CONTINGENT DELEGATION AND AMBIGUOUS PROPERTY RIGHTS. The Case of China s Reform. Nhat Le *

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1 COTIT DLATIO AD AMBIUOUS RORTY RIHTS The Case of China s Refom hat Le We econsie the theoy of ambiuous oety ihts in China. In a static ame context, this owneshi allocation is oo because a local enteeneu can obably et sevices ovie by local bueaucats at lowe costs than a ivate owne; but ba because once nowin the fim s unobsevable income, local bueaucats ae liely to encoach the fim. In an onoin elationshi, such a eatoy behaviou may be limite if local bueaucats cae enouh about futue etuns. Ionically, they often iscount futue too much. An aitional evice to sulement the shaow of futue is neee. In China, this is the continent eleation fom the cental. Une this olicy, local bueaucats must comete to ain moe autonomy on the basis of local economy s efomance. If the execte ain fom the cometition is sufficiently lae, it may become incentive comatible fo caable local bueaucats to enhance local fims, esite incaable ones shis. Fo those shies, the cental still ees eulatin thei activities as if they wee une the cental lanin eime. One then sees that the ace of efom is slow an uneven acoss eions o sectos. It may be seen as a ste bac comae with a ai an lae-scale efom such as the one in the Fome Soviet Union. Howeve, this olicy has seve easonably well to solve some incentive oblems in efom, incluin the cental contaiction: the local aencies blame the cental fo lac of autonomy; an the cental blames them fo lac of accountability. JL Classification numbes: C7, O, Key Wos: Ambiuous oety ihts; Owneshi Allocation; Continent Deleation; Reutation Mechanism; Tansition.. Intouction The theoy of ambiuous oety ihts Davi, Li, 996 focuses on a static ame of owneshi allocation when owneshi ihts ae unsecue an the owne of an asset has to fiht fo actual contols ex ost. The stoy is as follows: Thee ae two aents: fo an enteeneu an fo a local ovenment. The ame has two eios: In the fist eio, has to mae the ecision in investment. In the next eio, the ofitability of the oject is eveale but only fo the ownes of the fim. In the white state, the ownes of the fim enjoy the ayoff fom investment. In the blac state when some leal isutes aise, s effot is neee o othewise the fim s situation will be jeoaize. Thus, may exloe its baainin owe to extact some of the income eneate by. The ae iscusses the allocation of owneshi that may choose to mitiate such a CDS, Austalian ational Univesity, Canbea ACT 000 Austalia, nhat.le@anu.eu.au, hone: , fax: alie vesions of this ae wee istibute une the title Decentalization of Asset Owneshi in Tansition conomies. I am ateful to Steven Taelis an John McMillan fo thei uiance, to Avne ief, Walte Falcon, Ronal McKinnon, Ro Tyes, an the efeees fo helful iscussions an comments.

2 oblem. can eithe have to shae the owneshi an then fiht fo actual contol ihts ex ost; o can solely own the fim, in which case, she can ea all the ofit. The ownsie is that if the blac state actually aises, ex ost neotiations to et s sevices may be moe costly than those whee an shae the owneshi. The ae aues that une cetain business envionment ambiuous oety ihts ae moe efficient than un-ambiuously efine ivate owneshi ihts. In aticula, if the blac state is liely to aise so that secuin s sevice is imotant, the moe ouctive the aent is, the moe liely the owne of a fim wants to invite to shae ambiuous oety ihts. A sie ouct is that une ambiuous oety ihts, infomation about the fim s taxable income is shae between local fims an local aencies. This allocation of owneshi then has some avantae in tax uoses. It is quite common that, in tansition economies, local fims ae subject to encoachment by local aencies McMillan, 000. But othe than China, thee ae counties whee ambiuous oety ihts o not aise to esonse such a eation. Instea, we often obseve many lae fims ae eithe still owne by the ovenment o contolle by Mafia, while many small, ivate fims ae hiin themselves uneoun. An obvious answe one can aw fom the theoy of ambiuous oety ihts is that, in these counties, local bueaucats ae not ouctive. One then may as why Chinese local ovenments ae moe ouctive in enhancin local fims than thei counteats in othe tansition economies? An why Chinese local ovenments have ston incentives to omote local-economic eveloment? A ossible exlanation of the behaviou of Chinese local ovenments lies on the baainin ame between a local bueaucat an the cental ovenment McMillan, 997. The local bueaucat has baainin owe fom nowin moe about the osect of his local maets than the cental. The cental also has its ational counte. It can istinuish whethe the local bueaucat has low o hih ability by offein stone autonomy if he eveals himself to have hih ability in omotin the local economy. In this way, the cental can inuce the local bueaucat to exet effot to achieve cooeative outcome; which, when feasible, will incease income of all aties: local fims, the local bueaucat, an the cental ovenment. We then exten the static moel into a eeate ame between thee layes: a local enteeneu, a local bueaucat, an the cental ovenment. Reutation mechanism in this settin wos in two istinctive, but inteelate ways. In one way, eutation concens may oen the oo to achieve cooeation between the local fim an the local aency. If the one-shot ain fom eviation is outweihe by the futue loss, holu behaviou shoul not aise. The situations that local aencies ae involve in escuin local fims in istesse states ae exactly what we woul exect eeate tansactions shoul eominate an eutation effects shoul matte. As aleay mentione, eutation concens may wo in the othe way as well. If the efomance of local economy toay influences the cental ovenment s ecetions about the local bueaucat s ability, we shoul exect the local bueaucat woul exet effot to be ouctive.

