Command Economy

1. Command Economy • Why study command? • The command system creates initial conditions for transition • Legacies from command critical for transition • Path dependence • Two types of legacies • Structural • The result of past investments and other decisions • Enterprises, locational choices • Institutional • Behavioral patterns • How to reverse past decisions • Start with the analysis of command system

2. Command Economy • Attempt to replace markets • The command principle strives to fully and effectively replace the operation of market forces in the key industrial and developmental sectors of the economy, and render the remaining (peripheral) markets manipulable and subordinate to political direction. • Two Basic Imperatives • Growth • Control

3. 3 Key Purposes • maximum resource mobilization towards urgent and over-riding national objectives, e.g. rapid industrialization or the prosecution of war; • Used by many countries in wartime • radical transformation of the socio-economic system in a collectivist direction based on ideological tenets and power-political imperatives; and • not the least, as an answer to the disorganization of a market economy through price control, possibly occasioned by inflationary pressure arising from (1) and/or (2).

4. Basic Features of the STE • state-ownership of the means of production • centralized control by means of an administered system of planning in physical terms. • The system replaces the market with a set of directives from the center to the production units throughout the economy. • These directives are commands, not suggestions. They are directives that have the force of law, and subordinates are responsible for fulfilling them, even if the plans are not feasible. • The absence of markets implies loss of information about opportunity cost • absence of private property, except for households

5. STE • STE created by Stalin in 1928 • Exported to Eastern Europe after WW2 • Imported by China after 1949 • Yugoslavia mutates in mid-50’s • Self-management • North Korea, Vietnam, Cuba are underdeveloped examples of command economies

6. Basic Feature Continued, Implications • soft-budget constraints • chronic sellers market • emphasis on heavy industry • gigantomania • dynamic incentives problems • state control of investment • restrictions on entry, no exit

8. Distribution of Employment by Size

9. Structural Differences

10. Ownership • Not just commanding heights • In the Soviet Union, for example, • the state and collective sectors accounted for some 88% of the value added in agriculture; controlled 98% of retail trade, and owned 75% of urban housing space • The industrial sector was exclusively state owned. • In 1985, for example, 91% of employment was in state enterprises, and another 6% was in kolkhozy. • The extensive control of retail trade means that the smallest shops were state owned. • But key factor is hierarchical control

11. Sample Hierarchy

12. Old Gosplan (currently Duma)

13. Hierarchy • Only vertical information flows • But there are informal horizontal flows • Only at the top of the hierarchy can opportunity cost be assessed • Lower level agents cannot assess tradeoffs • Implies subordinate control crucial • Bureaucracy must exercise full control and discretion • But subordinates have their own interests, which implies: • Incentive problems • Need for monitoring systems (police, party, banks) • Corruption • Fundamental issue: how to get agents to reveal information and follow orders

14. Soviet Growth Model • Mechanism for extensive growth • Paradoxical attitude towards time • planners have a very low discount rate -- they are willing to sacrifice lots of current consumption for future consumption • On the other hand, haste implies that they want to industrialize fast. So they cut corners, and ignore side effects and other costs. • Diabetes example • Key point • Haste sowed the seeds of the barriers to longer-term performance. • In that sense, the rapid growth in output of the first couple of five year plans represent borrowing from future performance. • Balloon payment • Key defect of the SGM is that output growth is pursued without regard for the opportunity cost of that growth • E.g., environmental mess

15. Extensive vs Intensive Growth • Suppose that output is given by • Then the growth rate of output is given by • Thus growth occurs either thru growth of inputs (more K and/or more L) or technological change (growth in A) • Extensive growth is the former, intensive growth is the latter • Growth thru greater efficiency in use of inputs • Extensive growth is growth thru accumulation of inputs

16. Consumption Paths • Whose utility is being maximized? • Households versus planners’ objectives • Planners willing to defer present consumption versus future consumption • Planners combine haste with patience • Their haste for fast growth with public’s patience for deferred consumption • High rate of time preference on part of owners, cost paid for by public

17. Aral Sea

19. Soviet Growth Model (cont.) • Growth implies maximize investment • How? Via control of consumption • State is sole employer => monopsony • Let be the subsistence level of consumption • Then is aggregate consumption. • Let be aggregate consumption • Then investment is maximized, for given level of K, by choosing L so that • What if ?

20. Industrialization Strategy • Heavy industry • Maximize investment • Collectivization • Surplus labor argument • Transfer from rural to urban • State control over resources • But peasant response • Output growth versus welfare

21. USSR, Inc. • Soviet economy as a single corporation • The corporation owns a large stock of natural resources, • has no outside shareholders • (so that all "profits" can be retained for investment) • hires labor • Moreover, as a monopsonist in the labor market, USSR Inc. can minimize the expenditure on labor. • Transactions between enterprises are merely transfer prices between "divisions." • The exceptions are purchase of labor and engagement in foreign trade.

22. Exceptions • Labor is allocated partly by choice • State determines demand, but labor is supplied • Though vagrancy is a crime – full employment • Foreign Trade controlled by FTM • FTM trades with ROW • Intermediary between producers and ROW • Insulates domestic prices from world prices • Purchases (sells) goods at state prices and sells (buys) at world prices

23. Haste • Command system is good at mobilizing • achieving specific objectives • Extensive growth • Growth through accumulation of inputs • It is bad at assessing costs and tradeoffs • May be important for intensive growth • Growth via greater efficiency • Crucial Role of Resource Abundance • Delay in reaching BoP constraint

24. Growth Problems • Over time growth rates decline in all STE’s • Despite continued growth in capital-worker • Why? • Failure to transition to intensive growth • Extensive growth trap • Inability to substitute capital for labor • Innovation Problems • The system worked best when the fruit was low-hanging • mobilization

25. Soviet Growth Rates Decline

26. Intensive vs Extensive Growth • Start with • Then the growth rate of output can be written as: • Intensive growth means high • Extensive growth means accumulation • But notice that as capital accumulates, increases • What happens to rate of return?

