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-50s
• 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

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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

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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

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Extensive Growth
17
Intensive Growth
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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 publics
  patience for deferred consumption
• High rate of time preference on part of owners,
  cost paid for by public

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Consumption Paths
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Consumption Path with Balloon Payment
21
Feschbach on Environment

• In the last decade of the 20th century, there are
  no leading industrial cities in the Soviet Union
  where air pollution is not shortening the life
  expectancy of adults and undermining the health
  of their children. The growth that made the USSR
  a superpower has been so ill-managed, so greedy
  in its exploitation of natural resources and so
  indifferent to the health of its people, that
  ecocide is inevitable.
• Collapse of the system prevented ecocide?
• Why does Russia like Kyoto?

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Aral Sea
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Soviet Growth Model (cont.)

• Growth implies maximize investment
• How? Via control of consumption
• State is sole employer gt 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 ?

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Maximizing the Investment Rate
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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

27
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.

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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

29
Transfer Prices

• Prices used in transactions between parts of USSR
  Inc. are not terms of trade
• gt no need to equal opportunity costs.
• Transfer prices record activity, they do not
  motivate
• Agents are executants of orders from above
• Transfer prices could be randomly assigned
  without changing behavior
• But arbitrage opportunities could arise

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Monopsonist Labor Market
31
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

32
Growth Problems

• Over time growth rates decline in all STEs
• 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

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Growth Rates of Output by Eras
34
Soviet Growth Rates Decline
35
Growth in Capital-Worker
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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?

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Innovation Problems Recognized

• Malenkov (1941)
• ...highly valuable inventions and product
  improvements often lie around for years in the
  scientific research institutes, laboratories and
  enterprises, and are not introduced into
  products.
• Gorbachev (1987),
• ...many scientific discoveries and important
  inventions lie around for years, and sometimes
  decades, without being introduced into practical
  applications.
• Why?
• Dynamic incentives problems

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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

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Labor Force Participation Rates for Women
40
Role of Elasticity of Substitution
41
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., gt transfer pricing
• But illusion about sources of value
• Implications for transition

42
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 STEs
• Leads to sellers markets

43
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

44
SBC
45
Chronic Sellers Market

• Primary cause gt the emphasis on growth at all
  costs
• Taut plans gt uncover hidden reserves
• Soft-budget constraints
• Plan fulfillment imperative
• Excess demand for labor
• Shortage and priority
• Personality dominates
• Lack of quality

46
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

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Preferences

• Directors preferences
• Planners preferences
• Illustrative payoff matrix
• Equilibrium both lie

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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

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Canonical Bonus Function
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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

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Canonical Bonus Function
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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

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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

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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 gt CG the director will conceal true
  capacity
• Ratchet effect gt fear of a higher future target
  lowers current performance
• Predictability, Shchekino

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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

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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 weightlifting records
• Slow diffusion of innovations

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Result

• Who said this?
• Yuri Andropov, General Secretary, CPUSSR
• Top officials know the problem, cant solve it

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Lack of Observability

• Inflated reports simulation is commonplace
• Difficulty of monitoring
• Occasional audits show this

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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

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Vasily Alexeev
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Date of First Adoption versus Diffusion
(proportion of output produced in 1982)
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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?

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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)

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Schematic
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Material Balances, cont.

• Put the sum back into the material balance
• No reason to assume it equals zero.
• So adjust output targets
• Now we have a new set of input needs for each
  enterprise. For j we have
• And we just repeat the whole process, again, and
  again

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Material Balances, cont.

