Lecture 4. Dual-track liberalization and its properties.

1. Introduction. Price liberalization in China followed a “dual- track”. Plan track: production and prices are frozen at defined preexisting level (last year’s plan) Market track: liberalization at the margin for all goods with fully free transactions once the plan obligations are fulfilled. Producers are full residual claimants of market track.

1. Introduction. Dual-track liberalization has particularly interesting properties as Eastern European countries did not implement it. Can theoretically achieve the same efficiency as full liberalization if secondary markets (resale) are allowed. Has interesting political economy property not to create losers but only winners (!) Prevents output fall that was associated to price liberalization.

1. Introduction. Household responsibility system was first form of application of dual-track approach. A fixed quantity of grain was to be sold to the state procurement agency at planned prices, a certain quantity of inputs (mainly chemical fertilizers) at planned prices. Once these obligations fulfilled, farmers were free to produce, buy and sell what they wanted. Dual-track price liberalization introduced in all industry in For consumers, basic necessities assigned by rationing before After liberalization, coupon system still available until 1979.

State procurement remained stable over time despite the increase in total production (exception of where market prices were below state prices).

The dual-track under efficient supply and rationing A B C S D Q P

A case of efficient supply and inefficient rationing P S’ S D D’ Q

A case of efficient supply and inefficient rationing P S’ S” S D D’ Q

A case of efficient supply and inefficient rationing P S’ S” S D D’ Q

A case of efficient rationing but inefficient supply P S’ S D D’ Q s

A case of efficient rationing but inefficient supply P S’ S D D’ Q s

A case of efficient rationing but inefficient supply P S’ S D D’ Q s

Consider the more general case where Q P is not necessarily allocated between users with highest willingness to pay and producers with lowest marginal costs. Consider first the case of limited liberalization (without secondary market). Intuitively, if consumers with willingness to pay below P E were served under the plan, higher than efficient demand will drive the market price upward bringing in inefficient producers. If producers with marginal cost above P E served the plan, there are more efficient producers available competing at lower costs to serve residual demand. This will drive the price downward which will attract more demand. Inefficient rationing and inefficient supply under limited liberalization will not generally lead to efficiency because inefficient allocation of planning is not undone and distorts market allocation.

Under full liberalization, all inefficient trades of the plan can be undone. Those who receive planned goods and have willingness to pay lower than P E will benefit from reselling the goods at market price, thereby undoing the inefficient allocation. Similarly, producers with marginal costs higher than P E can benefit from not producing and purchasing the goods at market price thereby undoing the inefficient allocation. The rents accruing to those benefiting from these secondary transactions can seem morally unjust but they satisfy the Pareto criterion.

Properties of dual track liberalization Dual track liberalization is a way to enforce efficient reform without creating losers. It has no special informational requirements (no new informational asymmetry problem to be solved) It does not require new institutions but uses the existing institutions of the plan. Can be seen as a transitional institution itself designed to disappear as the importance of the plan fades away.

Dual track liberalization and the output fall. Models of the output fall (Blanchard and Kremer, 1997, Roland and Verdier, 2000) emphasize a similar mechanism: new trades from liberalization do not compensate disorganization related to breakdown of existing production chains. Dual track liberalization is an institutional means to prevent disorganization. Enterprises are given freedom to search for new business partners but cannot abandon their contractual obligations under the plan.

Wider applications of dual-track liberalization. Outside the context of China or even transition, the same idea can be applied in other contexts. Pension reform… Labor markets …. North Korea?