularly concerned with horizontal mergers, that is, with competition within a market. These are distinguished from


vertical mergers, in which a firm buys a supplier or a distributor, amalgamating the various stages in the production process within a firm. In practise, the question of whether a firm is too big is usually put as ‘What is the size of the firm relative to the market?’ Thus, the debate centres on the question of defining the relevant market. One generally talks of the market for steel or the market for aluminium. But when the government sets out to enforce a policy of competition within a certain market, it must have a concrete way of defining that market. In general, the problem of defining markets and a firm’s market power is related to two factors: the concentration of firms in the industry and the extent of product differentiation. Regarding firm concentration, respect to industry concentration policy analysis in the past was done in terms of concentration measures at the national level. More recently, international trade has increased in significance appreciably, and this has affected defining markets and measuring the extent of competition in product markets. Today, the degree of competition in a market must be assessed from a global viewpoint, rather than looking simply at how many firms produce a good in the country. Regarding product differentiation, while all firms that produce the same good and sell in the same location are clearly in the same market, when the goods produced by different firms are close but imperfect substitutes, there may be problems of defining the boundaries of the market. How do the courts work in practise? First, in defining market boundaries courts consider the extent to which the change in prices for one product affects the demand for another. If an increase in the price of aluminium has a large positive effect on the demand for steel, then steel and aluminium may be considered to be in the same market, the market for metals. Second, if a firm can raise its price, say by 10 per cent, and lose only a relatively small fraction of its sales, then it is ‘large’; that is, it has market power. (In a perfectly competitive market, a firm that raised its price by 10 per cent would lose all of its customers, so this is a natural approach to measuring the degree of competitiveness in the market.) Furthermore, the law sees to it that before one large company can acquire a competitor or merge with another, it must convince the government that the acquisition would not seriously interfere with competition. Dominant position legislation has a history that determines its evolution. Concern about business size and related manipulations has first led to the enacting of antitrust policies in USA as far back as the Sherman Antitrust Act of 1890. This outlawed every contract or conspiracy in restraint of trade or commerce. The Clayton Act supplemented the Sherman Act in 1914, which forbade any firm to acquire shares of a competing firm when that purchase would substantially reduce competition. The act also outlawed interlocking directorates among competing firms, on the presumption that they would naturally lead to reduced competition. These anti-merger provisions were further strengthened in 1950. Similar but less restrictive legislation started in Europe after the Second World War. Evaluations of past policies in developed economies show that the policy trend has been shifting towards favouring mergers, this under an increasing understanding that government intervention should be left to a minimum as


market behaviour is more efficient in the long run and is constantly expanding in a global economy. Furthermore, in much country legislation it is not dominance but its abuse that considered as incompatible with the spirit of dominant position legislation. Restrictive practice legislation. Another permissible intervention by the state in the firm intensive economic system is to limit restrictive practices between firms and their distributors or suppliers which may take such forms as tying, exclusive dealing, description (quantity and price setting) and price discrimination. In many OECD countries, restrictions accepted by two or more parties with regard to the above aspects have to be registered and are to be referred to a Restrictive Practices Court, RPC, which passes a judgement on whether the practice is against the public interest. Because of the existence of unwritten price agreements the RPC is empowered to call up any such arguments for registration.8 The RPC is usually helped by lay experts to assess the applicability of these gateways. Turning to restrictive practices legislation, this can be also privately enforced as it allows any firm that believes it has been injured by the anti-competitive practices of another firm to sue the latter, and if successful, the first firm can receive from the second firm several times the value of the damage claimed and attorney fees. There is the advantage here that the private firm – and not the government – is the best-motivated party to take initiative to sue. But there is the shortcoming that a suing firm may tackle its competitor unfairly to secure strategic gains. It is also true that the prospect of legal suing may hinder innovative actions by a daring firm. The assessment of restrictive practice legislation and its application has not been exclusively positive. Part of the legislation is unnecessary since other legislation exists to protect the public against injury. It is not possible to debate complex economic arguments in a court since many judges lack the technical knowledge. Penalties for registration may not be sufficiently severe to prevent the formation of secret cartels. After many costly negotiations, many practices become nevertheless legalized. The attitude towards application of restrictive practice legislation differs from country to country. With increased globalization and cross-country trade, competitors may sue multinational firms for non-competitive practices in more than one country. Given the extent of the phenomena it is more often that American multinationals are assessed by both the US and EU competition authorities than EU multinationals are subjected to American and EU testing of competitive conditions. Recent engagements of US and EU in competition assessments of common cases show that the US authorities are more lenient than the EU authorities. Such examples relate to proposed fusions of American Airlines with British Airways, which were not opposed by US but were refuted by EU. Another example is the prolonged EU case against Microsoft. The stricter attitude of the EU authorities vis a vis American multinationals is likely to be related to effective lobbies of EU competitors at the EU headquarters. There are academic calls for a streamlining of assessment criteria and applications in both camps and in Japan, but the business


Box 3.2

Firm intensity and open competition in FIM countries, 1995, 2000, 2005

While dominant position and restrictive practice legislation go a long way to combat imperfect competition among firms there are more areas of imperfect competition that can be jointly exploited by collaborating agents, i.e., firms and the state. The Heritage Foundation publishes annually an Index of Economic Freedom that ranks a large number of countries in terms of descending perfect competition. A most-perfect competitive country scores 100. The index is based on ten indicators covering competitive bias in the (a) state regulations, (b) foreign trade, (c) fiscal sphere, (d) government practices, (e) monetary sphere, (f) foreign investment, (g) banking sphere, (h) property rights, (i) black market, and (j) labour market. The table below shows a greater ability of firms to compete in the US than in Europe, which can be seen as evidence of a more firm intensive economic system in US than in Europe. The indicators also show that while Japan and Korea used to closer to US and Canada than most EU countries they have come over time below the EU average. The EU average remained stable. To compare, the scores in 2005 for China and India were 52 and 54. In contrast, Hong Kong and Singapore were most competitive with scores of 90.2 and 90.1. The scores are shown for 1995, 2000 and 2005. The score is disaggregated in the various components for 2005. Country

1995 Score

2000 Score

2005 Score

Regulation

Trade

Fiscal

Government

United States Canada

76.6 72.6

77.9 71.4

79.6 75.6

70 70

74.8 77.8

79.1 83.4

67.9 59.6

France Germany Italy Netherlands Sweden United Kingdom

65.6 68.8 64.3 75.0 63.9 79.1

61.7 65.2 65.7 71.5 67.6 77.9

62.9 69.0 63.5 72.7 70.9 79.9

50 50 50 50 50 70

75.2 75.2 75.2 75.2 75.2 75.2

63.2 72.3 66.4 63.8 54.1 74.9

32.0 43.8 41.9 42.1 30.6 55.7

Japan Korea

73.9 70.3

73.8 71.2

65.7 65.0

50 50

75.6 68.6

80.5 79.7

66.4 79.8

Country

Monetary

Investment

Financial

Property rights

Corruption

Labour

United States Canada

85.7 84.8

70 50

90 70

90 90

75.0 87.0

93.8 83.2

France Germany Italy Netherlands Sweden United Kingdom

86.0 88.0 84.7 84.9 86.0 85.0

70 90 70 90 90 90

50 50 70 90 90 90

70 90 70 90 90 90

69.0 77.0 53.0 89.0 93.0 87.0

63.5 53.7 54.1 52.2 49.9 80.8

Japan Korea

90.7 83.3

50 70

30 50

70 70

70.0 43.0

74.1 56.0

Source: Index of Economic Freedom, published by The Heritage Foundation, http://www.heritage.org/ research/features/index/downloads/2007PastScores.xls


sectors and allied governments in these countries are not keen to take action in this area.9 3.2.3 Technology bias and growth limits It is the expectations of large profits in a future monopoly position that make companies invest and introduce new goods and new methods of production. If the management of a company believes that large profits simply cannot be obtained in the future, it is likely to be more reluctant to undertake pioneering investment efforts, thus curtailing the growth rate of the company. Moreover, entrepreneurs facing strong competition may simply lack time for long-term planning and for undertaking more elaborate projects of research and development. Besides, in a situation of heavy competitive pressure, profits are usually so low that little room is left for the internal financing of research and development activities. Hence, in contrast to the previous sections, a more balanced opinion has developed in FIM asserting that restricted competition creates conditions favourable to rapid growth of cost efficiency in the long term, on the condition that the restricted competition does not lead to a monopoly power that eliminates competition. The rationale can be elaborated further as follows. Suppose a company X invests in developing a product or process, which it markets later, with the objective of reaching a calculated profit. If other firms Y will immediately imitate the new invention, and enter the market, the profits to X will fall down much below the stipulated return. Since any firm can foresee that this will occur, few firms will invest in searching for inventions. As long as investor X cannot privately appropriate the benefits – since imitators Y cannot be excluded – there is no incentive to invest significantly in technological development. The problem is partly due to the fact that innovations, ideas and technological change contain positive externalities that allow competitor Y to benefit from action of X without contributing to the cost incurred by Y. However, there is an opposite danger. Firms orient their investment, research and development efforts towards seeking a monopoly position. Supposing company X takes the risk and succeeds in innovating. It can use the advantage strategically for purpose of securing a rent seeking gain, in which case conditions of perfect competitive behaviour will not be realized. Here is a collective call for state interventions to foster the combined goals of technological growth and competitive behaviour. Theoretical insight is still lacking in the resolution of the trade-off between competition and monopoly in the context of state interventions to foster technological growth. For instance, up to which extent should the effort of firms in technological innovations be protected or regulated? Absence of a technology policy at the national level may retard company investment in technological development and growth because of the presence of positive externalities, full protection of the innovating firm may lead to monopoly formation, while imposing a strict short run competition policy may achieve short run competitiveness at the cost of retarding growth.


Box 3.3 Business and state resources in Research & Development in FIM countries, 1970–1980, 1990–2000 The figures below show that the funding of R&D has shifted over the years towards a greater share from business than from the state. By the turn of the century business funding exceeded state funding by 17 and 12 per cent in US and EU, respectively. In contrast, in Japan, business funding of R&D is more than three times that of state funding. Countries

Share of business in R&D funding

Share of state in R&D funding

1970–1980

1990–2000

1970–1980

1990–2000

US

.45

.54

.55

.46

EU

.51

.53

.49

.47

Japan

.70

.73

.30

.27

How large are the R & D inputs and the outputs in firm intensive economic systems? As a share of the GDP the US has been spending more than the EU. In recent years, Japan climbed to a higher share; this is reflected in a steep increase in patents in Japan. Caution is required in interpreting patents as an output indicator of R&D for the reasons that patents can vary significantly in importance and because firms with innovative discoveries may prefer not to patent them for strategic purposes. This is usually taken as the likely explanation of the drop in patents in US during the 1990s. Countries

Input indicators Per cent of total R&D expenditure in GDP

Output indicators Patents per million population

1970–1980

1990–2000

1970–1980

1990–2000

US

2.1

2.5

236

158

EU

1.3

1.9

37

51

Japan

1.1

3.0

10

79

Source: Oxford Review of Economic Policy, 1988, Vol. 4 no. 4, and 2002, vol. 18 no. 4. OECD Main Science and Technology Indicators, OECD, Paris, biannual.

The responses of firms and governments in the context of possible failures of technology and growth can be stylized in two approaches: the single company approach and the perspective synergy approach. In the first approach, individual firms are seen as technology leaders and the state would focus on the innovating firm and attempt to find the right balance between firm behaviour that capitalizes on innovations and sufficient incentives to motivate development and application of innovations.


The second approach focuses less on firms and more on industries. It accepts the presence of market imperfections but puts more emphasis on the future perspective of alternative technologies at the industry level. In this approach an evolutionary framework is followed which seeks to find the right balance between the knowledge cycle and information synergies, and suitable forms of cooperation between industries and the state. In countries where the firm intensive economic system is well established it is the firms rather than the state that take the initiative to bolster technology and growth, and this can take the form of the first approach or the second approach. Historically, the first approach that focuses on innovating firms appeared first in FIM countries. More recently, the first approach has given way to the second approach in which more firms belonging to more industries are linked, allowing more and new economies of scope and scale.

3.3 Uncertainties: Problems and firm-state responses 3.3.1 Problems Imperfect information creates uncertainty. In reaction to this uncertainty agents will search for better information as well as for its transmission. Yet there are technical limits to perfect information. In addition, there is intended behavioural distortion of information by agents. The shortcomings open the way for remedies by private and public institutions. Imperfect information can have two type sources, depending on whether the source is technical or behavioural, resulting in incomplete information and asymmetric information, respectively. It can be argued that because information is valuable, one might expect the emergence of a market for it – a place where consumers and producers could purchase, sell and exchange information. This does not happen fully, however. The nature of information makes it more allied to a public than to a private good. Information is not easily tradable since information, by definition, is indivisible in its use; and it is very difficult to appropriate. With regard to indivisibility, it pays a large-scale producer to acquire better information than a small-scale producer, hence causing a departure from the competitive economy. Regarding non-appropriation, an individual who has some information can never lose it by transmitting it. If the information is transmitted to one buyer, he can in turn sell it very cheaply, so that the market price is well below the cost of production. But if the transmission costs are high, then it is also true that there is non-appropriation, since the seller cannot realize the social value of the information. Both cases occur in practice with different kinds of information. The non-appropriation of a commodity means that its production will be far from optimal, or otherwise the firm will be induced to implement costly protective measures to obstruct entry. The firm’s objective to maximize profit, which is a basic premise of the firm intensive economic system, is also adversely affected under uncertainty. Uncertainty upsets this objective. In essence, the demand for and the price of the product that the producing firm face are random. As a result, profit is also


random, and strictly speaking, is difficult to set at a maximum. As a substitute for profit maximization, optimal decision-making theory perceives the objective function of the firm to consist of the firm’s attitude towards risk, and the firm’s perception of the likelihood of various outcomes. The greater the uncertainty the greater is the departure from risk neutral attitudes. Furthermore, the more incomplete the information on expected outcomes, the greater is the randomness of profits and the less is the validity of the profit maximization objective. Firms dominate the search for information. They spend resources on engineering and market research and on acquisition of information on the behaviour of other economic agents, including competitors, customers, workers and governments. Households also engage in search for information by looking around for the lowest price, the best deal, the highest quality and so forth. Thus, information is not merely a good that is desired and acquired but is to some extent a marketable commodity like others, but not fully so. 3.3.2 Incomplete information When information is incomplete or unequally distributed, there are market incentives not only to acquisition of information but also to the emission of signals and exchange of information among agents. In some instances, the buying and selling agents are pulled to each other in a collaborative search for information, which often results in changes in governance structures. Because searching is expensive, firms look for other, cheaper sources of information. Brand names and acquired reputation convey information about quality. If the consumer finds a brand of superior quality at a given price, he no longer needs to search for quality. He simply purchases the product with the brand name attached. Reputation, based on past searches, is attached to something easily identifiable like a label or name. If the consumer notices that the quality declines or the price increases when the quality does not, the consumer will need to search again. Firms do take advantage of the economizing behaviour by consumers to identify previously obtained information with a brand name; by differentiating the products they sell, thereby creating markets with characteristics of monopolistic competition. The costs of searching are also reduced when products undergo standardization and recognized circles monitor their quality accordingly. The technical limits to the endogenous creation of efficient information via business actions open the way for sponsoring a role for the state in the assessment and dissemination of information; though this is allowed to happen up to the point to which the firms consent. This cannot be otherwise given the fact that the firms are the basic suppliers of the information on their transformation activities and products. 3.3.3 Asymmetric information Akerlof (1970) was among the first to draw attention to asymmetric information. In the market for sale of used automobiles, the seller will in general have more


information about the properties of the cars sold than the buyers. Initially, buyers might think that the odds are 50–50 that a car they buy will be of high quality. When making a purchase, buyers would therefore view all cars as being of ‘medium’ quality. (Of course, after buying the car, they will learn its true quality.) As a result, fewer high-quality cars and more low-quality cars will be sold. This shifting continues until only low quality cars are sold. At that point the market price would be too low to bring forth any high-quality cars for sale, so consumers correctly assume that any car they buy will be of low quality. Because of adverse selection, low-quality goods drive high-quality goods out of the market. Moral hazard would occur when for instance the car buyer causes car damages due to his bad driving, chooses to shirk and claims guaranteed costless repair from the seller. Moral hazard on the seller’s side can also occur where the seller attempts to escape from the agreed upon terms and avoid genuine repairs. Risk and uncertainty due to asymmetric information, and their implication for the functioning of the economic system, often discussed in the framework of principal–agency theory, can be placed more generally in the framework of property rights theory. Barzel (1989) defines ‘property rights of individuals over assets’ as ‘rights, or the powers, to consume, obtain income from, and alienate these assets’. To obtain income from an asset and to be able to alienate it, exchange is necessary (usually through contracts). People’s rights are not constant. Property rights can change as a result of people’s own effort at protecting these rights, other people’s capture attempts and government protection. A commodity or service that is subject to exchange has many attributes. Some belong to the private property domain, others to the common property domain. The comprehensive or accurate measurement and monitoring of all these attributes of a commodity is too costly for the exchanges. In other words, transaction costs are very high. Transaction costs are defined here as costs associated with the transfer, capture and protection of rights between the exchangers. Since it is costly to measure all attributes of commodities fully, exchangers will never find it worthwhile to gain the total potential of their owned assets. Only in the case of perfect knowledge would transactions costs be zero, because everybody would know exactly all the properties of an asset, making it easy to transfer a right from one person to another. Because property rights are never completely delineated the opportunity for wealth capture arises. Whenever an exchange is taking place, some wealth will spillover into the public domain. An attribute of a commodity is said to be in the public domain if it is not charged for on the margin. The buyer and the seller mobilize, each on his own, to capture this public domain wealth. The maximization of the net value of an asset involves an ownership pattern that can most effectively constrain uncompensated exploitation. When the income stream from an exchanged property is subject to random fluctuations and both parties can gain by affecting that income streams the delineation of ownership poses some problems. If only one party can affect the income stream, then making him bear full responsibility for his actions will ensure that ownership will be secure. This person is called the ‘residual claimant’. However, when


both parties can affect the income flow generated by exchanged assets, ownership becomes insecure. In the property rights model individuals are assumed to maximize the value of their rights. This implies that whenever individuals perceive that certain actions will enhance the value of their rights they will undertake these actions. What is the economic solution in case of commodities with common property attributes? The general principle determining the maximizing allocation of ownership is that the greater a party’s inclination to affect the mean income an asset can generate, the greater is the share of the residual that party assumes.10 Coase’s theorem, Coase (1960), states that when property rights are well defined and transacting is costless, resources will be used where they are most valued, regardless of which of the transaction makers assumes liability for his effects on the other. A necessary condition for liability is variability. Only in the presence of variability that is too costly to eliminate does liability pose a problem. If property rights are to be well defined, a person who benefits another must be fully rewarded by the beneficiary, and a person who harms another must pay full compensation to the harmed person. By this criterion, a contributor to variability must assume the full effect of his actions if rights are to be fully delineated. In general, both parties to a contract can contribute to the variability in outcome. Since the individual effects cannot be isolated without incurring costs, property rights, as a rule, are not well defined. As a party’s effect on the value of the outcome increases, rights will be better defined if that party assumes a larger share of the variability of outcome, thereby becoming more of a residual claimant. The property rights approach provides a more general foundation for principal– agent theory. In principal–agent theory, the agent has the potential to act contrary to the interest of the principal. The property rights approach can explain why the agent is able to shirk. Because some attributes of every asset are in the public domain, someone will try to capture these. This is also the case for the assets of a firm. The manager, perceiving some attributes of these assets to be in the public domain, will try to capture these. This explains why there is a principal–agent problem. The property rights approach can be used to explain a wider range of economic phenomena in the firm intensive economic system, as will be shown below. Property rights do not only refer to the ownership aspect of an asset but also can include rights and obligations in managing the asset and deciding on its use. Governance relates particularly to these rights and obligations in management and use. Hart (1995) sees governance structure as a mechanism for making decisions that have not been specified by the contracting parties in the initial contract. For governance issues to arise two conditions should be present: (a) there should be a conflict of interest between different members of the organization or of the contracting parties; and (b) dealing with this conflict of interest through a contract involves very high transaction costs. Condition (a) states that there is a problem of defining property rights between principal and agent. This could, in theory, be dealt with through a contract. If everything were specified in the contract there would not be residual rights to be

78


decided on. However, if transactions costs are very high it is not efficient to write a contract in which everything is specified. Therefore the usual contract will not be complete. Condition (b) refers to the eminence of transaction costs, which can also be analysed in the frameworks of both property rights theory and principal agent theory. Efficient governance structures succeed in resolving incentive incompatibilities that are typical of principal–agency problems. Stated otherwise, governance deals with allocation of residual rights of control that were not specified in the initial contract. The more efficient governance structures are able to achieve the more efficient allocations of residual rights and a better performance of the economic system. In most product markets and factor markets, leading firms tend to respond to uncertainty problems by developing market solutions and institutions that other firms abide with. In these contexts, there is only a minor and indirect role for intervention by the state. This is usually limited to disseminating information and keeping an eye on disputed governance issues via the judiciary. For example, in the product markets firms combat consumer uncertainties by developing signals and transmitting them with the objective of eliminating adverse selection and moral hazard, firms redesign transaction technologies and reduce their costs, while ethical codes can evolve among firms and occupations, and be instituted to control ill behaviour. In the factor markets, firm-driven solutions to problems of uncertainty focus on corporate governance and profit sharing. Both topics will be reviewed below. Corporate governance in large firms can be approached as a response to agency problems and property rights problems. Large companies typically have a large number of small shareholders. Although these shareholders have residual control rights, they are too small, and there are too many of them, to exercise this control effectively. In practice, management takes everyday decisions. Small shareholders have little incentive to monitor management. Monitoring involves costs. The benefits of monitoring (e.g., higher efficiency) however accrue to every shareholder. Hence every shareholder is inclined to free ride. Very little monitoring will take place in such a situation, giving managers an opportunity to pursue their own goals at the expense of the goals of the shareholders (usually profit maximization). Corporate governance deals with this situation by designing mechanisms to constrain management of a company. In general, when capital is treated as a single asset, then shareholders are the residual claimants to the profits that are generated by this asset. Since property rights are never fully delineated due to high transaction costs some attributes of this asset are in the public domain, other people will capture these attributes, because these are not charged for on the margin. Managers can use the firm to increase their own status by investing in large, but may be unprofitable projects. Because this attribute of the firm is not priced, it will be overused, at the expense of the shareholders. Corporate governance deals with these issues, trying to make use of these attributes costly to managers. Corporate governance will constrain managers, for them to act in the interest of the shareholders. Mechanisms that are designed to combat managerial


slack and control management can be listed under the headings of installing a board of directors, proxy fight, large shareholders, hostile takeovers, financial debt structure, statutory rules, business reorganizations. The general conclusion is that corporate governance structures change when economic conditions change. Firms themselves are very well capable of creating a governance structure necessary for profit maximization. The case for statutory rules is weak. Government intervention with respect to governance issues is not to be welcomed, because it will limit firm’s capability to adapt to a changing world. Firms are restructuring when it is necessary. These general conclusions may require modification depending on the specific country corporate culture and the specific sector. At the country level, Anglo-American capital markets are known to emphasize exit, which refers here to the ease of selling stocks. In these markets there is usually little incentive to monitor management, because of freerider behaviour of small shareholders. Shareholders are more mobile and they can let a company go dead by withdrawing from it. In EU and Japan, there is more of an investor voice of large shareholders in corporate decision-making. In these countries the concentration of equity voting power, active participation of large investors and the important position of banks provide an incentive for monitoring management. At the sector level the applicability of corporate restructuring transactions seems to be restricted to low growth industries. Industries, which experience rapid technological or market change, may require greater managerial flexibility. Profit sharing is another major area of firm responses to uncertainty. The property rights theory argues that it may be advantageous for the workers to become residual claimants where their actions are especially costly to supervise. Otherwise, suppliers of labour are severely restricted in their insuring ability. Owners of labour are more likely to enter into contracts in which they are required to guarantee the difference between their market wage and their actual wage than they are to enter into contracts that require them to guarantee other possible effects of their behaviour. Equity capital is a factor specializing in guarantees. A firm may be seen as a set of contracts guaranteed by equity capital. There are a few empirical studies that used relatively small samples of profit sharing firms and found that the average rate of return on capital is considerably higher in profit sharing firms than in non-profit sharing firms, but more recent work by Bhargava (1994) shows that the rise in profitability is limited and is a one period rise when the firm shifts from non-profit to profit sharing. Another investigated relationship by Jensen and Murphy (1990) is that between base salary and bonus for top executives and stock market performance: this is found very weak in both the United States and United Kingdom, suggesting that incentive mechanisms are not very strong. Furthermore, the link between wider measures of compensation and performance does not seem strong. This weak link generates the widely expressed concerns about designing appropriate compensation of top executives and related issues of mechanism designs in the context of corporate governance. These concerns have led to discussions within business and state circles to set up guidelines and limits for the remuneration of top executives. There are no business codes

80


Box 3.4

Corporate governance patterns in FIM countries, around 2000–2004

US and UK stand apart from other countries with respect to corporate governance. There is no significant control of any one-shareholder party. In principle, all shareholders have equal control based on their degree of ownership that is no way particularly concentrated in some. The chart below shows these countries to have overwhelmingly outside governance in their top ten firms. The chart gives the fraction of top ten firms with different types of controlling shareholders. Other countries show higher incidences of insider governance. In continental Europe business family owners, industry groups and financial institutions have major stakes and a controlling power. The state may also be a major player. Corporate governance in Japan has some similarities with Germany such as the dominant role of business groups, but the state is a weaker stakeholder. In contrast, corporate governance in countries like Mexico and India, not reproduced here, show wealthy family owners to have 100 to 80 per cent control of the top ten firms in the country. US

OG

Canada

OG

France

OG

Germany

BF

Italy

BF BF BF

BG OG

Netherlands

BF

BI BF

Hong Kong

OG

Scale

BI

BF

ST BI

ST

OG BF

BG

OG

ST

BF

Korea Singapore

ST

ST BG

UK Japan

BI ST

BG

OG

Sweden

BG

BG

OG OG 10%

BF

BF 20%

30%

BG 40%

50%

BI 60%

BG

BI

BI

ST ST

ST 70%

80%

90%

100%

Source, note: National Bureau of Economic Research. The primary data appearing in Morck, R.K. and Steier, L., The global history of corporate governance, NBER, WP 11062, 2005, were indexed and adapted to fit to our presentation in the box. Control by a particular stakeholder type is assumed if any shareholder type controls 20% of votes in a company’s annual shareholder meeting. The stakeholders are OG no one controlling shareholder, this is the case of outside governance; BF = Business families (wealthy) in control; BG Business groups (industrial) in control; BI Business institutions (financial) in control; ST State controls.

emerging on this issue yet among the concerned firms. There is even less in terms of parliamentary legislation and state intervention in this area yet. It was stated above that in most product markets and factor markets, leading firms tend to respond to uncertainty problems by developing market solutions and institutions that other firms abide with. Emphasis is laid on most and not


all markets. While market solutions to uncertainty problems have evolved voluntarily in the case of real products and factors, this is not the case for financial products and factors that are usually much more complex, less open and less transparent. Given the nature of the products, sellers, buyers and a host of intermediaries in the finance and banking sectors are generally more protective and secretive regarding information on their transactions. The information gap and moral hazard are also the reasons why it is more difficult for the state to regulate and monitor the financial sector. Uncertainty failures in the financial market are the areas that pose the greatest systemic challenges to the FIM. The governance failure in the financial sector is vividly demonstrated by the financial crises that started in the US in 2007, took the proportions of a financial meltdown in October 2008 and spread globally to other linked financial markets economies, with a likely global economic recession in 2008 and 2009. The main cause is an overexpansion of lending activities from 2001 much beyond the ability of borrowers to meet obligations to pay back. Although the overexpansion was highest in US, other countries followed suit. Reckless borrowing, complex securities and a vast unregulated shadow market became nearly worth US$ 50 to 60 trillion; which is about four times the size of the US national debt. The overexpansion was facilitated by the use of very risky, dubious, undisclosed and complex newly introduced financial products and credit default swap insurance contracts that defy monitoring and regulation, and a relaxed attitude towards regulation by the state central bankers who embraced a blind eye attitude as long as asset prices kept rising. Credit default by homeowners in subprime mortgages in US in mid-2007 triggered much bigger defaults among the mortgage lenders who are borrowers from other higher-up lenders, and so forth upwards. Speculative short selling on the expectation that security prices would fall further caused more falls. It is in the nature of a credit crunch confronting bankers to spread to producers causing a decline in production, layouts, spending and eventually recession. The governance failure described here has led to state interventions in the US and other FIM related countries ranging from the temporary nationalization to capital injections in exchange for state ownership stakes and bailouts of troubled investment banks, in an attempt to restore financial confidence and rescue the economies from a threatening downturn. An important issue in economic system that can be raised is whether this state intervention would affect the basic firm-driven orientation of the FIM. While the stipulated state interventions constitute a deviation from FIM, they are not estranged enough as not to be accommodated within the FIM and embedded in it.

3.4 Externalities: Problems and firm-state responses 3.4.1 Problems In general terms, an externality can be said to exist when a decision variable on buying or selling of one producer or consumer cannot be excluded from entering directly into the utility or production function of some other producer or consumer. This can be expressed by the following expression U A U A ( x1A,... xnA, y B )


where utility U of agent A depends on excludable goods x ranging from 1 to n, produced and/or consumed by agent A, as well as some non-excludable activity y carried by agent B. In real life, producers depend upon other producers and upon consumers in their attempts to maximize their profits and thus their behaviour via the goods they produce and consume can hardly be described as without having side effects. Since great deals of these economic interdependencies are incorporated in the exchange economy and these results in the market prices and resource allocations that are observed, they are accounted for and cannot be called externalities. The policy concern of externalities relates to economic interdependencies, which are not incorporated, or to say not effectively internalized in the exchange economy. So, which side effects should fall under externalities? These are side effects, which are conventionally recognized as economically relevant, and which are not internalized and uncompensated. Externalities are, therefore, those conventionally recognized gains and losses that are sustained by others as a result of actions initiated by producers or consumers or both and for which no internalization takes place as yet. It must be noted that interdependence alone is not sufficient to constitute an externality. In the above equation yB must be conventionally recognized as economically relevant for UA and also be shown that there has been as yet a failure to internalize it in the decision-making process via payments or otherwise on account of any gains or losses. The notions of recognition and internalization are closely related. Recognition means that the inter-property rights of parties involved in a side effect are made explicit. Once made explicit, internalization mechanisms will develop which can be applied later. Internalization takes several forms: (a) unification or merger of the parties involved; (b) private contracting, covenants and arrangements whereby each producer pays for the externality rendered by other producers private contracting; (c) creation of new markets in which the property rights are exchanged; for example, a market for environmental property rights in which emitting and affected agents can trade damage for compensations; and (d) when the above remedies do not succeed in eliminating the externality problem, a final solution lies in state intervention. When to recognize an effect as external or not? Figure 3.5 is helpful in tracing an answer. An economically legitimate side effect may, for some reason, not be recognized as an externality. The reasons can be many: (a) imperfect information, (b) higher incomes over time and place may lead to higher valuations of well-being and recognition of environmental pollution as a negative externality, whereas elsewhere it is not recognized as such, (c) transaction costs that go with the recognition of a side effect can be too high for the time and place, and (d) since recognition requires a specification of the property rights of the transacting parties and such a specification has as a consequence a redistribution of property and income, it follows then that if the group which is to be disadvantaged has sufficient coercive power this group may not permit recognition. Take, for example, air and water pollution which were a common day experience already from the


Internalization mechanisms absent as yet

externality persists

recognized

potential externality arises

Internalization mechanisms exist in the form of (1) unitization (2) private contracting (3) creating markets (4) state intervention Mechanisms unused Realization status of mechanisms due to imperfections Mechanisms used

externality persists externality eliminated

not recognized due to one of the following reasons (1) relevant and implementable but obstructed by powerfull party (2) relevant, but not implementable due to excessive transaction costs

externality persists indeterminate

(3) considered as irrelevant, given preferences

no externality

(4) considered as irrelevant since both parties undergo the same sideeffect

no externality

Figure 3.5 Scheme for tracing the conditions under which a side effect can be identified as an externality and justify a policy measure

early days of industrialization, but the externalities involved were not recognized as such until recently. With rising incomes, attention goes to higher needs that increasingly take the form of merit goods. The delay in the recognition can be also reasoned in terms of imperfect information, very high transaction costs or obstacles due to a powerful position of the losers versus a weak position of the gainers. Two additional comments need to be made before dealing with state interventions. First, an externality was defined as a side effect, either good or bad, that results whenever a person or firm making a decision does not consider social costs or social benefits of the particular decision, and, as a consequence, directly affects the utility or profits of other consumers or producers. It is understood that by the activities of decision-makers is not only meant the actually materialized activities but also potential activities, which could not be possibly executed because of the involved externality effects. Second, externalities can be positive or negative. A common example is air or water pollution; this is an output of one producer that enters into the utility or production functions of other consumers or producers. This example is a negative externality since the consumption of pollution reduces the utilities or profits of consumers or producers, respectively. An example of a positive externality is the development of the railway system and seaports, which allows industry and commerce to flourish, or the setting up of an iron and steel industry that allows the exploitation of many forward and backward linkages.