• Process continues till all the Djs are zero
• Notice how simple are the operations
• If the process goes on long enough a feasible
  plan result
• But the number of iterations could be very large
• In practice only one or two iterations
• So plan as implemented is infeasible
• Some plans taut, others slack
• Note emphasis on intermediate goods
• But optimal plans look at final goods
• Central control and subordinate responsibility
• Micro-balance is the imperative
• Process assumes truthful revelation

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Incentives versus Complexity

• Mises, Hayek thought central planning problem was
  too complex to solve
• Lange and Lerner suggested market solutions
• Set Q such that MC P
• But this ignores incentives problems
• Why would managers follow the rules?
• Private information (about actions or conditions)
  is valuable
• Agents must be induced to reveal this

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Command Problems

• Detailed planning and the corresponding
  directives are often late, are insufficiently
  detailed, may lack the requisite information,
  hence often cannot be effectively coordinated
• Owing to their rigidity they are peculiarly
  vulnerable to uncertainty
• Planning in a command economy must be largely in
  physical terms due to the crucial importance of
  balance.
• The bottom line of the planning process must be
  available physical units of required inputs, in
  appropriate assortment, quantity and timing,
  necessitating physical targets for production and
  input utilization.
• Success indicator problem

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Success Indicator Problem

• Bonuses are non-synthetic
• One linear price schedule produces imbalances
• No secondary market
• Planners cannot know tradeoffs at each enterprise
• Pollution permits
• Emphasize priority
• Quality problems shifted to users
• Because micro-balance is priority
• Teaching versus research?
• Bonus for retention

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Command

• Command is good for well-defined measurable tasks
• Build the Atom Bomb
• Dont worry about cost 25.7 billion at current
  prices
• Command is bad at assessing tradeoffs
• No prices to measure opportunity cost
• Physical indicators lead to success indicator
  bias
• Teaching is harder to measure than research

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Shortage

• SBC, fixed prices, output fixation gt shortage
• In production, to avoid wasted resources full
  utilization to achieve growth
• In consumption, because planners do not want to
  divert output
• Of course, flexible prices could eliminate
  shortage, but command means dominance over market
• Market allocation weakens central control
• Implication Generalized shortage

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Shortage
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The Big Nail
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Problems with Linear Pricing
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Mormon Comparison

• Many similarities
• Sense of encirclement
• Holistic vision of utopia
• Virtuous haste
• Totalitarian leadership (without terror)
• Primacy of collective over individual
• Hostility to speculation, private initiative
• Insulation and isolation
• Need for autarky to conserve foreign exchange
• Like the Soviet economy, economy was
  collectivist, mobilizational, centrally planned,
  largely command-managed, and often
  redistributional in regard to factors, products,
  and the economic surplus.

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Mormon comparison, cont.

• More similarities
• Property owned by church
• Capital formation
• Via tithes, mostly in kind
• Prices as accounting devices, economy demonetized
• Frequent reforms
• Cooperative forms of organization
• Key differences
• Voluntary, not coercion
• Building on virgin soil

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Seeds of Transformation

• End of isolation
• Immigration of gentile tradesman
• Like the second economy of USSR
• Railroads lower transportation costs
• Raises cost of autarky
• Hostile US legislation
• Trade leads to corruption and sub-rosa
  privatization

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Second Economy

• Informal economy arises to meet challenges of
  command
• Precisely because command economy cannot achieve
  balance, and as terror dissipates
• 2nd economy defined as all production and
  exchange activity that meets at least one of two
  criteria
• being directly for private gain
• being in some significant respect in knowing
  contravention of existing law. See Grossman,
  1977, p. 25.
• These market-mediated activities are at times
  supportive, helping to achieve tolerable
  micro-balance in the increasingly complex
  economy,
• but they often are in violation of planned
  implementation and regime values.

