Wedevelop a theory of institutional change and apply it to analyze China's transition toward capitalism. We focus on how product market competition induces institutional change through the interaction between bureaucrats and managers in regional government-controlled economies. When cross-regional competition is sufficiently intense, each region has to cut production costs. Given that the efforts of managers are not verifiable, local governments may have to grant total or partial residual shares to the managers. In general, intense product competition stimulates the rise of a private property system. We submit our theory to a vigorous empirical test using China's industrial census data of more than 400,000 firms. The test supports strongly our postulation that cross-regional competition is the driving force behind China's transition toward capitalism.J. Comp. Econom., June 2000, 28(2), pp. 269–292. City University of Hong Kong, Kowloon, Hong Kong; and Peking University, Beijing, China.
Institutional arrangements, particularly property rights, are central to incen-
tives and hence to economic performance. Under the condition that information
about individual attributes and actions is largely decentralized, most economists
agree that private ownership is the most high-powered incentive instrument. This
view is supported by the fact that more than twenty former socialist economies,
with about one-third of the world population, are trying to undergo the transition
to capitalism.2Yet our knowledge of institutional change is limited. How do
institutions change? What factors drive efficient institutional change? In partic-
ular, what are the driving forces behind the transition from government to private
ownership? These questions provide both unprecedented challenges as well as
opportunities for economists to study institutional change.
Among the transition economies, the Chinese case is particularly intriguing.
When Deng Xiaoping and his comrades began the reform in 1978, no one,
including Deng himself, expected to witness a nearly double-digit annual growth
rate in the subsequent two decades and the rise of a predominant non-state sector.
China’s phenomenal performance is cited by some economists as an example of
why privatization is not a necessary precondition for efficiency because the high
growth rate in China has occurred under the dominance of public ownership (e.g.,
Stiglitz, 1994). Some argue that the success of township and village enterprises
(TVEs), which are a form of collective ownership, challenges standard property
rights theory (Weitzman and Xu, 1994; Li, 1996). However, the Chinese expe-
rience is not consistent with these arguments. In the last two decades, especially
since the early 1990’s, both state-owned enterprises (SOEs) and TVEs have been
increasingly privatized and most newly established firms are private enterprises.
In 1978, nearly four-fifths of the total industrial output in China came from
SOEs. By 1997, the SOEs’ share had shrunk to slightly more than a quarter
(Statistical Survey of China, 1998, p. 99). The major players behind the rise of
a private ownership system are local governments at various levels (China
Reform Foundation, 1997; Cao et al., 1999).
Interestingly, the Chinese economic reform began with decentralization, rather
than with the development of a private ownership system, and with revitalization,
rather than privatization, of state firms. What are the driving forces behind the
unintended and accelerating rise of a private ownership system in China? What
motivates local governments to privatize the enterprises under their control and
to issue licenses to newly established private firms?
The work of North (1990) and Weingast (1995) provides some hints about
answers to these questions. North (1990) maintains that institutions are the rulesof the game, while organizations are the players, and competition among orga-
nizations is the key to institutional change. Weingast (1995), and Qian and
Weingast (1997) propose that market-preserving federalism provides a good
political foundation for economic development. They argue that cross-regional
competition played a central role not only in the rise of England’s economic
power in the eighteenth century and that of the United States in the nineteenth
century but also in the rise of the Chinese economy during the last two decades.
More recently, Cao et al. (1999) argue that federalism, Chinese style, has induced
privatization, Chinese style. However, one issue these authors do not address, at
least not formally, is how cross-regional competition stimulates the rise of a
private ownership system. It is not clear whether it is in the interest of local
bureaucrats to privatize. Although privatization generally makes the pie that they
share with firm managers and others bigger, it also decreases the relative shares
of the local bureaucrats.
We develop a theory of institutional change for transition economies by
characterizing it as the rise of a private ownership system. We then apply our
theory to explain China’s road to capitalism. We argue that the rise of the private
ownership system consists of two essential components, the privatization of
existing SOEs and collective-owned enterprises (COEs) and the establishment of
new private firms.
For ease of exposition, we focus on how cross-regional competition in the
product market triggers privatization of SOEs and COEs. However, the same
logic can be applied to analyze how cross-regional competition induces the
establishment of new private enterprises. In our paper, firm ownership is defined
by residual claimancy.