Concerned firms, unable to take voluntary collective actions to internalize externalities are inclined to mobilize the state to intervene. The remainder of this section will consecutively deal with state industrial policy as an example of reaping positive externalities, and state environmental policy as a response to curbing negative externalities. 3.4.2 Positive externalities A positive externality is a side effect that exists whenever the social benefits associated with a particular decision are not fully considered by the person or firm making the decision. In Figure 3.6 the demand curve, D0, summarizes the market participants’ individual willingness to pay for road extension, that is, the private marginal benefit (MBp) obtained from road extension. (It is the horizontal sum of each individual’s willingness to pay for additional roads.) However, D1 summarizes the social marginal benefit of roads (MBs), including the benefit to others when other firms are connected to the road. Hence, (MBs) (MBp). In the presence of the externality, the market equilibrium is Q 0 and P0. If consumers of roads, inoculations or education were compensated for the utility they rendered to other producers and consumers, the market equilibrium would be Q1 and P1. The market price would be higher and more of these goods and services would be both produced and consumed. The situation can be analysed in terms of its efficiency and equity effects. First, we deal with the efficiency effect. If the use, consumption or enjoyment of a commodity creates benefits for those who do not purchase it, the marginal social benefit of additional use (MBs) is greater than the marginal private benefit (MBp) that those who pay for the commodity receive. The social optimum is at (Q1, P1), but the market equilibrium is at (Q0, P0). At market equilibrium, the market price, P0, is less than the social value of the commodity, which can be measured by [MBs at Qe]. That is, the marginal cost of producing additional commodities is less than

Price

S = MC Deadweight loss

MBS at Qe P1 P0

D1 = MBS

D0 = MBP Q0 Figure 3.6

Q1

Deadweight loss from positive externalities

Quantity


the marginal social value that those commodities provide. The market outcome is inefficient: the market price is too low, too few scarce resources are being devoted to this activity and too little is being produced. Compare quantities Q0 and Q1. This inefficiency has a deadweight loss of the shaded size indicated in the figure. Second, the equity effect cannot be fully traced in Figure 3.6 because the transfer between producers and consumers is not as relevant in this context. The transfer effect would have to be analysed with two states and two parties in mind. The two states are the current state in which too little is produced and a prospective state in which Q is increased to its social optimum. The two parties are consumers and producers alike of the commodity who pay for it, and consumers and producers alike who do not pay, but could become payers in a prospective state. Note that if the positive externalities are exclusive there will be always some non-payers who benefit. Industrial policy. Positive externalities form the rationale for industrial policy. Commonly, industrial policy would refer to government actions which aim at growth and change either via (a) a general shift of productivity and/or enhanced activity across the board or via (b) a reallocation of means in the economy in such a way that current and new activities with better perspectives (high rates of social benefits to social costs) get higher weights at the cost of other activities which are less attractive (low rates of social benefits to social costs). The first channel is often called the neutral approach; the second channel is the targeted approach. OECD countries show differences in how they combine the two approaches. The neutral approach to industrial policy in the sense of a stimulation across the board takes the form of generic instruments such as standardization, provision of information, investment in science, technology, human and physical infrastructure, and the setting up of financial institutions and judiciary systems. The targeted approach to industrial policy in the sense of influencing consciously reallocation of production among activities makes use of four broad policy areas: (i) exploitation of positive economies of scale and/or economies of scope; (ii) strategic trade and investment policy in relation to sunrise industries11; (iii) economic restructuring in response to sunset industries and regional development; and (iv) encouragement of business clusters of linked technologies, industries and firms. How do the neutral and targeted approaches combine in FIM related countries? Although the United States is known to avoid industrial policy, technology policy in the United States is active and has not been neutral. The approach adopted by the US government can be described as a ‘mission- oriented’ approach to promoting industrial, technological change in the post-war period, cf. Ergas (1986). The goal is to achieve a technological breakthrough in specific areas, so that entirely new industries using this technology come into being. The mission-oriented approach is associated with activities that carry a high cost for the first mover; compared to the relatively low cost of diffusion (copying) once the innovation has been made. This approach has led to the creation of

86


prestigious projects with disproportional high costs, especially in the area of the military and aerospace. Civilian applications of related innovations came much later and in a limited extent. Another example with a mixed performance is the development of the semiconductor industry, cf. Audresch (1993). In the beginning of the 1960s, the contracts for integrated circuits came from the government. By the end of the sixties, as the technology spilled over, the computer industry replaced the government as the major buyer of semi- conductors. The government has not been able to capture the rents accruing from the investments made, and it is no longer in a position to influence the future direction of technological research in this area. Industrial policy in Western Europe is mixed. British industrial policy is based on a liberal philosophy, that industrial performance is best left to the private sector, assisted only at the margin by state activity. As a result the British industrial policy fits best into the neutral approach. It is difficult to assess the performance of British industrial policy, since one needs to know how the economy would have fared otherwise and no material of this kind is present. Germany has applied both approaches to industrial policy. Declining industries were targeted for support, either to maintain the current level of output, or to adjust to new conditions in the industry. Examples are agriculture, the railroad sector and housing. On the other hand, the most successful sectors (in terms of export performance), like the moderate technological intensive industries, have in general not received governmental support. The success of these sectors is mainly due to the neutral industrial policy of investment in industrial infrastructure and workforce. So, the success of Germany does not reflect targeting policies but rather the policies of investing in a skilled workforce and infrastructure, which can be considered as an indirect form of industrial policy, leaning more towards a neutral approach. Japan has mostly used the sectoral approach to industrial policy. In the mid1950s industrial policies focused on the heavy and chemical industries, whereas in the early 1970s the attention shifted to knowledge-intensive industries. Throughout the years the Japanese government has given special assistance to small- and medium-size enterprises. Under pressure of the US and the EU in the 1980s, Japan withdrew supporting measures to prevent trade conflicts with foreign governments. Economists are divided over whether Japanese industrial policies have been successful or not, but most argue that the Japanese targeted approach has not contributed to the Japanese growth.12 In contrast to FIM countries, industrial policy of Russia and Eastern Europe has been heavily targeted. Industrial policy here was characterized by state ownership of economic assets, centralization of these assets and a planning system to allocate their use. Furthermore, large-scale production (mass production) was regarded as the only efficient way of production, leading to a high concentration of industries. These factors allowed a temporary comparative advantage for Russia and Eastern Europe in some heavy industries in the past. However, the policy has not been useful for promoting their international competitiveness in heavy industries over the longer period, and barred them from entering high


technology and information intensive markets, where frequent entry and exit is conducive to innovative behaviour. What can be concluded from country experiences? The evidence emphasizes importance of enhancing factors of production in gaining competitive advantage. While capital, technology and raw material can be replaced, this is less true for labour skills. Labour quality has been the focus of a successful neutral industrial policy. The evidence on the targeted approach shows that sectors that have received support have not always been successful, and similarly successful sectors have not been targeted by industrial policy. The case for state support of infant industry, typical of early phases of positive externalities, is functional if it is able to launch the protected industry towards a sustainable competitive advantage. Continued protection beyond that point will be detrimental to competing firms and will be opposed by them. How are industrial and trade policies changing under globalization? Under the auspices of the General Agreement on Tariffs and Trade (GATT) the first steps were taken by member countries to extend and harmonize trade liberalization policies and eventually achieve a shift towards neutral industrial policies. The initiatives can be seen to be set into motion by business forces that are eager to introduce more competition and secure mutual gains, supported by expertise analysis and enforced by governmental authorities. The initiatives gained momentum with the formation of the European Common Market and the Kennedy Round of mutual tariff cuts. In the Tokyo Round, governments attempted to reduce both tariff and non-tariff barriers, next to agreeing on codes of conduct relating to government purchases from firms, export subsidies and dumping practices of multinational firms. The slowing down of economic growth and the rise in unemployment in US and EU in the late 1970s and early 1980s, encouraged protectionist measures. In the US and EU, import competition from Japan and Korea among others impacted established firms and trade unions in textiles, steel, shipbuilding and the car industry. Trade adjustment assistance to impacted firms and labour and limits on imports of related manufactured goods were instituted. Although these measures benefited the incumbent firms and labour transition in the short run, they did not solve the problems of sunset industries in US and EU. Other complex developments as a consequence of the import limits were the increasing numbers of trade disputes between trading nations. This together with the greater integration within the European Union, establishment of the North American Free Trade Agreement (NAFTA) and other regional trade arrangements increased the complexity of resolving inter-trade policies within the GATT framework. The Uruguay Round of trade negotiations in the 1990s led to large cuts in tariffs in manufactured goods, inclusion of farm products via limits to export subsidies, lesser interference with prices and restrained use of compensatory transfers to farmers. It led also to replacement of GATT by the World Trade Organization (WTO) with additional tasks of liberalization trade in telecommunications and financial services, and as the undisputed non-veto forum for the settlement of trade disputes between member trading countries.


Box 3.5 Response to liberalization initiatives of the World Trade Organization in FIM countries The WTO plays a central role in the promotion of greater competition between firms in member countries and enhancing international trade via encouraging neutral industrial policies and trade liberalization. Among the developed countries, industrial protection at the turn of the century was highest in EU, less in US and least in Japan. In contrast, protection of the agricultural sector is highest in Japan with subsidies reaching 55 per cent of off-farm prices, quite significant in EU at 34 per cent and less significant in US at about 14 per cent. Liberalization effects over the reported period for both industry and agriculture were relatively higher in US and Japan than in EU, reflecting the relative lobbying pressures of incumbent producers. Countries

Industrial protection as measured by tariff rates on imports of industrial goods, %

Agricultural protection as measured by producer support estimate as % of gross farm receipts

Before Uruguay Round 1986

At eve of Doha Round 2000

% change

Rank in protection. Highest = 1

United States

4.6

3

35

2

22

European Union

5.7

3.6

37

1

41

3

64 38

Japan

3.9

1.7

56

All OECD

6.3

3.9

38

1986–1988 2004–2006

% change

Rank in protection Highest = 1

14

36

3

34

17

2

55

14

1

29

24

Source, note: OECD: Agricultural Policies in OECD countries: Monitoring and evaluation 2007, OECD, Paris; Appendix Table III.1. Column 3 (col. 1 col. 2)/col.1. Column 7 (col. 5 col. 6)/col.5.

It is important to emphasize the distinction between monopolistic practices of a multinational firm and the industrial and trade policies of a national government, even though there are many instances in which the two coincide. The WTO focuses on government policy and does not have the authority to question or prohibit monopolistic practices of trading firms.13 3.4.3 Negative externalities Negative externality is a side effect that exists whenever the social costs associated with a particular decision are not fully borne by the person or firm making the decision. Pollution is an example of a negative externality. Land degradation, overgrazing or deforestation, polluted air, acid rain, garbage deposited along roadsides, trash blowing in the wind or toxic wastes leaking into water supplies, all exist because particular consumers and producers do not fully account for the


Price

S1 = MCS

MCS at Q0

Deadweight loss

S0 = MCP

P1 P0

D = MB

Q1

Figure 3.7

Q0

Quantity

Deadweight loss from negative externalities

costs associated with their decisions. The costs are external to their decisions and the result is a negative externality. Figure 3.7 illustrates the market effect of a negative externality. In this figure, it is assumed that, although producing the commodity has a negative externality, there are no externalities associated directly with consuming it. That is, the willingness to pay for additional output accurately reflects all the benefits associated with consuming a good. On the other hand, disposing of by-products without paying for their disposal (by dumping them into the water or into the air) implies that private marginal cost (MCp) – that is, the marginal cost that firms actually incur is less than social marginal cost (MCs) – that is, the social marginal cost of producing the commodity from society’s perspective. The difference, of course, is the cost of the externality that is imposed on someone in society but that the firms do not have to pay. A competitive market will produce Qe when the horizontal sum of the marginal cost curves over all firms is MCp. If Qe is supplied to the market, the equilibrium price will be Pe. By contrast, if firms actually paid the true social cost to dispose of their by-products, the horizontal sum of the marginal costs over all firms would be MCs, and the market would have an equilibrium output of Qe and an equilibrium price of Ph. The market price would be higher, and less would be both produced and consumed. Notice that the externality is caused by what appears to be a free method for firms to dispose of by-products. Society essentially subsidizes the producers, in this case by the difference between MC s and MCp. The situation can be analysed in terms of efficiency and equity effects. If there is a negative externality, the true marginal cost of producing Q 0 is measured by [MCs at Q0]. Consumers pay only P0 for this output, however. At the market equilibrium, as a consequence, the true marginal cost is greater than the market price, and hence, greater than the amount that consumers would be willing to


pay for additional output. That is, consumers pay less than it costs the economy to produce this additional output, when all costs, both internal and external, are considered. Put simply, it is as if the economy was using x in scarce resources to produce y of additional satisfaction, whereby x y. There is thus a deadweight loss equal to the shaded area. When there is a negative externality, the economy is using too much of its scarce resources in producing too many goods that are less valued. The issue of equity relevant here is not that of the distribution of total surplus between consumers and producers but between the group of consumers and producers taken together who are causing the pollution to the group of consumers and producers together who are suffering from the pollution without being compensated for. Environmental policy. The interaction between firms and government in the context of environmental policy in FIM countries is a relevant example of reinforcing responses to negative externalities. Market prices are important because they convey information. If market prices do not incorporate the correct information because of an externality, agents will be led by the market price to make the wrong decisions. The problem of environmental damage can then be seen as a problem of ‘wrong’ prices. The challenge for the economic system at hand, then, is to get the prices ‘right’. It is a search for the right quantities with the right prices, implying that there is an optimal amount of environmental damage (and environmental protection) and optimal prices to be paid for such a balance between goods and bad. It was stated earlier that the ways open for society to assure that ‘right’ prices hold are via a variety of firm-market solutions or via state measures, as would be treated below. Firm responses include creating internal markets via forcing unitization, and defining and enforcing property rights. One solution to the externality problem in some settings is unitization of the separate activities that are connected by the externality. For example, if a factory owner also owned all of the land affected by the smoke and other pollutants created as by-products of the factory’s production, any increase in by-products would lower the value of the land. Therefore, the owner of both the land and factory would have to consider the effect of a decision to produce more at the factory (that would increase his factory income) on the value of land that he owned (where pollution would tend to decrease the value of the land and the income from land sales or rentals). Unitization is the creation of single ownership and control of resources whose uses might conflict to create an externality. Unitization does pose one problem, however. Creating a single owner for the different activities may create a firm with market power. Then solving one problem – an externality – creates another problem – a monopoly. Another way out is to create markets via property rights. Externalities almost always appear when certain kinds of markets do not develop. For example, firms dispose of by-products in the air because air is a common property, and it is not


easily convertible in private property. Because lack of ownership creates externality problems, an externality problem can sometimes be solved, if technically feasible, by establishing explicit ownership of previously undefined ownership of resources.14 Even if there are market remedies to some externality problems, when transaction costs are high, these remedies frequently fail. Then, property rights cannot be effectively defined, transferred from lower-valued uses to higher-valued uses or enforced against producers of externalities. In such cases, the state is called upon to pursue direct legal, regulatory or fiscal remedies. State responses include mediated negotiations, tort law and liability, regulation methods to prohibit the firm from producing more than a specific quantity of pollution and emission fees. In theory, emission fees are more efficient than regulatory measures. First, such taxes on pollution are attractive for several reasons: they not only move a market towards a more efficient equilibrium but also, if they change with changes in the quantity or type of pollution, they provide incentives for polluters to find cost-effective means of lowering pollution. Second, the cost of achieving a specific amount of pollution reduction can be minimized if the marginal costs of pollution control can be set equally for all activities that create the pollution. Third, in a sense, if firms are taxed on the basis of the pollution that they create, there is a market for pollution. Either a firm can buy the right to pollute from the state by paying the tax, or it can avoid the tax by reducing its pollution. If it pays the tax, its costs will increase and it will produce less, including less pollution. Fourth, these emission fees lead to favourable effects in the long term. Research activity will then concentrate on developing new methods of production aimed at economizing on the now more expensive factor of production. In this way, prices will ‘inform’ the consumers about the true social costs of producing. In practice, controlling governmental departments in FIM prefer physical regulations to emission charges. A policy effect that can be monitored and attained with certainty, such as in regulation, is particularly valuable, when environmental damages are expected to increase dramatically if this level is surpassed. In contrast, the effect of charges on emission volumes is less certain. One reason is that the cost structure of polluting firms, which determines the effect of charges imposed on them, may be essentially unknown to the governmental department concerned. It was seen earlier that with increased globalization there are increasing externality effects among trading countries. This has led firms and countries to push for a harmonization of industrial and trade policies so that firms may face comparable competitive conditions in competing countries. In the same globe environmental pollution in one country has negative side effects on other countries. Here too, the nature of environmental policy is changing towards a sharing of the burden of global environmental protection among producing countries. The Kyoto Protocol is a perfect example of global cooperation.

92


Box 3.6

Responses of FIM countries to the Kyoto Protocol

The Kyoto Protocol (KP), negotiated in December 1997, is the first international treaty to limit emissions of greenhouse gases. KP offers an illuminative example of the changing nature of environmental policy across rich countries. The table below gives a summary of emissions and targets by countries intending to participate. The US Congress, and hence the government, declined to participate and are proposing other unilateral ways to reduce pollution and meet the collective obligation. Other countries signed. KP studies, implemented by the Clinton Administration in 1998, estimate the marginal cost of meeting the Kyoto targets by the participating countries at a similar value to the global marginal damage of the emissions, about US$ 18 per ton, meeting optimal marginal conditions. The Kyoto targets are expressed in net emissions; this allows effective use of alternative instruments. Net emissions are equal to greenhouse gases emitted by industrial activity less gas removals through forestry, which is very effective in absorbing these gases. Substitution is introduced by including next to carbon dioxide other gases that cause greenhouse effects. Abatement of a ton of nitrous oxide is put equal to 315 tons of carbon dioxide. KP requires that the above targets be met over the years 2008–2012 on average, and not every year. Countries are allowed to carry forward additional reductions they achieve to a future control period, allowing trading over time. KP allows also trading over space. EU can trade its emission target with transition countries where abatement cost is cheaper. The environmental effect will be the same for the globe as a whole. This provision will help creating a global market for trading environmental burdens. KP excludes developing countries from emission reduction target until 2012, based on the understanding that for many years to come the developing world needs to intensify its industrial activities in a catching-up growth process. But KP allows and extends projectbased joint implementation by participating countries to developing countries. In this way an incentive is created for implementing abatement in the developing world and persuading countries of the developing world to endorse the protocol. Non-participating third world countries will acquire comparative advantage in the polluting industries that will tend to shift from the North to the South. Emission will increase in the South so that some leakage is unavoidable. Leakage in the South is estimated at about 10 per cent of the abatement in the North. Shifting industry can hurt some parties who will lobby for protection in the North. The agreement is greatly handicapped by non-participation of US. The burden of implementation lies on the EU given last minute commitment of a less enthusiastic Russia. Aspects of implementation and inspection are not yet worked out, which are problematic. Countries

Actual emission 1990 gigagrams CO2

Projected emission 2000/actual emission 1990

Kyoto Target 2008–12

Share in total emissions % in 1990

United States 1 country

4,957,022

104

93

36.00

European Union 15 countries

3,288,667

103

92

24.05

Other OECD 9 countries

2,065,119

109

98

15.35

SIM in transition 13 countries

3,364,259

81

103

24.60

Total 38 countries

13,675,067

98

95

100.00

Source: Cohen (2001). For a more detailed treatment, see Barrett (1998).


3.5 Collectivities: Problems and firm-state responses 3.5.1 Problems If certain goods are not profitable, the firms will fail to produce them. If, nevertheless, a community collectively considers such goods as necessary, then production must be undertaken despite the negative signals of the price mechanism. Under these circumstances it is usually the government that plays an active role in the provision of public goods. A first feature of a public good is that it cannot be supplied to one consumer without simultaneously being supplied to others. It is in this sense that the public good is an extreme example of externality. When the good is provided for one agent, it will bring external benefits to many other agents. This feature is known as non-excludability. It results in the problem of ‘free-riders’. People will not like it to pay for goods that they think can be acquired free. As a consequence of free riding, the demand for a public good understates the true value of the good to the agents. The second feature of the public good is that once the good has been supplied to a single consumer there is no additional cost in supplying it to others. The supply of benefits generated by the good is in no way depleted no matter how many people use it. This feature is known as non-rivalry, implying that the cost of supplying an extra user with the good is zero. The benefit enjoyed by the second, third etc., street walker from the street lighting has not resulted in an increase in costs, nor has it reduced the amount of light available, in terms of the Pareto criterion it would be inefficient to charge a price. Indeed, when any extra user can benefit from the good at no extra cost to society, charging a price would clearly discourage some potential users and result in a loss of total benefit to society. As there are by definition no costs involved in serving additional consumers, a price should not be charged for these services. But with a zero price and non-zero production costs, output cannot be determined in the usual way by demand and supply on a market. The following example highlights the above issues and lays down basic links between general equilibrium theory and game theory in treating the problem of collectivities. Assume there are several closely located firms each denoted by a, each owning its own paved road i and they share a desire for expanding, building and using a railway line and warehousing facilities, j. Assume a marginal rate of transformation, MRT, of 2 units of paved roads to 1 railway line. To obtain ‘general’ Pareto efficiency it is not necessary that the marginal rate of substitution, MRS, between road and railway for each firm should be 2. If there are 20 firms, it is, in principle, sufficient for each to give up 0.1 of road to have full use of the common railway. For ‘general’ Pareto efficiency to be realized in the context of MRSia, j MRTi , j . public goods it is not necessary that MRSia, j MRTi , j , but rather a The efficiency problem is, therefore, transformed to one of reaching a satisfactory distribution among the firms. Whether it is feasible or not to reach agreement on the allocation of costs and benefits to the individual firm depends on the prospects of collective action.


The co-ordination problem in the case of collective failures can be presented along the lines of a prisoner’s dilemma. This applies also to externality failures. Let the only two existing firms a and b assess the consequences of each one’s initiative to build a non-excludable railway on its own or collectively. In the example given below, total cost of building the railway is 8, while the benefit of using the railway for each firm is 12. The two strategies give four combinations of net benefits in Table 3.2. A co-operative decision to collectively build the railway gives a highest total benefit (8,8). This may not occur, however, as long as the individual returns from acting as a free rider are higher, and it is very likely that no railway will be built at all given the relative individual returns. Intervention of a third player who is entrusted with maximizing the collective benefit, i.e. government; can enforce (or facilitate) the construction of the road. Table 3.2

A game theoretic presentation of the problem of collectivities Firm b

Build railway

Do not build railway

Build railway

(8,8)

(4,12)

Do not build railway

(12,4)

(0,0)

Firm a

Of course, this government has to arbitrate, earn an arbitration income, monitor execution and settle the distributive problem of allocating costs and benefits to the individual firms in correspondence with their respective revealed preferences and displayed strategies. 3.5.2 Responses Where there are unresolved collective needs governments are anticipated and invited to act. Government intervention relating to public goods is necessarily coercive, however. As long as agents can free-ride on private or governmental provision of a public good, they will not reveal their true preferences for it. The remedy to the free-riding problem is to manoeuvre agents to behave in ways consistent with collective interest. Extending the above example, the financing of transport networks countrywide, building of schools, hospitals and parks and alike require levying taxes. All firms and households have to pay such taxes whether or not some of them value the public goods provided by the government. The coercive nature of tax incidence and of public provisions implies that some individuals who really do care about the public good will be taxed too little. This discrepancy occurs because taxes are not based on willingness to pay. Thus, forcing agents to pay a ‘fair share’ is difficult as government provision almost always unintentionally redistributes income. The lengthy public debates about how much should be spent on national defence, business infrastructures, skill development or how much should be spent on police, health or social security and so forth reflect difficulties in obtaining informed guesses of the real needs, as well as the concerns associated with the


redistributive effects of the associated taxes. The actual allocation between these alternatives is often a reflection of the relative strengths of opponent beneficiaries, consisting mostly of business and community interests, together with political bias in the implementation of the political functions of state agents, as will be laid out in the next chapter. This is a suitable moment to emphasize the differences in the degrees of firmsstate response to the different economic failures so far. In the cases of economic failures due to indivisibilities and uncertainties, it was seen that the response of firms was more significant than state intervention. Such past state interventions in FIM as nationalization and regulation have been converted over time into privatization and deregulation, respectively, and thus enhancing the scope for more activities in firm settings. As to the problems of imperfect information in FIM, firm responses have taken the lead over state intervention in matters of signalling and reputation, and in the upgrading and monitoring of corporate governance. Regarding the problem of externalities in FEM, firm responses in the way of internalization and state actions to close the gap between private and social benefits and costs appear to combine in remedying the problem. In contrast, the solution of problems of collectivities in FEM relies more on state actions than firm responses. This happens for two reasons. First, the coordination problem, as depicted in Table 3.2, cannot be solved by the two firms without access to the providing services of a third party, the state. Second, the collective needs posed by opponent firms are relatively small when compared to the demand for public goods put forward by households and supported by the electorate.15 Public expenditures, and the task of collecting public revenue to finance the public spending, are managed by the state in all modern economic systems. In general, public expenditure is divided into two categories: exhaustive public expenditures and transfer expenditures. Exhaustive public expenditures consist of purchases of current goods and services (e.g., consumption goods, employee costs in health, education, administration and alike) and capital goods (e.g., investments in roads, buildings, construction and alike). Exhaustive expenditures are purchases of inputs by government that are then used to provide public goods. This has been the concern of this section. The second category (transfer expenditures) is more important in the context of income redistribution and will be treated in the next section.

3.6 Income distribution: Problems and firm-state responses 3.6.1 Problems Welfare economics postulates that for a given income distribution, the market mechanism will result in an economically efficient outcome whereby costs will be minimized while satisfaction will be maximized. This implies that there will be as many technically efficient outcomes as there are possible distributions of income and wealth. One technically efficient outcome above others requires that the existing distribution of income and wealth for that one is more ‘fair’ or more ‘equitable’ than those for the others. The market failure comes in the picture

96


when more agents feel that the existing income distribution is unfair, to them or to others; and when this feeling is transformed in actions that would affect the economically efficient outcome of that moment negatively. To prevent a market failure the economic system responds with measures that assure ‘fair’ outcomes for all agents. For the economist a crucial question is thus what is ‘fair’? Since the topic is not value free it is difficult to determine consensus answers in objective ways; but economic research has achieved a lot in narrowing the scope for value judgements. Conceptually, there are two approaches economists use in treating the question of what is ‘fair’: a positive and a normative. We treat these approaches below. The positive approach. The focus here is on causal explanations of income distribution. First, the measurement of income distribution has to be treated. Second, as factor earnings play a prominent role in determining income, these factor earnings need to be decomposed for a causal explanation of differing patterns of income distribution. Third, there are also many supplementary causes than factor earnings that influence income distribution, and that need to be considered. Fourth, the positive analysis of income distribution has the ability of distinguishing between causes that are consistent with FIM motivations, and causes that can be termed market failures in the FIM context. Such market failures call for policy corrections. First, there is a wide range of concentration measures that describe the actual income distribution among the population in a region. Most commonly used concentration measure is the Gini index (or Gini coefficient) which can be derived from the Lorenz curve, obtained by plotting the percentage of total income (national income) earned by the various income groups within the population. The Gini index gives the area between the observed Lorenz curve and the diagonal line of absolute equality as a proportion of the total area under the diagonal line in Figure 3.8. Percent of income 100 75

50

3 2

25 45° 0 Figure. 3.8

25

Lorenz curve and Gini index

1 50

75

100

Percent of population


With complete equality, the poorest quarter would have a quarter of the national income, and the poorest half would have half of the national income, etc. The equality would move along the diagonal. With a great deal of inequality, as depicted by curve 1, the poorest 25 per cent can have 2 or 3 per cent of national income. More generally, as curve 2 lies more northwest of curve 1 the distribution of income in curve 2 is more equal than in curve 1. Note that when one curve crosses another, like curves 1 and 3 in the figure, it cannot be optically determined which distribution is more equal. It can be shown that for a quite broad class of social welfare functions, including the utilitarian form as a special case, moving from an income distribution such as 1 to one such as 2 in Figure 3.8 will increase social welfare. Intuitively, with diminishing marginal utility of income and equal capacities to enjoy income, a reallocation from a higher income person to a lower income person yields a utility gain to the lower income person that exceeds the loss to the higher. Thus, social welfare must increase when we move from the more unequal income distribution to the more equal one. Second, since factor earnings play a prominent role in shaping distribution of income, a decomposition of factor earnings in exclusive elements and information about the relative significance of these elements will contribute to a positive analysis of income distribution. Factor earnings of an individual can be analaysed in terms of: (a) the types of factor endowments possessed by the individual, various skill types, land, capital; (b) the quantity of the factor that the individual chooses to transform into earnings; (c) the ability of the individual to get a higher remuneration per unit of factor use above the average remuneration as determined by market forces for that factor; and (d) Market forces beyond the individuals determining differing factor remuneration. Those who gamble and succeed become wealthy. Those who try and fail go broke. Hence, some income differences arise voluntarily. How much of the inequalities are due to each of the four elements above? Although the question can be treated quantitatively, the available data do not allow this as yet. The following can be speculated, however. Take first the distribution among the population of the ‘earnings potential based on ability’. There are many measurable abilities of people that probably influence their earnings. For example, physical attributes such as height, weight, strength, endurance, intelligence can all be measured objectively. All of these measurable attributes appear to have what is called a normal distribution in the population. For example, if the horizontal axis in Figure 3.9 measures intelligence levels and the vertical axis measures the number of persons at each intelligence level, the curve in the figure would trace the percentage of persons at each height. The distribution is symmetric. That is, for each person above the average score of ability there is another person who is below the average by the same amount so that the two are like a mirror image of each other. The range of individual ability is a major source of differences in income and wealth. But it is not the only source. If it were, the distributions of income and wealth would have a normal distribution curve that describes the distribution of


Number of people

Score of ability Figure 3.9 The untouched normal distribution of abilities

Percentage of the population

25

Most frequent income

Medium income

20 Average income 15 10 5

0

Figure 3.10

10

20

30 40 50 60 70 Income in thousands euros per year

80

90

100

The real world distribution of income

ability and a large number of other human characteristics as in Figure 3.9. In the real world, the distribution of income looks like figure 3.10. There are many more people below the average than above it and a relatively small number of people receive extremely high incomes. The asymmetric shape of the distribution of income and wealth is partly explainable by ‘differing intensities of factor use’. For example, the distribution of weekly is symmetric around an average rate of x dollars an hour. But, since people who earn a higher hourly wage tend also to work longer hours, their weekly income becomes disproportionately larger than that of people with low hourly wages who work shorter hours. Choices make the distribution of income skewed, therefore. The wage rate of the highest paid is only 9/5 1.8 times that of the average wage; in contrast, the ratio of income of the highest to the average is 300/130 2.3 times. This example is, of course, artificial. But the point that it illustrates applies in the real world. Other things being equal, the higher the wage rate, the more labour will a person supply; therefore the distribution of income is more unequal than the underlying distribution of abilities. Even if the distribution of abilities is symmetric, the distribution of income will be skewed. More people will have incomes below the average than above the average.16