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Second Economy

• Brezhnev on second economy
• You don't know life. No one lives on wages alone.
  I remember in my youth we earned money by
  unloading railroad freight cars. So, what did we
  do? Three crates or bags unloaded and one for
  ourselves. That is how everybody lives in our
  country.
• Blat markets
• 2nd economy activity necessarily introduces
  discretion
• Potential for diversion

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Second Economy

• Virtually every area of economic life is touched
  upon, and often entangled with, second economy
  activities
• legal private activity naturally opens a loophole
  for illegal trading and entrepreneurship,
  generally below the purview of the authorities.
• Dual contradictory roles of 2nd economy
• First, it addresses a number of the problems of
  coordination and balance endemic to the command
  mechanism
• But, second, it mocks the pretense of social
  direction and control, subverts its egalitarian
  impulse, accentuating differences in access and
  income, and gives lie to the pretense of a new
  ideologically correct (Soviet) man

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Evaluation and Size

• 2nd economy completes the cancerous development
  of agent autonomy
• Generates undesirable (system perspective)
  redistribution of incomes,
• although recipients, including many high placed
  officials, find it very desirable.
• Size
• Estimates based on the surveys of Soviet
  emigrants relate to the second half of 1970s and
  range approximately between 10 and 30 of
  incomes of urban households.
• An alternative set of estimates based on the
  Soviet-era official family budget survey data
  puts the second economy at around 23 of
  household income (Kim, 2003).
• Could be as large as 12 of GDP in 1979
• But double counting

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Legacies

• Two types
• Structural legacies
• Institutional legacies
• Financial underdevelopment
• Absence of rule of law
• Khruschev Whos the Boss we or the law? We are
  masters over the law, not the law over us so we
  have to change the law we have to see to it that
  it is possible to execute these speculators.
• FTM

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Structural legacies

• Industrial structure
• Industry bias
• Industry intentional, agriculture unintentional
• Under-provision of services
• Hypermilitarization
• Industrial concentration
• Gigantomania
• Absence of small enterprises

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Distribution of Capital Stocks
85
Structure by Labor Force
86
Indicators of Raw Materials and Energy
Consumption, 1988
87
Enterprise Size in US and Russia
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Hypermilitarization and Climate

• Size estimates difficult
• Pricing distorts measurement
• Cost shifting
• Defense burden unsustainable
• Locational burden
• Interaction with climate problems
• Soviet Union got colder in 20th century!
• Too many people in the wrong places
• Big problem for market economy

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Location in RussiaPopulation of Siberia and Far
East in 1989 37 mln (25 of RF total)
Manufacturing employment 1.8 mln (16 of RF
total)
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Location in CanadaPopulation 85 000. (0.34 of
Canadian total) Manufacturing employment
295people (0.017 of Canadian total)
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TPC in Canada, USA, and Russia
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Duluth, population 86,000
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Omsk, population 1.2 million
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Perm, population 1.008 million
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Internal vs External Inefficiency

• Internal inefficiency
• Lack of high-powered incentives
• Input combinations and X-inefficiency
• External inefficiency
• Lack of market pricing
• allocative
• Dynamic inefficiency
• Lack of innovation

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Legacy of Never-ending Reform

• Waves of reform
• Why a treadmill?
• Rejection of alien organisms
• Pitfalls of partial reform
• Cooperatives
• Supply diversion
• Timber and boxcars

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Example

• Efficient rationing of timber
• Plan price P, excess demand in housing
• Cooperatives bid for timber
• x units of timber diverted to housing from
  boxcars

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Supply Diversion

• Notice that P is the shadow price of timber
• With freedom to sell, timber sector sells qm to
  the housing (cooperative) sector, cutting back
  deliveries to the boxcar sector
• Shadow value of timber is now much higher in
  boxcars
• Consumer surplus falls by A in boxcars and rises
  by C in housing note A gtgt C
• Producer surplus in boxcars falls by B 2C
• Notice that the problem arises because the boxcar
  industry cannot compete for timber, and the
  capital in that sector cannot flow to housing.
• The moral of this story is that as the state
  loses control over the state sector, diversions
  make things worse.
• But China will be different!

