Feb 09, 2017 03:36 PM

Opinion: Making the ‘Second-Best’ Choice

One of the most significant events in the global economy in the 20th century was humans’ attempt to replace the market economy with a planned economy in the hope of creating a system that operates more efficiently and more equitably. But decades of experiments showed that planned economies couldn’t achieve this goal. In the last two decades of the 20th century, almost all the planned economies started shifting to a market-oriented model. China is one example in this great historical trend, and it is also the most significant one.

Centrally planned economies had two salient problems: inefficient resource allocation and the problem of incentives. The first problem exists because prices in a planned economy are determined not by the market forces of supply and demand, but by planners, resulting in great distortions when allocating resources. The second arises when economic incentives fail to influence behavior amid the blind pursuit of egalitarianism and the problem of soft budget constraints in a government-dominated economy. Given these conditions, individuals, firms and governments aren’t motivated to increase efficiency.

The essence of transition from a planned economy to a market economy is to replace the whole set of systems underpinning it with market-based resource allocation methods, as well as incentives, or reward-and-punishment mechanisms. In my view, economics research on countries making this shift, including China, focuses on two main issues: the way in which resources are allocated and observing how effective incentives are, as well as the interaction between the two. On resource allocation, the key issues are the fundamental and decisive role of the market and the supportive role of the government, where prices, including product and factor prices, are of great importance. When it comes to incentives, upholding property rights, contracts, ownership rights and good governance are important issues. Of course, incentives are also closely related to prices and also influence the allocation of power between the government and individuals, government and businesses, and among different levels and departments of government.

For more than three decades, China's economic reform efforts have been carried out along these two lines. The agricultural reforms in the late 1970s and early 1980s highlighted the importance of having the right incentives in place. The reforms in prices, taxation, exchange rate and interest rate systems in the mid-1990s solved the problem of resource allocation and also played an important role in changing incentive systems. And issues such as changing state-owned enterprises, their ownership, property rights, governance and increasing emphasis on the rule of law have run through the whole course of China’s reform push. And all this requires fundamental changes to the incentive system, not only for individuals, but also for corporations and governments. In addition, the reforms also play a significant role in improving resource allocation.

What does studying the incentive systems of governments and companies mean? Our research on institutions, property and ownership rights should be carried out within specific institutional environments and specific power allocation frameworks to understand how they influence the behavior of policymakers, businesses and citizens. Many of these studies share a common feature — the need for theoretical innovation. That is recognizing that many theoretical analyses are supposed to follow the "second-best principle" due to incentive distortions caused by the nature of institutions in a transition economy. This approach opens up a broader space for the analysis of many problems facing economies in transition, including that of China.

To understand the “second-best principle,” we should start with the "first-best principle." It means that, in a case where there is only one distortion, reducing this will certainly improve efficiency. Similarly, if there is no distortion, adding a distorting factor will reduce efficiency. This is our intuition, the method we usually adopt to analyze problems. The inferences about reform we’ve made in various occasions use this logic. We will start by saying that some distortion is harmful and then conclude that reforms targeted at reducing the distortion are necessary. This makes sense in many cases, but is not always right, especially in situations where several distortions coexist.

The so-called “second-best principle” refers to a situation where multiple distortions exist, and reducing one of them does not necessarily increase efficiency. Meanwhile, when there is at least one distortion, adding another one does not necessarily reduce efficiency either. Hence, conclusions need to be made according to specific circumstances.

For instance, when property rights are secure, private enterprises are more efficient. However, if there are other distortions in the real economy, such as when property rights are insecure due to the absence of the rule of law, a private enterprise will have to pay the extra cost of seeking protection for property rights. This is a waste in a sound system, but in an imperfect system, it makes economic sense. Under this condition, reform may be conducted to reduce one type of distortion by adding another one. For instance, using local governments’ powers to protect property rights and fend off predatory behavior from a higher-level government can increase efficiency. This is a specific example of applying the "second-best principle."

If you analyze further, applying the "second-best principle" often leads to "second-best institutions," which I call "transitional institutions." This is an important new idea, which was not been discussed previously in economic literature. It’s obvious that a "second-best institution" is not as good as the optimal or best institution, because distortions still exist. However, it is not so obvious that, when other institutions are distorted, the “second-best institution” can improve efficiency and play a positive role during a period of transition. But this “transitional institution” must fulfill two conditions: it must increase efficiency and at the same time be “incentive compatible,” meaning it should benefit all stakeholders. In the long run, the “transitional institution” is likely to create the conditions or groundwork for shifting to a better system, but it may also hinder future reform. That depends on specific circumstances.

This kind of meticulous analysis is of great significance at a conceptual level. It allows us to think beyond the oft-heard debate between the “China-model theory” and the “simplistic market theory.” The “China-model theory” tends to think that anything with Chinese characteristics is good, while the “simplistic market theory” tends to believe that only the pure market system is good. A fresh approach to analyzing modern economies based on the “second-best principle” can point out the reasons behind the Chinese characteristics and what a “transitional institution” means, and at the same time clarify their costs and limitations.

Theoretical and academic studies are not intended to directly impact policy-setting, but they will help shape ideas, build frameworks and find a focus. They will allow us to recognize key problems and to avoid misunderstandings. Economic problems are complex. Economics theory is useful to arrive at the conclusions that can be tested by empirical evidence through simple hypothesis and rigorous logical reasoning. The current conditions of the Chinese economy are quite different from those that existed in the 1980s and 1990s. However, this method of analysis still works. For example, the anti-corruption drive is a major recent development. Both corruption and anti-corruption efforts have a significant impact on government and enterprise incentives. How this campaign has affected both governance and the economy are not yet obvious, and careful studies are required.

Back to the question of planned economies vs. market economies. Is the debate over? Probably not! The debate has been revived as some transition countries are experiencing stagnation or have fallen into recession. Meanwhile, new arguments crop up as technology improves. For example, with the development of big data, cloud computing and artificial intelligence, people may subconsciously think of the potential for a planned economy. But workers won’t be replaced by machines, because machines don’t have imagination, passion or ideals. At the same time, because humans have these intangible qualities, they struggle with issues of motivation or incentives. Therefore, no matter how developed technology becomes, the incentive problem is always an unavoidable issue in economics research.

Qian Yingyi is dean of the School of Economics and Management at Tsinghua University. This article is an excerpt from Understanding Economic Research by Qian Yingyi, published in the journal Comparative Studies. Qian received the first-ever China Economic Award for his study of the economic incentive system.

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