Third, there are other causes for the skewed distribution of income than causes a, b, c and d discussed above. Wage differentials are maintained to compensate for jobs that are more arduous or dangerous than others. More experienced workers earn higher wages, too. Gender and race matter: those with higher incomes tend to be males, not females, and whites, not blacks. Income differences associated with these two characteristics imply involuntary choices as they are caused by unfair starting positions and distorted market operations. Not all income is derived from work since a tiny number of people inherit enormous fortunes. Furthermore, wealthy individuals seek wealthy partners, giving rise to assortative mating, which has the consequence that inherited wealth becomes more unequally distributed. These sources of income differences are involuntary. Fourth, can the positive analysis of income distribution identify among the causes of income inequality those that can be justified in terms of the FIM motivations and those that can be termed as market failures, also in terms of FIM motivations? So far it was maintained that while differences in individual abilities and work intensities tend to closely associate with differences in incomes, there is yet no full correspondence between favourable/unfavourable characteristics and high/low income. Thus, income inequalities can be due to (a) some individuals having innate abilities that differ (as, for example, with special talents), and because they choose to put more effort to increase their earnings; other individuals being less naturally endowed; or (b) some individuals, even though willing to pursue efforts to increase their earnings, are overpowered by circumstances and cannot move forword; while other individuals experiencing the contrary. The relationships between earnings and individual characteristics can be thus decomposed into two parts. Some favourable individual characteristics are innate and/or can be chosen, but some other parts are unfavourable and may have come into being involuntarily, mostly due to nature, or to informational imperfections, discrimination and other barriers. The public at large, and the policy-makers, are inclined to focus on the second case when they call for collective actions on distribution issues. The second case stands for an involuntary bias and is identical with ‘blame freeness’. As such it is a market failure. It is also the most reachable by appropriate policies. The normative approach. Turning to the normative question of what constitutes a ‘fair’ distribution, economists and non-economists alike opened inquiries about whether there is such a thing as an objectively fair or equitable distribution of income and wealth. Some believe that there are inconclusive answers on this.17 It has been suggested that a fundamental weakness of welfare economics is its apparent inability to choose between these possible outcomes come to agreement about what ‘fair’ distribution is. Others believe that the normative question should be formulated otherwise. In the context of the current chapter, the normative question can be asked as follows. Why should welfare economics, or in particular issues of fairness in income distribution, be of interest at all to the prospering agents in a firm


intensive economic system? In this system all agents are maximizing their individual material benefits, so why bother on relative material benefits of the less fortunate? The answer then follows: yes, there is reason for the firms, and the maximizing society at large, to bother about the issue if they keep to their maximizing principle. The reasoning can be displayed in several steps, i to iv, that coincide at some points quite closely with the positive analysis stated earlier. (i) In a firm intensive economic system, some people with skills or abilities that are in great demand, but are very scarce, will end up rich, or enormously rich. Other individuals with skills or abilities that are in abundant supply or not demanded at all will, involuntarily, end up as poorest. (ii) There is thus bound to be inequalities because (a) individuals have innate abilities that differ (as, for example, with special talents) or individuals choose not to make changes to increase their earnings; or because (b) the maximization principle in the system may make particular individuals – the unfortunate few – economically redundant and unable to sustain an earning level sufficient to maintain basic needs. These displaced persons can be seen as a ‘corner solution’ in an optimization problem seeking the ‘firm-efficient’ allocation of resources. The displaced persons, unable to maintain themselves, may end up in crime activities that are nevertheless judged as involuntary and ‘blame-free’. (iii) The firms, and the society at large, face a dilemma. The choice is between more real resources going into combating crimes and protecting firms and their employees, or entitling and guaranteeing to all individuals a blame-free income.18 (iv) Of course, the institutional structure of the economy under consideration forms the basis for judgements on the blame-freeness of any agent’s acts and his/her entitlements. This is necessary because the entitlements that need to be installed do not exist in a vacuum. It is here that the relative distribution of income becomes relevant in making judgements on entitlements. The above exposition demonstrates a convergence between the positive and normative approaches in handling the distribution issue in welfare economics. The converging conclusion is that there are some roles for state interventions to correct for unnatural causes of income inequality and to combat unfairness related system damages. The rationale for these roles is thus fully consistent with the principle of the maximization of material benefits in the firm intensive exchange system. 3.6.2 Responses Private responses are less vital than state intervention in the area of income redistribution towards reaching more fairness. State intervention to redistribute


income and wealth take two forms in FIM countries: influencing earnings and public transfers. Each form will be briefly introduced. The first form involves the manipulation of earnings so that some would earn a bit more than they would have done. Where parliaments impose minimum wage rates for employees or maximum rent charges on landlords, they are indulging in this type of behaviour. A side effect is that the working of the price mechanism is thus distorted. As regards public policy on earnings in OECD countries, it is generally recognized that there is less labour legislation on minimum wages in the US than the EU. The second form involves direct income transfers from one group of households to another. Here too, there is a side effect as these measures can alter the relative incentives that the market mechanism would provide. In countries where the welfare system provides an effective floor to incomes, i.e. most EU, there is a tendency that such a policy results in a greater number of unemployed, more government transfers, a higher budget deficit and a lower economic growth. The austere welfare system in US is a contrasting example, suggesting a trade-off between redistribution and growth.19 We mentioned that private forces respond less than government policies in addressing the problem of fair distribution. The earlier conclusions reached in the previous section on a greater role for state intervention than private responses in resolving the collectivities problem is also valid with regard to distribution. Public spending on public goods and income transfers are major instruments that the state manages in tackling the two problems. In the next chapter, we touch again on state interventions with regard to public spending on public goods and income transfers, but the focus there is on the political role of state agents in fixing the levels and designs of spending and revenue collection. The reasons for the light response of firms in case of the distribution problem are similar to those encountered in the case of the collectivity problem. First, firms are engaged in economic transformations and they pursue profit maximization to survive in the firm intensive system FIM; firms are not specially suited for coordinating transfer payments to eligible persons even though some firms in some countries are marginally engaged in such social transfers. Second, the distribution problem is much more relevant for agents in households than for agents in firms. Eligible persons for social transfer payments are those in households with little or no income. What if the time horizon is expanded to consider intergenerational mobility and private versus public endowment strategies that could enrich the productive levels of those child segments of future generations that are denoted as poor today? This opens the way for considering long-run privately steered mechanisms of growth with equity, with complimentary public support, which may escape the trade-off between growth and inequality with least mobilization of government policies in the future. Optimizing redistribution policies is delicate because policies that narrow the inequality in the distribution but make mobility more difficult may very well increase rather than decrease inequality at the

102


Box 3.7

Recent trends in income inequality and poverty incidence in FIM countries

In general, there is a positive correlation between these two indicators. US is shown to have the highest income inequality and poverty rate. Japan, with Sweden and Netherlands, show lowest income inequality and poverty rate. The other European countries occupy intermediate positions. In most of the countries both indicators increased over time. Most countries have become more competitive over time. This gives support to the hypothesis stated in this chapter that income differences tend to accelerate with greater firm competition in firm intensive economic systems. As a result, the phenomena of involuntarily displaced persons and corner solutions may occur more often. The organizational culture of the economic system, while acknowledging involuntary displacements, acts collectively to compensate the involuntary displacements via income transfers for the needy. Between the two reported periods, there is a noted tendency for the Gini index to rise in US and Canada, being more stable in other FIM countries. Relative poverty as defined here follows suit. Countries period

Gini index

Poverty rate

Final level

Change over period

Final level

Change over period

US

(1985–95) (1995–05)

34.4 40.8

0.4 6.4

17.1

1.2

France

(1979–90) (1995–05)

29.1 28.0

0.5 1.0

6.8 9.0

1.5 0.0

Germany

(1984–94) (1995–05)

28.2 28.0

1.8 1.0

9.1 9.0

2.9 3.0

Italy

(1984–93) (1995–05)

34.5 33.0

4.4 0.0

14.2 13.0

3.9 2.0

Netherlands (1977–94) (1995–05)

25.3 27.0

3.0 2.0

8.0 6.0

3.0 0.0

Sweden

(1983–95) (1995–05)

23.0 26.0

1.5 1.0

6.4 9.0

0.4 0.0

UK

(1983–95) (1995–05)

32.0 34.0

0.0 2.0

10.0 11.0

0.0 1.0

Japan

(1984–94) (1995–05)

26.5 24.9

1.3 1.4

8.1

0.8

Source, note: Figures for the first reported period are from OECD Economic Review NO.29, 1997/II. Figures for the second reported period are from http://devdata.worldbank.org/query/ for non-EU and from http://www.eurofound.europa.eu/areas/qualityoflife for EU countries. The Gini index is based on equivalent household disposable income per individual. Poverty rates are defined in relative and not absolute terms. These refer to the share of individuals in the population with equivalent household disposable income less than 50% of the median income of the distribution. For a disaggregated review of tendencies in factor earnings and their impact on income distribution patterns in OECD countries, see Atkinson (2003).


Box 3.8 State spending on income transfers for the working age population in FIM countries The box shows income transfers expressed as percentage of GDP. The transfers are in lieu of unemployment, occupational injury invalidation, sickness, housing subsidies, poor family and other welfare allowances. There is a large diversity by country and period reflecting country differences in institutional arrangements and periodical fluctuations in the size of the receiving target groups. Note, however, that received benefits are often taxed more heavily in countries with higher income transfers. Notwithstanding, while in the US around 3.0 per cent of the GDP is transferred by the state, the figure for EU is 7.7 per cent, supporting the hypothesis that the EU is a more state-oriented firm intensive economic system. At the other end, state income transfers/GDP in Japan do not go beyond 1.3 per cent, which is possible as Japan makes greater use of traditionally developed sharing arrangements in the context of inter-household allocations that are also applied within firms for the needy workforce and their families associated with the firm.

Countries

Level 1980

Level 1992

Change

Average 1980–92

US

3.0

3.2

0.2

3.1

France

6.5

7.0

0.5

6.75

Germany

6.5

6.0

0.5

6.25

Italy

3.5

3.7

0.2

3.6

12.9

12.7

0.2

12.8

Sweden

8.7

11.7

3.0

10.2

UK

5.1

8.1

3.0

6.6

Japan (1984–94)

1.3

1.2

0.1

Netherlands

1.25

Source: OECD, Social Expenditure Database, various years. OECD: Economic Studies, 1996/II.

individual career level. Conversely, policies that enhance mobility may very well increase measured annual inequality while decreasing truly experienced inequality. However, empirical evidence on intergenerational mobility in US and EU does not show major breakthroughs. 20 Hence, the collective demand for government policies of redistribution in both the short and long run is in place. Three boxes show how state interventions respond to redistribution needs in the FIM countries. Box 3.7 gives recent trends in income inequality and poverty rates. Box 3.8 follows up with recent trends in total state spending on income transfers for the population of working age, expressed as percentage of GDP. In Box 3.9, current and future demographic changes are shown to have a significant influence on transfer expenditures.

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Box 3.9 Social security spending and projected composition of the population in FIM countries Demographic changes primarily influence transfer expenditures. Transfer expenditures consist of public expenditures on pensions, subsidies, unemployment benefits and so on. It is important to notice that these expenditures do not represent a claim on resources of society (in contrast with exhaustive expenditures!). Rather, transfer expenditures are flows of income from individuals in society to other individuals in society passing the government sector as an intermediary. These flows can be compared with reimbursements made by an insurance company for which premiums have already been paid in the past. When, over time, the demographic composition of the population changes, this influences the amount of transfer payments. Clear examples of this are an increase (decrease) in the percentage of elderly or unemployed persons in society, which lead to a higher (lower) public share. Obviously, the factors leading to an increase in the public share are outside the scope of the government sector, and therefore cannot be seen as a government failure. A demographic change like population growth is often seen as a factor that increases public expenditures. The larger population demands more goods and services from the public sector. To meet this demand more inputs are needed, i.e. the derived demand for inputs increases and thus public (exhaustive) expenditures.

Social security spending as percentage of GDP 1970 USA

1990

Percentage change in aged population ( 65) 1990–2010

2010–2030

Percentage change in aged dependency ratio 1990–2010

2010–2030

7.9

11.2

18

65

2

69

France

17.0

21.2

22

33

17

46

Germany

13.1

15.2

21

10

37

42

Italy

12.4

18.2

22

17

28

Netherlands

17.4

25.8

Sweden

35

3

39

11.1

19.5

UK

8.7

11.4

Japan

4.6

11.5

71

2

82

8

OECD

9.1

13.7

28

36

19

45

1

Source: OECD, Social Expenditure Database, 1995, Table 6.3; and OECD: Ageing Populations: The Social Policy Implications, 1998.


3.7 Summary and conclusions We reviewed the economic principles of the pure firm intensive economic system. The firm intensive system can be seen to consist of firms (and individuals) who are motivated by commercial self-interest. Firms maximize profits subject to technological and budget constraints. Individuals follow suit and maximize their utility subject to budget constraints, which are the incomes the individuals earn from the firms for work done in these firms. The firm intensive system relies on the competitive price mechanism, which is characterized by indirect exchanges between many independent sellers and many independent buyers. The firms are sellers. The optimal performance of the perfect market economy centred on firms depends on the fulfilment of four presumptions; that is, absence of indivisibilities, uncertainties, externalities and collectivities. There are technical and behavioural dimensions to these presumptions. The optimal performance of the market economy would require fulfilment of the technical presumptions as well as absence of behavioural bias in the four directions. Non-fulfilment of underlying presumptions in the real world results in inefficiencies – market failures – that are remedied by firms and market solutions and/or state interventions. There is a fifth market failure. Welfare economics states that any Pareto optimal state is equilibrium for some initial distribution of endowments. The market failure comes in the picture when more agents feel that the existing income distribution is unfair, to them or to others; and when this feeling is transformed in actions that would affect the economically efficient outcome of that moment negatively. To prevent a market failure the economic system responds with measures that assure ‘fair’ outcomes for all agents. For economists and politicians dealing with economic systems a crucial question is thus what is ‘fair’? Conceptually, there are two approaches economists use in treating the question of what is ‘fair’: a positive and a normative. Both approaches are highlighted in the context of FIM countries. In subsequent sections, the five market failures are treated. We reviewed the ingredients of the problem and examined the response of firms in remedying the problems and state intervention. We made use of FIM related country data to illustrate the problems and show how firms and state have responded in US, Japan and major EU countries. In relative terms, the US stands closest to the modern firm economy where free markets are paramount in determining the character of the economic system. In comparison, the EU allows for a greater influence of collective features typical of state settings, while the Japanese economic systems manifest elements of sharing typical of kinship settings. The chapter made use of additional comparative boxes. We examined (1) changing country patterns of nationalization and privatization in infrastructural sectors in 1980, 1990 and 2005; (2) indicators of firm intensity and open competition for 1995, 2000 and 2005; (3) business and state resources in Research & Development in FIM countries, 1970–1980, 1990–2000; (4) corporate governance patterns in FIM countries, around 2000–2004; (5) the response to liberalization

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initiatives of the World Trade Organization in FIM countries; (6) pollution control in the framework of responses of FIM countries to the Kyoto Protocol; (7) recent trends in income inequality and poverty incidence in FIM countries, and (8) state spending on income transfers for the working age population, and social security spending and projected changing composition of the population.

4 The Firm Intensive System: Polity Functioning and National Accommodations in US, EU, Japan

4.1

Introduction

All nations face collective needs. State authorities have evolved as the effective institutions to resolve many of these collective needs. In doing so, state authorities secure and enjoy a political monopoly. This allows state authorities to acquire and practise political influence. The circumscription of the economic system by state institutions brings with it political dynamics and political influences that usually go beyond the initially posed problems and proposed solutions. Resolution of economic imperfections requires the functioning of and intervention by the state, this in turn can lead to political influences that may run counter to the intended resolution of collective needs, and furthermore, may bias the structure of the economic system and undermine its performance. In the previous chapter, it was emphasized that the business community in a firm intensive economic system, FIM, and the population at large, call on state authorities and national politics to provide collective solutions for problems they cannot solve privately. This chapter will examine the needs for polity and the behaviour of the polity in general terms as well as their practical accommodation in countries with a firm intensive economic system. The relationship between the state and firms in a capitalist economy has been a regular subject of modern political and economic thinking. Schumpeter contributed to the view that the capitalist system would be dominated by monopolist firms which will collaborate with a powerful state. The partnership strengthens both forces to the detriment of other players. Then there is an opposing view by Hayek that monopoly firms are transient and the capitalist economy will manifest a competitive and continuous entry and exit of firms, which by implication will exclude coalitions between firms and the state. There is a third position that lies somewhat in between. Stigler coined the word capture to denote the tendency of monopolistic firms to use the regulatory state to bolster the firms’ own market power. Stigler allows also for newcomer firms to lobby for their entry and use the state accordingly. In all three cases, the firms are dominant actors and the state 107


rulers are sideline beneficiaries. However, the state seems to be more active under Schumpeter than in the cases of Hayek and Stigler. There were periods in recent history in which large firms collaborated with a powerful state.1 But contemporary countries, that have a FIM economic system, correspond more with the viewpoints of Hayek and Stigler, than Schumpeter. Regulatory captures and state lobbying by incumbents and newcomer firms occur in Europe, US, and Japan, but these captures are transient in a FIM economic system where regular entry and exit of firms wipe out such captures. While Stigler holds in the short run, Hayek holds more for the long run. In either case, firms are the dominant players and profit maximization is the dominant motive in the FIM economic system. In countries that lie close to a purely firm dominant system, the closest to this will be the US, the behavioural motive of profit maximization would have sufficiently spread across the spectrum to become the institutional norm that guides not only the actions of the firm but that of the state, too. In the extreme, all actors in a firm dominant system will behave as profit maximizers. Political behaviour can be interpreted in a FIM economic system in terms of economic motivations. Where acts of mutual capture involving firms and the state occur, these acts can be interpreted in terms of the motive of profit maximization as well. In more competitive economic and political settings, where the legal system incorporates more checks and balances on non-permissible handlings, less mutual captures can be expected. In a FIM economic system, it will be plausible to consider profit maximization as the underlying common behavioural pattern of all actors, thus both firms and state.2 The political process in such a system can be described as exchanges process subject to laid constraints, or in short, a constrained market. The functioning of state institutions and state agents, and these include voters, political parties, governing politicians, bureaucrats, interest groups public sector employees, can be described as a marketplace where actors maximize their gains, and subject to checks and balances that serve the FIM system. The elaboration of such an analytical framework and its application to the FIM system/countries requires addressing several questions and answering them. (a) Who are the main actors in this polity? How do they function and interact with each other in the FIM nation state? (b) There are many areas in which the state is neutrally active, in the sense that it is not taking side with one or the other beneficiary. But in the areas of public regulation and public spending state agents may not be always neutral. The question is how to interpret the functioning of the polity in the FIM nation state regarding the task of public regulation, and what are the consequences of this functioning for the economic and social welfare of the nation as a whole? (c) In similarity with the above, there is also the question of how to interpret the functioning of the polity in the FIM nation state regarding the task of public spending, and what are the consequences of this functioning for the size of

Firm Intensive System: Polity Functioning

109

the public sector versus the private sector, and for the economic and social welfare of the nation as a whole? (d) Even though a group of nation states share the FIM economic system, the independent functioning of differing polities in different nation states tend to increase country divergences within the FIM group. The question is then how to position and understand country divergences and system convergence among the FIM countries? Accordingly, this chapter falls further into four sections that treat these four sets of questions. Use will be made of comparative country examples to illustrate the extent and variety of the political influence of the executive branch on the economic system and its economic performance.

4.2

The political process as a political market

4.2.1 Overview Since we are dealing with a firm intensive economic system where economic motives are dominant, it is logical to explain and analyse the political functioning of the state in economic terms as well. If the functioning of state institutions, and state agents, can be described as a political market where actors maximize their gains, then who are the main actors in this political market, how do they interact, what are the results, and what is the end assessment of this political market in terms of consequences for the economic system and social welfare? The historical evolution of the firm intensive economic system went hand in hand with an associated evolution of a political regime that is characterized by a voting public that elects a parliamentary democracy, that assigns a government, that is supported by a bureaucracy; a separation of state powers in the spheres of the executive, legislature, and the judiciary; and a host of checks and balances on each sphere to assure accountability of the functioning of each political actor in each sphere to the electorate. The checks and balances can be seen as controlling devices on behalf of the electorate, which includes all agents in all firms and their dependents, for assuring that the authorized political actors act consistently and fairly to the benefit of the electorate, and for preventing the rent appropriation perils of monopolistic state settings. Who are the political actors in a political market? These are the voting public, political parties, government leaders, state bureaucracies, interest groups, and political media. Although public sector employees are not active political actors, they will be seen to play a prominent role in shaping the polity and the economy. All these political actors and their interactions play significant roles in shaping government policy, political influence, the polity, and the economy. And, ultimately influence economic and social welfare. It can be initially assumed that these political actors behave in ways that maximize their individual material utilities, material self-interest. As such, the functioning of the state can be analytically simplified in some respects to that of an application of standard microeconomics to the political market.3

110


In the microeconomic terminology that associates with the firm intensive economic system and that is typical of exchange markets, the political market can be described basically as consisting of buyers and sellers who undertake mutually beneficial exchanges of political compromises and material benefits within a world of varying uncertainties. The voters are the buyers: they demand security, regulations, services, and redistributions from the political parties and governing leaders. In exchange they supply taxation. The buyers are assumed to maximize their utility, which is derived from alternative government policies, taking into account differential benefits and taxation schemes that are related to these government policies. Political parties compete for a majority of electoral votes to form the governing party or a coalition of governing parties. The winning political party in an election usually institute the government leaders. The political party in charge of governing is comparable to an incumbent company that supplies goods; the opposition party is an aspiring company. Political leaders, who are appointed in government, as ministers or deputy ministers, direct the plans of the (winning) government party. While it is logical to assume that political parties strive to maximize votes gained, political leaders within a political party, once elected or appointed in government, may not necessarily pursue this consistently. In the real world, some or many of the political leaders may opt for short run personal gains, acquire rewards and satisfactions while in office rather than seeking the office to implement the party beliefs, or use the office to maximize future influence outside politics. The roles of the political party and its political leaders are comparable to those of the company shareholders and the company board of directors. State bureaucrats implement the plans of the ministers and deputy ministers. State bureaucrats can be compared to business managers. State bureaucracies are responsible for overseeing and implementing regulations and provision of public goods like defence, roads, health, education, and so on. The appointed ministers and state bureaucracies run the government and are the final suppliers of political solutions. The relationship between the minister and the bureaucrat has much to do with principal–agent relationships and asymmetric information. Bureaucracies are experts on their field of research whereas their political superiors, the ministers, only have the general view of what is going on in the departments. Because it is too costly for any individual minister to monitor bureaucracies, the latter have an opportunity to influence the quantity and efficiency of public sector output in biased ways. Several models describe bureaucratic behaviour that will be examined. Lower in the hierarchy of decision-makers is the large number of other public sector employees who execute and deliver the public services provided by the various ministries and allied publicly funded organizations. Although public sector employees are not active agents in the political process, they indirectly play a central role in shaping the polity and economy. The nature of the delivered public services of public sector employees differs from that of the private sector results in productivity differentials. Furthermore, the political commitment for


111

equal pay to public sector employees and private sector employees has significant consequences for the operation and outcomes of the polity and economy. Another set of actors in the political marketplace consists of interest groups. A narrow notion of interest groups would refer to pressure groups like individual firms or associations of firms, employer organizations, trade unions, regional areas, and so on. These pressure groups share in common the motive of influencing policies to meet their objectives. In reaching their objectives they mobilize bureaucrats and politicians to circumvent regulations and raise public provisions to the advantage of the pressure group concerned. The notion of interest group can have a wider interpretation when it refers to large socio-economic groups or classes within society; for example, the higher income and lower income classes. These groups are not in a position to organize themselves and apply pressure; but their interests shape the polity and economy since they are eligible voters and governments strive to maximize votes. The next political actor is political media. We started with the voters who are buying. They are comparable to consumers. Voters, as consumers, are also subject to information constraints, their information base is limited, and the search for information costs money. The search for information applies not only to voters but also to all political actors. This provides an opportunity for political parties, politicians, bureaucracies, and interest groups, which do dispose of specialist information, to influence opinion, voting, and policy. Political media is an additional political actor that engages in information search and dissemination. Their role is close to that of advertising agencies that highlight the merits and demerits of political suppliers, their leaders, associates, and operations. As stated above, we shall assume that these political actors, in a FIM system, behave in ways that maximize their individual material utilities, i.e. material selfinterest. This is in correspondence with the behaviour of economic agents in the FIM system. In terms of outcome, it has been analytically shown in the previous chapter that the maximization of material self-interest is not a guarantee for the highest economic and social welfare. This has applied to the functioning of the economy in the previous chapter and it applies also to the functioning of the polity in the present chapter. Just as the economic market in the FIM has its failures, and the FIM responds by creating institutions that check and correct these economic failures, so the polity in the FIM may falter also and hence the institution of checks and balances in the FIM to control the functioning of the polity. The checks and balances are instituted at the legislative, executive, and judiciary levels. In a FIM system, the economic and political markets share various similarities. Just like a normal market for economic exchanges, the political market can be described to face similar limitations in the way of a perfect functioning. Perfect competition, in the context of political market, exists if parties would compete and thereby eliminate abnormal ‘profits’ that might arise due to discretionary behaviour on the supply side. So with a large number of voters and political parties and with no significant entry barriers a Pareto optimal solution would result, in which parties respond to demands of voters. However, in reality many of these

112


conditions are not satisfied, just like in normal markets. Various imperfections exist, which lead to Pareto sub-optimality. It is sufficient to mention a few examples of imperfections that relate to indivisibilities, uncertainty, and externalities. As regards indivisibilities, competition in the political market is of the all-or-nothing type; the winning party gets the whole market and gain monopoly power. Regarding uncertainty, all political actors are faced with imperfect information and there are no existing institutions that resolve this problem in effective ways. Externalities abound. Interest groups are able to influence in indirect ways the policy-makers and the implemented policies, without taking part in a direct process of political selection that is sanctioned by popular vote. Furthermore, the electoral system influences the preference revelation of voters: usually the voter votes for a package instead of specific issues. This means that indivisibilities are present, and voter preferences are not genuinely revealed. Besides, voters cannot commit politicians to do as they have promised so that there is room for discretionary behaviour on the side of politicians, more uncertainty and greater externalities. Now that the political market has been introduced in more general terms, attention will be directed in the following sections to examining the roles of the various political actors, the generated political influences, and outcomes for the economic system and social welfare. 4.2.2 Voters The polity rules in a parliamentary democracy are that voters elect representatives freely and periodically, and that the elected majority governs until a next period. Theoretically speaking, as voters are comparable to consumers who maximize utility, they can be assumed to be able to assess the merits and demerits of actions taken by alternative representatives in the past and in the expected future before making a choice for specific representatives who will give them the highest utility. Voters will consider then the past record of political representatives, related to what they had promised to do initially, as a basis for future performance and based on this they make their final decision on which party to elect. In practise, the ability of the voter to assess the utility he gets from each and every act of alternative representatives in government and opposition is not feasible due to rationalizing limits and uncertain information. So, the voter looks for additional short cuts that can help in making voting assessments and electoral choices. Short cuts are found in voting along political parties that stand for advocated ideologies, or in voting for political parties led by admired leader. Examination of voter behaviour cannot be done in isolation from political parties and political leadership. Therefore, political parties and political leaders emerge and end up occupying central roles in the polity in all parliamentary democracies. Political parties are eager to announce and disseminate their ideologies and allied policy implications in an attempt to win more voters, and in this same process they provide the highly needed information that voters search for. Similarly, a political party tries to select from among its members the most vote gaining leaders and does its utmost to expose the best of their leadership qualities


113

in an attempt to gain more votes; and in doing so the voters are helped in their information search for assessing leadership. If rationality and information were fully certain, the assessment by voters of alternative ideologies would have tended towards uniform outcomes. A diversity of party political ideologies can exist only because uncertainty prevents a judgement of the superiority of one ideology over the others. More or less applies to party political leaderships. The responses to uncertainty by voters, parties, and leaders result in a clustering of voters into abstaining groups and a variety of voting groups that manifest high to very low degrees of confidence in their election decisions. The sub-optimality in voter behaviour translates in a sub-optimality of voting outcomes, and a distorted allocation of political authority. The above account on voter behaviour, which constitutes a first phase of the political process, is indicative of (an early phase) polity failure in the political system that has evolved with the FIM. 4.2.3 Political parties Voters want to elect a government responsive to their wants; they make use of political parties to run the government. Political parties want to take charge of governing the country; they make use of voters to get elected. The two processes, with different motivations are interlocked to form the political system of parliamentary democracy. The main goal of the parties is the winning of elections. Parties campaign to maximize votes. They compete with each other for the votes, which are necessary for control of the government apparatus. If a political party believes it can enhance its probability of gaining office by announcing unchecked policies, disseminating imperfect information, being vague on policy standpoints, allowing contradictions or pursuing ambiguous actions that discourage voters from being rational, it is rational for the party to do so, up to the point that voters do not lose trust in the whole political system for at that point the parties, as main stakeholders, would be main losers. The urge for political parties to win as many votes as they can, drive them to adopt policies favoured by the median voter. Thus, the majority-voting equilibrium is the policy preferred by the median voter. Where there are tendencies of political parties, and politicians, to move towards the median voter, consensus politics is likely to emerge. Both parties agree on any policy issue favoured by a majority of voting. Although parties in a two-party system tend to converge ideologically towards the median voter, the fear of losing outlying voters avoids them from being identical. The limits to convergence/differentiation are determined by the characteristic distributions of the voters; the more heterogeneous the voters the more likely that parties gain by distinguishing themselves more distinctively, and eventually resulting into a multiparty system. There can also be one-issue parties who attract segments of the population that are more concerned with a specific issue. The common denominator that unites a party can be also regional interest, ethnic background, or religious belief. Faced by ambiguities, contradictions and uncertainties, created by interacting parties, voters may step side the political debate and vote parties in along

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emotional, incidental, or predetermined a-political lines that can be described as irrational and sub-optimal in terms of decisions and impact. In this respect, a major conditioning determinant of political development and social welfare is the distribution of voters along political and non-political scales. The more heterogeneous and divided the voters the greater the chance that parties will exploit the divisions, which in turn reinforce a divided voter behaviour along a-political lines. The performance of the polity is likely to be more optimal in countries where voters, and parties, are more homogeneous. Another conditioning determinant is the historically installed voting rule; it happens that the majority rule associates with more homogeneity and two-party systems, while proportional representation has gone more with heterogeneity of voters and multiparty systems. Ambiguity and contradictions in party politics are not only characteristic of the voting phase but show up also in the governing phase. In general, these anomalies are more common in a government by a coalition of parties as each party’s reasonably integrated programme must be adjusted at parts to the programmes of the co-governing parties, resulting in overlapping policies and sub-optimal performances. 4.2.4 Governing politicians The governing party, or parties, commonly strive to apply those policies that are favoured by a majority of voters. For if they do not, opponent parties will propose those policies in a next election and defeat the incumbents. But the government may follow an inter-temporal strategy: take unpopular measures at one time that may please more of the electorate at a later time, if indeed more voters will conceive the final effect positively. Political leaders of the majority elected political party, or parties, take charge of running the government. Political leaders running a current government may not abide with the political programme that formed the basis for electoral votes and which brought their political party to run the government. This can be explained in terms of the inter-temporal strategy mentioned above: causing disappointment among some loyal voters now for the sake of gaining more voters later. This anomaly can be also understood in terms of acquired information that requires a change in positions previously defended and/or deviating interests between the political party and its self-interested appointed ministers. The anomaly is very common in a world of uncertain information and moral hazard. Countless accounts of such anomalies can be recalled in many FIM relating countries. The impact of the anomaly on the performance of the political system, and the economic system, is of more concern here than how and why it occurs. The anomaly can be indicative of a polity failure in the sense that other policies than the promised policies are realized. The deviation can be exploited politically, irrespective of whether it is justified or not, and this can lead to a loss of confidence by the voters in the governing political party and in its leaders, with loss of valuable votes in a next election. But this may also not happen due to a weak memory of the electorate, putting the blame on the deviating politician, discounting the