3 A caveat fo the above oositions is that in oe fo eutation mechanism to wo, the aties must cae enouh about futue etuns. Ionically, ue to the oo conition of financial maets, aents often have a shot-tem hoizon. In this esective, the simle eutation mechanism may not wo as foceful as eicte by ame theoy. This suests that the incentive stuctue in the ame laye by the thee aties hee may be moe comlex. In what follows is ou stoy. In some extent, it eveals what allocation of owneshi may be moe efficient in facilitatin cooeation. Fo simlicity s sae, let us slit the ame laye by the thee aties into two ames, one is line with anothe. One is the eleation ame between the cental an the local ovenment. The othe is the maet enhancin ame between the local ovenment an the local enteeneu. Let us focus on the latte fo the moment. In this ame, the two aties, an imlicitly aee to tae the efficient actions that maximize thei joint ofits: will imlement the fist best investment; an have access to s sevice wheneve neee with the ice equal to the mainal cost. In etun, will ain some shae of the income eneate by s investment in tems of local tax. Deviation fom the aeement will tie etaliation, in which hase, the aties will evese to the ash equilibium of the static ame escibe by Li. Obviously, if the aties ae vey atient, cooeation can be achieve une any allocation of owneshi. We ae inteeste in situations whee aties ae so imatient so that cooeation is not incentive comatible une any owneshi stuctue. evetheless, thee ae some iffeences between ivate owneshi an ambiuous owneshi with ea to infomation constaints. Une ivate owneshi ihts, ash evesion statey has bein the sole owne of the fim. She is the only aty who has infomation about the intinsic value of investment, an hence, the fim s income subjecte to tax. In the cooeative aths, this infomation is eveale to in exchane fo havin access to s sevice at a low cost. Howeve, once this infomation is eveale, may beach the aeement by altein the shae ule in favou of him; fo instance, by taxin the fim s income moe heavily. Anticiatin that, ationally lays ash evesion statey: be the sole owne an hie the fim s activity uneoun. then must ely on monooly owe to extact aent s wealth wheneve she nees his sevices. Such a tansaction too, is also suose to be hien uneoun amon the insies. Subsequently, the local economy no lone ovies infomation to the cental about the ability of the local ovenment. This maes continent eleation unfeasible. ext, let us consie the ambiuous oety ihts. ovie that iscount ates ae too hih, shoul en u with the same conclusion that will eviate fom cooeation. Theefoe, ash equilibium will emee if this is the sole ame to be laye. The only iffeence with the evious case is that, as a shae owne, now has infomation about taxable income of the fim. This conition may allow the cooeative outcome to emee in a boae context, when the cental ovenment s actions an ayoffs ae taen into account. As aleay sueste, the cental ovenment may offe the local bueaucat, aent, with ewas continent on efomance of local economy. The incentive 3