27. Two Explanations of Slowdown • TFP growth declines due to increased complexity of the economy • Difficulty with diffusing innovation • Low elasticity of substitution • K/L increase due to high savings rate and limits to growth in labor force • If substitution is difficult output growth is reduced • Note that this is organizational, not technological • No entry, limited exit • Input-output conservatism in planning • Extensive growth and natural resources • Energy was underpriced and over-utilized • when prices are liberalized many industries are producing negative value added

28. Price System • Prices unrelated to social costs • Socially necessary costs • Average not marginal • Non-existent charges for rent and capital • Raw materials underpriced • Costs of production were thus calculated based on an incomplete enumeration of costs. • Prices biased based on user • Circus mirror effect • Does it matter? • USSR, Inc., => transfer pricing • But illusion about sources of value • Implications for transition

29. Price System (cont.,) • Why have prices in a planned economy? • an accounting device • Monitoring of plan performance • Related question, why have money? • Active and passive money • Soft-budget constraint (Kornai) • If budget constraints are not binding a resource constraint must eventually be reached • Implies that shortage is an equilibrium phenomenon in STE’s • Leads to sellers’ markets

30. SBC • Dynamic Commitment problem • Subsidy available ex post not ex ante • Effort costly for manager, bonus for fulfillment is B • Effort is sufficiently costly so • If effort is low, Y = 0 with no bailout, Y – R with bailout • If low effort manager must be bailed out because low output is bad for planner • Manager knows this so he supplies low effort

31. SBC

32. Chronic Sellers’ Market • Primary cause => the emphasis on growth at all costs • Taut plans => uncover hidden reserves • Soft-budget constraints • Plan fulfillment imperative • Excess demand for labor • Shortage and priority • Personality dominates • Lack of quality

33. Dynamic Incentives Problems • Planning from the achieved level • Enterprise exploits hidden information • Agents must be induced to reveal information • Simple 2-person game • Enterprise director can tell the truth or lie • Planner can issue a feasible or a taut plan

34. Preferences • Director’s preferences: • Planners’ preferences: • Illustrative payoff matrix • Equilibrium: both lie

35. Bonus Function • To get director to reveal information planner implements a bonus function • But why pay to overfulfill? • Need for extra resources to meet shortages • Increase effort

36. Canonical Bonus Function

37. More on the Bonus Function • Solves static problem • Assume that effort is required to produce more output • Moral hazard • But that this differs depending on productivity • Hidden information (adverse selection) • Then preferences depend on the nature of the enterprise

38. Canonical Bonus Function

39. Canonical Bonus Function • Generates separation • If no bonus for overfulfillment, then pooling • Sets up the dynamic incentives problem • Fulfillment today risks fulfillment tomorrow • Consequences • Need for a safety factor • Ratchet effect • Taxing high performance

40. Dynamic Problem • Let be utility for fulfilling the plan for the high productivity enterprise • Current gain from overfulfilling is: • Loss from revealing information is • Then director must compare

41. Dynamic Problem • LHS is the current gain from revealing (CG) • RHS is the present value of future losses (DFL) • Depends on the time horizon of the agent • Whenever DFL > CG the director will conceal true capacity • Ratchet effect => fear of a higher future target lowers current performance • Predictability, Shchekino

42. Shchekino Experiment • Planning experiment • Planners commit not to change targets for 5 years • Enterprise can keep costs savings • Labor productivity rose so fast, 52% in first year, planners reneged • Changed plan targets 7 times in 10 years • Another plant 17 times in 5 years • Inability of planners to commit

43. Ratchet Effect • More severe the greater is • Time horizon • Utility loss • And the smaller is • The discount rate • Leads to reduced incentives to perform and innovate • Alexeev and weightliftingrecords • Slow diffusion of innovations

44. Result • Who said this? • Yuri Andropov, General Secretary, CPUSSR • Top officials know the problem, can’t solve it

45. Lack of Observability • Inflated reports – simulation – is commonplace • Difficulty of monitoring • Occasional audits show this:

46. Enron, Global Crossing, Stock options • Similar problems occur in corporations • Directors and managers engage in simulation • simulation of performance to achieve bonuses • Simulate earnings to benefit from options • Incomplete information necessary but not sufficient • it is also necessary that rewards be skewed toward the present, • especially if those costs can be shifted on to others in the future. • Much harder to keep simulations hidden in markets • Need to hide losses, but Soviet pricing does not reveal losses

47. Vasily Alexeev

48. Date of First Adoption versus Diffusion (proportion of output produced in 1982)

49. Structure of Command Economy • Imperative is microbalance • Planning by material balances • Feasibility, not optimality • Iterative process of vertical information flows • Basic idea • Sources = uses, good by good • For good j we have: • Where does come from? • The input requests from other enterprises • Where does this come from?

50. Material Balances, cont. • Planners start with a target for sector j: • Enterprise calculates its input needs assuming fixed coefficients: • So multiply to get needs: • Now planner adds. E.g. for sector 1 (such an equation for each sector of course):