115

deviation as an incident, or a timely reversal of government policy towards voter friendly issues as the next election round is approached. In either case, the functioning of the political process is sub-optimal. Uncertainty causes additional complications. Governing politicians, as well as the political parties to which they belong, are uncertain as to what the electorate wants. Governments and parties rely upon bureaucrats and other intermediaries to find out. The intermediaries include favour-buyers, interest groups, and paid as well as unpaid political advisors. As any of these intermediaries has its own biased agenda of political interest, its contributions to governing leaders in terms of opinion formation and policy formulation carry cost tags. In general, the more resources an intermediary possesses, the higher is its political influence. Furthermore, as information providers to government groups, all intermediaries taken together are able to master proportionately a greater political influence than their relative size in the electorate. Thus, government leaders, under uncertainty and gaps in their information, reward their informants in unequal ways, and depart from the principle of equality of political influence of individual voters. In the above paragraph it was maintained that government leaders facing uncertainty are forced to engage intermediates, resulting in unequal political influences. The polity is bound to drift in more sub-optimal performances when a governing politician goes beyond the mobilization of intermediaries strictly for the purpose of forming an opinion, and assumes an active role in fixing deals with intermediaries against benefits for the government politician in question, and/or his associates, now and/or later. Political influence is thus gained in the process of governing and instituting political solutions to problems that individuals cannot solve. The governing politician unequally distributes political influence, and he may not be able to do otherwise under uncertainty. Political influence can be intentionally used also to realize unintended gains for the politician involved at the cost of negative side effects for the voters who elected him/her. Both are instances of polity failure, whereby the latter is a greater one. Numerous cases can be quoted of both instances in the context of FIM relating countries. 4.2.5 State bureaucrats Bureaucracies are governmental departments. They advise governments (local, regional, national) on present microeconomic policies and on opportunities for new initiatives. In practice this ranges from the provision of public goods, like defence, to purchasing goods and services from the private sector. They also take care of collection of taxes, regulation of firms and industries, and of redistribution policies. As can be expected, the profiles of state bureaucracies are much more stable than those of governing parties. Less obvious, but more important, are the inclinations of bureaucracies to cause upward budgetary bias and hazardous regulation bias. This section will elaborate on both aspects. Upward budgetary bias. In the context of the political marketplace, bureaucracies are the suppliers of goods, services, and information to the governing party and

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the community. Because of their protected position (entry is restricted, and all property rights are allocated towards the existing bureaucracies) they are the sole suppliers in their specialist area. Because each bureaucracy specializes in a certain area, there is usually no competition within the public sector. The special position of bureaucracies is similar to that of the interest groups: they are also extremely well informed in their specialist area, and in the absence of alternative information resources the government is not sufficiently well informed to question a bureau’s behaviour. To increase their departments, bureaucracies often want parts of the public sectors to be centralized. In this way a bilateral monopoly will come into being: the bureau is the sole supplier, whereas the government is the monopsonist who purchases goods, services, and information in return for an agreed budget. The lack of competition leads to opportunities for discretionary behaviour. Discretionary behaviour is typical for large organizations operating in noncompetitive markets with ill-defined objectives. The larger an organization is, the bigger the control loss which gives rise to opportunities for discretionary behaviour. In such an environment politicians and top executives will find it difficult and costly to ensure that their orders are carried out. With more levels in a hierarchy, the chance that the original order will be changed (accidentally or not) increases. In such an environment bureaucrats have an incentive to deliberately distort or hoard information for the furthering of their own objectives. This is reinforced by the fact that the employment contract of a bureaucrat is often incomplete and lacking in efficiency incentives. Private markets encounter moral hazard as well; in these contexts consumer choice, competing producers, and market institutions serve as ‘policing’ mechanisms. They provide incentives to improve efficiency. Unfortunately, such controls are absent in the political marketplace so that another solution has to be found. Measures to reduce distortions are the appointment of external advisors or independent audits. Also, awarding the release of new and valuable information might create incentives. Various models of bureaucracy behaviour will be discussed below based on presentations by Hartley and Tisdell (1981) and Cullis and Jones (1998). These are known as those of maximizing bureaucracies, information misrepresentation, and paperwork models. Maximization of ministerial budgets. Niskanen (1971) assumes that bureaucrats maximize their budgets. By increasing their budgets they can satisfy personal needs like perquisites of office, job opportunities, higher salaries, and so on. The government, the sole purchaser of goods and services from bureaucracies, has to pay for these large budgets. The political marketplace thus is characterized by a bilateral monopoly with bureaucracies acting as monopolists and the government acting as monopsonist. Niskanen assumes that bureaucracies are perfect price discriminating monopolists as they take away all consumer surpluses from the purchasing government. Figure 4.1 reflects on the budgetary bias.4 The government will demand a certain amount of goods and services from the bureaucrats. The median voter determines this demand, as a vote-maximizing,


Benefit B cost

117

MC

D MR X

A

AC

C

E

Q Figure 4.1

Qm

Qc

Qb

Output

Upward budgetary bias I

government will adopt that policy that is favoured by the median voter. So D represents the demand function of the median voter. MR is the marginal revenue and MC and AC are the marginal cost and average cost, respectively. A bureaucracy maximizes its budget, but of course under the constraint that total cost is covered by total revenue. The maximum output level at which the budget is maximized, subject to the cost coverage constraint is Qb. The total cost is equal to OACQb. OBEQb represents the budget, which is revenue for the bureaucracy. Because OACQb equals OBEQb, all costs are covered. As expected the solution is not socially optimal: Qc, the socially optimal output level (found by equalizing the demand curve and the MC) is less than Qb. The consumer surplus at Qc (ABX) is fully captured by the bureaucracy. The bureaucracy uses ABX to increase total output to Qb. Going from Qc to Qb extra cost equal to QcQbCX arises, which is not fully covered by the increase in the budget of QcQbEX. ABX is then used to cover this ‘extra’ cost (XCE). The figure can also be used for analysing the difference between a public and private monopoly. The solution under a private monopoly would be Qm, which is less than Qb, the solution in case of a public monopoly. Qm is socially preferable to Qb because at Qm the consumer surplus is still positive, while at Qb it is zero. Underestimation of specific costs. Figure 4.1 has shown that bureaucracies by maximizing their budgets tend to ‘overproduce’ compared with the socially optimal output level. Additional misallocations are caused by the distortion of information from agent (bureaucracy) to principal (the government or the minister in charge): bureaucracies have an incentive to misrepresent information on costs and benefits, because by doing so bureaucrats can increase their budgets to an even greater extent, as will be shown in Figure 4.2. First, departments have an incentive to exaggerate or overestimate the demand for policies or projects that they have to carry out. They are likely to stress (exaggerate) benefits of projects in the form of creation of employment, technology push, and an improvement of the balance of payments.

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Benefits cost MC0 AC0 MC1 AC1

D0 0 Figure 4.2

Q0

D1 Q1

Output

Upward budgetary bias II

Bureaucracies often make use of expert knowledge of interest groups, particularly producer groups, who are willing to help because they benefit from the project (or policy). Also, departments can hire independent consultants to provide further expertise supporting their case. Governments are likely to listen to the advice of producer groups because they are vote maximizers: the median voter is usually uncertain about cost and benefits: voters with median voter preferences are usually wary of the costs but positive about the potential benefits. In such circumstances the government is likely to listen to those people who are best informed. At the same time, the costs of projects and policies are usually underestimated to make them look more attractive in terms of costs and benefits (including external effects). Projects that seem to be relatively cheap are more likely to be accepted by the government. In this way ‘too low’ cost estimates can lead to the purchase or spending of ‘too much’. This also implies that in the implementation the project will cost more than the biased low figure of the (average) cost in the budget. But any recognition of this will in general be too late because, once the implementation has started, the process is usually not reversible. Again, a lot of producer groups like architects, engineers, scientists, surveyors, unions are involved and have an interest in the continuation of the project. Using the support of these interest groups bureaucrats can easily show vote-conscious politicians that the project is in the ‘national interest’ and will produce substantial social benefits (in the form of jobs, and so on). One might say that cost escalation also occurs in the private market, and therefore is not necessarily a typical public failure. But private firms are less likely to underestimate costs in the first place, or to continue a project with unnecessary high costs in the second place, simply because their profitability and thus competitiveness in the market will suffer from both. Figure 4.2 shows what happens when bureaucracies misrepresent information on costs and benefits. Bureaucracies will create an impression of allocation efficiency


Total costs and budgets, B

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TC2 TC1 TC0

B2 B1 B0

0

Figure 4.3

Qb Output, Q

Upward budgetary bias III

by overestimating demand, so that the original (true) demand curve D0 shifts to the right to D1. At the same time costs are underestimated which shifts downwards the original marginal cost curve MC0 to MC1 and respectively AC0 to AC1. Compared to the original situation output increases substantially from Q0 to Q1. In general one may conclude that the system creates incentives to spend and to overproduce. Obviously, the tax payer is the one that ultimately bears the full cost. Overestimation of general costs. This model incorporates the presence of X-inefficiency (slack) in the public sector. The model distinguishes general public costs (administration costs), as different from specific public good costs. Specific public good costs were mentioned in the foregoing discussion. It was argued there that costs of a specific public good will be underestimated, whereas now it is argued that bureaucracies will overestimate general administration costs, the so-called paperwork. Therefore, the distinction between general and specific costs is an important one. Cost of administration, a typical characteristic of bureaucracies in dealing with the private sector, has been introduced to model X-inefficiency: it can be used as an output indicator to inflate costs. The government cannot easily check this, so that a higher budget to cover these ‘costs’ is easily obtained. Once a bureaucracy has obtained such a budget it can try to shift some of the costs of paperwork onto private firms. The bureaucrats can use the ‘cost savings’ for their own purposes (e.g. office perquisites). Figure 4.3 shows how this works. The government requires an output of Qb from the bureaucracy, and in return the government will pay the total cost for it. The true cost of the bureaucracy of producing Qb is represented by TC1. The budget at these true costs is equal to 0B1. The bureaucracy will try to get a higher budget by misrepresenting information on

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costs: the department will claim that its true cost is represented by the TC2 curve. In that way it will obtain a budget of 0B2. Now, by hiving off some of the cost of paperwork to the private sector, the bureaucracy can increase its discretionary expenditures even more. As a result the bureau’s new total cost curve is equal to TC0, so that the total amount of discretionary expenditure amounts to B2B0. There are limits to the opportunity of this kind of discretionary behaviour: firms will respond by lobbying politicians, arguing for less bureaucracy, and for the work to be ‘hived off’ to the more efficient private sector. The above paperwork model, combined with the misrepresentation of information, leads to the following conclusions. Bureaucracies, in maximizing their budgets, have an incentive to misrepresent information on costs and benefits. In particular, when a specific project or public good is under consideration, bureaucracies will underestimate costs (overestimate benefits), while costs of general public administration will be overestimated. Bureaucratic bias in the running of state regulation and state ownership of enterprises. Finally, attention can be directed to bureaucratic bias and economic distortions related to state regulation and state ownership. These are (a) economic distortions due to catch and/or corruptive behaviour of bureaucracies and/or enterprises in the actual implementation of regulation rules, which was discussed in the previous chapter; and (b) economic distortions due to incentive problems commonly encountered in publicly owned and run enterprises, and known as the ratchet constraint, and the soft budget constraint. Berliner (1952), Kornai (1979), and others treated the ratchet and the soft budget constraints in the context of a centrally planned economy. It is noted that they apply only marginally to the public sector in FIM, given the very limited extent of a simultaneous state ownership and state management of public enterprises in FIM. The ratchet constraint arises in a situation where the ministerial authority (or central planners) fix a future output target for the public enterprise Q t1 at a higher level than the achieved current output Qt. Calculative managers of the public enterprises will deliberately produce low Qt and pass to the central planners underestimates of their real production to avoid compelling targets. The ratcheting of targets by the central planners creates an X-inefficiency. The problem can be solved by persuading public enterprises to disclose their true estimate of maximum enterprise output, given input authorizations; but developing such mechanism designs is difficult. The soft budget constraint problem applies in situations when the state guarantees that the operations of loss-making public enterprises will be continued nevertheless. As a result, there is no incentive for the public enterprise to economize in the use of capital and to minimize on other costs. The ratchet and the soft budget constraints are incentive problems that are best analysed in the framework of principal–agency theory. Both constraints are also linked to each other in the context of cross-subsidization, as when the ratcheting of output targets for the better performing enterprises is used to finance the soft budget constraints of the loss-making enterprises. Responding rationally to this


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cross-subsidization, both firms will not maximize their effort and will end up in lower efficiencies. 4.2.6 Public sector employees A large number of public sector employees execute and deliver the public services provided by the various ministries and allied publicly funded organizations. public sector employees are lower than the bureaucracy in the hierarchy of decisionmakers. Although public sector employees are not active agents in the political process, they indirectly play a central role in shaping the polity and economy. The nature of the delivered public services of public sector employees differs from that of the private sector results in productivity differentials. Furthermore, the political commitment for equal pay to public sector employees and private sector employees has significant consequences for the operation and outcomes of the polity and economy. Most of the public sector consists of public services. This implies that the product (service) which is produced (delivered) is labour-intensive, and, more importantly, that the employed labour itself is the end product. Public sector employees can be seen as the input that goes in public services, but it is also in a sense the end product of public services. Substituting capital for labour is then simply impossible without changing the nature of the product. This is like trying to replace something (labour) that is part of the product itself. Growth in labour productivity in the public sector is quite limited.5 In contrast, in the private sector labour can easily be substituted by capital without changing the nature of the product, because labour is just an input (an instrument) to the production process from which the end product results. So while substitution of capital for labour in the public sector would change the product completely, such a substitution in the private sector does not change the nature of the product at all, and it has been always occurring, resulting in the increasing productivities of the private sector. These technological differences give rise to the productivity differential between employees in the public sector and the private sector. In the public sector, the growth in productivity stays behind that of the private sector, in relative terms. To what extent are these labour productivity differentials translated in differences in labour remuneration rates? In the private sector, increases in labour productivity are followed by equal increases in wage rates. As a result, unit costs remain constant over time. If this economic principle were followed for the public sector then the relatively lower productivities would go with relatively lower remuneration rates for public sector employees. But, this does not happen. There is a widely held political commitment, a convention, to equalize the remuneration rates of equivalent labour efforts. To prevent labour moving from the public sector to the private sector, wages in the low productivity public sector are set to match those in the high productivity private sector. Given that the productivity growth is less in the public sector compared to the private sector, this implies that unit costs in the public sector will rise. With an income elasticity of demand that exceeds the price elasticity of demand, the output of the public sector will not fall. Rising input costs will then lead to higher total costs of the public sector and

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thus to higher exhaustive public expenditures, presumably destined towards the provision of public goods. As the high productivity private sector would increasingly carry the obligation of financing the low productivity public sector at equal remuneration rates, and the public being a sector with a high demand elasticity, economic growth would tend to slow in the long run. Baumol (1967) analysed formally this problem of productivity differentials that for some non-economic considerations are not transformed in equivalent wage differentials. In his analysis he distinguishes two types of sectors: the (private) progressive sector and the (public) non-progressive sector. A progressive sector is characterized by economies of scale and technological change, which lead to increases in productivity per unit of labour. In the non-progressive sector labour productivity grows at a much lower rate. He righteously recognizes that this difference in productivity is caused by differences in the nature of the product that is produced. The following model summarizes the problem formally. Take X1 as the output of the non-progressive sector, and X2 as the output of the progressive sector. The production functions of each sector are then as follows: X1t a1L1t X2t (a2ert)L2t

(1) (2)

with L1 and L2 being the labour force in the non-progressive and the progressive sector respectively, t is the time index and a1 and a2 are constants. The production in the progressive sector is assumed to grow at an exponential rate of r. Equations (1) and (2) are used to derive the ratio of government output to total output, as shown in equation 3 below:

X1t ( X1t X2t )

a1 L1t ( a1 L1t ( a2 e rt )L2t )

(3)

An implication is that if the ratio of public sector output to private sector output is to remain constant, then it must be that labour is transferred from the private to the public sector. This is indeed observed in reality. It is assumed that wage rates are equal between both sectors and that they follow increases in productivity in the private sector. w0 is a constant, and wt is the wage in period t. wt w0ert

(4)

From the equations above, unit costs can be derived for the public sector in equation (5) and for the private sector in equation (6).

C1t

( w0 e rt ) L1t a1 L1t

w0 e rt a1

C2t

( w0 e rt ) L2t w0 = ( a2 e rt )L2t a2

(5)

(6)


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From equations (5) and (6) it follows that unit costs in the public sector will rise steadily, while private sector costs remain constant. Together with equation (3) another conclusion of the model is that public exhaustive expenditures will rise faster than private sector expenditure on inputs. The growth potential of the economy is only partially realized. 4.2.7 Interest groups Pressure groups are groups that try to influence policy in their own favour. For example, when several firms strive for a monopoly position each of them might try to ‘buy’ these rights by lobbying for protection against competition. The firm who bids the most is likely to get the monopoly position. Each firm’s maximum bid will be equal to the expected profit that will be made in the monopoly position. This example shows that lobbying for favourable policies can be regarded as an auction: the governments supply favourable legislation to groups that outbid their rivals. A group is willing to pay a price equal to the expected profit of protective legislation. Payments in general may take the form of bribes, votes, cash contributions to the governing party, supply of persuasive information, provision of campaign speakers, and so on. These payments are not necessarily socially wasteful: e.g. in the above example, the payments are not more than transfers from the (potential) monopolist to the government. The government, however, spends the received payments. First, it supplies favourable regulations to the one that outbids his/her rivals, which mostly lead to social distortions (deadweight loss). Furthermore, the rest of the money is likely to be used in a non-optimal way by politicians and bureaucracies. For a recent overview of the modelling of government as a rent seeker, see Nitzan (1994). The most influential type of interest group is the one that arises from the income-earning side of the voters. In the market substantial information and transaction costs are present. In such an environment people are likely to be best informed in the area of their speciality, which is their income-earning (production) activity. So producer groups, like firms and unions are important sources of information that have to be taken into account by the government. An additional advantage that adds to their strength is that they dispose of substantial amounts of money that can be used to influence government policy. To influence politics, producer groups have to show that they are more knowledgeable than the best-informed voters. This is very easy because voters usually are generalists, whereas producer groups are specialists. To become a specialist in a certain area a lot of information has to be acquired, although producer groups already dispose of much information. If new information is required it is easy for producer groups to acquire it, not the least because of scale economies in the collection and distribution of data. Producer groups not only acquire information just because they have to, but also because they find it worthwhile to: the potential returns from purchasing information to influence policy are high enough to make the initial investments worthwhile. Of course, income earners will gain directly from any policy that is in their favour. And because this money is spent in a lot of areas, the area of earning is much more vital to them than their spending or consuming activities.

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Policies of democratic governments tend to favour producers more than consumers. Voters whose income is directly influenced by a policy are likely to be well informed (producers), whereas voters whose income is not directly influenced (consumers) will be less informed. Therefore, policies of democratic governments tend to favour producers more than consumers. Examples are tariffs and import control that favour domestic firms and create domestic jobs, while consumers pay in the form of higher prices; or policies that support higher prices in agriculture to protect farmers, and the price incidence is shifted to consumers. This all sounds reasonable, except for one thing: it seems unlikely that votesensitive governments ignore large numbers of consumers and focus only on a small group of producers. Vote-maximizing governments will only be concerned about the income of voters if this affects votes. If this is not the case, or if the voter does not realize that his income is affected, the government does not need to look after the effects on income of voters and can behave discretionary. The argument above still does not explain why consumers do not organize themselves in an interest group, to protect themselves against producers, and so influence policy in their favour instead of the favour of producers. The reason is given by the fact that it is costly to form such groups: consumers have to be located, and negotiations have to take place about how much each individual has to contribute to the group and about how the benefits are divided up. For an individual consumer it is too costly to acquire all relevant information and the benefits to this consumer are likely to be (relatively) small because others can free ride. So overall, the government will tend to oversupply policies favouring producer groups. There are organizational limits to the number and size of interest groups as formulated by Olson (1971). Large groups have higher costs of communication, identifying potential group members, bargaining, higher cost of staffing, and so on. If the group is small, these costs are much lower. As a result more groups will be formed. On the benefit side there is a problem of free riding: the benefits of government policies, partly brought about by lobbying of interest groups, are available to all so that no individual has an incentive to join a specific group. This is the problem of free riding. In that case no group would exist, reality shows otherwise. Olson concluded that groups only exist if they are small (low costs of forming and maintaining the group), or if there is coercion or some incentive to make individuals act in their common interest. Olson explains the existence of large groups in terms of their linkage with private organizations. These groups come into being either through coercion (people working in a certain branch are obligated to become a member of a certain group) or by offering private (non-collective) benefits to individual members. Examples of groups that result from coercion are professional bodies consisting of accountants, doctors, or lawyers, who govern themselves by specifying rules of conduct and minimum standards and qualifications for practitioners. These bodies have the power to discipline members who fail to maintain the required standards. Examples of benefits that can be acquired by membership of a professional body


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are favourable access to insurance, access to recognition, exchanges in conferences and journals, and professional support. So both negative (coercion) and positive (incentives) stimuli are used to maintain large organizations, which can then act as powerful interest groups. Mueller and Murrell (1986) were the first to develop and test the hypothesis that pressure groups increase the size of government. They showed that the formation of bargains between political parties and interest groups leads to an increase in government size, as usually the government budget, together with the passing of specific legislation and political appointments are basic ingredients in the formation of bargains. Empirical results support the hypothesis in that the number of interest groups was found to be positively related to the relative size of government. Interest groups can be also interpreted in a wider sense meaning socioeconomic strata of the population: among others, income classes with distinct interests and expectations. Although these groups do not organize as a pressure group for reasons displayed above, they indirectly influence the political process and political decisions via their voting power, and allegiances to opposing political parties. As policies tend to focus on the median voter, then the median voter, and thus all voters that favour the same policies as the median voter, automatically become a powerful interest group. In such a situation, patterns of income distribution that favour the median voters, and which associate with specific income classes, are more popular and are most likely to be enacted by politicians and be realized. Such a powerful interest group will reject a policy that negatively influences the median voter income. This means that either the policy has to be revised or redistributionary measures towards the median voter has to take place via the tax system or via public spending to their benefit. These measures are meant to prevent loss of votes. If the median voter belongs to the middle-income class redistribution will be towards this middle class, whereas if the median voter belongs to the poor class, redistribution will be directed towards the poor. Downs (1957) calls this the coercion-via-the-ballot-box argument: ‘many poor outvote the fewer rich to impose redistributive tax and benefit regimes’. Apart from their electoral power (when forming a majority), the middle class and the poor could influence policy by acting as ‘real’ interest groups, e.g. poverty lobbies. The size of the public sector in terms of public revenue and spending, and their composition, are thus affected by redistribution of income towards the median voter, who can belong to the poorer or richer income classes. This can be shown by Figures 4.4 and 4.5. The preferred level of public expenditures is given by the maximum utility of a certain level of public expenditures (public goods). At this point the marginal cost in utility terms, or the foregone utility of consumption of private goods due to taxation, is equal to the marginal benefit (utility) of increased public expenditure. In other words, the net marginal benefit (utility) from additional government expenditures is equal to zero. Poor individuals are less willing to give up consumption of private goods for an increase in public goods compared to rich people. They also gain from additional public goods, but

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Utility rich

Utility Utility middle income Utility poor

Gm

Gp

Figure 4.4

Gr

Quantity of public goods

Uniform taxation

Utility rich

Utility

Utility poor

Gr Figure 4.5

Gp

Quantity of public goods

Progressive taxation

this gain normally is less than the foregone utility of consuming private goods due to higher tax payments. Therefore, rich individuals prefer higher levels of expenditures on public goods. This is shown in Figure 4.4 where a uniform taxation regime holds. Moving to a progressive taxation regime (where rich people are taxed relatively more than poor people), as shown in Figure 4.5, poor individuals have to pay now relatively less taxes as expenditures on public goods increase. As a result, poor individuals would prefer a higher level of public expenditures, since the preferred quantity of public goods by poor individuals actually exceeds that of rich individuals. Finally, whether the high preference of poor people for more public goods, and thus a bigger government, will also mean that the poor people will realize the highest benefits from the public goods is not certain. In some countries there is evidence that tertiary redistribution benefits the rich more than the poor as far as health and education facilities are concerned. Housing, public parks, etc. are more utilized by the poor, so that it is more likely that poor people mostly benefit from it.


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The relationships between the interest and influence of income classes via electoral power and voting lobbies on the size of the public sector and the composition of its revenue and spending has been extended in some studies to consider effects on growth and equality. Perotti (1996) emphasizes two mechanisms through which distribution and growth interact, with implications for the size and composition of the public sector. They have been named the fiscal policy mechanism and the socio-political instability mechanism. These mechanisms have in common that equality positively influences growth, reduces the need for redistribution of income from rich to poor income classes, and thus leads to a lower size of the public sector, and a less complex composition of its revenues and spending. By implication, inequality requires redistribution, a greater size of the public sector, more taxation, and less growth. The fiscal policy mechanism states that the preferred level of public expenditures and thus the preferred level of taxation are negatively related to the income of an individual. Since this is also true for the median voter, the median voter’s income and the level of expenditures and taxation are negatively related. At the same time, the level of expenditures and thus taxation negatively influence growth through their disincentive effects. In sum, this means that more equality, implying less need of redistributive expenditure and less distorting taxes, leads to higher growth. The socio-political instability mechanism emphasizes the phenomenon that in a country where urban slums and backward regions endure, and distribution of income and endowments are highly unequal, dissatisfied groups will ask for redistribution policies. If not listened to, the leaders of the dissatisfied groups will ultimately organize themselves in an interest group in the sense of a pressure group and put pressure on the government. This can be done by using political channels or by using ways outside the political marketplace, such as engaging in protests, riots, assassinations, and so on. In such a context, an unequal distribution of resources and opportunities will lead to socio-political instability that will further discourage investment and growth and cause uncertainty and market disruptions. By the same reasoning, equality ensures socio-political stability and growth. In FIM countries agents employ the state to redistribute income beforehand, so that a situation of socio-political instability is less likely to occur. The government therefore has to increase the public share by an amount that is reserved for redistribution purposes. By doing so, FIM countries and their governments manage to sustain a moderate level of stability and equality, combined with a relatively high share of the public sector in the economy, and a lowered prospective for economic growth. These relationships will be examined further in the chapter. 4.2.8 Checks and balances: Country tendencies In a FIM environment private agents, households and firms alike, would allow state agents freedom of action up to the point where the returns to costs of involving state institutions is equivalent to returns from average private activities. As there is no way of calculating such margins, private agents take comfort with the

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presence of checks and balances on the actions of state agents. In a FIM environment, state agents would also appreciate the presence of checks and balances on their actions since these would function as a guarantee of their political credibility. The observance of the checks and balances by state agents enhances the acceptance of the polity, together with what one can call permissible political influence, in a socio-economic system that is otherwise dominated by firm intensive behavioural features. To obtain an idea of the forms and extent of checks and balances imposed on state agents in the FIM context, and the systemic changes that these institutions may undergo over time, we show in Table 4.1 values for four proxy indicators in FIM related countries in 1975 and 1995. The indicators relate to the composition of the executive authority: proportion of fractionalization in government (indicator 1), special interest party in government (indicator 2), legislative control on government (indicator 3), and autonomy of the judiciary in relation to government influence (indicator 4). The table shows a stable system of controls on government in US and Canada in the sense that the height of the indicators remains the same over two decades. The table shows also a convergence among the EU

Table 4.1 Political power and political institutions in firm intensive systems: Country tendencies Country

(1) Fractionalization in government

(2) Special interest party in government

(3) Legislative control on government

(4) Align courts to government

1975

1995

1975

1995

1975

1995

1975

US Canada

0.00 0.00

0.00 0.00

0 0

0 0

4 3

4 3

1 1

1 1

France Germany Italy Netherlands Sweden UK

0.45 0.00 0.00 0.70 0.19 0.00

0.50 0.45 0.00 0.66 0.00 0.00

0 0 1 1 0 0

0 1 0 0 0 0

6 3 4 7 3 3

4 4 2 5 2 3

0 0 1 0 0 0

1 0 1 1 0 1

Japan Korea

0.00 0.00

0.47 0.00

0 0

0 0

2 3

5 2

1 0

0 0

1994

Source, notes: Indicators 1.2.3 are from T. Beck’s database of political institutions at http://econ. worldbank.org/wbsite/external/extdec/extresearch/0. Indicator 4 is from W. Heinsz’s dataset on political constraints, at http://www-management.wharton.upenn.edu/henisz. (1) Proportion of government fractionalization, indicator reflects the strength of minority fractions in executive affairs. (2) Is executive party special interest? Is first government party special interest? Are any coalition parties in government special interest? (3) Composite score of checks and balances by legislative on government actions. (4) Are judiciary courts aligned to government (majority appointed by sitting executive or 2/3 appointed by sitting executive’s party)?


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countries, Japan, and Korea towards the degree of control on the polity held in US and Canada, with the exception of fractionalization in government. This indicator is significant in most EU countries and Japan, which can be interpreted as an additional check on the discretionary behaviour of political agents. This can be expected in national contexts where voters are more fractioned along differentiated political interests.

4.3

Public regulation and national welfare

In the previous chapter it was shown that economic failures in the FIM, urge firms to innovate divisible technologies, engage in signalling and transparent governance, and act to internalize externalities, and where the limits for firm responses are reached, firms call for government actions to correct the economic failures. Firms urge for state actions in the sphere of public regulations to combat monopoly, reduce uncertainty, and internalize externalities. Households too urge for public regulation of matters relating to civil rights and community matters. Firms, and households alike, call also for state interventions in the sphere of the public spending. Public spending is the basic instrument for provision of industrial infrastructure and other public goods, securing income maintenance, and applying law and order. This section assesses state intervention relating to public regulation, while the next section assesses the task of public spending and its financing. If the objective of an analysis is to determine the degree of state power in a given economic system, then one has to go beyond considering only the extent of public regulation and the share of public spending, and extend the analysis to consider a host of other aspects falling under control of the state such as foreign exchange financial reserves, property ownership, appointment rights, mass media, etc.6 Public regulation of private business may carry disadvantages and repercussions that can be described as polity failures. We have already introduced in the previous section the background to these polity failures. In this section we shall review two potential polity failures: (1) uncompensated gainers-bias and losersbias, (2) acquiring and use of political influence by state agents for rent appropriation, carrier promotion, etc. First, state interventions cause gainers-bias and loser-bias and these can potentially reduce social welfare to the extent that the gainers do not compensate losers. State interventions in the sphere of regulations are almost always bound to favour one party at the cost of another party. For a state intervention to be socially efficient the sum of benefits and costs for all parties need to be sufficiently positive to compensate the interventionist service of the state and satisfy all parties concerned, which is not always the case. A similar reasoning would apply to the state budget. The costs and benefits of the state budget are never evenly distributed on all taxpayers. There is thus in the FIM economic system an economic failure with lost opportunities. Combating the economic failure with state interventions realizes gains in opportunities for some agents A and losses for other agents B. To the extent


that the imposed losses on B are not compensated somehow by the windfall gains of A, one can argue a case for polity failure as well. Considering the sum of benefits and costs, it is evident that gainers can significantly outweigh the losers in the case of public spending on public goods with significant positive externalities; but the issue is whether the compensation from the over-gainers to the losers is actually realized. Second, we have already treated various aspects of the acquiring and (distortion) use of political influence by state agents. We examined selected aspects of the functioning of the executive branch, the sources of political influence, and the impacts of the political influence on the economic system. It was maintained above that while the basic function of the executive branch in the FIM system is to apply state interventions to remedy market failures, the state interventions have consequences that go beyond the remedies of market failures. Being political in motivation, the executive branch can acquire and use political influence for the benefit of the beholders, and that can negatively affect economic performance and social welfare, and thus constituting a polity failure. In the sphere of public regulations state agents can act with discretion to benefit themselves and other state agents. Where this happens discretionary behaviour becomes a major source of polity failure. We have emphasized that the FIM system includes checks and balances at various levels and a juridical structure that aim at minimizing and eliminating such discretionary behaviour. Even though the state settings may be able to appropriate some rent, the checks and balances in FIM see to it that rent appropriation if it happens is not institutionalized and is prevented from getting a permanent place in the economic system.