4 is clea: bette efomance of local economy means lae tax base. Fo this uose, the taxable income of local fims can act as infomation about the local bueaucat s futue efomance. Continent on this infomation, futue ewas ae ovie fo aent. If such execte etuns ae lae enouh, it may become incentive comatible fo the local bueaucat to cooeate with the local fim, aent. ut iffeently, since efection in the local ame will is to be etaliate in all ames, the local bueaucat will hesitate to hol u the local fim Benheim et al, 990. Aain, one caveat shoul be ae to this oosition. Often, the cental ovenment eleates its owe fo local bueaucats moe on olitical citeia than fo thei ability. A labou maet fo local bueaucats shoul be ceate o othewise the incentive mechanism will not wo Laffont an Tiole, 987. Cometition can eveal who amon the osect caniates is the most able. Thus, intoucin a maet-base selection mechanism imoves local aencies quality McMillan, 997. One then sees that by emloyin eeate ame famewo, we can examine local bueaucats ability an attitue in helin local fims enoenously athe than just iven exoenously as in the static context. Moe secifically, this ae ties to aess seveal questions: Does owneshi stuctue matte in on oin elationshi? Can incaability of local bueaucats an thei eatoy behaviou be mitiate in any owneshi stuctue? What aitional institution may be neee to facilitate cooeation an euce local bueaucats incometence? What ae the lon-tem imacts of such institutional aanements on economic efom? Ou ae comlements Che an Qian 998. Thei ae examines the efficient allocation of owneshi in multi-tas context. As aleay mentione, ou ae exloes the scoe of achievin cooeation when the layes inteact without the shaow of the law an only atly in the shaow of futue. In this esective, ou eseach toic is elate to the liteatue that focuses on lon-tem eveloment of maet-suotin institutions. This inclues the aes by Aow 997, McMillan an Woouff 00, Qian 994, 000, Qian an Rolan 998. The est of the ae is oanize as follows. Sections an 3 eview the theoy of ambiuous oety ihts. Sections 4 to 7 esent the theoy of continent eleation. Section 8 conclues the ae. This ae benefits fom the liteatue on incentives an oanizations, which inclues Ahion an Tiol 997, Bae et al 999, ossman et al 986, Halonen 00, Holmstom 98 an Taelis 00.. The Stae ame Ou stae ame is a simlifie vesion of Li, Davi 996. We consie a business elationshi between aents an, which last fo two eios. In the fist eio, ex ante must mae an investment,, which is secific to asset of 4

5 the fim. In the secon eio, the ofitability of the fim, θ, is eveale, but only fo the insies. At that stae, ue to the absence of the shaow of the law, eithe a white state o a blac state will aise. In the white state, the ownes of the fim obtain all the ains fom the investment, θ. In the blac state, howeve, the fim is tae in a leal isute. In oe fo the fim s owne to eobtain the ofits, θ, the escuin sevice fom is neee o othewise the fim s owne will ain nothin. Li assume that the effots that o ut into the business ae too comlex to have exlicit contacts that secify who will et contol iht continent on what will haen at time. At time, ex ante contacts can only be witten on the allocation of owneshi. The only elevant choice is eithe is the sole owne of the fim, o an shae the owneshi, in which case, they both must fiht fo actual contol ex ost when time comes. ASUMTIO : the cost of investment,, is C such that: C 0 = 0; C' > 0; an C " > 0. Below ae assumtions that facilitate comutation: ASSUMTIO : θ follows a unifom istibution θ ~ U[0,], an this is common nowlee. ASSUMTIO 3: At time, the blac state has obability. Futhemoe, this istibution of states is ineenent of the istibution of θ. Let us biefly examine the otimal allocation of owneshi in the static ame. Une ivate owneshi, in the white state, no sevice,, fom is neee. The ayoffs fo the aents ae: W W = θ C = 0 Whee, enotes the ayoff, the suescit inicates the state of natue, the subscit enotes the aent. In the blac state, without s sevice, will ain nothin. Theefoe, can chae the hihest ate fo his sevice,, so lon as still can affo it; that is θ 0. This imlies: θ /. Subsequently, s execte ayoff is: = θ / = 0 / B 0 whee, 0 is the unit cost of s sevice. Otimally, shoul chae at the ate execte etun becomes: + 0 =. Consequently, s 5

6 B = θ θ / C = C 4 Oveall, s execte etun is: = θ + C 4 Consequently, the investment,, shoul be chosen by to maximize this sum. Une ambiuous oety ihts, in the white state, aent s effot is elatively moe imotant an aent s effot is elatively unimotant. In the blac state, this elation of owe is evese. Otimally, shoul have full contol iht in the white state an so shoul in the blac state. We then assume that, in the white state, acts as if she ha full contol ove the fim s asset. If fully cooeates, the fim s ofitability is θ. If thei neotiation beas own, will ain nothin, but aent can still eneate λθ without, whee 0 λ. Une ash-baainin with efect infomation about θ, each aty then can exect to et half of the joint sulus: W = λθ + θ C W = λ θ On the contay, in the blac state, acts as if he ha full contol iht λ = 0. shoul ive u he contol iht, in which case, the joint sulus shins to θ 0, eflectin some cost bon by the coalition ue to leal isutes with outsies. If thei neotiation beas own, they both will en u with nothin. This is because has no eal contol in the blac state an is not ouctive without s effot is not syneistic with the fim s asset. ach aty then exects to et half of the joint sulus, so lon as θ /. Fom the fist-eio esective, s execte ayoff becomes: 0 B { 0 0 = θ 0 θ / 0 C = C Oveall, s execte etun is: a [ 0 0 = λ + θ + ] C Aent then shoul choose a to maximize this value. 3. Owneshi Decision in the Static ame 6