3
Privatization is the process of shifting residual claims
from the government to managers. In our model, there are two local governments
and two enterprises or firms. The enterprises were formerly owned by the central
government. At the initial stage of reform, the central government gave the
enterprises to the local governments, with each local government owning one
enterprise. After the localization, the central government still maintains the
authority to set tax rates as well as to retain a share of the tax revenue, but the
local government obtains the residual claim on after-tax profits and also has the
right to decide whether or not to shift residual claims to management. In other
words, the local government has the autonomy to decide whether or not to
privatize. To simplify our analysis, we assume that the manager has all the
control rights over the firm’s business, except for the rights of taxation and
privatization. We further assume that the manager’s residual claim rights are welpreserved in privatized firms. Thus, when the manager holds all residual claim
rights to the firm, he is the de facto owner of the firm, enjoying both residual
control rights and residual claim rights.
The two firms play a Bertrand–Nash price game in markets with differentiated
products. The production cost is determined by the manager’s non-verifiable
effort. The local government is concerned with its own total revenue, i.e., the sum
of its share of tax revenues and any profit remittance, which depends on its
market share and the profit margin. We show that, when competition is suffi-
ciently intense in the product market, the local government will be induced to
shift the residual claims to the manager. The reasoning for this is inductive. As
the product market becomes more competitive, the market share, and therefore
the profits, is more sensitive to production costs. In order to maintain a minimum
market share for survival, the manager must be motivated to work harder. Given
that verification of the manager’s effort is impossible, privatization is the only
effective means by which the local government can motivate the manager. In
contrast, if the central government sets the after-tax residual share or if two local
governments collude perfectly to maximize their joint revenue, public ownership
may prevail. We find that efficiency generally improves as a consequence of
privatization
In this paper, we develop a theory of institutional change in the context of a
transition economy. We show that the rise of a private ownership system occurs
as a consequence of cross-regional competition. Initially the Chinese economic
reforms were not intended to privatize state and collective enterprises. However,
the decentralization policy triggered privatization eventually and the establish-
ment of new private firms through cross-regional competition. In 1997, the
Chinese Communist Party’s Fifteenth Party Congress promoted the formation of
joint-stock systems and various other organizational forms to bail out the vast
majority of failing SOEs; this move is widely viewed as a covert act of
privatization. Formal open privatization in China has thus far not been adopted
as a central government policy for ideological reasons. However, competition is
far more powerful than ideology. Regardless of whether or not the central
government will draw up a blueprint for full privatization, both our theory and
reality show that the privatization process will continue to accelerate with its own
logic and vigor. China has reached a point of no return on the road to capitalism.
The Chinese experience demonstrates that the invisible hand is not only
powerful in allocating resources; it is also powerful in creating institutions. Once
decentralization begins, market competition may precipitate a self-enforcing development of a private ownership system. The newly founded and privatized
firms intensify, in turn, market competition. This is the major lesson that other
transition and emerging economies may draw from China’s experience.
Nevertheless, the emergence of a private ownership system requires a sound
legal system to protect property rights. In particular, de facto ownership by
managers must eventually become de jure private ownership. Commercial laws
are also needed to enforce contracts between enterprises. Although China enacted
the General Principles of Civil Law in 1986, the Law of Civil Litigation in 1991,
and the Contract Law in 1999, and many other laws since these, there are two
major problems in its current commercial law system. First, there are no clear and
detailed rules to protect private property. To facilitate efficient private invest-
ments, detailed civil codes and procedures are needed to protect private property
under different contingencies. Second, cross-regional commercial disputes are
settled in local courts that are virtually controlled by local governments, in that
the local governments provide the courts with both financial and personnel
resources. To mitigate local protectionism and to facilitate interregional compe-
tition, local courts must become independent of local government control or
major cross-regional commercial disputes must be settled by higher-level courts,
whose jurisdiction is common to the regions.
We are only beginning to understand the driving forces behind institutional
change, in general, and the rise of private ownership systems, in particular. Much
work remains to be done. Although we have demonstrated how decentralization
can promote the development of a private ownership system through competi-
tion, we do not yet have a theory to explain what drives decentralization, nor do
we have a theory to explain how de facto property rights evolve into de jure
property rights. Exploration of these topics will enhance our understanding of
institutional change. This study provides a foundation on which to base such
endeavors.