4.4

Public spending and national welfare

Tendency towards a larger size of government. It was observed in this chapter that the political market in FIM is likely to lead to the overexpansion of public spending, and to result in a larger public sector at the cost of the private sector. This is borne out by historical facts. On the whole and for many decades, public spending has been increasing at a higher rate than private spending in the FIM nation states. This section will evaluate the comparative empirical material on these trends and will seek interpretations of these trends in terms of the interests and interactions of private and state agents in the FIM environment. We have maintained that there are different forces that push up the public share: those driven by private agents, and those driven by state agents. For example, (a) firms and households alike have an increasing demand for public goods and this requires more public spending and an extended state sector; besides, there are inevitable exogenous forces such as periods of wars and emergencies that raise the need for collective action and a greater share of public spending, and the community as a whole recognizes and endorses these needs and their implications. Likewise, (b) various state agents are politically motivated to enlarge their spheres of influence and expand public spending.


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We maintain that for the FIM nation states of US, EU, Japan and alike, taken as a whole, the role of (a) is far greater than (b). This does not exclude differences between the countries apart. For instance, it can be reasoned that a lower public share outcome in US than in EU would reflect a relatively greater dominance of (a) on (b) in US than in the EU. This section will examine further comparative empirical evidence that suggests that the overexpansion of the public sector at the cost of the private sector may slow economic growth and lower welfare in the long term, next to causing resource misallocation. Adolf Wagner (1835–1917) was among the first to specify the relationship between the public sector and GNP. Wagner’s law, as it became to be known, states that an increasing share of public expenditure in GNP accompanies the development of an industrial economy. Wagner observed and predicted that public spending grows at a higher rate than GDP. Table 4.2 demonstrates the applicability of Wagner’s thoughts. All OECD countries experienced an annual growth rate in public expenditure greater than that in GDP. The OECD mean of the public share amounted to 39 per cent in 2000, with US and Japan consistently below the average over the mentioned periods and EU countries above the average. Although the share of tax revenue in the GDP has been lower in US and Japan than in European countries, the latter have consistently higher budget deficits than the former due to the relatively higher public spending. The share of the budget deficit in the GDP was around 2 per cent in US and Japan as compared to an average of about 5 per cent in the six EU countries in the reported years. Since the year 2000, the gap tended to close. Under the common Euro currency, the EU maximum target for the budget deficit that participating member countries should observe has been fixed at 3 per cent, and most participating member countries are operating within this limit.

Table 4.2 FIM related countries: Fiscal shares in the GDP, 1960–2000 Share of total government expenditure in GDP ⴝ GE/GDP

US Japan France Germany Italy Netherlands Sweden UK OECD mean

1960

1970

1980

1990

2000

Growth 2000/1960

27.6 18.3 34.6 32.5 30.1 33.7 31.1 32.6 28.3

31.3 19.3 40.3 39.2 34.7 43.9 42.8 39.6 32.3

32.9 32.0 45.5 47.7 45.2 58.0 61.1 43.4 38.7

32.1 31.3 49.8 46.3 50.5 56.7 58.1 38.0 37.7

31.6 35.6 53.9 47.4 49.5 47.5 59.6 39.2 39.0

1.14 1.94 1.56 1.46 1.64 1.41 1.92 1.20 1.38

GE/ GDP Average ‘60–2000

TR/GDP average ‘60–2000

Share of budget deficit

31.1 27.3 44.8 42.6 42.0 48.0 50.5 38.6 35.2

29.1 25.0 40.4 36.4 31.2 42.7 47.5 36.4 33.6

2.0 2.3 4.4 6.2 10.8 5.3 3.0 2.2 1.6

Source: OECD Expenditure and Revenue Statistics of OECD Member Countries (1963–94), Tables 1 and 6.5, and supplemented from the OECD sources for year 2000. Share of government expenditure in GDP GE/GDP. Share of tax revenue in GDP TR/GDP. Share of budget deficit in GDP GE/GDP TR/GDP.


Furthermore, the table shows a tendency for a downward correction in the public share after remarkable rises as in the case of not only UK and the Netherlands but also Ireland and New Zealand, which are not shown in the table. The table shows also upward corrections after long periods of a low public share, such as in the case of Japan. The downward corrections are often associated with calls by political parties in opposition and on the verge of parliamentary election to downsize the public sector, reduce the budget deficit, and follow a smaller public share as in US, Japan. Economists attribute the tendency of a rising public share to a rising demand for collective goods as the economy grows. The primary driving forces behind this demand for collective goods are the private agents who demand these collective goods, even though state agents may contribute to pushing the demand further. These forces and other specific causes have been covered in abundant empirical investigations of the rising public share over time for specific countries and across countries at different levels of development.7 Changes in the pattern of governments over time tell much about the changing tasks and changing areas of focus of the state and the forces lying behind the changing pattern of collective needs in the longer run. The works of Musgrave (1969) and Rostow (1971) have looked at the time pattern of public expenditure in the development process of countries fitting most in the FIM. Following them, three phases in the development process are commonly distinguished: the start up phase, the growth phase, and the maturity phase. In the start up of economic development, some basic physical and human infrastructures are essential to start up the economy for economic growth. As this infrastructure has necessarily a public goods character the state leads, and is assigned, the task of providing the capital infrastructure. Government investments in the early stages consist primarily of investments in physical and social infrastructure: roads, education, health, law, etc. In this phase public sector investment as a share of total investment is relatively high. In the growth phase, the government continues to invest in the same types of sectors, but now these investments are complementary to private sector investments. Market failures can arise which frustrate the push towards maturity. Governments are called upon to deal with these market failures. Whenever this happens, government expenditures and revenues rise. The rise is moderate in case of state interventions in the sphere of regulation and monitoring (typical for market failures relating to indivisibilities, uncertainties, and externalities problems), but the rise is greater when public goods and income transfers are expanded (typical for market failures relating to collectivities and distribution problems). At one time, the maturity phase is reached. Here, total investment as a proportion of GNP increases, while the relative share of public sector investment falls. In the maturity phase the mix of public expenditures shifts from expenditures on infrastructure to expenditures on education, health, and welfare services, like income maintenance programmes. Also redistribution policies become more important. And, the public expenditure elasticities with respect to these social services tend to be higher than for infrastructure. This is also the phase


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that is observed in all FIM countries today, where the state is allotted the task of caring for public goods arising from collective needs of households rather than firms and organizing income transfers and security payments to least privileged households. The changing composition of the population towards the more aged accentuates these tasks.8 Among the inevitable tendencies that drive the public share upwards in FIM countries is the changing demographic composition. A greater share of the aged in the total population increases the demand for public goods and public transfers for income maintenance.9 While the changing pattern of collective needs of private agents is the primary force behind the changing pattern of public spending, private agents influence public spending in other ways. Mention was already made of the mutual interaction between the motives of politicians to gain the votes of interest groups, and the desire of competing interest groups to be served first and foremost in terms of public spending. The political motives of state agents and the private desires of interest groups reinforce each other and push the state in the direction of higher public spending on both public goods and income transfers. We dealt also with a built-in bias towards a bigger public share that is due to a productivity differential between public sector employees and the private sector labour that is not transformed in wage differentials. The requirement of equal pay for public and private sector workers can be described as a political objective, but it can be rationalized also on techno-economic grounds as a merit proposition that conforms to consumer preferences. It is important to emphasize that if the principle of equal pay is merited and endorsed by the concerned community, then it will not be correct to consider the principle a polity failure even though the application of the principle would lead to a higher public share, a slower economic growth, and a lower level of economic welfare. The implication is that the community prefers to get and give a higher weight to public goods relative to private goods, while accepting that the aggregate level of economic welfare will be lower. There are changes in the external environment, such as in times of war and insecurity, which tend to extend the functions of the state, and elevate public spending. For example, during wars or fears for wars, public sector expenditures rise at a higher rate to finance military necessities. Peacock and Wiseman (1961) have made a profound study of the time pattern of public expenditures that accounts for the influence of periods of unrest and insecurity on public expenditures. Their argument runs as follows. As an economy grows, tax revenue (tax rates are constant) increases proportionally, thereby enabling public sector expenditures to grow at the same rate, in line with GNP. In normal times therefore public sector expenditures show a gradual increase. During periods of unrest and insecurity this gradual pattern will be disturbed. Public expenditures will suddenly rise disproportionately, whatever cause of the unrest or insecurity. To finance the increase in expenditures, it is necessary to raise taxes. This is largely accepted in times of unrest and insecurity, because people realize the necessity of raising taxes. Peacock and Wiseman call this a displacement effect: during crises, public expenditures, financed by an increase in tax levels, displace private


expenditures. After the period of the crisis, public expenditures tend to fall back but they do not fall to their original level before the crises. Mention was already made of politically motivated state bureaucracies in a FIM environment that pushes for an over-expanded budget of the public sector. Where state bureaucracies use imperfect information to exaggerate the demand for public goods and income transfers, overestimate general and project public expenditures, and underestimate public revenues, they succeed in raising the share of the GDP that goes to the public sector, i.e. the public share, at the cost of the private share. However, this influence of state bureaucracies is regularly constrained by governing politicians and opposition parties in a FIM environment, on behalf of voters who are inclined to demand downsizing of government when excesses occur. Size of government and economic growth. With due consideration of cyclical tendencies, the real growth rate of the GDP in FIM focused economies manifests a declining trend since the 1960s. There are various explanations of the declining growth. These vary from the less verifiable argument that higher levels of living in a matured economy are likely to associate with a lesser need to economize on material goods, to more verifiable arguments such as the ageing population that is more consumptive than productive, higher labour costs, diminished returns to capital, outflow of capital and investment to countries with lower labour wages and higher capital returns. Another argument for the diminishing growth, which is of special concern here, is the increasing size of government. We shall examine here the empirical tendencies and ways of interpreting these tendencies. The two variables of public share and GDP growth show opposite trends since the 1960s, as is demonstrated in Table 4.3. The table polarizes the relationship by focusing on the five countries with highest and lowest public shares in 1960 and 1990 and examining the GDP growth record in the consecutive five years, respectively, i.e. 1960–65 and 1990–95. Countries with lowest public share show a reduced GDP growth of 1.6 per cent with an increasing public share of 19.2 per cent , giving a falling GDP growth/public share propensity of .08. The propensity for the countries with highest public shares can be calculates at 5.5/33.5, or 0.16; which is further evidence of the acceleration of the negative tendency for countries with relatively more public spending. The negative relationship between the two variables is also directly observable from plotted observations in Figure 4.6. In principle, a minimum public share to cover such state activities as civil security and provision of basic public goods is required to allow a sustainable economic growth. These are the beneficial effects. However, as government continues to grow and relatively more resources get channelled via the public sector at the cost of the private sector the beneficial effects tend to reverse into detrimental effects for economic growth. There are various mechanisms behind the negative tendency. First, as government grows it may adopt activities that are more suited to the private than public management, causing diminishing returns for the adopted activities. Second, next to the negative effect of extended public spending on the


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Table 4.3 FIM related countries: Public share and economic growth, various periods Public share = GE/GDP Countries

1960

1990

Change

Growth rate of real GDP 1960–65

1990–95

Change

Five countries with smallest increase in public share US

27.6

32.1

4.5

4.4

2.2

2.2

Iceland

28.2

37.3

9.1

4.5

1.5

3.0

Ireland

28.0

37.7

9.7

4.1

5.9

1.8

UK

32.6

38.0

5.4

3.5

1.2

2.3

New Zealand

27.7

42.3

14.6

5.0

2.5

2.5

Average

28.9

39.1

19.2

4.3

2.7

1.6

Five countries with largest increase in public share Spain

13.7

45.4

31.7

8.5

1.8

6.7

Greece

17.4

49.4

32.0

7.2

1.2

6.8

Finland

26.6

59.4

32.6

5.6

0.0

5.6

Sweden

31.1

58.1

27.0

4.9

0.6

4.3

Denmark

24.8

60.8

36.0

5.9

2.0

3.9

Average

22.7

56.2

33.5

6.4

1.1

5.5

Source: OECD Historical Statistics and OECD Economic Outlook, various years.

9

GDP growth 1960–5, 1990–5

8 7 6 5 4 3 2 1 0 0

10

20

30

40

50

60

70

Public share 1960, 1990

Figure 4.6

Negative relationship between public share and GDP growth in FIM countries

Source: Table 4.3 columns 1, 2 on the X-axis, and columns 4, 5 on the Y-axis.


long-run economic growth, the over expansion of public spending, as when it is due to bureaucratic influence and is not endorsed by the community as a whole, results in the misallocation of resources and a reduced national welfare. Third, once adopted, counterproductive activities tend to stick to the public sector as compared to the more dynamic private sector where adjustment to change is more rapid and elastic. Of course, expanding the public share to satisfy more collective needs can be a matter of legitimate choice. The adoption of more public goods that are particularly more demanding in terms of national resources and are consumptive in nature cannot be avoided, especially when the voters unanimously endorse them. There is a trade-off between these consumptive public goods and economic growth. There is the noncommittal view that the value of this trade-off is not an absolute figure but a value judgement that varies with the respondent, implying that the issue of an optimal size of government may not be identifiable without weighing preferences. The problem arises when voters are not unanimous in endorsing the collective need. There is the opposite view that if one abides with the common practise of giving equal weights for all agents then working with indicators of life satisfaction across the nation would indirectly include both objectives of collective needs and economic growth, and the issue of the trade-off can be ignored. Along this line of thinking, cross-country empirical studies show that life satisfaction indicators are negatively affected by an increasing government size.10 Finally, any public spending requires public revenue collection. In evaluating the impact of public revenue collection on national welfare the following can be stated. Taxes that are collected for spending on strengthening market institutions, stabilization in the face of uncertainties, and correcting externalities are designed to make allocation of resources more efficient in the sense of Pareto optimality. Tax collection and its use for meeting collective needs and income redistribution may also bolster the efficient allocation of resources. But taxes can also lead to misallocations of resources if the ensuing effects run contrary to consumer preferences. Apart from the spending avenues of a tax, there is the incidence effect of levying the tax and this depends on the type of tax levied. To demonstrate the argument take the simplest case, which is that of an excise tax on good j, ti. The tax will result in a consumer price pj, which differs from the producer price pj tj. For goods i and j the consumers are faced with MRSij pj/pi. Producers are faced with MRTij (pj tj)/pi. With MRSij unequal to MRTij the conditions for Pareto optimality are violated and both consumers and producers will have to adjust their utilities downwards as a result of the relative price distortions. A sales tax gives a distorting effect similar to the excise tax but is biased against consumption and in favour of savings. An income tax has a substitution effect (makes work less remunerative and encourages leisure) and a negative income effect (implying less leisure to maintain same income level). The distorted outcome is a mixture of both effects. A lump-sum tax is not related to the individual’s economic activity and does not have a substitution effect. This neutral character of the tax makes it highly recommendable for economic policy.


4.5

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National accommodations to differing polities

In this and the previous chapter we demonstrated the application of the FIM in various industrialized economies. Even though these countries share common features within narrow ranges, the diversity is significant and meaningful. In principle, differences can be sporadic or systemic. If these differences are randomly distributed, then there are as many forms of capitalism as there are nation states, and there is thus no ground for analysing country groups as belonging to major types of economic systems. Fortunately, this is not the case. The differences are systemic: groups of countries tend to cluster around common heritages and paths reinforced by differing polities. So, where do FIM countries differ, and why? Where do FIM countries differ? On the basis of various indicators on degrees of nationalization and regulation, corporate ownership and governance, outward openness, and public share (including both public goods and income transfers), and other considerations to be displayed below, we have positioned US in the centre of the firm intensive economic system, and placed Japan to the left of US on the firms-household axis, and EU to the right of US on the firms-state axis, as in Figure 4.7. This configuration is consistent with classification results in past and more recent comparative studies. These studies generally agree on a distinction between three configurations for industrialized economies11: the liberal-oriented, the reconciliation-oriented, and the control-oriented capitalist systems. The liberal-oriented capitalism is the configuration where coordination is run along commercial logic and profit maximization by firms, and where there is moderated competition monitoring, and limited public goods provisions and income transfers. Countries in this category have a freer operation of the product and factor markets, and relatively greater competition, higher factor mobility, wider income differences, and smaller public share in the GDP. The initiatives and responses of firms weigh more than the response of the state in matters of market failure. Firm settings dominate state settings. The English-speaking industrialized countries are found in this group, led by the United States.12

Japan

US

HIM

FIM

EU

SIM

Figure 4.7

Positioning of FIM countries


The reconciliation-oriented capitalism is one based on frequent negotiations between firms, workers, community leaders, and public authorities at various levels of decision-making with the object of reaching consensus agreements among these groups on restrictive and promotional measures that correct for market failures and bolster group welfare. The reconciliation approach often contains elements of fair sharing of benefits and costs among the involved parties, which is a common principle in household settings, and HIM in general. The reconciliation can be coordinated at higher or lower levels of decision-making and under initiative and guidance of one or more of the involved parties. In Japan and Korea reconciliation occurs at a higher level of decision-making such as under corporate guidance. Big firms, allied workers, and community interests combine together to form conglomerated groups not only big enough to internalize externalities among its components, but also big enough to stand for recognized interests and to deal directly with ministerial authorities and formulate common strategies and actions.13 The control-oriented capitalism assumes regulated competition, moderate factor mobility, moderated income differences, and a larger state budget. Countries with a control-oriented capitalism are characterized by an array of state interventions at national, regional, and local levels meant to correct for market failures. Firms tend to shift part of their response in the correction of market failures towards the state. Although the resulting state interventions can be interpreted as serving the social interest, state interventions may at times serve the benefit of special interests, and if they are too many these interventions can restrict the free operation of commercial exchanges. This profile is typical of most continental European countries, with France being foremost. We elaborate further on the positioning of US, WE, and Japan. Among the FIM countries the US is likely to show a greater domination of the economic motive on the political motive in most behavioural settings. The positioning of US at par with FIM needs to be seen in a relative sense to the other countries, and specially when US is contrasted with the ex-Soviet Union as representative of a state dominated economic system. The order of subordination is reversed. While the economy directs the polity in US, it is the polity that stands above and controls the economy in the ex-Soviet Union, as will be shown in Chapters 5 and 6. All indicators considered in the previous and the present chapter show that market mechanisms and firm dominance are more advanced in US than the other FIM countries. The public share is also remarkably lowest in US, followed by Japan, and after some distance by the WE countries. Japan, a FIM country with sharing and reconciliation features, carries influences of a HIM environment. This fact is reflected in the positioning of Japan closest to FIM with a stretched link to HIM as in Figure 4.7. The reconciliatory orientation associates with agent interactions over long times within agricultural households, tribal environments, and the isolated island environment. At the same time, there are the drives to exploit outside relations and these associate with limited domestic resources, a large population, and the desire to maximize welfare.


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Households have long-term relationships with the employing firm, resulting in a relatively low labour mobility. Direct wage payment tends to be below labour productivity, and the difference used to ensure more income. Households have high savings ratio and prefer safe investment. Firms, mostly conglomerates, remunerate labour inputs following features of a share economy. Next to a base wage, there is often a share in profits, amounting to about a quarter of all earnings. Employees have long-term career development with employing firms, and lay-offs are relatively limited. Internal management of firms follows horizontal coordination and hierarchical incentives. External management is characterized by the firm being coupled to a main bank that is the primary stockholder. External management would delegate decision-making fully to corporate management and would intervene only in case of anticipated firm failure. Banks avoid bankruptcy and choose for restructuring and takeovers. Firms are mostly conglomerates. Government has a close understanding and coordination with firm conglomerates and main banks, and a qualitative role in industrial policy (government offices are invited to supervise individual industries, and larger sectors, negotiate low tax rates, investment incentives). In spite of the state support, the share of the public sector in the GDP remained low, around 25 per cent, which is closer to US than to EU. This is possible because the business sector takes care of such imputed transfers as social welfare and unemployment benefits. The orientation of Japan towards exports and the position of US as main importer, next to the position of US as an introducer of modern occupier policies shortly after the Second World War contributed to an extension of firm settings and associated behaviour. There is more recent evidence that Japan may be shifting more and more towards a fully fledged FEM, at the cost of some sharing features.14 The case of EU is more complex. We have positioned the EU closest to FIM with a stretched link to SIM, Figure 4.7. This is at best an aggregate picture of the European Union, as the EU members are quite diversified. In the EU there is a country like UK which shares the liberal-oriented capitalism of the US, and there are the Scandinavian countries, and to a lesser extent the Netherlands and Germany, which have reconciliation-oriented capitalism, with incidental elements that resemble some of those in Japan. Though, the rest of the EU countries led by France, Italy, Spain, and undoubtedly the newly accessing member countries of Central and Eastern Europe, are more inclined to the control-oriented capitalism. Taken across the board, although agent settings in the EU are intensively centred on firms, there are on the average more important influences of the state in matters of market regulation and public spending in most EU countries, as compared to US or Japan. The individual countries of EU are undergoing structural changes towards a unified structure in the framework of further unification and integration. It is more likely than not that the outcome of the unification process would reflect the tendencies in the majority of the EU countries, which is a control-oriented capitalism. However, the process of unification is complex and long, and the outcome can be subject to many influences that are unknown yet. A significant fact is that the

140


national jurisdiction in the EU countries is overlapping. Approaching a unified jurisdiction would require significant institutional balancing among the members. How much jurisdiction and decision-making should be integrated at a central level in the EU, and how much of these matters should be left as they are in the hands of national parliaments and governments is by far the greatest problem waiting for solutions in the EU unification process. The EU Parliament and the EU Commission, which is the executive branch, have been so far advocating a greater shift of legislation and decision-making authority from the national parliaments and governments towards the EU Parliament and EU Commission.15 Governments in individual countries are not enthusiastic for centralization as this implies loss of political influence at the national levels. The country differences and the difficulties faced in reducing these differences are accentuated by country politics and vote catching that tend to accentuate national identities. To simplify and strengthen collective decision-making at the highest levels a proposed EU Constitution was drafted and put to vote for EU member countries. However, an increasing number of governments of EU countries have capitalized on the failure of the proposed EU Constitution to gain majority support in popular referenda in France and the Netherlands, and likely other members too if referenda were held there; and have subsequently called for adjusting the proposed EU Constitution to accommodate for greater autonomies of the member states. If greater autonomy will be the outcome of the unification process the implication would be a continuation of the control-oriented capitalism at the national level. In general, a transfer of polity power from nation states to the central authority in EU will tend to reduce state intensive interactions in state settings of the member countries and is likely to promote more firm intensive interactions, and further rapprochement of a FIM in the US sense. At the same time, a shift of more decision-making powers to the central authority of the EU need not mean a more powerful state at the cost of firms. A greater centralization of EU authority, and less political influence of national governments, often gives more freedom to firms to extend their influence. Besides, a central authority is not only able to speak for the whole, engage in negotiations at a world level, extend its influence but also be subjected to interaction with and the influence of other major powers. One indication of a gradual policy shift towards the liberal-oriented capitalism of the US is that after significant negotiation pressures in the context of the World Trade Organization (WTO), the highest authorities of EU agreed to liberalize its agriculture and remove agricultural subsidies by 2013. Another indication of a shift in similar directions is the debates on relaxation of regulations on market power and legislations on labour mobility. Why the differences and whereto? The above three varieties of countries share basic features of the firm intensive economic system, and yet they manifest significant differences between them. How to explain these differences within the framework of the FIM, and what are the expectations on convergence?


141

The US was portrayed as the corner stone of the firm intensive economic system, FIM. The EU countries were portrayed as generally FIM but with a closer link to state settings. Japan was portrayed as generally FIM but with a closer link to household settings. There are two viewpoints for explaining the mutual presence of the three contrasting varieties within the same general system. The first viewpoint appeals to path dependence and supporting beliefs leading to multiple equilibria. The second viewpoint appeals to the universality of one development trajectory, though with phases, in which the US is in a phase ahead of Japan and EU. The two explanations can be displayed making use of themes from a few recent comparative studies. The first explanation sees the differences as the result of common sense responses to specific environmental settings, which develop later on in embedded traditions and path dependencies. Once a set of institutions develops and reasonably functions within the polity setting, and is being reasonably accepted by the actors concerned and endorsed by the polity, most of these actors tend to accept that large investments have gone into maintaining these institutions and that it is too costly and not worthwhile to replace a coherent set of institutions for an alternative, even though the alternative can be shown to render other benefits elsewhere. Applied to the welfare state, it was observed earlier that the public sector plays a greater role in transferring social security payments, unemployment, health and poverty benefits to the needy in the EU than in the US; and hence tax incidence is higher in EU than US. There is also empirical evidence showing that the greater these benefits are the greater their possible misuse, and thus having surprisingly as consequences the prolongation of unemployment, low mobility, and retarded economic growth. Higher taxes retard growth as well. These phenomena are more common in the EU than the US, cf. Gabisch (2000), Lindbeck (2003). The tendency to carry on with what one has gets further support via the belief in the goodness and fairness of what exists as more persons experience it. In reference to the European setting, some emphasized that as the share of welfare beneficiaries increases the belief in the goodness of the extended welfare state and associated public policies get strengthened.16 In contrast, a striking aspect of the American free enterprise system is the extent to which people, rich or poor, feel that individuals are entitled to the incomes they earn, no matter how large; and that poverty is the fault of the bearer.17 Alesina and Angeletos (2003) modelled the interaction between the real world, government policy, and people belief in two different settings representing the US and EU. Their conclusion is that when the interactions settle they are bound to produce multiple equilibria.18 Benabou and Tirole (2005) show similar results.19 Empirical surveys by Alesina, Ditella, and Macculloch (2001) support the differences between the two settings. The survey questions applied to European and American respondents showed that Europeans prefer more equal societies than Americans, and that this attitude associates with a lower social mobility in the EU than in the US.

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The second explanation singles the advanced phase of the US as a FIM country, and the tendency of countries in lagged phases to adopt US examples. More intensive interactions within and between firms in the US result in a greater practicing and acceptance of maximization of financial benefits, greater competition, lower public share, and less state regulation. Japan and EU are seen to be in an early phase of this interaction process. As these countries experience more FIM interactions and features, and due to more interaction with US, these countries tend to adopt more US examples.20 The duration of the convergence process is long, and hence different varieties of FIM can be observed. The two explanations are reconcilable to the extent that a turnaround from three equilibria to one equilibrium is predictable. When the median voter in US is financially better off for the same unit of effort than the median voter in the EU or Japan, and under conditions of complete communication between agents in the US, EU, and Japan, then the median voters in the EU and Japan would be induced to move to US or push for a transformation of the EU and Japan setting and institutions towards the US setting and institutions. Such moves will require long times to materialize. As of the present moment, the median voter’s ratio of financial gain/effort is thus likely to be equivalent in the US, EU, and Japan, which explains the mutual presence of differing variants within basically the same economic system. The interest in the issue of convergence or divergence of the EU towards US is not only of academic interest but is also highly political, and it is currently very relevant as the European Union elaborates further on its future integration trajectory. There is an intensification of the political discussion in the EU on the desired ultimate steady state and on the prospective union policies that go with that. The heated discussion reflects the contrasting institutional orientations of the member countries.

4.6 Summary and conclusions In countries that lie close to a purely firm dominant system, the closest to this will be the US, the behavioural motive of profit maximization would have sufficiently spread across the spectrum to become the institutional norm that guides not only the actions of the firm but that of the state too. In the extreme, all actors in a firm dominant system will behave as profit maximizers. Political behaviour can be interpreted in a FIM economic system in terms of economic motivations and economic exchanges. The political process in such a system can be described as exchange processes involving state agents acting within constraints laid by political institutions, similar to the functioning of an institutionalized market. The elaboration of an analytical framework that interprets the polity transactions as economic ones, and application of such an analytical framework to the FIM related countries requires addressing several questions that are treated in the chapter. Who are the main actors in this polity? These include voters, political parties, governing politicians, bureaucrats, interest groups, and public sector employees.


143

For each of these we explained how they function and interact in the FIM nation state in relation to two main activities: public regulation and public spending. As regards political institutions we touched upon their role as checks and balances that constrain arbitrary behaviour of state agents. The political institutions are viewed as instruments serving the FIM system. Cross-country and cross-period comparative data are used to detect systemic changes in political institutions. There are many areas in which the state is neutrally active, in the sense that it is not taking side with one or the other beneficiary. But in the two areas of public spending and public regulation state agents may not be always neutral. Separate sections examined the functioning of the polity in the two areas and consequences of this functioning for the economic and social welfare of the nation as a whole. In the case of public spending, this has been increasing in the recent past at a higher rate than private spending in the FIM nation states. We evaluated the comparative empirical material on these trends and sought interpretation of these trends in terms of the interests and interactions of private and state agents in the FIM environment. We examined also the plausibility of retarding effects of higher public shares on economic growth and found that the empirical evidence supports the statement. In the case of public regulations we focused on uncompensated gainers-bias and losers-bias, and the acquiring and use of political influence by state agents for rent appropriation, carrier promotion, and alike. Finally, even though a group of nation states share in common the FIM economic system, the independent functioning of differing polities in different nation states tended to increase country divergences within the FIM group. We elaborated in this context on several features of the divergence between US and EU, among others, and sought system oriented explanations for these divergences.

5 The State Intensive System: Past Polity of the Soviet Union and Allied Countries

5.1

Introduction

Why do we call the economic system a state intensive economic system, SIM, and not socialist, communist, centrally planned as some others call them? The first chapter reflected on this question. The point is that state settings dominate other settings in this system. State settings in this system are all-political in their behaviour and via their dominance over and interaction with other settings, these latter get reshaped and are ultimately geared towards adopting rent appropriating behaviour typical of intrinsic state settings, organization structures, and coordination mechanisms. The main features common to the communist regime of the Soviet Union, but generally speaking to an all-political state intensive economic system, SIM, can be summarized in four categories. (a) The state has a (communist) ideology that offers the best promising prospects for the people. (b) The (communist) ideology and realization of its promises are contracted to the state’s party. (c) State is the sole owner of property. (d) State is the sole coordinator and driver of the economy via a system of central planning and monitoring. The operation of the four features stated above in the real world deviates from what the control sphere desires it to be. There are substantial differences between the prescribed rules and practice. It is important to recall here the distinction by Kornai (1967) between the control sphere and the real sphere. In the Sections 5.2, 5.3, 5.4, and 5.5, we describe the real world practices for each of the four features (a) to (d), listed above. Understandably, we shall go in more depth when we deal with feature (d) on central planning and monitoring. We shall treat in (d) the procedures, methods, forms, and the practical operation of central planning, look 144

State Intensive System: Past Polity

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into the obstacles it encounters, examine how principals and agents inside and outside the state settings respond to each other, consider the problems which these responsive interactions create. In these contexts, governments in these regimes have initiated several rounds of planning reforms to save the situation, but in most of the concerned countries they were mostly failing reforms. The reforms will be reviewed and the failing results evaluated. To increase focus, we shall deal mostly with the Soviet Union, supplemented by some examples from Soviet satellites in Eastern Europe. In Section 5.6, attention is directed to the economic policies pursued by the governments of these countries regarding the major issue of where to allocate the factors of production. There is the difference between ‘how’ and ‘where’ to allocate. The ‘how’ relates to the economic system, while the ‘where’ relates to economic policies. There is an association between both but not a complete one. Although the communist regimes we examine follow more or less the same ‘how’, the ‘where’ differed: the economic policies pursued by the different governments were different. We shall look in Section 5.7 at the past performance of the Soviet Union and its allies. We shall introduce a few quantitative indicators such as economic growth, its decomposition in factor inputs and factor productivity, and indicators of wellbeing and apply them to these SIM countries. These will be compared with those of FIM countries to obtain a grasp into the missed opportunities of communist countries to achieve more. Not only did most of the reforms, policies, and performance fail, but the whole regime fell short of achieving the announced objectives which it promised for its people. The collapse of these communist regimes in the early 1990s became imminent. Since then the economies concerned entered into a transition phase towards a more normal mix between the state and markets and between the public and private sectors. Section 5.8 reviews alternative explanations for the failure of the communist regimes. The explanations rely, to different extents, on economic, social, and political theory. We present four explanatory complementary views of the communist failure as seen by Pesovic, Eggersston, Stiglitz, and Ellman. Immediately with the collapse of the communist regimes, recessions set in, with durations of four years or more. The recessions reduced production and wellbeing in the concerned countries by levels varying between 30 and 40 per cent. The next chapter reviews the recession and its background and examines the transition issues that these countries face, and how they respond to them.