7 In oe to now which owneshi aanement shoul choose, it is useful to comae both cases above with the fist-best situation when obtains unambiuous contol ihts all the time an has access to at the ice of 0, when neee. Secifically, the social welfae in the white state is θ C. In the blac state this value becomes: θ 0 / 0 θ 0 C = 0 C. Thus, total execte social welfae is: 0 = θ + 0 C 3 ROOSITIO Li, 996: So lon as <, both ivate an ambiuous oety ihts aanements ae inefficient. Futhemoe, the lowe the obability,, the lowe the 0, an the hihe the λ, the moe liely it is that the ivate owneshi is stictly ominate. oof: The fist oe conitions of oblems,, an 3 ae witten as follows, esectively: 0 + [ ] = C' λ + [ a a ] = C' [ ] = C' 6 By comaison, we see that max{, a } so lon as <. Ceteis aibus, a if λ an ae lae, an 0 is sufficiently small. Intuitively, because λ eflects the baainin owe of, when λ is too low, ambiuous oety ihts will less liely to be efficient. Liewise, the invese of 0 can be inteete as ouctivity of fo the fim in a istesse state. Thus, when is ouctive, involvin as an ambiuous owne is efficient. In shot, the elative efficiency of ambiuous oety ihts ove the ivate one eens on the tile, λ, 0. otice that these aametes vay fom one secto of ouction to anothe. The oosition then suests multile equilibia. In the secto of small business owne by an iniviual o a family, we shoul exect that λ is low. Thus, in this secto, ivate owneshi ihts ae moe liely to be 7

8 chosen by enteeneus. On the contay, in inustial sectos, one may exect ambiuous oety ihts to aise, if aent is ouctive. As inheite fom the cental lannin, the inustial sectos ae chaacteize by a comlex set of hihly secific elations between fims. In the absence of the shaow of the law, eeulation oens the oom fo baainin Blancha an Keme, 997; an Li, Wei, 999. If many aties ae line in a comlex set of secific elations, contactual isutes may be sevee. Futhemoe, systematic shocs, such as fiscal an banin cisis, can cause an economic-wie fluctuation of ouction with consieable uncetainty McKinnon, 993. As a esult, the obability of blac state,, is execte to be hih fo each iniviual fim in those sectos. Secuin ovenment aencies sevice becomes imotant. If the ovenment aencies ae ouctive, o equivalently, if 0 is low, an othewise ivate fim woul choose to have ambiuous oety ihts. 4. Reeate Tansactions ow let us suose the ame is laye eeately. Futhe, the aties aee imlicitly to act accoin to the fist best: At time, imlements the socially otimal level of investment,. At time, still ees all contol iht an has access to s sevice at the ice of 0 if the blac state actually aises. The two aties then shae the sulus accoin to the efficient ule,. The shain ule will be efine late. Deviation fom cooeative action will tie unishment hase. We shoul see that the aent s omise to imlement is assume ceible, since in eality can obseve s move an can etemine ex ost allocation of ains. The oblem then is a tye of One-Sie isone s Dilemma ame. It is well nown that, une onoin elationshi, the efficient investments coul be suote usin the tie statey an evesion to ash equilibium of static ame as unishment Halonen, 00. Obviously, if the aties ae vey atient the iscount ates ae not too hih, cooeation can emee une any owneshi stuctue. One obstacle to elational contactin in tansition economies is that iscount ates ae hih McMillan Woouff, 999. Most ivate fims ae exclue fom fomal financial maets. The un-eveloment of financial institutions also inicates that, in eneal, the hih inteest ates, actual o imlicit, limit any fowa-looin cooeation. We ae inteeste in situations when the aents ae so imatient that incentive constaints ae incomatible an theefoe, no owneshi stuctue alone can uaantee the fist best in eeate tansactions. Ou aim is to investiate whethe thee exists aitional institutions that elax incentive constaint an mae it to become incentive comatible fo aties to cooeate. Towa this en, let us fist consie the incentive constaint. It is easy to see that will aee to cooeate if an only if he shae of sulus in fist best situation is not lowe than he ayoff in unishment ath in which both aties imlement ash-evesion stateies of static ame. Secifically, = τ 7 8