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Achievements

• Full employment
• By law gt no unemployment insurance
• Soft budget constraint
• Free health care
• Good at infections, bad at modern diseases
• Low income inequality
• Gini Coefficient
• Ratio of the area between the Lorenz curve and
  OB, and the whole area OAB.
• Wealth v income, and access to goods

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Lorenz Curve
102
Earnings Distribution, Full-time workers
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US Income of Top Decile
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Social Uncertainty

• Command economy minimizes income shocks
• Full employment, socialized medicine
• Social insurance is high
• Underemployment vs unemployment
• Risk taking is low
• Institutions to cope with uncertainty in modern
  economy are absent

105
Life Expectancy at Birth, Russia, 195859,
196162,196364, 19652002
106
An Alternative Factor

• Decline of Oil prices
• When rents exploded, so did commitments
• Rents market value of revenues less natural
  costs of extraction
• Including subsidies to Eastern Europe
• When rents declined hard to cut commitments
• Resource abundance is addictive
• increase in energy investment between 1981 and
  1985 absorbed nearly 90 pct of increment
  allocated to industry
• Production maintained by borrowing from future
• Tightened the resource constraint

107
An Alternative Factor
108
Rents and GDP
109
Rents, Addiction

• Resource rents postponed day of reckoning
• "In sum, the Soviet economic system became what
  it is in part thanks to the country's rich
  resource base, which permitted the planners
  largely to ignore the day-to-day discipline of
  the balance of payments and therefore also the
  imperatives of the market place and the pains of
  real economic cost. On this basis an elaborate
  and rigid institutional edifice sprang up. This
  economic system thrived for two human generations
  and achieved marked successes by its own
  criteria. But inevitably it hardened and came to
  be supported and protected by powerful vested
  interests Grossman, 1983 202.
• addiction to rents postponed fundamental reforms,
  made the system more fragile
• The lesson is that resource abundance,
  misapplied, can be addictive

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Addiction

• Addiction leads to short-time horizon
• This leads to an inability to implement reforms.
• Three characteristics
• tolerance - the need for an increasing amount of
  the substance to obtain the same effect
• withdrawal - severe unpleasant effects when the
  addict ceases to use the substance craving
• "willingness to sacrifice all (to the point of
  self-destructiveness)" in order to obtain and use
  the substance.
• In Soviet case tolerance arose because windfall
  was used for many new activities
• defense, East European subsidies and other
  international adventures
• interests created that depend on rents, makes
  withdrawal painful
• where is the methadone for an addicted Soviet
  economy?

111
Defense Addiction

• Marshal Akhromeev on addiction
• Why it was necessary to produce so many weapons?
  Akhromeev answered
• "Because at a great cost of many sacrifices we
  created first-class factories, no worse than the
  American ones. Would you order them to stop work
  and begin producing cooking pots?"
• Shakhnazarov described the "military-industrial
  mentality" as a "cancerous growth" that had
  metastasized to every sphere of Soviet life
• This is an example of addiction. The investment
  in factories created interests that were very
  costly to reverse.

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Aspects of Collapse

• Macroeconomic
• Budget crisis, inflationary finance
• Shortages, stolen hours, more queues
• Weaker state lower tax collection
• Microeconomic
• Misallocation of resources
• Lack of property rights
• Pseudo privatization

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Two Views on Collapse

• Essentialists
• Essentialists hold that the Soviet system
  collapsed because it was essentially abnormal
• The nature of the Soviet system made its eventual
  collapse inevitable and even predictable
• Of course, few made this prediction before the
  system collapsed. Autopsies are easier on dead
  bodies.
• Voluntarists
• Soviet economy was murdered, or its death was
  decisively hastened, by voluntary acts of policy,
  though the consequences may have been unintended.
• We tend to confer the mantle of inevitability on
  accomplished facts, and arguing that what
  happened did not have to happen is likely to be
  dismissed as inventing excuses for the losing
  side. But the collapse of the Soviet system was
  the unintended result of a small number of
  disastrous decisions by a few individuals

114
Was Demise Inevitable?

• Productivity growth slowed, but never turned
  negative
• The odds on overtaking fell
• Reforms upset performance
• Reforms made the system more fragile
• Monitoring costs rose and deterring corruption
  became more costly
• Erosion of belief in system
• So small shocks could lead to collapse