5.2 The state’s ideology The ideology is communism. The origins of communism go back to the early days of the industrial revolution in Britain and France. Labour working in the new industries earned very little. And thus, the vast majority of people lived under poor conditions. A few individuals had considerable wealth and authority; they possessed the factories, hired workers at survival wages, and obliged them to work for long hours in risky and unhealthy conditions. Concerned with both the

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efficiency and equity of this capitalist system, Karl Marx observed people working hard and long, but the fruits of their work reaped by the owners of the firms, these being the capitalist class. Marx postulated that workers will not be able to increase their wages, since capitalists want to accumulate and save. Capital will be substituted for labour that becomes increasingly redundant. Marx was convinced that the workers will and should unite; that power will shift, and that the system will inevitably change towards socialism, and eventually communism, and become thereby more efficient and equitable. Marx thought of a communist system where effort and goods are organized along the lines of from each according to his ability, and to each according to his needs. Such a system, he argued, would require abolition of private property and establishment of a guardian state that would make all mobilization and allocation decisions. The two basic works of Marx, Das Kapital and The Communist Manifesto, caught the imagination of many engaged thinkers and leaders. The first to have had the opportunity to bring Marxist’s ideas in practice was Vladimir Lenin, after a revolutionary takeover of government in Russia towards the end of the First World War in 1917. Russia itself has hardly touched capitalism at the time of the communist seizure; it had a poor, large and sparsely dispersed population, and an undeveloped economy. From 1917 onwards the declared ideology of the country became communism, and it was the task of V. Lenin, and his followers starting with J. Stalin, then N. Khrushchev, L. Breznev, etc., and ending with M. Gorbatshev to defend the declared communist ideology and soviet promises, safeguard state capitalism and develop procedures and programmes for running the economy in ways which will hopefully approach these promises. As things have developed, it is now obvious that fulfilling the soviet promises was a mission impossible. We shall come back to this theme later on.

5.3

The state’s party

The communist ideology required that there be a dictatorship of the proletariat. The underlying thought is that the regime must be a dictatorship of the proletariat, by the proletariat, and for the proletariat. Since obviously the proletariat in its totality cannot exercise a dictatorship, some representative body must be called upon to exercise it. Traditionally, this is the Communist Party. The working class is supposed to exercise its leadership over the state through its vanguard, the Communist Party. It is the only party the state tolerates. The party controlled many aspects of political, social, and economic life in the communist regimes. At school and workplace people were taught how to respect and love what the Communist Party and its chairman have done for the country. The party took good care of its members. The best jobs, housing, privileges were reserved for them. Accession to the membership of the Communist Party is highly esteemed and is very valuable for the member. The party would pick and choose the suitable members, those who have mobilization qualities, follow orders faithfully, and have trustful personal connections. In the Soviet Union, the phenomenon of the party cadres as caretakers is known as nomenklatura. The top


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of the nomenklatura is the Politburo, whose decisions become the law of the land. Members of the Politburo do not have tenure. To be removed from the Politburo is a very great loss, hence the eagerness of persons in the top to form protective alliances among themselves. In practical terms, the economic system, no matter how it will turn out to be, it is embedded in a political dictatorship. The subjection of the economic order to the political order is manifested in many ways. By simultaneously politicizing all information and decisions, the party eliminated possible corrective feedback mechanisms. Party leadership in this context has an interest in exaggerating statistics on production and export, and in hiding the extent of economic failures, famines, productivity declines, inflation, deterioration in health standards and the like, so as not to undermine the image of the promised glittering future to which the party is leading the country. Politics superseded economics. Indeed, some party leaders recognized that a major reason why economic reforms in the past were not carried to their ultimate ends was that in practice the reforms would weaken the role of the state and the Communist Party in the management of the economy. The power of the Politburo has limits, however. The limit is Politburo’s perception of the maximum price people are willing to pay so that the ruling party can pursue its political objectives and personal benefits. Communist rulers have been always anxious to know the attitude of the people. Opinion polls to that purpose were conducted under cover, and on a regular basis. In the Soviet Union and Eastern Europe the maximum price was exceeded around 1990, paving the way for the fall of the communist regime.

5.4 State ownership of property Marxist thinking blames the contradictions in society on the division of the population between owners of the means of production and the proletarians who are non-owners and have to sell their labour cheaply to the owners. To overcome the contradiction, the solution is that the state should become the sole owner, this being the highest form of social ownership. The other argument put forward for state ownership in communist regimes is that it is necessary for realizing strategic decisions on large investments and delayed consumption that would bring the country to the promised glittering future, and that a consistent national economic plan cannot be formulated and executed otherwise. The law of state ownership allowed the state to own all natural resources including land and all enterprises, whereby the authority to run state property is assigned to the Politburo. Collective farms and gardening plots for the collective farmers are tolerated but are not transferable. The only fully accepted private property is that of consumption goods which people pay for from the earnings or transfers they receive from state enterprises or state authorities, respectively. In the real world, the law of state ownership is reducible to merely a façade hiding the true owner. The Politburo of the Communist Party, being the legitimate caretaker, has absolute property rights on decisions regarding the use and


disposal of the total outcome from the state wealth. The institution of state ownership opened the way for the marriage between political power and material benefits for those in charge of decision-making. Individuals can thus acquire material benefits only by joining the ruling party. State ownership provided the ruling party two rights: the right to appropriate a large share of the outcome for its own consumption as deserts and benefits, and the right to allocate the remainder on the population at large. The institution of state ownership and a legitimized caretaker with a monopoly on the economy are basic instruments in this respect.

5.5

The central planning system

With nationalization of the means of production in the Soviet Union by the ruling Politburo, a system of central planning and administrative command was put in place in 1928. We shall explore this system in terms of procedure, methods, practical operation, and planning reforms. (1) Procedure. The economic plan is formulated in the following way. General directives on economic development are provided by the Politburo, and converted into control figures by the central planning department, Gosplan. Tentative production targets for major commodities are then sent to the ministries for further specification, and from there down to the level of individual enterprises falling under the supervision of each ministry. The enterprises are supposed to send back comments and information on limitations and prospective. Ministries adjust and send ministerial plans to Gosplan. It is here that the final matching between inputs and outputs for a large number of commodities, varying at times between a few hundred to a few thousand, is done via the use of material balancing methods, resulting in final production targets. These are disaggregated further and disseminated to the ministries and through them to the concerned individual enterprises. Consequently, there are ministerial plans focusing on aggregates and enterprise plans that take up details. The plan for each enterprise contained detailed directives on input provisions, operations, outputs, and deliveries – from whom and to whom – for the forthcoming year. While the enterprise plans are legally binding, they are simultaneously supported by incentive designs to comfort and motivate enterprise managers in fulfilling the enterprise plans. (2) Methods. Gosplan applied some kind of planning-in-stages methods. Two main types of methods are used. In the upper stage, the material balancing method is used to formulate commodity plans, for which the respective ministries carry the responsibility to implement. At the lower stage, the investment effectiveness method is used in the selection of expansion projects at the enterprise level. The material balance method is an iterative process of concurrent adjustment of the supply and demand for each commodity considered, resulting from an exchange of information between Gosplan, ministries, and enterprises, and ending when the closing balance shows the sum total of all demands for a commodity equal the sum total of the supply for that commodity.


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Table 5.1 SIM planning: Demonstrative scheme of material balance for a major commodity, i.e. coal in 000s tonnes Supply (or availability) Domestic production

Demand (or requirements) 1100

Using stocks

50

Imports

50

— Total

Intermediate inputs for productive sectors

800

Collective consumption

300

Private consumption

100

Exports 1200

Total

0 1200

Moreover, in principle, this balance should hold simultaneously for all commodities considered. The iteration process can be done at different levels of sophistication It made use sometimes of input-output tables, consistency and optimality criteria, but it has mostly settled at partial tabulations as in Table 5.1, which satisfy consistency criteria only. The aim is to remove imbalances that appear in such tables via adjusting technology in the use of intermediate inputs, and adapting collective and private consumption, or through changing domestic production, calling on accumulated stocks from the past, and exporting or seeking foreign supplies through imports. The definite adjustments are then detailed in operational directives. Traditionally, ministries and planning agencies in communist regimes formulate targets in physical terms, so many tonnes, cubic meters, thousand pieces, and so on. Although money exists, and there are financial flows corresponding to the physical flows, the former are subordinated to the latter. Prices, which converted the physical into monetary, are cost-plus based. The primary function of prices in the system is only to serve as means for aggregating physical data and for financial control. The dominance of the physical on the monetized form has important consequences for achieving equilibrium at the macro level and the micro level, which will be reviewed. The investment effectiveness method operates at the lower level of the enterprise. It is placed as a stage below that of material balances where the production targets are determined. Soviet authorities used the investment effectiveness method for choosing among proposed investment projects that expand production capacity of a specific product. The equation can be written as Ci rK i A i

(1)

where Ci annual operational costs of investment project i K i capital costs of investment project i A i annual total costs of investment project i r normative rate for discounting capital use, exogenously fixed The objective is to select projects with the lowest Ai. In periods and sectors in which capital was especially scarce, the value of r was raised. From 1969 a


standard value of r 0.12 was used, although it was sometimes allowed to vary per sector. C, K, and A can be eventually specified per unit of production to allow for economies of scale. (3) Practical operation. On paper, the picture depicted above of the central planning system in the Soviet Union is a strictly centralized one. Truly also, here is the most centralized of modern economies. Nevertheless, the rigidity gave way to quasi-market mechanisms that existed economy-wide. We review here the practical operation of the planning system from the points of view of different agents involved in the process, consider the problems they face, how they are affected, and the effects of their responses. We shall take up in consecutive order the (i) Gosplan, (ii) the ministries, (iii) enterprise managers, (iv) individual consumers, and (v) hidden dealers. (i) The Gosplan level. Theoretically speaking, the role which the auctioneer of Leon Walras-or the invisible hand of Adam Smith, plays in bringing equilibrium prices and an efficient allocation of the quantities of goods and resources in the perfect market economy, this same role can be played by the state. If the state can model the economic behaviour of the agents in numerous equations, solve for the equilibrium prices, and fix them accordingly, then an efficient allocation in quantities would follow. As Pareto and Baron have shown around 1908, the allocation problem is the same in both systems. This idea has functioned as the working proposition of all attempts at central planning, including the Gosplan. The practice is otherwise. In the first place, indivisibilities, uncertainties, externalities, and collectivities persist in all economies and make it impossible to reach an efficient allocation, see Chapter 2. Second, there is no way for the Gosplan of getting all the correct information and processing it. The subordinates may transmit distorted information, unknowingly or on purpose. In the transmission of information important parts are lost. The information can be out of date. If really all the relevant information is to be used the data processing problem and the discovery of the right allocations will be computationally an impossible task. The material balances, which are very crude approximations, are never iterated to their ultimate round, but are stopped prematurely. Third, the Politburo feeds the Gosplan with information on its own preferences which can be in variance with that of the population at large; as a result, the targeted allocations will be different than the spontaneously desirable allocations of the population and this will cause imbalances in supply and demand. This problem does not occur in competitive markets. Fourth, for specific goods, direct contact between demander and supplier is necessary to settle design questions, and this is impossible to settle at the central level. Also in competitive markets these specific goods have to be negotiated personally between buyer and seller. Of course, the Gosplan did not ignore market forces in all respects. Market forces of demand and supply did play a role in some segments of the economy. Wage differentials were used to influence the distribution of labour by profession, sector, region, and season. Furthermore, a hidden market was tacitly accepted to deal with exchanges that cannot be planned, these took place in the hidden economy.


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(ii) The ministry level. In a previous chapter we made reference to bureaucratic behaviour within ministries, and its distortion effects for the economic process. These apply here too. Bureaucratic considerations such as risk aversion, subservience to superiors, adherence to periodical plan fulfilments, carrying instructions to the letter, take precedence over economic considerations such as cost saving, wastage avoidance, quick delivery, customer satisfaction, technical progress, and so on. The latter aspects have been adversely affected by bureaucratic behaviour. (iii) Enterprise managers. The formal plan was only the initial blueprint for economic activity at the ministry and enterprise levels. In the course of plan fulfilment many mechanisms are activated by ministerial authorities and enterprise managers, which affected economic performance as well as the feedback of information for the next round of plan formulation. At the end of the day, the enterprise gets a production plan in physical terms that it has to execute. The plans are imperative orders and not desirable forecasts. The availability of physical inputs is necessary for achieving the production targets. For the enterprise it is far more important to obtain an allocation certificate for scarce physical inputs than money. The risk of not securing the physical inputs in time for production of its own output brings tension in the enterprise. The response of the enterprise manager in such a context is varied, and it betrays many deficiencies in the planning system. We list here some of the responses. First, frequently the plans sent by the ministries arrived late at the enterprises, so the enterprises continued to operate on the basis of the old plan. That by itself was not problematic for the enterprise, since many plans for year t were, in effect, little more than revisions and update of the plans for t-1. The results are delays in introducing change and a tendency to increase the dependence of the state on the discretion of the enterprise managers. Second, the monitoring of the execution of enterprise plans is weak and the sanctions for counteractions by the state in case of management failures are limited, for ministerial authorities responsible for the failure would be uncovered as well. So there are tendencies for cover-ups. Third, in a situation of a general scarcity of excellent managers the state paid managers average bonuses of 25 per cent of their base salary, and reaching 50 per cent for top managers. The result has been dysfunctional managerial behaviour; this caught communist thinkers by surprise for they assumed that managers would obey the orders of superior authorities. Fourth, fulfilling the gross output targets is a crucial condition for safeguarding his position as enterprise manager. To do that he bargains intensely and lobbies for obtaining allocation certificates of inputs, and he uses the resources of his office for exchanging favours with local party and state officials, he may manufacture attractive but hidden products that he can fruitfully exchange with the associates, thus there emerge cross-departmental cliques whose members dispose of their respective official prerogatives to mutual advantage. It is through these local power elite that plans are modified and implemented.


Fifth, alternatively the enterprise manager may expand his informal delivery network and engage unofficial supply agents in arranging deals in the hidden economy, but he may also neglect assortment targets and adjust quality downwards to meet the quantity targets. Sixth, enterprise managers supply information to the responsible ministry higher up that underestimates production capabilities for next year, in this way biasing the ministry to opt for easy gross output targets which the manager can achieve with least effort. A slack enterprise plan has the additional benefit to the enterprise manager of creative excessive reserves of material, equipment, and labour to which he has access in periods of shortages, or which he can exchange for other favours. Slack enterprise plans are associated with the ratchet effect. This arises in a situation where the central planners fix a future output target for the public enterprise Vt1 at a higher level than the achieved current output Vt. Calculative managers of the public enterprises will deliberately produce low Vt or pass to the central planners underestimates of their real production to avoid compelling targets. The ratcheting of targets by the central planners creates an X-inefficiency. The problem can be solved by introducing mechanisms that persuade public enterprises to disclose their true estimate of maximum enterprise output, given input authorizations; but reforms have failed to design such mechanisms. Seventh, the state guarantees that the operations of loss-making public enterprises will be continued nevertheless, a condition known as soft budget constraint. As a result there is no incentive for the enterprise manager to economize in the use of capital and to minimize on other costs. Eight, most of the above responses are best analysed in the framework of principal–agency theory. Some responses are also linked to each other in the context of cross-subsidization, as when the ratcheting of output targets for the better performing enterprises is used to finance the soft budget constraints of the lossmaking enterprises. Responding rationally to this cross-subsidization, both enterprises will not maximize their effort and will end up in lower efficiencies. (iv) Individual consumers. The overruling of the preferences of the Politburo over the preferences of the consumers manifests itself in the chronic dissatisfaction of the latter. This manifests itself in widespread shortages of consumer goods and queues, a limited assortment of goods and services, poor qualities, very slow introduction of new goods. Consumers respond in different ways to the shortages. Consumers can try to obtain their desired goods at a higher cost if they can afford to, from informal dealers in the so-called second economy. Consumers, who are also state workers facing mutual shortages, may practice moonlighting. Consumers may also delay consumption and hoard savings for spending in a future period; the effect can be a strengthening of repressed inflation. A passive attitude can also develop among consumers that ultimately reduces the drive to consume better and more and the working effort towards that end. (v) Informal dealers. In communist regimes the planned economy is often identified as the first economy, in contrast to the second economy that has developed, to the dismay of planners, to resolve imbalances between demand and supply which are created by plan directives. Terms that describe this second economy


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more fully are underground economy or hidden economy. Informal dealers are the primary coordinators in the hidden economy. As was clear from the above accounts, the imbalances arise in the contexts of (a) inter-deliveries among enterprise managers, and (b) sale of scarce goods to individual consumers. Transactions of type (a) arise because it is not easy to fulfil the enterprise plans with the issued allocation certificates of inputs. Enterprise managers often use the services of a tolkach. This is an unofficial supply agent or organization whose job is to see that the necessary materials and equipment will arrive from one enterprise to another. These agents do this via arranging a deal, or using unorthodox means like bribery and agitation. They are remunerated in kind. These activities are normally tolerated by the local party authorities since otherwise the official economy could scarcely function, but at the same time leading to erosion of work ethics and dealing norms. Later, during the transition, these organizations would come in the open and merge with the remnants of the official allocating agencies to build strong bartering corporations that eye on non-competitive privatizations and takeovers. Transactions of type (b) have created a small class of market-oriented business people who sell scarce goods and services to affording consumers, such as owners of vehicles providing private transport services; producers of farm products from gardening plots and collective farms; craftsmen fixing repairs privately in exchange in kind; and medical doctors charging more for better treatment. The prospering of a hidden economy encouraged the emergence of activities that are legally forbidden, some of which criminal, but are difficult to sanction. Such activities may relate to the misuse of official positions for personal advantages such as moonlighting and use of state buildings, enterprise resources, and managers inning personally the sales of speciality goods to high payers. The activities may involve criminal actions such as officials granting unofficial foreign exchange transfers, facilitating illegal trades along borders and in seaports, and dealing in contraband merchandise. The activities may extend further to participation of officials in the formation of powerful mafia groups who are able to influence police, civil servants and infiltrate in and collaborate with the nomenklatura cadres. (4) Planning reforms. It was observed above that the limitations of the central planning techniques manifest themselves in processing distorted information, delayed and frequent revisions in enterprise plans, disturbances in the production process, wrong deliveries, and so on; causing significant losses in labour time that some estimate to amount to 10 per cent. The planners do not see these problems as consequences of an infeasible central planning system; they see them instead as obstructions in procedures, methods and practice, which can be removed by planning reforms. The reforms applied in the 1970s in the Soviet Union and Eastern Europe focused on improving the information structure, planning techniques, and incentives. Furthermore, in later years and especially in Eastern Europe, economic reforms were tried with the purposes of introducing commercial considerations in running public enterprises and integrating the hidden economy with the official economy.

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The multi-information channels were reduced to only two, those of the ministry and the enterprise. An attempt under Khruschev to decentralize and involve the regional governments was abandoned when he left. Regarding planning techniques, Kosygin introduced greater use of mathematical programming, management information systems, and computers. The efforts were effective in shortening the planning process but the pressure for more advanced technologies kept outpacing the introduced efforts. Kosygin reforms have also tackled the incentive problem at the enterprise level. This was done via taut plans. The equation for rewarding the enterprise with a bonus B can be written as B aVp b (Va Vp)

(2)

where Vp is the planned value of the bonus forming index that can simply consist of output but can include other indicators as well, Va is the actual value for the bonus forming index, and a and b are rewards whereby a b 0. The first term provides an incentive to adopt a big plan. The bigger the planned value, the higher is the bonus. Besides aiming at taut plans the second term in the bonus equation encourages the over-fulfilment of plan targets. There is higher weight for the first term than for the second term. The intended result of avoiding the ratchet effect did not work as was anticipated. Instead of mobilizing the hidden reserves of enterprise resources, it strengthened the inclination of enterprise managers to strive for slack plans, that is a smaller Vp, and in a bonus on the second term, while ignoring the bonus on the first term. The reform had also the adverse effect of motivating ministries, which are eager to report that not only have they fulfilled their plans, but that most of their subordinate enterprises have also, to alter the original plans of the enterprises in an ex-post manner to present a better performance for the lagging enterprises. Just as they did in the 1960s, Soviet leaders under Gorbatchev debated the perestroika reform in the mid-1980s with the objective of changing incentives of enterprise managers by relating their rewards to enterprise profitability. This has been defined as the ratio of profits to the stock of capital. The reformer’s hope was that managers would then go for less use of capital, seek efficient production techniques, more innovation, and upgrade quality. To let work the reform implied changing the management’s property rights in capital goods. However, to implement the principle of profitability, the Politburo must accept a reduction in its own property rights as regards its authority on the stock of capital held by business firms, and the future pattern of capital formation. This is a conflict in principles, and conflict of interests of rulers versus ruled, which brought the inadequacy of the institutional rules in the communist regime in the open. Finally, some brave attempts of economic reform were tried in Czechoslovakia, Hungary, Poland, and the GDR in the late 1950s and 1960s to increase decentralized decision-making at the enterprise level and make it more commercially conscious. But these reforms were doomed to fail at that time due to the absence of four prerequisite conditions. These are microeconomic consistency


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(this requires that cost calculation, profit maximization, price fixing, and competitive bidding should fit to each other and form a harmonious whole), macroeconomic consistency (the input and output outlets, should be readily available and undisturbed by instability and uncertainty), institutional governance that guarantee fairness in case of mischief, and a peaceful and benevolent political environment. Later on, in Hungary from 1982 onwards, decentralization reforms were introduced, next to moving somewhat away from soft budgets, permitting the setting up of private enterprises up to one hundred workers, and stimulation of branch associations to sell in export markets. These reforms were relatively successful and can be interpreted as the starting steps in the transitional process. The relative success of these reforms was possible as the economy inched in a slow tempo towards the above-mentioned prerequisite conditions. In this context it is important to realize that Hungary, of all communist countries, is probably the closest to Western Europe by reason of history, culture, and heritage.

5.6

Pursued allocation policies

Economic policy makers in the Soviet Union and Eastern Europe faced very difficult choices in the allocation of the limited resources. On the one hand, they were committed to the socialist aim of maintaining incomes for all citizens at levels sufficient to buy basic goods at cheap prices; this in addition to freely provided collective goods. On the other hand, they were committed to the communist ideology that sees a deepening of capital formation as the development strategy, which will bring success in the longer run. Policy makers wanted to do and did both, with the result that they encountered shortages of all types of goods. They saw the shortage to be associated with the underdeveloped industry, so they diverted even more of the scarce resources to huge investment programmes, resulting in a vicious circle of chronic shortages. The policy makers faced a policy conflict between cheap consumption now or investment now in capital extensive industrial projects with long gestation periods permitting more consumption much later. Whenever they chose for the latter solution the results were less goods to consume, and greater shortages, now and in the future. It is estimated that the planned share of gross investment in the net material product varied between 25 and 40 per cent in the SIM countries. The actual share was even higher as investment agencies underestimated their budgets to get approval. The problem was aggravated by a desire for political equality with the capitalist countries, leading to a significant leakage of unproductive capital allocations to defence, space, and military technological research. There was little feedback between the results of this research, and innovative research in general, and applied production, due to lack of incentives and networks in the planning machinery to effectuate the link. Besides, collectivization of farmlands and transfer of peasants to cities pushed the needs for more capital. Furthermore, the higher priority was given to industrial over agricultural production; resulted in wheat shortages that had to be bought with scarce foreign exchange. Export of

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mineral resources was the main source of foreign exchange in an otherwise semiclosed economy. Insight into the policy conflict, how it was dealt with, and the consequences can be gathered from the following two equations. To reach equilibrium aggregate demand D should equal aggregate supply S. In the communist context aggregate demand D can be simply written as the wage income, i.e. the average wage W multiplied by number of earners L, less hoarded savings H. The aggregate supply S is the physical quantity of consumer goods Q plus the change in inventories from last year I, these multiplied by the price level of consumer goods P. Note that prices for most consumption goods are based on cost, they are fixed and are hardly affected by imbalances. D WL H S (Q I)P

(3) (4)

To satisfy the population, the soviet authorities were under pressure to increase wages, and with more earners, the aggregate demand increased appreciably; but as is well known, the physical production of consumer goods Q lagged behind due to reasons of lagging priority and general shortages caused by increasing inefficiencies. At the same time, prices P were not allowed to increase fast enough to absorb the increase in demand. In such circumstances equilibrium between a demand that is driven by money and a supply that is physically fixed can only be reached by increased hoarding by consumers and a depletion of inventories, implying delayed consumption and repressed inflation. The accumulated tension will turn to be significant in empowering the inflationary pressure, once at some time later, when the economy in transition would allow price liberalization. Although the Politburo was committed to pursuing a policy which gave priority to capital formation in heavy industry on consumer goods, the Politburo was responsive to political pressures from the consuming population to change course underway, halt the heavy construction plans, and go for more consumption goods; this continued only for a while after which policy reversed back again. The Politburo’s power to invest in capital deepening is limited by its perception of the maximum price the community is willing to pay in exchange for the granted delegation of authority to the ruling class to pursue the political objectives and economic strategies of a communist state. Conceptually, the ruling class will invest in capital deepening up to a point where its own gains from the last unit invested is equal to its own costs from violating the preferences of the consuming public. So, Soviet leaders responded to consumer grievances between now and then. In the late 1960s, under Khruschev, consumption growth caught up with investment growth, but lagged again from the early 1970s. In the late 1980s, under pressure of public opinion, investment plans were again interrupted to allow for an enhancement of consumer goods. The limited interruptions in investment, which were necessary to satisfy the public, tended to increase gestation lags, postpone production operations of installed capacity, and accentuate the shortages of goods.


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Another set of pursued economic policies related to the selection of the optimal unit of production. The policy has been to minimize costs by exploiting economies of scale. The result was to choose for very large capital extensive enterprise units and a highly concentrated industrial structure. Such a skewed structure happened also to be preferable in a central planning context on grounds of easier control and administration. As a result, industrial concentration in the Soviet Union is much higher than in EU and US, noting that the background to the concentration is different in the two systems. The communist trusts are not the results of mergers as in Western economies, but are the outcome of political-administrative and costeffective decisions, and are not related to a competitive outcome. Outside the large enterprises there are no medium or small enterprises. Small workshops, where they exist, are internalized within the large enterprise. This inherited, highly concentrated industrial structure will make it very difficult to execute a competitive privatization programme in a transitional phase later on, for these giant enterprises capture a monopoly share of the market, and they will require a de-monopolization as much as a privatization strategy. Furthermore, the pursued policies in the past saw to it that these giant enterprises are not only just production and management units; they have also political, administrative, and social functions in support of the workers and as control leverage on their political allegiance. When we shall deal later on with the transitional phase, it will be important to realize that, because of the previously pursued policies, the conversion of the communist industrial organization into a modern one would have to involve much more than a conventional privatization programme.

5.7 The failing past performance In which ways can one really measure system performance? Why is comparing performance relevant? In which sense is the past performance of the communist system a failing one? The three questions are highly related. Following our propositions that we laid down in Chapter 1, agents are inclined to compare the outcomes they receive from the setting in which they are actively working and living, with the outcomes of competing settings. If their system is seen as an underperformer beyond doubt then they will either transform the foundations of their setting towards the superior one, or if feasible, they will physically move from their system/country to the superior system/country. Obviously, under the communist regime there are no possibilities for any large-scale movement of people from their country to other countries with brighter prospects. Hence, the drive to abandon the communist foundations becomes the only alternative left, and to replace them with more successful foundations. The best evidence of a failing system is the failure of its performance versus other systems. Failing performance is by definition a relative concept based on comparing and evaluating outcomes accruing to the agent in competing settings. In the context of the Soviet Union and Eastern Europe – the SIM related countries – the agents there looked at Western Europe and US – the FIM related countries – for a comparative evaluation.


The outcomes that people are interested in range from intangibles such as happiness and freedom to tangibles such as material well-being, present and future income, purchasing power, employment security, civilian security, etc. We shall use some of these indicators to review the past performance of Russia and Eastern Europe. The average annual growth of the GDP, and the GDP per capita, for SIM and FIM related countries are displayed in Table 5.2. Both groups experienced high growth from 1950 to 1970. The growth of SIM countries started declining in the mid-1970s and reached a standstill in late 1980s. Why did growth decline? What is the source of the decline? To get more insight in the problem distinguish between extensive growth that is identical with growth of factors of production such as labour and capital inputs, and intensive growth that is identical with growth in total factor productivity, i.e. more output per unit of input. It is generally acknowledged that during the early stages of economic development economic growth tends to be of the extensive growth type, as output expansion is achieved largely from mobilizing and using more factor inputs. At higher stages of economic development intensive growth dominates as factor productivity increases significantly through better use of the factors of production, higher technology, more efficiency, etc. The usefulness of these distinctions is readily seen from eq. (5). Take v, for growth rate of output, to consist of the two components: growth in factor use and growth in factor productivity. The first component is the weighted sum of the growth rates of inputs of labour l and capital k, the respective weights should reflect their respective marginal returns as represented, under market equilibrium conditions, by each input’s share in the national income, thus rl and rk . The second component is the growth in factor productivity, denoted by y. v (rll + rkk) y

(5)

By inserting the value of the growth of output v and the growth of weighted input (rll rkk) and deducting, the growth in factor productivity y is obtained as Table 5.2 groups

Average annual growth of GDP and GDP per capita in the SIM and FIM country

1950–60 1960–65

1965–70 1970–75 1975–80 1980–85 1985–90

SIM countries GDP GDP per capita

5.4 4.5

4.5 3.7

4.1 3.5

4.5 3.9

2.1 1.7

1.1 1.1

0.9 0.8

FIM countries GDP GDP per capita

5.0 3.7

5.1 4.3

4.5 3.7

2.8 2.4

2.7 2.4

2.3 2.3

2.4 2.4

Source: Various sources reported in and adapted from Gregory and Stuart (1999), p. 220. East includes the Soviet Union and six East European countries. West includes US, Canada, Japan, and eleven West European countries.