9 Whee, τ is the local tax ate on s ofits,, une cooeation; is s ayoff in unishment ath. Liewise, in oe fo not to eviate fom the shain ule afte has aleay imlemente, his shae of the sulus in fist best case must be sufficiently hih. Secifically, τ δ = + δ δ δ 8 whee, is s one-shot eviation ayoff an, is s ayoff in unishment ath in which both aties imlement ash-evesion stateies. Thus, the tax ate, τ, must not be too hih in oe fo to imlement the efficient level of investment,. But that tax ate also must not be too low in oe fo not to eviate fom the shain ule. These two equiements may be inconsistent, causin eutation mechanism to bea own. Below, we will iscuss this issue in a eate etail. We fist notice that fom 7, will cooeate, if an only if: τ 9 On the othe han, fom 8, will act in accoin to the efficient shain ule if an only if: τ δ + δ 0 To uaantee the best incentives fo cooeation, we must have: δ + δ o equivalently, + δ δ = ASSUMTIO 4: Aent efes eceivin the ayoff in ash evesion stateies,, ove bein cheate o ainin only, that is, >. 9

10 Conition means that the moe the aent islies to be cheate an the less sevee it is the unishment aainst aent s eviation, o equivalently, the smalle it is the iffeence between one-shot ain fom eviation an the ayoff in the unishment hase fo, the hihe the fowa-looin behaviou the aents must have in oe to illicit the aties to imlement fist best. ROOSITIO : Une eeate tansactions, the lowest iscount facto that uaantees the fist best is δ +,. Futhemoe, the facto δ _ is monotonically inceasin in the fist tem an eceasin in the secon tem in the bacets. To investiate the ane of aametes that allows the incentive constaint to hol, we fist examine the ain an the loss fom eviation fo aent. otice that, fom 9, the hihest tax ate aent can eman to ay in fist best situation is τ =. Thus, s shae of the sulus in fist best simly is. Fom assumtion 4, only imlements the ojects such that >. But then, iven the otimal tax ate, always has incentive to eviate fom the efficient shain ule, no matte what allocation of owneshi is chosen. In aticula, Une ivate oety ihts, the execte ayoff fom eviation fo is = / 3-0 whee, + 0 =. Une ambiuous oety ihts, this one-shot ain becomes: 0 0 = [ λ θ ] + 3-a As aleay mentione, we measue the loss fom eviation by usin the iffeence between the one-shot ain fom eviation an the ayoff in unishment ath. The lae the iffeence, the moe sevee the unishment. We measue the seveity of unishment ath by the amount = This sum amounts to + +, which is laest when the ain fom eviation is lowest elative to the loss fom eviation. This imlies that the unishment is most sevee when the a laest. is. 0

11 Une ivate oety ihts, this loss fo is: 0 0 = [ ] 4-4 Une ambiuous oety ihts, that loss becomes: = a λ θ + 4 a 0 0 [ ] a Tae the execte value of the iht han sie, we have: a a 0 0 = [ λ + { }] 4 a 4-a The followin oositions come iectly fom 4-, 4-a, an the fist oe conitions 4 6. LMMA : Une any owneshi stuctue, the less ouctive the aent, o equivalently, the eate the cost, the weae it is the theat of unishment fo aent, o equivalently, the smalle it is the a 0. ext, let us consie aent s efeences ove the ossibility of bein cheate. This eflects by the fist tem in the bacets of oosition. Let = θ +, we have: LMMA : Une the ivate oety iht, = [ C C ] [ + { 0 0 }] 4 5- iven <, one can chec that the secon tem in 5- is stictly ositive. evetheless, by assumtion, C >0 an C >0, the tem is stictly ositive fo a wie ane of ouction technoloies. Futhemoe, the moe inefficient the system is, that is the eate C an the eate 0, the lae it is the tem. In this esective, assumtion 4 can be estate as follows: If the system is vey efficient so that < 0 ; the ain fom cooeation becomes sufficiently lae such that holu oblem no lone mattes. We ae inteeste in the cases, in which the system is inefficient. Thus, aent has incentives to efect. The followin Lemma is ambiuous oety iht counteat of lemma. LMMA 3: Une the ambiuous oety iht,