115
Weakening of Central Control

• Critical difficulty for central planning
• Brezhnev Communism Stalinism without terror
• Raises the prices of information and action
• Loss or resources at center
• Agents have two options
• Fulfill the plan, F
• Dont fulfill the plan, NF
• Payoffs depend on whether observed or not
• Let be the probability of being observed

116
Stalinist Incentives

• Let be the payoff to NF if unobserved
• Suppose that
  and
• Then the expected payoffs are
• Planners want
• Two instruments, detection and punishment
• We can plot this

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Stalin v Brezhnev

• Stalinist system set punishment - infinity
• Lowers cost of detection
• Brezhnev system
• Cheating is optimal for larger range of
• Problem is more severe with greater complexity
• Glasnost makes it even worse
• Explosion of Second Economy
• Loss of central revenue

119
Multiple Equilibria

• The same system can have two equilibria
• High output
• Low output
• Consider the producers decision to supply effort
• Depends on gains and penalties
• And whether this is observed

120
Producers Choice of Effort
Producer works hard, if
Gain from working hard gt cost of working hard
If work is hard and monitoring is strict, then
If work is hard and monitoring is lax, then
Work hard if reward gained penalty avoided gt
cost of effort
Dont work hard
No rewards gained, low effort supplied
Gain reward for working hard, avoid penalty for
not working hard, spend effort working hard
121
Dictators Choice

• Dictator wants to deter stealing
• Two key parameters
• Cost of incentives provided
• Costs of monitoring
• Over time these parameters shift
• Complexity raises monitoring costs
• Weakening center (decline in oil revenue) raises
  costs of providing incentives
• High output is no longer an equilibrium

122
Dictators Decision
Dictator Monitors if
Effort is high, and if
Effort is low and if
Cost of monitoring lt value of output stolen
future output lost
Else, dont monitor
Costs of monitoring lt output stolen future
output loss
Else, dont monitor
123
Parameter Shift

• Evolution of the system led to parameter shift
• Complexity raises monitoring costs
• Information flow weakens central authority
• Value of incentives decreases as their cost rises
• Second economy grows
• High output is no longer the equilibrium
• Reforms weaken the structure
• Do not lower monitoring costs
• Reforms make defection easier
• Cooperatives
• Law on state enterprise

124
Bank Run

• Why the sudden collapse?
• As center weakens officials defect
• Race to cash in on assets
• Solnick on the collapse
• Key to bank run
• Illiquidity
• Sudden loss of trust

125
Solnick

• ...the image of a "disintegrating"
  state...is...seriously incomplete. Soviet
  institutions did not simply atrophy or dissolve
  but were actively pulled apart by officials at
  all levels seeking to extract assets that were in
  any way fungible. Where organizational assets
  were more specific to their particular use by the
  state, as in the case of draft boards, for
  example, hierarchical structures proved more
  resilient. Where organizational assets were
  chiefly cash and buildings, hierarchical
  breakdown was almost total. At both ends of the
  spectrum, the catalysts of state collapse were
  the agents of the state itself. Once the bank run
  was on, these officials were not merely stealing
  resources from the state, they were stealing the
  state itself."

126
Shock to Loyalty

• Income of an official is
• Probability of detection
• Strength in numbers
• Expected value of defection
• Critical value of loyalty

127
Critical Loyalty Value
128
Add Theft

• Race to cash in
• Each defecting agent steals
• Not enough to steal, illiquidity
• Official income is now
• Output falls faster
• Critical value reached sooner
• Agents know nothing will be left if

129
The Bank Run Case
130
Conclusion

• Was the collapse a disaster?
• Implications for transition
• Political and economic collapse
• Is this more difficult than just economic reform?
• Macroeconomic imbalance
• Window of opportunity
• Agenda for reform?
• No blueprints

131
Midterm One Results