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Table 5.3 Annual growth rates of output, inputs, and factor productivity for the SIM and FIM country groups Countries

SIM

FIM

Years

0utput v

Labour l

Capital k

(rll rkk)

Factor productivity y

1950–60

5.2

0.8

4.2

1.7

3.5

1960–85

3.0

0.8

5.1

2.1

0.9

1950–60

4.8

0.9

4.7

1.8

3.0

1960–85

3.7

0.9

4.7

1.9

1.8

Source, note: Various sources reported in and adapted from Gregory and Stuart (1999), p. 225. The shares of rl and rk we assumed in these calculations are 0.75 and 0.25 for 1950–60, and 0.7 and 0.3 for 1960–85.

residual. These productivity calculations are shown for the two groups of countries, in Table 5.3. Of course, the rough nature of these productivity calculations should be emphasized. Note that the income shares will reflect the returns under restrictive conditions of market equilibrium. However, the general magnitudes of the results remain intact under varied plausible weights. The 1950–60 period saw factor productivity to grow at similar rates, in the SIM block by 3.5 per cent and in the FIM block by 3.0 per cent. After 1960, a great drop is noted for SIM, with growth in factor productivity declining to 0.9 per cent, as compared to a growth in factor productivity in FIM of 1.8 per cent. This means that in the SIM countries economic growth in the past four decades depended increasingly on the mobilization of more and more factor inputs and decreasingly on growth in factor productivity. Rather than becoming more intensive, the growth of the communist regimes continued to be more extensive. For a modern economy, the opposite pattern of intensive growth should have happened. The very low past performance with regard to factor productivity has manifested itself in what was previously mentioned as failing outcomes of the communist system, such as persistent shortages, waste due to misallocations, backward technology, low quality of goods and services, and retarded advancement of well-being. Another measure of the performance of economic systems concerns fairness in the distribution of income and wealth. There are many possible measurements of inequality. But given our approach to the field of economic systems the important issue is not which indicator is analytically more meaningful, rather which is the relevant indicator of fairness that people in one country commonly experience, observe, and employ in a comparative evaluation with the fairness outcome in another country and, thus, in forming an opinion on the relative fairness of one setting versus another setting. The search for such indicators is a major study apart. It is very likely that such subjective indicators may correlate with analytical indicators that we use in economic investigations. For lack of alternatives we give in Table 5.4 for SIM and FIM countries readily available statistics of the ratio of per capita income for persons in the 75th percentile to the per capita income

160


Table 5.4

Equity indictors for selected SIM and FIM countries Per capita income of individuals in the 95th percentile/same for the 5th percentile

Bulgaria 1964 Czechoslovakia 1965 Hungary 1964 USSR 1966 Average SIM Canada 1971 Italy 1969 UK 1969 US 1968 Average FIM

Per capita income of individuals in the 75th percentile/ same for the 25th percentile

3.8 4.3 4.0 5.7 4.45

1.7 1.8 1.8 2.0 1.83

12.0 11.2 5.0 12.7 10.23

2.4 2.5 1.9 2.6 2.35

Source, note: Various sources reported in and adapted from Gregory and Stuart (1999), p. 231. The income statistics for East exclude top income earners like state officials, and remunerations earned in the second economy.

for persons in the 25th percentile. A second indicator is calculated using the 95th and 5th percentiles. Discounting for the shortcomings and the incompleteness of these statistics it can be generally established that the income was more equally distributed in the SIM than the FIM countries. The average ratio for the first indicator for the SIM is 1.83, for the FIM it is 2.35. The second indicator emphasizes the differences even more: the ratio in SIM is 4.45, and in FIM it is 10.23. The smaller differences between rich and poor in SIM than FIM, as shown in the table, are consistent with the prevalent contrasting priorities that the two systems hold on the equality issue. Clearly, state property and centrally fixed remuneration levels are two conditions in East that secure more effective policy instruments to effectuate a more equitable income. If the two conditions are removed, which is by definition what happens in the transition to a more optimal mix between state and markets, it will be seen that the equity ranking of SIM and FIM would immediately reverse, and to a much more significant degree. Alternative equity promoting policy instruments such as safety nets, fiscal transfers, and social security do not exist in SIM but are well developed and form a coherent part of the economic system in FIM. Next to growth and equity, the past performance can be evaluated in terms of commonly experienced and observed indicators like unemployment and inflation. Unemployment did not exist in an open form in SIM, although hidden underemployment in ministries and enterprises was common. In general, a high degree of material security was present, even though the basic level available to each and everyone was, by FIM country standards, on the lower side. Inflation as a process of continuously rising prices did not exist in the communist countries. Prices were fixed for long periods. After the mid-1970s, sporadic


161

rounds of price increases took place. More significant is the price hike which producers charged to willing consumers for delivery of scarce goods or better quality in the second economy. Important, too, is the built-in repressed inflation that took the form of hoarded savings for lack of consumption outlets, and which was the result of pursued allocation policies.

5.8

Causes of system rise and failure

We shall briefly reflect on the rise of the communist regime, and the economic success of the Soviet Union up to around 1965, before examining the slow downturn in the economic system that finally ended with its collapse some thirty years later. We shall give our interpretation based on the propositions on the functioning of economic systems that we displayed in the first and second chapters. There are various other economic interpretations and theories that reflect on the collapse of the communist regimes. We shall subsequently review these other interpretations of the failure. Russia’s rise. To start with, the initial environment in Russia in 1910s and 1920s was featured with a heterogeneous and highly skewed population groups in terms of intellectual and material endowments. This environment was functional for the start sign of a communist regime. The more endowed leaders, headed by the Politburo and party cadres, and supported by central planners, state bureaucrats, and enterprise managers, took charge of running the regime on behalf of, and for the good of, the population at large; supported with an ambitious communist ideology. The institution of closed borders and imposed isolation from the rest of the world over many years allowed tendencies to develop that would adapt the internal structures in the system to each other to form an apparently coherent whole. In Chapters 1 and 2, we identified four internal structures. These are the personal attributes of the endowed leading groups and the population at large, Q, the physical–technological transformation, T, the institutional rules, I, and the information structure, N. The systemic adaptation that took place was geared to the tunes of politically behaving state settings. The following is a demonstration. For example, the economic system operated along the lines of state plans for state enterprises, but because important aspects of the real world could not be incorporated in instructive plans, the control system deviated from the real system. In practically all areas of economic activity more examples of deviations between the control and real systems can be quoted. In resolving these deviations and frictions agents transact with each other, but under the circumstances they are inclined to do that in hidden ways that exclude competition, and pursue non-transparent behaviours that allows for monopoly rents. Such a political behaviour pattern – typical for pure state settings – permits the better-equipped agent to extract and secure a quasi-permanent rent from the less-equipped agent, over and above a normal one-time remuneration.

162


This political behaviour was reinforced repeatedly by state settings that behaved politically. State settings, in their intrinsic form as was used to be the case in the Soviet Union, were driven by political agents seeking political gains.1 Political behaviour, and the rent extraction traits that associate with political behaviour, were observable features for all agents in an all-political state intensive social system. When the coverage of a political behaviour extends beyond some threshold, it tends to become the norm that is expected in mutual behaviour and gains more momentum. The internal structures referred to above tended to unify along the same lines. In such a politically based system the economy is subordinate. This does not mean that a dominant polity will show up in a slow economic growth. As long as there is a sufficient yearly flow of inputs of land, labour, and capital to produce the economic growth, this growth remains positive and can accelerate. This happened in the period of the economic rise, from the 1920s up to the 1960s–1970s. In this period, the material achievements of the Soviet Union were a source of inspiration for many countries of the developing world. Russia’s fall. In a systemic analysis of Russia’s fall we would like to distinguish between internal pressures and external pressures that caused the end of the communist regime. The internal pressures date from around the 1960s and 1970s, when by that time, the population increased significantly and its profile Q changed appreciably. Demand for more goods, and of a more specific nature, contrasted with a draining up of factors of production. To meet the demands a shift upward in production possibilities was badly needed. One and the other required renewing and modernizing the technological transformation processes T, changing the institutional rules I from privileged control on state property towards a coupling of individual property rights to individual work efforts to enhance incentives, and a decentralization of the information structure N towards micro agents, to avoid problems of incomplete and asymmetric information. If such changes would take place the management functions of the economy as well as the created surplus would flow to non-state agents, which would have made the party cadres and most bureaucrats redundant. The prospective losers opposed such changes; the changes were also unthinkable for the Politburo who acquired its political legitimacy as custodian of collective property rights. The apparent harmony between the four internal structures that characterized the first few decades of the communist regimes cracked from the 1970s onwards. The four structures could not adapt to each other primarily due to conflict of interests under changing circumstances. With inconsistencies increasing and the same old policies continuing, inefficiencies, waste and shortages multiplied, leading to reductions in overall growth. Rent extraction practices added more distrust and a further deterioration in the daily running of the economy. With the well-being of the endowed leading groups hardly affected, the incidence of the reductions shifted to the population at large. And the differences in well-being were observable and noted by people. The external pressures came later. The external environment circumscribing the communist regimes, has appreciably changed in the 1970s and 1980s. Media and travel made information over the performance of the industrial world, living


163

levels, and liberties readily accessible. As the closed regimes gradually opened up, their public was in a position to compare and evaluate their performance versus that of neighbouring market economies, and come to the conclusion that their regime performed less. Our introductory principles tell us that one of three choices is decided in such evaluations. The first choice is to remain loyal to the regime and the rulers in the hope that promises made will one day materialize. Some did that, but in relative terms that was only a very small minority. The second and third alternative actions are either to exit or to voice. Possibilities of exit are extremely limited, even though some outflow took place from East to West Germany. Voice was the popular and anticipated action by the new wave of political leaders and their massive supporters. This started in Eastern Europe and spread to the Soviet Union. The targets were to wipe out the communist rule and to replace it with a reorganization of society along new structures similar to neighbouring market economies.2 Other interpretations. Economists have put forward other interpretations of the system failure that focus on or another feature of the communist regimes. We shall review them below with the understanding that our interpretation based on our introductory principles as well as each other interpretation are not exclusive of each other. Each can be said to look at the failure from a different angle. Pejovic (1982), and extended in Pejovic (2001), focuses on the first and second features introduced at the beginning of this chapter. His thesis is that the original terms of contract between the Politburo and the Soviet people lost validity due to the realization that the Marxist thesis that socialism is a historically superior system to capitalism is refuted in view of the proven lower performance of socialism as compared to capitalism; besides, new generations are less willing to trade the quality of life today for a hazy vision of future improvements. The ideological justification of the communist regime became void as its leaders increasingly abandoned the ideology, or paid only lip service to it, so that the regime came to be uncovered as simply equivalent to that of any other ordinary and arbitrary dictatorship that lacks popular legitimacy. Eggersston (1990), close to Winiecki (1986), put emphasis on the second and third features of the communist regime. They place their interpretation within the analytical frameworks of agency problems, transaction costs, and property rights. They argue that (a) the managers of state enterprises respond to incentives which discourage cost minimization, and (b) the organizational structure of state enterprises have not adapted to technological developments, resulting in rising transaction costs. The solution of these problems would require replacing the command by prices, i.e. writing off the communist regime and instituting a profit-maximizing market economy. A competitive market for managers would represent a huge transfer of wealth away from party functionaries who hold property rights at the managerial levels. This explains the opposition of party cadres to meaningful reforms. Eggersston adds If a state is to prosper and stay close to the economy’s technical production frontier, it must have the political strength to adjust the structure of property

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rights to changes in the economic environment. However, adjustments are often blocked by agents of the state, who believe that reforms threaten their self-interest. When structural changes are expected to raise society’s aggregate wealth, both ruler and subjects may find it in their self-interest to offer state agents compensation for expected losses and to attempt to buy their compliance. Yet high transaction costs are likely to prevent such side payments. (Eggersston (1990), p. 333; the italics are my emphasis) An interesting question arises in the above context as to whether the state agents could be treated as a homogeneous group. As will be seen later some skilful party members and ministerial authorities were able to capture significant property rights in the privatized enterprises in the transition period immediately after the collapse of the regime. What they captured is much more than the possible sidepayments. But most of the remaining party cadre and bureaucrats have ended as losers, and their side-payments would have been insignificant. The problem is that it is hardly possible to identify beforehand who will be the winners and the losers. Stiglitz (1993) focuses on problems of incentives and information in his interpretation of the communist failure. The interpretation of Stiglitz fits neatly within the principal–agency analytical framework. The principal is the planning bureaucrat while the agent is the enterprise manager. Firms could not keep any profits they made. There was no competition, and the soft budget further attenuated managerial incentives. Equally important, here was no incentive for innovation and growth ... Socialists wanted to replace the market mechanism for allocating resources with central planning. But they encountered two problems. First, the bureaucrats did not have the requisite information to know how to allocate resources efficiently. Managers of firms had no incentive to tell the central planners what the minimum inputs required to meet their production goals were. Rather, they had every incentive to claim they needed more than they really did. This made their job easier. And they had no incentive to exceed their goals for if they did, the planners would raise their targets for the next year. Second, planners could not perfectly monitor the various firms in the economy ... And firms had only limited incentives to comply with the planners’ directives. There were no rewards, and they knew they were only imperfectly monitored. (Stiglitz (1993), pp. 196–97) Ellman (1989) focuses on difficulties concerning the fourth feature of communist regimes, i.e. central planning, as the cause of failure. The theory of rational social decision making implicit in the traditional Marxist-Leninist theory of planning is inadequate because it ignores the fundamental factors of partial ignorance, inadequate techniques for data processing and complexity. (Ellman (1989), p. 34)


165

Finally, some economists have blamed the economic policies pursued, rather than the economic system, as an explanation of the communist failure. Given the scarcity of capital, this opinion argues that the Soviet strategy of heavy industrialization was wrong. The performance would have been better if more attention would have been given to industries that require less capital, and to foreign markets as additional outlets.

5.9 Summary and conclusions In the state intensive economic system, polity matters overrule economy matters. In this chapter attention is directed to how such a system has been working under the communist regime in the former Soviet Union and its East European allies, and how it has come to an abrupt standstill. As will be appreciated in the next chapter, which deals with the transition, the political paths pursued in the past under state dominance, have been very influential in determining the course of economic transition that SIM-related countries went, and are going. To contain the analysis, we focused more on the past system in the Soviet Union, but elaborated on situations in the East European allies when they differed significantly from the Soviet Union. Among the features passing the review were the communist ideology, the assignment of the Communist Party as sole interpreter and formulator of the communist ideology, and the motor for its implementation via state institutions; the elevation of the state as the sole owner and manager of property; the introduction of a state system for the planning, implementing, and monitoring of the economy’s production and distribution. The chapter examined the procedures, methods, forms, and the practical operation of central planning, looked into the obstacles it encountered, examined how principals and agents inside and outside the state settings responded to each other, considered the problems which these responsive interactions create. In dealing with the above we adhere to the important distinction made by Kornai (1967) between the control sphere and the real sphere. The operation of the system of planning, implementing, and monitoring in the real world deviates from what the control sphere desires it to be. There are substantial differences between practice and the prescribed rules and practice. These differences betray why the control system was not able to work in the face of upcoming contradictions. In this context of upcoming contradictions, governments in the ex-communist countries initiated various rounds of planning reforms to save the situation, but in most of the concerned countries the reforms failed. The reforms were reviewed and the failing results evaluated. The chapter then directs attention to the economic policies pursued by the governments of these countries. There are greater differences between the countries in this respect and that explains differences in economic performance between them. But, taken as a whole, the past performance of the Soviet Union and its East European allies in terms of economic growth did not match those of FIM related countries over the longer run. Growth accounting showed a remarkable decline in factor productivity in the SIM-related countries in contrast to a rising

166


contribution of factor productivity in FIM related countries. In contrast, indicators of income inequality showed a more equal income distribution in the SIM as compared to FIM related countries. Not only did most of the reforms, policies, and performance fail, but the whole regime fall short of achieving the announced objectives which it promised for its people. The collapse of these communist regimes in the early 1990s became imminent. There are alternative explanations for the failure of the communist regimes. The explanations rely, to different extents, on economic, social, and political theory. We presented our own interpretation based on the analytical framework developed in Chapters 1 and 2. We state also four different, though complementary, views by other economists that explain the communist failure.

6 The State Intensive System: Economic Transitions

6.1

Alternative paths

The regime crises in the SIM relating countries ended in the collapse of the state intensive dictated regime in the Soviet Union and European allies, and the break up of the Soviet Union in Russia and a large number of independent countries. Understandably, the new leaders in these renewed countries looked Westwards to EU and US for a helping hand to restructure their polity and economy. US and EU responded enthusiastically, displayed their systems of national institutions for adoption, and mobilized technical assistance towards that end. International agencies such as the IMF, WB, and other UN agencies, mobilized their resources and gave advice and aid in transmitting these countries from state economies to market economies. In practical terms, there was only one alternative economic-political system available for adoption. This is the commercial market based system prevalent in US and EU. In that sense, the ex-Soviet Union and allied countries are rightly described as transition economies: a transition from a state intensive economic system to a firm intensive economic system. These count 25 countries in total. China is not counted among the 25 transition countries. The situation that China faced in restructuring its polity and economy was different. China introduced and institutionalized systemic reforms way ahead of the Russian bloc and did not experience a regime crisis or regime collapse as the Russian bloc did. In some sense, China was able to be master of its own destiny. The scope of the required change in agent behaviour accompanying transition from a state dominated system to a firm dominated system can be grasped from Table 6.1, which displays the macro frameworks (items 1 and 2) and the micro behaviour in opposite systems (items 3 to 8). In the short term it is plausible to consider that behaviour of agents at the micro level is conditioned by the macro features. For the longer term it is logical to expect that changes in the behaviour of agents at the micro level will have their bearing on the macro features of the system. The new political authorities in the transition economies introduced market elements in different ways and at different speeds. This led some analysts and 167


Table 6.1 to FIM

Required changes in agent behaviour accompanying transition from SIM

FROM Typical situation in SIM

TO Typical situation in FIM

Macro framework

Macro framework

(1) Revenue and expenditure in state budget overlap, not instrumental, due to state prefixing of prices and of values of revenue, payroll, subsidies, current, capital spending.

(1) Conditions of macro stability observed (low price inflation, tax burden, etc.) in managing the balance of revenue and expenditure in the state budget.

(2) Balance of foreign payments determined by state fixing of exports, imports, capital flows, and exchange rate.

(2) Balance of foreign payments determined by market forces. Fully or quasi liberalized movements of prices and quantities.

Micro behaviour

Micro behaviour

(3) Monopoly of communist party in governing the state.

(3) Political parties compete for government power in an elected parliament.

(4) All agents accept state ownership of property.

(4) All agents accept private ownership of property.

(5) Preponderance of bureaucratic coordination in the management and distribution of state ownership.

(5) Preponderance of market coordination in the management and distribution of private ownership.

(6) State enterprises are driven by quantitative targets, plan bargaining, soft budget, etc. not responsive to prices. Commercial law and related judiciary system irrelevant and absent in the context of state enterprises.

(6) Commercial firms are driven by profit maximization, face hard budgets, and are responsive to prices. They operate within the boundaries of commercial law and related judiciary system.

(7) Consumer response: Seller market, demand certain, enterprise not motivated to sell more than instructed by production plan, no effort to attract buyer or improve quality, chronic shortages.

(7) Consumer response: Buyer market, demand uncertain, firm likes to sell more to increase revenue, effort to please buyer and improve quality, cleared markets.

Quantity coordination: Minor role for prices, weak price responsiveness.

Price coordination: Firm is highly responsive to prices. Quantities determined by prices.

(8) Financiers response: Financial violations, wage and inter-enterprise credit arrears, nonperforming loans, negotiated tax relief, no outsider accountability of financial accounts, no valuations of assets, and no exchanges of ownership.

(8) Financiers response: Financial discipline, factor payments in accordance with contract, loans paid back, tax obligations met, yearly accounts filed and verified by accountants, value of firm determinable and ownership exchangeable in stock exchanges.

Enterprise mobility: No free entry, no exit in case of failure due to soft budget.

Firm mobility: Free entry, exit in case of failure due to hard budget.

State Intensive System: Economic Transitions 169

advisors to distinguish between ‘gradual change’ and ‘shock therapy’ as two alternative approaches in transforming the economy. The two terms were never given rigorous and exclusive definitions. In general terms, the gradual change approach is understood to mean a slower but more balanced approach that transforms the economic system in a stepwise fashion. At each step reforms of macro features and micro behaviour are adopted and adjusted to each other. In contrast, the shock therapy, or big bang as called by others, is more abrupt in its strategy, tends to introduce once and for all sudden and significant changes in the external environment. By nature it focuses more on reforms of the macro features while shifting the burden of micro adjustment and the learning of new behaviour to producers and consumers at the micro level.1 While the gradual change approach requires policy interventions over more years, the shock therapy approach concentrates policy interventions in a shorter period, but the successful completion of micro adjustment takes more years and may ponder. Hungary is considered to have followed a gradual change approach. All republics of the ex-Soviet Union and most allied countries have undergone sudden shocks in their economic environment, these shocks being characterized by the precedence of exogenous macro measures over an otherwise endogenous selfcorrecting micro adjustment at the micro level.2 The collapse of the state dominated system and its abrupt replacement by elements of the market dominated system could not possibly happen without a general downturn in economic activity along all branches of the national economy in each and every transition economy. The recessions, which endured from four to ten years depending on the transition economy, were serious; wiping on average about 40 per cent of the GDP of the pre-transition period. This chapter will be organized along the following lines. In Section 6.2 the magnitudes and causes of the transitional recession in the ex-Soviet Union and European associates will be examined. In Section 6.3 we give a review of transitional reforms and their phasing into what is called short transition and long transition. Section 6.4 treats the short transition, Section 6.5 treats the long transition, and Section 6.6 summarizes and concludes. A SIM country undergoing the long transition is confronted with economic failures that appear also in the FIM countries. These are economic imperfections due to the presence of indivisibilities, uncertainties, externalities, collectivities, and inequalities. It will become clear that the responses of firms and state settings to these economic challenges are different in the two systems. In contrast to FIM countries where firms orchestrated the remedies, the responses in most of the transition countries reflect a dominance of state interests that is consistent with the assumptions of the state intensive economic system.

6.2 Magnitudes, causes, and effects of the recession in transition countries All 25 transition countries experienced significant falls in their GDP, but with wide variations. Table 6.2 shows that output has fallen in the group Baltic, Central


Table 6.2

GDP performance in transition countries

Country

LY = lowest year of GDP

GDP decline 1988–LY, % of 1988

Annual growth GDP LY–2000, %

Annual GDP GDP GDP Ratio of growth change change change cumulaGDP 1988– 1988– 1988– tive GDP 2000–05, 2000, % 2005, % 2005, 1988– % of 1988 of 1988 billion 2005/ US$ 1988

Czech Rep.

1992

–15.4

1.7

3.7

0

19

10.9

16.6

Estonia

1994

–36.5

3.2

7.6

–12

27

1.7

15.0

Hungary

1993

–18.1

3.1

4.2

6

30

13.2

17.0

Latvia

1993

–52.8

2.6

8.1

–27

8

0.9

13.0

Lithuania

1994

–40.8

3.0

7.6

–31

0

0.0

12.9

Poland

1991

–13.7

5.1

3.0

35

56

71.3

19.9

Slovakia

1993

–24.7

4.9

4.9

2

29

5.8

16.7

Slovenia

1992

–20.4

3.8

3.4

11

31

5.4

17.3

Albania

1992

–39.9

6.6

5.4

14

48

1.6

17.5

Bosnia

–

–

–

5.0

–

–

–

–

1997

–36.9

3.0

4.9

–26

–6

–1.0

13.4

Bulgaria Croatia

1993

–37.6

2.2

4.7

–17

5

1.0

14.2

Macedonia

1995

–45.6

2.0

1.4

–37

–33

–1.9

10.5

Romania

1992

–26.6

0.0

5.7

–25

–1

–0.6

13.8

–

–

–

5.2

–

–

BCEE group (a) (b)

Serbia

1993

–31.5

3.2

5.0

–8 4

16 27

8.3 108.2

15.2 16.8

Armenia

1993

–65.1

5.4

12.3

–6

68

1.4

17.5

Azerbaijan

1995

–63.1

5.9

13.6

–48

–2

–0.2

10.6

Belarus

1995

–36.9

6.0

7.5

–14

23

3.4

14.9

Georgia

1994

–76.6

5.8

7.3

–67

–53

–4.9

7.3

Kazakhstan

1998

–40.2

1.7

10.4

–33

10

2.8

13.4

Kyrgyzstan

1995

–50.5

4.1

3.8

–28

–13

–0.3

13.2

Moldova

1999

–69.2

–

7.0

–64

–49

–1.7

9.1

Tajikistan

1996

–74.0

3.7

9.5

–65

–44

–1.2

Turkmenistan

1997

–49.6

10.5

–

–

–

Ukraine

1999

–64.5

–

–58

–39

7.7

–

8.6

0

–

–28.8

10.1

Uzbekistan

1995

–14.4

3.1

5.4

3

34

4.5

17.3

EXSR group (a) (b)

1996

–54.9

5.1

8.4

–38 –43

–7 –16

–2.4 –25.0

12.2 11.7

Russia

1998

–46.5

3.2

6.1

–36

–14

–55.1

12.3

Source, note: Columns 1, 2, 3 are from International Monetary Fund, International Financial Statistics, World Economic Outlook, IMF staff estimates; as published in Fischer and Sahay (2000). GDP decline is from 1989 to the year in which output was the lowest. Columns 4, 5, 6, 7, 8 are from http://devdata. worldbank.org/query/. GDP is measured in US$, in constant prices of 2000; Output is measured in real GDP on an annual average basis. a = group average, b = group total.


and Eastern European countries, to be named BCEE by about 32 per cent on average by the time it bottomed out. By 2000, six countries have recovered back their loss in the GDP, and by 2005, eleven of thirteen reported BCEE countries have recovered the GDP loss. Countries of the ex-Soviet Republics, to be named EXSR, lost on average about 55 per cent in their worst year. In 2000, the loss was about 38 per cent of their GDP level of 1988, on average. In 2005, the loss was reduced further to about 7 per cent of the GDP level of 1988, on average. When the EXSR is summed as a whole instead of taking a simple average, the loss in GDP of EXSR is shown to be more severe. The losses in the GDP in 2000 and 2005 are 43 per cent and 16 per cent, respectively. The average is biased downwards because of the high performance of Armenia whose GDP has a small weight in the total of the EXSR group. It is noted that the opposite results are found for the BCEE group, where the performance in terms of the total GDP is higher than in terms of the simple average. The main cause is the very low performance of Macedonia with a relatively small GDP, which biases the simple average downwards. The magnitude of the recession in Russia was similar to that of the EXSR group, with a highest loss in the real GDP of about 47 per cent in the lowest year of GDP as compared to 1988. Recovery followed bringing down the loss by 2000 to 36 per cent, and a further reduction of the loss by 2005 to 14 per cent. For highlighting the GDP decline and recovery Table 6.2 includes next to growth rates and percentage changes in the GDP, two other indicators that tell the same story in a different form. Column 7 gives the absolute loss (or gain) in the GDP of 2005 as compared to 1988 in US$ in constant prices. The BCEE has a gain, EXSR and Russia show losses of about 25,000 and 55,000 billion US$, respectively. Column 8 highlights another aspect of the recession and recovery. It gives the ratio of cumulative GDP in constant prices from1989 to 2005 to the GDP of 1988. Since the period covered counts 17 years, recession and recovery are even for ratio scores of around 17. Poland has the highest score of 20 and Georgia has the lowest score of about 7. Figure 6.1 highlights the differences in GDP fall and recovery between the three groups of transition economies. The figure highlights the shorter duration of the recession in BCEE, from 1989 to about 1992, and a quicker recovery afterwards that pushes the GDP gain in 2005 to 27 per cent. The recession in EXSR and Russia is extended to 1995 and 1998, respectively. In EXSR, the GDP decline is in 2005 at about 16 per cent. For Russia, it is slightly lower at 14 per cent. Figure 6.1 displays along the x-axis the corresponding annual growth rates of the GDP for the three groups. The different orientations among the 25 transition countries indicate that a division of countries into the above-mentioned three groups is a sensible step for understanding why and how these economies experienced different paces in their fall and recovery.3 When countries change from one system to another they go through heavy adjustments that reduce activity now but can promise more growth in the future. The decline was severe and varied appreciably per country group. What are the causes of the downfall in production? Four groups of causes are behind the

172


20 10 0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 –10 –20 –30 –40 –50 –60

BCEE GDP index

EXSR

RUSSIA GDP index

BCEE GDP growth

EXSR

RUSSIA GDP growth

Figure 6.1 Transition countries: Time profile of GDP decline and recovery by country group Source, notes: World Bank at http://devdata.worldbank.org/query/ GDP index = (GDP(t) – GDP(1988))/GDP(1988). GDP growth = annual growth rate. GDP in constant prices.

downfall: statistical distortions, system disorientation, transition policies, and external effects. Statistical distortion is one cause. To meet plan targets, there has been built-in over-reporting of output figures in the old system. But also in the transitional phase, there were statistical distortions caused by an under-reporting of production by public enterprises to evade taxes. The transitional phase saw also a strengthening of activity in the informal sector, which is not traceable in national accounts statistics. The Polish downfall estimated by 1990 at 20 per cent was revised favourably to 10 per cent after applying statistical corrections along the above lines. Observers tend to agree, however, that the magnitudes of the GDP recession in most transition countries will not be significantly affected by statistical revisions. System disorientation came abruptly. Planning institutions and supportive mechanisms vanished instantly with the collapse of the regime, before new market institutions were created. This led to coordination failures in incentives, production, and trade. System disorientation took different forms. ●

●

Labour inputs diminished as people encountered shortages, faced political uncertainties, and lost work appetite. Faced with shortages of basic goods, enterprises diverted their reserves to buying consumption necessities for their workers, at the cost of provisions for investment and production.

State Intensive System: Economic Transitions 173 ●

●

●

●

●

●

Uncertainty on privatization, and the political climate in general, encouraged expropriation of public enterprises by managers and ministries, and the flight of the appropriated capital, reducing investment and production further. Plan instructions, supported by informal networks on deliveries of intermediate inputs, ceased to be obligatory as the old system collapsed. These led to a melting down of obligations to mutual delivery between enterprises and to a widespread inter-industrial supply defaults and production decline in view of established but unfulfilled input–output relationships. Republics and regions, anticipating shortages, took measures to restrict mobility of goods to other regions, and causing production bottlenecks in the latter. In Russia the Law on State Enterprises, 1988, which required self-financing, caused a credit crunch that held production back. Financial arrears between enterprises, based on real production deliveries that could not take place, accumulated and there was no mechanism to settle them. The phenomenon obstructed the further obtainment of inputs for regular production plans. Bank managers, in control of supplying credit, favoured enterprises from which they profited most at a personal level, this leading to a misallocation of financial resources, and a prospective deadweight loss in production.

Transition policies were expected to reduce production temporarily. This is natural, as resources would have to be moved from less to more desirable activities that reflect consumer sovereignty. But there were also specific initial conditions and policies that intensified the transitional recession. They are reviewed briefly below. ●

●

●

●

●

●

Consumer hoarding that was built up before and during transition, and which constituted a potential purchasing power, was wiped out by inflationary measures and consecutive devaluations. Transition policies redistributed income from wages to profits, and increased the proportion of the non-earning population. These policies led to a further deterioration in aggregate demand. Price liberalization pushed prices up, leading to a reduction in aggregate demand. Price coordination failures led to cuts in production. For example, as the equivalent price of fodder exceeded that of animal products, livestock production activities were cut down. As was stated above, the transition aimed at a restructuring of industrial production. This started with a rapid decline in the production of military equipment and capital goods that had knockout effects on other industries as well. The parallel restructuring that was intended to enhance the light industry did not materialize either due to input shortages, or weak demand from consumers in view of not only lower aggregate demand but also non-saleable goods, low quality, inferior technology, and hardly competitive goods in an opening economy.