12 a a = a 0 0 [ C C ] [ + λ + { }] 4 a 5-a Combine with Lemma an Lemma, we oose that, ROOSITIO 3: Une any owneshi stuctue, the moe inefficient the system, that is the moe aily the cost of ouction inceases in an the hihe the cost of s escuin sevice, the eate it is the lowe boun fo the iscount facto, δ. Subsequently, the naowe the ane of iscount factos that suot cooeation. ovie that the system of ouction an oanizations in tansition economies ae inefficient, the minimum iscount facto, δ, must be lae. In othe wos, the aties cooeate only if they ae vey atient. Ionically, ue to the weanesses of financial institutions in those counties, contactual aties cae little about futue etuns. As a esult, eutation mechanism is not as foceful o eictable as in the simle eeate-ame stoy an theefoe not an effective mechanism. To ensue cooeation, aitional evices ae neee to sulement the shaow of the futue. The main focus of this ae is on that issue. To this en, let us iscuss the infomation constaint une each allocation of owneshi. 5. Infomation Constaint We have shown that the otimal tax ate shoul be chosen such that 9 hols. That is, τ =. This imlies that if i not iscount futue etuns too + much, o equivalently, ifδ wee eate than δ =, this tax ate woul allow the fist best outcome to emee. We ae inteeste in situations, in + which oes iscount futue etuns heavily; that is δ < δ =. Obviously, socially otimal outcome will not emee une any allocation of owneshi. ssentially, nows that if she imlements the fist best investment, will eviate fom the efficient shain ule because his shot-tem ain fom eviation is lae than his lon-tem loss. then ationally chooses to lay ashevesion statey. U to this oint, thee ae some iffeences between ivate oety ihts an ambiuous oety ihts with ea to infomation constaint. Une ivate oety ihts, ash evesion statey has bein the only owne of the fim. She is the sole aty who has infomation about the fim s ofit. then has little choice but chaes aent as much as ossible wheneve is foce to see his sevice. Anticiatin that eatoy behaviou, otimally hies infomation about the fim s ofit, main this statey ofile to become a sub-ame-efect-ash equilibium.

13 Une ambiuous oety ihts, ash evesion statey has as a shae owne of the fim. What events the aties to achieve fist best is no lone the infomation oblem, but solely the incentive oblem. Clealy, if thee wee no aitional institution to suot the shaow of futue, both aties will en u with the low equilibium. ow suose thee is anothe aent, the cental ovenment, C, that comes to lay an aitional ame with aent. Bein moelle as the aent who wants to maximizes fiscal evenue, C caes about efomance of local maets; but its isavantae is that it lacs infomation about them. By contast, aent nows moe about the osect of his aea, since he is a shae owne of local fims; but he may have insufficient incentives to omote local economy. C howeve has its ational counte to esolve this inconsistency. It can inuce aent to wo ha by offein ston incentives if he eveals himself to have hih ability. Secifically, suose aent exets effot to omote local maets. Fo instance, he oely esolves leal isutes an shaes income with local fims accoin to the efficient ule, τ. The local maet eventually evelos. It attacts mobile caital ouin into the eion an ceates moe ootunities fo local fims. Since tax collection eens on how local bueaucats manae to exloe such avantaes, the cental ovenment may fin it easonable to eleate moe autonomy to aent. Subsequently, may exect to havest some esiual income fom his effot. If this execte etun is sufficiently lae, it may become incentive comatible fo aent to enhance local fims. We then see that in eeate ame famewo, the ambiuous oety iht may be moe efficient than the ivate oety iht. This is not because one tye of owneshi allocation is bette than othe in facilitatin cooeation. This issue is eunant since the aties ae vey imatient. But this is because the ambiuous oety iht eleases infomation constaint, main continent eleation feasible. The local bueaucat now not only involves in shain ambiuous owneshi with local fims. But he also has his stae in the ame laye with aent C eain eional eveloment. By eleatin autonomy continent on the local bueaucat ability, the cental ovenment may be able to alte the ayoff stuctue of the ame in favo of cooeation. a Fomally, let V be aent s esent value of the lifetime execte etun in the cooeative ath laye with aent. That is: a a τ V = = 6 δ δ Similaly, let V be the esent value of his execte etun fom ainin autonomy ove his eion. By contast, if he efects when shain ambiuous owneshi ihts, he ains a cuent ayoff, lus the futue execte etun in the unishment ath: 3