174


The greatest drop in output occurred in the first year of transition, and continued for some time concurrently with the liberalization and stabilization programmes. Output began to grow two years after execution of these programmes, on average. This is also about the time that inflation started subsiding from its highest growth levels. Finally, external factors influenced production differently in the different countries. Weak oil prices did not help Russia, and the war in Chechnya diverted resources to non-productive uses. Foreign trade between the communist countries declined substantially with the dismantling of the Soviet Union, leading to reduction in related production. Border countries of Russia that imported energy and raw materials at cheap prices experienced deterioration in their terms of trade. Some countries ended with severe debt crises. Other countries situated close to the European Union have gone through reforms that were directed towards their eventual integration in the EU and had the benefit of a larger inflow of foreign assistance per head than countries of the former Soviet Union. Cumulative net capital flows during 1992–97 amounted to between 600 and 800 US$ per capita for BCEE, and between 0 and 200 US$ per capita for EXSR and Russia.4 Table 6.2 and Figure 6.1 have shown that the recession was shorter and milder and recovery was stronger in the Baltic, Central and East European country group (BCEE). The incidence of the above four causes favoured the BCEE country group more than the ex-Soviet Republics (EXSR) or Russia. Next to these causes, differences in the level of economic development in the individual countries before the transition period are also behind differences in performance in the transition period. The BCEE group contained countries that are economically more advanced than EXCR and Russia. Various empirical studies that attempt to explain the variance in GDP performance among the transition countries conclude that the different initial conditions and the different implemented policies during transition were significant. Both contributed to the differences in the magnitudes of the recession and recovery among transition countries.5 Turning to distribution issues, SIM countries exhibited relatively low levels of income inequality compared to other countries. But once they entered transition, transition countries tended to take over profiles of income distribution typical of other countries at a comparable level of economic development. Table 6.3 gives the Gini index in the pre-transition period and about five years later, in 1995. We show 1995 as this was the average year with lowest level of GDP for transition countries as a whole. The Gini index increased by about six points in the BCEE group to reach 31, and twelve points in the EXSR group to reach 39, and showed a remarkable jump in Russia from 25 to 44, a rise of 19 points. These changes tended to stabilize in later years at the reached levels. Latest comparable figures available for 2005 show the Gini index to settle in BCEE group at 32, in the EXSR group at 39, and in Russia at 42. Income distribution has thus worsened less and is more equally distributed in BCEE than in EXSR and Russia, which suggests that rent seeking behaviour associated with the SIM is less spread in BCEE than in EXSR and is most in Russia. The remarkably increased and higher disparity in Russia are


Table 6.3

Socio-economic performance in transition countries

Country

GDP per capita

US$ 2005 Czech Rep.

ppp$ 2005

Gini index, %

1989

Change in Gini index

1995

2005

1995/ 1989, %

2005/ 1995, %

Income based Gini index/Earnings based Gini index

2005– 1989, points

Progressive Regressive 1995–2005 1995– 2005

11,220

19,560

20

22

26

10%

18%

6

9,060

14,660

28

40

36

43%

–10%

8

10,070

16,780

22

24

28

9%

17%

6

Latvia

6,770

13,490

26

b32

b30

23%

–6%

4

0.92

Lithuania

7,210

14,140

26

b34

b36

31%

6%

10

0.90

Poland

7,160

13,370

28

32

37

14%

16%

9

Slovakia

7,950

15,200

20

a26

26

30%

0%

6

Slovenia

17,440

22,140

24

26

b22

8%

–15%

–2

Albania

2,570

5,410

Bosnia

2,700

Bulgaria

3,450

9,140

Croatia

8,290

12,620

Macedonia

2,830

7,130

Romania

3,910

8,980

Serbia

3,220

–

Average BCEE group

6,923

13,278

25

Estonia Hungary

–

–

–

–

–

23

38

36

a36

– 24 –

30 31 – 31

– 34 –

36

32

1.00 0.71

1.11 –

–

–

–

–

–

–

–

65% 0%

–11%

11

–

–

16% –

23%

3%

–

12 –

– 7

0.96

1,470

4,990

25

b34

43

36%

26%

18

0.89

1,240

4,380

31

b46

a51

48%

11%

20

–

Belarus

2,760

7,920

23

25

24

9%

–4%

1

0.72

Georgia

1,320

3,410

28

a50

a46

79%

–8%

18

0.95

7,120

28

c35

c34

25%

–3%

6

Kyrgyzstan

450

1,860

27

b34

39

26%

15%

12

Moldova

930

2,360

25

b43

43

72%

0%

18

Tajikistan

330

1,300

28

38

36%

–

–

–

–

Turkmenistan Ukraine Uzbekistan

– 1,520 520

–

–

28

28

–

6,770

23

47

b33

0% 104%

–30%

–

0.89

Azerbaijan

2,940

–

1.22

Armenia

Kazakhstan

–

1.19

30% 29%

–

0.81

–

39

–

0.89

10

–

–

0.85 1.09 –

–

–

–

0.80

2,060

28

c45

c37

61%

–18%

9

Average EXSR group

1,348

4,217

27

39

39

44%

–1%

11

0.88

–

Russia

4,460

4,460

25

44

b42

76%

–5%

17

0.93

–

Source, notes: Columns 1, 2 are from World Bank at http://devdata.worldbank.org/query. Gini index data in Columns 3 to 9 are derived from Transmonee 2007 database at http://www.unicef-icde.org/research. Observations marked with (a) relate to one or two years around the reported year. For observations marked by (b) earnings based are converted into an income based Gini index using concerned country weights for 1996 to 2005. Observations marked by (c) are from http://devdata.worldbank.org/query.

176


manifested in the reduced incomes in real terms of manual workers, the pensioned and the unemployed and the alleviated incomes for the more educated and the self-employed small entrepreneurs and related workforce. Of course, the aggregation level of the Gini index does not reflect the income disparities arising from the formation of new riches at the highest top of the income ladder, but this too is much more pronounced in Russia than the other transition countries. In general, there are relatively more persons and groups benefiting from monopoly rent in a SIM than otherwise, and this shows up as well in a worsening income distribution when the SIM experiences transition. Within the country groups there is a tendency for countries that showed more than average increases in income concentration during 1989–95 to have less than average increases during 1995–2005, which suggests convergence tendencies. This is shown in Table 6.3 in the columns that calculate the percentage change in Gini index in the two periods. For example, Gini index for Russia experienced one of the highest rises in the early transition, 76 per cent, and was somewhat compensated by a fall in later years by 5 per cent. For all countries as a whole, the secondary income redistribution mechanisms organized by the state result in a more progressive income distribution. The ratio of Gini indices based on income to that based on earnings, last columns in Table 6.3, is averaged at .96 for BCEE, .88 for EXSR, and in-between at .93 for Russia. Even though the aggregate picture suggests progressiveness, there are individual countries where state actions clearly result in regressive redistributions. In the BCEE group, as the last two columns of Table 6.3 show, the ratio of Gini indices in Bulgaria, Poland, and Macedonia amounts to 1.19, 1.11, and 1.22, respectively; which is indicative of a regressive role of the state in the secondary income redistribution mechanisms. These three countries happen also to have within the BCEE group the highest concentrations of income, with Gini index at 34, 37, and 39, respectively. Redistribution mechanisms are most progressive in Slovenia, Hungary, and Czech Republic with the ratio of Gini indices at .81, .71 and .89; these are also the countries with lowest Gini index at 22, 28, and 26, respectively. In EXSR, Moldova is most regressive and Belarus is most progressive in income distribution policy and results. The sharp rise in income inequality during the first years of transition shows up in more transparent indicators such as poverty headcounts, unemployment rates, and unpaid pensioners. The magnitudes of these indicators, the needs they imply for income redistributive measure, and what has actually happened in terms of income transfers to these groups is dealt with in a later section, see Section 6.6. The relationship between economic growth and changing income inequalities is multi-sided. Empirical evidence for the transition economies as shown in Table 6.3 and Figure 6.2 shows Slovenia positioned in the upper left-hand quarter, this is where positive economic growth associates with a progressive reduction in income inequality, i.e. Gini index declining. Most of BCEE are in the upper right-hand quarter showing higher growth with increased income inequality, i.e. Gini index increasing. Russia and some EXSR are in the lower right-hand quarter showing retarded economic growth with increased income inequality.


change in GDP percent

80

60

y = –2.2673x + 30.43 R2 = 0.1822

40

20

–5

5

10

15

20

25

–20

–40

–60

change in Gini points

Figure 6.2 Transition countries: Relationship between percentage change in GDP 1989–2005 (y-axis), and change in the Gini index 1989–2005 (x-axis)

A multi-sided causal relationship can be also sought from Figure 6.2. One is that in a country that is more inclined towards the state intensive economic system, like Russia, an economic transition would inevitably bring about a sharp increase in the Gini index, and this hinders factor mobility and economic growth. Simultaneously, lower economic growth due to distributional bias or other limiting factors would drain out trickle down effects and can result in greater income inequality. For most of the transition economies the heightened economic growth in later years must have had sufficient progressive trickle down effects to maintain the Gini index in 2005 at about the same level as that in 1995.

6.3 Overview of reforms and their phasing in transition countries The economic elements of system transformation, and the sequencing of the transitional reforms, were developed and recommended by the World Bank, WB, and the International Monetary Fund, IMF, respectively.6 WB and IMF proposed Table 6.4, which distinguishes between four areas of policy reforms: macroeconomic stabilization and control, the more microeconomic oriented price liberalization and market reforms, then private sector development and privatization of public enterprises, and finally and throughout the process, redefining the role of the state. These policy areas are then distributed over time in what is called the sequencing of transitional reforms. As can be seen from Table 6.5 that gives the sequencing, the transitional reforms phasing is not linear. Although groups of policy reforms are introduced after each other, there is overlapping that allows for complementarities. The particular consequence that takes place in any country


Table 6.4 Economic elements of system transformation 1 Macroeconomic stabilization and control Governments and enterprises: Fiscal tightening, Tight credit policies, Addressing existing problems (money overhang, bank losses), Expenditure-switching measures for external balance 2 Price and market reform 2.1 Goods and services: Domestic price reform, International trade liberalization, Distribution systems (transport and marketing services), and Housing services 2.2 Labour: Liberalizing wages and labour market 2.3 Finance: Banking system reform, Other financial markets, Interest rate reform 3 Private sector development, privatization, and enterprise restructuring 3.1 Facilitating entry and exit of firms 3.2 Enterprise governance 3.3 Establishing private property rights 3.4 Clarifying and allocating property rights: i.e. agricultural land, industrial capital, housing stock, and commercial real estate 3.5 Sectoral and enterprise restructuring, including break-up of monopolies 4 Redefining the role of the state 4.1 Legal forms: Constitutional, property, contract, banking, competition, and so on, Reform of legal institutions, Regulatory framework for natural monopolies 4.2 Information systems (accounting & auditing) 4.3 Tools and Institutions for indirect economic management: Tax system and administration, Budgeting and expenditure control, Institutions of indirect monetary control 4.4 Social areas: Unemployment Insurance, Pension, Disability, Social services: health, education, and so on Source: Adapted from World Bank and IMF.

Table 6.5

Transition sequencing

Policy measures

Transition sequencing phases

Macro stabilization Currency reform Current account convertibility Independent central bank Small-scale privatization Price and market reform Large-scale privatization Autonomous banking system Other financial markets Fiscal reform Social safety net Institutional reforms Periods

intense continuing x x prepare execute x x continuing prepage execute prepare liberalize prepare apply as market develops create tax administration and budgetary procedures x institutionalization establish legal and regulatory institutions 1 2 3 4 5 6 7 8 9 10

Source: Adapted from World Bank and IMF.


would depend on the state of the economy, the political situation in each country, and on the tolerance of the population at large who may lose from specific reforms versus the pressure exerted by the gainers. The early phase of transitions started with the two components of liberalization, following our terminology: deregulation of prices and quantity restrictions in the product markets, and the privatization of state-owned small enterprises. Any large-scale liberalization programme will temporarily lead to an output decline, inflationary pressure, and worsening of the internal (fiscal) and external (payments) imbalances. In due time, as a successful stabilization takes place, the economy recovers. Once the early phase of transition, which we shall call short transition, is successfully completed and the economy is reasonably stabilized, actions can be continued in other directions that take longer periods to accomplish with success. We call this phase long transition, see Table 6.6. The deregulation is extended here to the factor markets of labour and capital. After the necessary preparation the time is then ripe for a privatization of medium and large enterprises. In practice, some governments have hastened with large privatizations and executed them without serious preparation in the short transition. This was done under pressure of interest groups that have benefited from the chaotic situation. Legal and institutional reforms are supposed to commence in the short transition but to intensify in the

Table 6.6 Proposed discussion in terms of short and long transition phases SHORT TRANSITION in a couple of years Macroeconomic stabilization

real imbalances, unemployment, monetary balance, curb inflation fiscal balance, payments balance

Microeconomic liberalization

deregulation in the product market deregulation in the factor market (privatization of small enterprises)

LONG TRANSITION in about a decade 1 Conversion of state enterprises to competitive enterprises

privatize large state enterprises, institute financial markets, Introduce labour legislation

2 Promotion of market confidence

reduce hidden economy, combat corruption practices introduce modern, financial, and legal institutions

3 Internalization of externalities

industrial restructuring directed towards conforming with comparative advantages in an integrated world economy

4 Public goods provision

– replacement of full state by mixed provisions – start social security

5 Income maintenance transfers

– safety networks – progressive taxation

180


long transition, noting that legislation is only a starting step. Setting up of the apparatus and skills to implement the law is a matter of training and learning by doing that requires more time to acquire. We reorder in this section the elements of transition reforms and their sequencing, and we find sense in grouping them under short transition and long transition reforms, that we discuss in more detail in the next section. In the real world, the short transition has taken from two to three years and for some countries a few years more, depending on how successful are the particular countries. The experience with the long transition is now about midway for some transition economies and is about just starting for many others. The long transition can take a decade or more. To facilitate the exposition in the next two sections we display the elements of the short and long transitions in Table 6.6. It is noted that the short transition focuses more on macro stabilization measures pertaining to the balance of revenue and expenditures in the state budget and to the balance of foreign payments as a result of related price liberalization in these two balances. The long transition gives due attention to the changing behaviour of agents at the micro level.

6.4

Short transition

6.4.1 Stabilization reforms Any large-scale liberalization programme is bound in its first months to destabilize the economy in the form of a steeply rising inflation and displaced businesses. Hence, liberalization programmes have to be coupled to stabilization programmes. Transition economies passed through a stage that is fully uncontrolled, and a stage to gain control. The uncontrolled stage started with freeing prices. Once freed, prices soared to unexpected levels. In the first year of the transition repressed inflation and hoarded savings contributed to an excess of money over the value of goods demanded and available. The monetary overhang drove prices up. The fiscal budget balance deteriorated due to falls in revenue and insufficient cuts in expenditures. At the same time the foreign payments balance was destabilized by huge currency devaluations. Among the highest is that for the Russian ruble which fell to one-tenth of its pre-transition level, pushed by political unrest and capital flight. Severe payments problems for interstate trade followed. The Russian central bank reacted by issuing extensive credits to former soviet republics for the purchase of Russian goods, which were in shortage anyhow. The first year was practically a lost year in terms of stabilization, and particularly for Russia. In the next phase firms needed finance and workers demanded more wages in the face of rising prices. Most of the BCEE transition economies did not give in to the demand for issuing more money, and kept wages within temporary control. They held tight credit and sharp cuts in subsidies. The maximum annual inflation was restrained to 610 per cent in BCEE, and if outliers such as Baltic, Croatia, and Macedonia are left out, the figure is reduced to 126 per cent. These maximum inflation rates can be compared with much higher maximum rates in EXSR, 2430 per cent, and in Russia 1490 per cent, as shown in Table 6.7.

State Intensive System: Economic Transitions 181 Table 6.7 Stabilization programmes and inflation performance in transition countries Country

Czech Rep. Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia Albania Bulgaria Croatia Macedonia Romania BCEE group Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyzstan Moldova Tajikistan Turkmenistan Ukraine Uzbekistan EXSR group Russia

Stabilization Year of Maximum Inflation programme highest annual in date inflation inflation, 1995, % % Jan 1991 Jun 1992 Mar 1990 Jun 1992 Jun 1992 Jan 1990 Jan 1991 Feb 1992 Aug 1992 Nov 1994 Oct 1993 Jan 1994 Oct 1993 – Dec 1994 Jan 1995 Nov 1994 Sep 1994 Jan 1994 May 1993 Sep 1993 Feb 1995 Not started Nov 1994 Nov 1994 – Apr 1995

1991 1992 1991 1992 1992 1991 1993 1991 1992 1997 1993 1992 1993 – 1994 1994 1994 1993 1992 1992 1992 1993 1992 1993 1994 – 1992

36 874 36 933 942 55 29 247 250 949 1467 1272 227 – 4107 1385 1945 7486 1472 830 945 1207 2773 3335 1239 – 1490

Inflation in 2005, %

GDP change GDP change billion billion US$, US$, 1988–95 1998–2005

17 31 27 28 46 41 10 25 10 63 5 17 35 25 161 546 662 163 161 42 39 346 195 416 371 323

1 6 3 9 6 3 3 4 4 4 3 3 12 45 3 10 17 8 18 7 7 9 – 20 16 11

–4.3 –2.0 –6.1 –4.8 –7.2 4.4 –3.0 –1.9 –0.4 –3.9 –6.6 –2.6 –10.0 –48.3 –0.5 –6.4 –5.5 –6.9 –10.9 –0.9 –2.1 –1.8 – –39.4 –2.0 –76.4

10.9 1.7 13.2 0.9 0.0 71.3 5.8 5.4 1.6 –1.0 1.0 –1.9 –0.6 108.2 1.4 –0.2 3.4 –4.9 2.8 –0.3 –1.7 –1.2 – –28.8 4.5 –25.0

144

20

–165.3

–55.1

Source, notes: Columns 1, 2, 3 are from International Monetary Fund, International Financial Statistics, World Economic Outlook, IMF staff estimates, as reported in Fischer and Sahay (2000). Columns 5, 6, 7, 8 are from World Bank at http://devdata.worldbank.org/query. Pre-programme inflation is inflation in the 12 months previous to the month of the stabilization programme. Columns 4 and 5 are GDP inflation deflators. Columns 6 and 7 give GDP change in billion US$ expressed in constant prices of 2000.

For most countries in the BCEE group the fiscal deficit went down to around 6 per cent. Currencies of successful reforming countries recovered in foreign exchange value due to remarkable export growth and trade surpluses. The EXSR group and Russia went the opposite way and were generous in the money supply growth and net domestic credit, which grew by 150-fold in 1992–94. The growth of this credit to dubious enterprises and clients at negative real interest rates in Russia has been interpreted in terms of rent seeking and corruption practices between a too closely linked government to enterprises. The result is an inflation reaching the above-quoted average maximum of 2430 per cent a year, a fiscal deficit of around 12 per cent, and a series of foreign exchange crises, the last of which in 1999. Russia had also difficulties in denying credit in lieu of pervasive arrears. Collection of tax arrears is still a problem. It

182


2000

1500

1000

500

0 billions US$ –500 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 BCEE inflation rate

EXSR inflation rate

RUSSIA inflation rate

BCEE accumulated GDP change

EXSR accumulated GDP change

RUSSIA accumulated GDP change

Figure 6.3 Transition countries: Average annual inflation rates and the loss and gain in real GDP Source, note: World Bank at http://devdata.worldbank.org/query. Inflation rates are GDP deflators. The accumulated GDP changes, plotted along the x-axis, are in billions of US $ in constant prices of 2000.

took Russia and associated countries more years than first two groups of transition economies to reduce inflation and stabilize the economy. Figure 6.3 displays the inflation profiles in the three groups of transition countries over the period of 1988 –2005, and their association with the accumulated GDP changes. These are losses or gains obtained by deducting GDP in year t from t-1, and adding the change to the previous changes. The accumulated GDP change in year t is equal to deducting GDP in year t from GDP in 1988. Values are in billions of US$ in constant prices of 2000.7 Figure 6.3 shows countries with least inflation to have secured least losses and highest gain in the GDP. Even though the inflationary trend in Russia was lower than in the EXSR, the realized losses in the GDP were higher in Russia than in EXSR. In general, indicators of the stabilization effort such as the growth of money supply and credit, fiscal, and payments balance for the transition economies are not readily comparable. Fortunately, the result of the stabilization policies is readily observed from inflation statistics, which are utilized in Table 6.7 and Figure 6.3. The inflation statistics show the inflation rates in all transition countries to have been significantly reduced in later years. Most of the country figures for 2005 are comparable to those found in many developing countries. 6.4.2 Liberalization reforms Economic theory of competitive markets ascertains that the efficiency prices – that is, the right prices – are those formed by the free play of demand and supply forces. Once the right prices come into being scarce resources would move to


activities with highest returns. Price reform is thus a crucial step in transitions. Hence, governments started with price liberalization of domestically traded and internationally traded goods in the product markets. The liberalization in the factor market followed later. The liberalization of domestic trade in the product market meant dropping subsidies for necessity goods such as staple food, rent etc., and abolishing price regulations for some other categories of goods. The price liberalization can lead to substantial price hikes, as the supply is inelastic in the short run. Besides, monopolists can exploit the deregulated situation. Hence, price liberalization had to be accompanied by strengthening competitive forces and the stimulation of a greater entry and exit of suppliers. Some countries went for a radical liberalization such as Poland in 1990 when they freed about 90 per cent of all prices simultaneously. At the same time Poland experienced an enormous growth of new businesses that were attracted by the newly emerging price structure, as evident from the fact that over half a million privately owned small firms have registered in 1990. Most other countries followed a more gradual approach that took four or five years to reach comparable degrees of deregulation and state trading monopolies. The liberalization of foreign trade started with the partial elimination of export controls and taxes, substitution of moderate import duties for import quota and high tariffs, and foreign exchange convertibility for current account transactions. Liberalization of foreign trade contributed not only to greater supplies of goods but also to mobilizing competition. The opening of the economy to foreign trade allowed the institutionalization of international prices and benefits of international competition, so that the authorities get more time to pass domestic laws to combat monopoly and prepare the machinery to execute them. The liberalization of foreign trade requires the right foreign exchange price for the national currency. One option is a floating exchange rate. Another option is the fixing of the exchange rate within a range, this is more desirable in view of its predictability, but its enforcement depends on the available foreign exchange reserves. The transition countries differed in their response towards choosing the terms for currency convertibility depending on their available currency reserves, among others. Turning to liberalization reforms in the factor market, it is easier to privatize small firms than large firms. Small firms have intermediate technologies, have simple management structures, and are concentrated in agriculture, food retail, and in processing and trade of other light consumer goods and services. Their privatization and active mobilization in the new competitive setting would enhance production and relieve consumer shortages during the short transition. Complex problems of valuation, transfer, and governance arise in privatizing large and infrastructural firms; these take time, which is why most countries reserved their privatization for the long trajectory. Widespread privatization of small firms was first achieved in Czech Republic, Hungary, and Poland, and was followed at high speed by the three Baltic countries and Russia. The transition economies followed different paths in the privatization of small enterprises. The Czech Republic used open competitive auctions that were locally administered. Hungary had already a large number of prospering small enterprises under leasehold arrangements with local and central authorities;

184


this trend was continued for newly privatized enterprises together with sales to outside owners. Poland gave large concessions to employees who were allowed to take ownership over small enterprises. At the other extreme is Russia that transferred ownership of small firms in informal ways to firm insiders, consisting of a mixture of the unit manager, workers, officials, and intermediaries. For measuring the extent of liberalization in the short transition the World Bank developed an Index of Liberalization (WBIL) on the basis of various indicators of undertaken policy measures.8 Results are shown in Table 6.8. The highest scores are found among the newly acceding BCEE countries to the European Union with values ranging from 8.1 to 9.3 for 1995. The other BCEE countries score less, giving an average for BCEE of 8.2 for 1995. EXSR have an average score of 5.3, and Russia is in-between at 6.9. An annually updated and a more widely held comparative indicator of the extent of liberalization is the Heritage Index of Economic Freedom (HIEF) published by the Heritage Foundation. Table 6.8 shows the score of the transition countries on this index in 1995, 2000, and 2005.9 Figure 6.4 displays the differences between the three blocks of countries following alternative measures of the liberalized economy. At an aggregate level the two alternative measures show equivalent results: BCEE is most liberal followed by Russia and then EXSR; though in 2005 the Index of Economic Freedom shows

Table 6.8

Extent and pace of liberalization in transition countries Word Heritage Index of Bank Economic Freedom(HIEF) Index of liberaliza1995 2000 2005 tion (WBIL) 1989–95

Word Heritage Index of Bank Economic Freedom (HIEF) Index of liberal1995 2000 2005 ization (WBIL) 1989–95

Czech Rep.

9.3

71.8

71.6

66.6

Armenia

5.8

38.9

62.4

67.7

Estonia

9.3

65.2

74.2

76.6

Azerbaijan

4.3

–

47.1

52.5

Hungary

9.0

58.2

66.4

63.4

Belarus

4.8

41.2

37.8

45.3

Latvia

8.1

a54.6

63.0

63.0

Georgia

5.8

–

51.1

55.6

Lithuania

8.6

–

63.3

69.5

Kazakhstan

5.7

–

47.5

51.1

Poland

8.9

52.3

63.0

59.0

Kyrgyzstan

8.2

–

53.2

54.7 55.1

Slovakia

8.6

58.9

52.7

64.7

Moldova

6.8

33.0

58.1

Slovenia

8.5

a46.3

56.2

60.9

Tajikistan

3.9

–

42.9

49.9

Albania

7.4

54.3

51.0

56.6

Turkmenistan

2.3

–

36.8

43.7

Bulgaria

6.1

47.8

50.4

59.9

Ukraine

5.8

33.7

47.4

53.7

Croatia

8.5

–

52.7

52.5

Uzbekistan

5.3

–

35.5

44.2

Macedonia

7.3

–

–

55.6

EXSR group

5.3

36.7

47.3

52.1

Romania

7.1

42.9

55.3

50.8

–

–

–

–

BCEE group

8.2

55.2

60.0

61.5

6.9

49.7

50.1

50.1

Russia

Source, note: Column 1 is from World Bank (1997). Columns 2, 3, 4 are from the Index of Economic Freedom, published yearly by The Heritage Foundation. (a) = 1996


90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 HIEF1995

WBIL1995

BCEE

HIEF2000

EXSR

HIEF2005

Russia

Figure 6.4 Transition countries: Extent of liberalizations as measured alternatively by World Bank Index of Liberalization (WBIL) and Heritage Index of Economic Freedom (HIEF)

Ratio of accumulated GDP 1989–2005 to GDP 1988

25

20

15

10

5 y = 0.0986x + 6.8499 R2 = 0.2426 0 0

10

20

30

40

50

60

70

80

90

100

WB index of liberalization measures 1989–1995 as of 1995

Figure 6.5

Transition countries: Liberalization and cumulative GDP

a reversal in the relative free market orientation of Russia and EXSR, with the Russian economy becoming less liberal than the EXSR. It was mentioned earlier that the empirical evidence on the explanation of different economic growth performances among transition countries pointed not only to differences in past and initial conditions that favoured the BCEE more than EXSR and Russia, but also to pursued policies with regard to income distribution, inflation control, and liberalization reforms.10 The empirical evidence

186


suggests that countries that introduced faster liberalization have recovered their lost output at a greater pace. Figure 6.5 displays the relationship between the World Bank liberalization index for 1975 against the ratio of the cumulative GDP over 1989 to 2005 to the initial GDP of 1988.11 Although many countries that lie across and in the neighbourhood of the regressed line in Figure 6.5, there are outliers: countries which did not liberalize as much but nevertheless showed high economic growth, as well as a couple of countries experiencing the opposite. When the Index of Economic Freedom is plotted against the ratio of cumulative GDP the result is a much weaker correlation, and statistically less significant, suggesting that the more specific World Bank index of liberalization measures it is better equipped in representing the extent and pace of liberalization in transition countries than the more general Index of Economic Freedom.

6.5

Long transition

Application of welfare economics to firm intensive economic systems distinguished five areas of market failures, or rather economic failures. It was noted in the chapters on FIM that there are technical and behavioural obstacles that result in the five types of economic failures. The areas were described as indivisibility, uncertainty, externality, collectivity, and distribution. The remedies to correct for these failures included five areas of actions by firms and government. They are respectively: promoting firm competition, institutionalizing good governance and reducing uncertainty, internalizing externalities, provision of public goods, and transfers to assure basic income maintenance. Although transition economies face the same five types of economic failures, and similar remedies suggest themselves, the situation is usually more complex in the SIM context than the FIM context. First, economic failures are more interlocked, concentrated, and severe during the transition period. Second, the inherited political behavioural patterns of the state regime reappear again during the transition, as has become evident in some of the transition countries, especially Russia. This comeback of a SIM-like regime prolongs behavioural traits characteristic of rent appropriation and political gains and brings into doubt the inevitability of an economically successful long transition. Consequently, questions arise about the ability and speed of particular countries to convert from SIM to FIM systems within reasonable times. In this section the responses of state agents and private agents to the five areas of economic failures in the long transition will be in transition economies. The responses point to a drifting away from the state-like dominant setting, or a likely moderation, in some transition countries;12 and to a possible rehabilitation of the state-like dominant setting in some other transition countries.13 6.5.1 Competitive entrepreneurships 6.5.1.1

General

Because of technological indivisibilities, and also because of other economic and non-economic reasons, all countries had at one stage some public enterprises that


were state-owned. Under changing technological and other conditions these public enterprises were converted into privatized companies in the FIM countries. The situation is different in the SIM countries. One of the crucial principles for the functioning of the economic system in SIM countries is the state ownership of enterprises and of factors of production, and this is based on a declared and authorized political ideology. State ownership of enterprises in SIM countries is not based on an economic argument of technological indivisibilities but is based on a communist viewpoint of the optimal order. The fall of the communist regime implied that the primary and foremost basic changes that the transition countries have to introduce are (a) private ownership and the privatization of state enterprises, and (b) viable factor markets in which the private ownership in the privatized enterprises can be traded. These two elements are major constituents of the long transition. They will be treated in this section. 6.5.1.2 Privatization of state enterprises It was stated earlier that privatization of small sized public undertakings in agriculture, distribution, and services started immediately after the fall of the centrally planned regimes, and that the transition countries followed different forms of privatization of these small undertakings. More important is the massive conversion of medium and large state enterprises into private enterprises that started shortly after. This massive privatization was launched in Russia in July 1992, the European transition economies started at a year earlier, while the Asian transition economies a year or two later. There are four general features of this massive privatization: (a) the methods and modes of privatization followed were bent to institute insider rather than outsider governance of the newly privatized firms in most transition countries, but a few did otherwise, (b) the privatization was rapidly and chaotically implemented without the presence of required legal and institutional setups to guard against personal misuses by state agents and influential associates, leading to illegal captures and looting during and after privatization in many transition countries, (c) the contribution of the mass privatization towards a viable restructuring of the economy and freely competing private firms has not been realized in some of the concerned countries, due to additional limitations inherited from the past SIM, and (d) where there is a disappointment with privatization, such as in Russia; there is the reverse tendency for a re-concentration of top business decisions in major areas of economic activity in the hands of the state, and a virtual return to a state-like dominated economy. Before dealing with the experiences of individual transition countries in this massive privatization, some introductory remarks will be made on options regarding enterprise governance, privatization method, and privatization strategies. The first feature of the privatization of state enterprises in the transition countries is its inclination to insider governance rather than outsider governance, which has important consequences for the performance of privatization. There are basic differences in enterprise governance between state enterprises and private enterprises. The case of state enterprises is one in which the owners, i.e. the principle or the people, delegate their rights to such agents as politicians

188


and bureaucrats who in turn install enterprise managers to lead the state enterprises, who are then monitored by bureaucrats. Since the interests of politicians, bureaucrats, and state enterprise managers overlap, and since there is no control on all three by the ultimate owners, the people, decision-making in state enterprises and governance become non-transparent and highly politicized. Governance in privately owned small firms is straightforward; owners are usually the managers. In corporations, the owner shareholders and company management are different, and the need for monitoring by the first of the second raises complex issues of governance designs. A more or less complete separation between shareholders and management and a tight monitoring by the first of the second is generally known as outsider governance. Where corporate management and major shareholders overlap and there is a little monitoring possibility of corporate management by minor shareholders, this is a case of insider governance. Entry and exit of firms, and therefore a more competitive market and competing firms, are generally more present when enterprise governance is of the outsider type rather than the insider type.14 When governments privatize policy, choices are made as regards the method of privatization. There is an association between the method of privatization followed and the enterprise governance that ensues after privatization. When government sells shares of the privatized company to the general public at the stock exchange, or organizes a competitive sale among contending buying companies, or a takeover in an investment fund, domestically or foreign, the resulting enterprise governance tends to be an outsider governance. When the method of privatization takes the form of management–employee buyouts, the resulting enterprise governance is an insider governance. This applies also in case of a partial privatization when the state owns a major share and mobilizes a selected financial group to own remaining shares. The privatization of state enterprises that occurred in the recent past in Western Europe were of the outsider type, privatization in the transition economies of Eastern Europe followed a mixture of outsider and insider governance with more emphasis on the latter. As Table 6.9 shows, Hungary and Estonia transferred about 40 per cent of state ownership to outside owners, which makes these two countries more inclined to outside governance than the other transition countries. The Czech Republic distributed equal-access vouchers to citizens, which is also primarily an outsider governance oriented policy. The new owners were encouraged to place their vouchers in competing investment funds that monitored the privatized companies. To the extent that the investment funds tend to collide, there is a reverse to insider governance. Poland emphasized ownership by municipalities and semi-public bodies and maintained strong links between management and state, and thus promoting insider governance. The Russian government’s choice for the insider owned policy is rationalized on the grounds that the transition economies have no stock markets to float initial public offers, the public lacks purchasing power, there are no high performing domestic companies to take over the ailing state enterprises, and selling to foreign companies is felt to be against the national interest and would raise unsolvable negotiations on asset valuation.

State Intensive System: Economic Transitions 189 Table 6.9 Privatization methods for medium and large state enterprises in six transition economies, by number and by value, per cent Country

Sale to outside owners

Equalaccess vouchers

Management– employee buyout

Restitution

Other(a)

Still in state hand

By number Czech Rep.

32

22

0

9

28

Estonia

64

0

30

0

2

10 4

Hungary

38

0

7

0

33

22

Lithuania

25

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