14 a a v = δ 7 In eion-wie, he obtains bibes, whose total value is ϕ, lus the futue execte etun fom bein the local bueaucat of an economically uneveloe eion, v. These ayoffs, ϕ an v, will be etemine late. The local bueaucat then will not efect if an only if: a a V + V > + ϕ + δ [ v + v ] 8 ovie that the aties ae vey imatient, that is δ < δ, we have: τ δ < δ δ o equivalently, a +, V a < + δv 9 a The question whethe the incentive constaint 8 is satisfie o not boils own to the followin conition: V > ϕ + δv 0 In othe wos, it may become incentive comatible fo aent to cooeate with local enteeneu if an only if his execte ain fom eleation of owe fom the cental, V, is sufficiently lae. By contast, if the slac 0 is too small, say, because the cental ovenment eleates its owe to local bueaucats moe on olitical citeia than fo thei ability, such an initial failue to ovie the iht incentives may ta the local economy into eatoy state, in which, local bueaucats hol u local fims. The success o failue of efoms theefoe cucially eens on how eleation of owe fom the cental to the local aencies is imlemente. We then nee to exlicitly incooate this ame into ou analysis. 6. Continent Deleation of owe Suose the cental ovenment must ecie whethe to eleate autonomy to the local ovenment o to etain its contols ove local activities. If the cental ovenment, aent C, oes etain its owe, the local bueaucat, aent, woul suffe, if he exets hih effots since most of the ain fom his wo woul be taxe away. Anticiatin that, aent will choose to shi an ain a net ayoff 4

15 s ϕ by tansessin the wealth of local fims, but he nees to mae a sie s ayment αc to aent C in oe to stay in the osition. As will be shown, when ovenment boies collue in such a way, thei actions constitute a sub-ameefect ash-equilibium. The two aties as well as the local fims, which is omitte hee, howeve, can achieve a socially otimal outcome if the cental ovenment ees its hans off while the local ovenment maes effots to omote the local economy. In ayoffs, the latte ains esiual incomes o es φ,, which inceases in the numbe of the local fims,, an the cooeative outcome in the shainowneshi ame,, while the fome eceives a tax-evenue τ which also inceases in. Fo simlicity s sae, we assume that the tax buens, φ, + τ, ae bon evenly by each local fim an ae inclue in thei cost function at the fist best investment, C. This eflects the at of total cost each fim ays fo usin ublic oos ovie by the ublic secto, such as infastuctues, leal institutions to suot contacts 3. otice that eeulation of owe fom the cental ovenment is necessay fo aent to wo efficiently. But the latte may be temte to abuse this owe to catue ϕ fo esonal ain. Fo examle, local bueaucats may collect bibes fo oviin emits an licences, fo eectin baies aainst enty of cometitos Shleife an Vishny, 993. In these cases, the cental ets the wost outcome γ. This leas to one-sie isone ilemma, in which, the collusive state emees as a sub-ame ash equilibium, esite the fact that eeulate wo is socially s s otimal: φ, + τ > ϕ + α. C We nee to emhasize that, in eality, if eleation of owe is moe on the olitical citeia than fo local bueaucat s ability, then it is moe liely that aent abuses his owe. Collusive state theefoe often emees when the cental ovenment fails to eleate its owe on the basis of local bueaucats ability. ext, let us assume that the cental will eleate the autonomy to aent only if the latte has ove his caability, ε, to omote the local economy. Obviously, ε is unnown fom the beinnin. But maet leanin will eventually eliminate the imefection of infomation. Fo instance, mobile factos, such as caital an labo, ten to ou into the eions whee the local ovenment s caability, ε, is hih 4. In othe wos, a labou maet fo local bueaucats is ceate. Thus, in 0, the value V can be inteete as the execte ain fo a ilient local ovenment in the cometition with othe juisictions to attact mobile caital Hee we abuse the notation by usin τ to inicate national tax. 3 Subsequently, these taxes ae concetually iffeent with, the shae that the local ovenment ains in cooeative ath laye with a local enteeneu. One may exect that, when thee is an incease in the use of fomal institutions to cooinate activities between iffeent fims, the fomal tax system will become moe imotant in tax evenue. 4 It is essentially Tibout s theoy 956. τ 5

16 an ain autonomy ove the local business. We then can mae the conition 0 moe ecise by assumin that: ASSUMTIO 5: the esent value of Aent s execte etun fom ainin autonomy ove his eion, V is efine as follows: V = φ, + δ [ εv + ε v ] quation eflects that the local ovenment may fail in the cometition with the obability ε. otice the incentive constaint 0, it is clea that aent will not shi his uty, if φ, + δ [ εv + ε v ] > ϕ + δv o, equivalently, if ϕ φ, ε > δ V v The inequality in may she liht on some inteestin featues of China s eeulation that ae summaize in the followin oosition: ROOSITIO 4: ovie that local bueaucats must comete to ain autonomy ove local business, eflectin by the ule. Then:. If bibesϕ ae neliible, even a local ovenment who is not vey caable still wos ha to omote local businesses. Imovements in the accountin system, stanaization of oucts, an bette-efine oety ihts seem to be imeative in ecentalization.. The hihe the on-job consumtion es, φ,, the moe the fasihte oientation, δ, an the lae net execte ain fo a caable local ovenment, V v, the moe liely it is local ovenments will wo ha. 3. When the values of these factos ae elatively neliible while bibes ae lae, only the cometent local-ovenments will wo honestly fo the oseity of thei community. But incaable ones ae liely to shi. Howeve, the cometition amon iffeent juisictions in oe to ain moe comman ove oeties may ut a chec on incometent local ovenments. Consequently, cooeation in the ame of eleation of owe is conventionalize Ceteis aibus, the moe innately caable is the aent, o equivalently, the hihe the value of ε, the e, φ,, an the lae the net execte ain fo woin ha, V v, the eate it is the slac 0. When sufficiently lae, it 5 One may econize that these thee featues ae closely elate. ains fom the evolution of owe inuce local aencies to comete, which in tun, inceases the execte ains fo a ilient local ovenment. As the two foces wo eciocally, they boost the efom to avance McMillan,

17 otentially elaxes the binin constaint 9, main fist best in the maetenhancin ame feasible. 7. Comments on Continent Deleation Tae into account the effect of multile institution linaes on aent s incentive constaint; oosition 4 can be e-exesse as follows: ROOSITIO 5: Assume that δ / δ <. The effective ability, the lowest level of ability, with which aent fins it in his own inteest to wo iliently fo local fims an exects to ain lae esiual ihts ove his local business, is: S ε = ε δ / δ,,, ϕ, ϕ 3 Futhemoe, ε is monotonically eceasin in monotonically inceasin in ϕ an S ϕ. δ / δ,, an ; an Diffee fom, δ now aeas in the incentive constaint. Intuitively, the lowe the actual iscount facto, δ, in comaison with the lowe boun δ, the less incentive fo aent to cooeate with local fims when shain owneshi. Theefoe, hihe ain fom eleation of owe fom the cental is neee to inuce aent to lay maet-enhancin ole. This maes hih ability local bueaucats actions an ayoffs iffee fom the low ones. Fo those, whose innate ability is hih, thei execte ain fom havin moe autonomy ove thei eion, V, is hih. Thus, they ae ovie with ston incentive to wo ha fo thei community. On the contay, fo those whose ability is meioce, they will shi anyway since thei execte etun V is so low. Rationally, the cental, C, will etain its owe, main those aents its iect suboinates. Thus it ees eulatin thei activities as if wee une the cental lanin eime. One then sees the lowe the value δ / δ, the hihe the effective ability ε is equie. An inteestin imlication is that, une continent eleation, the aces of eeulation ae slow an uneven acoss eions an sectos. This miht mae continent eleation seeme to be a ste bac in comaison with a ai, laescale efom, such as the one imlemente in the fome Soviet Union. As we have seen, howeve, this olicy seves easonably well fo China to solve some secific incentive oblems uin efom. It also mitiates the main contaiction of eeulation: local aencies blame the cente fo thei lac of authoity while the cental blames the locals fo thei lac of accountability. Let us mae some seculative comments on lon-tem effect of this olicy on maet eveloment. 7

18 As aleay sai in oosition 4, the effective ability, ε, ensues cooeative behaviou of aent eceases in the factos that incease the execte etun of an ilient local bueaucat elative to that of a shiin one. These ae the size of local maet,, an the fist best investment of local ame,. This theshol value inceases in the factos that incease the elative ains fom one-shot eviation that is ϕ an ϕ. S Recall fom oosition 3, the moe efficient the system of ouction, in aticula, the moe slowly the cost of ouction inceases in, the lowe δ o the eate the scoe fo cooeation. otice that tax chae on local fims affects thei cost of ouction. We intouce the followin assumtion. Let us enote T, = φ, + τ. ASSUMTIO 6: The total tax evenue, T,, inceases in the size of T,. T,. maet: > 0. But the tax buen e fim,, tens to convee to zeo when is sufficiently lae. ASSUMTIO 7: The lowe the tax buens e fim, the moe slowly the cost of ouction inceases in. Subsequently, it is easonable to believe that if the size of the local maet,, becomes lae, local ouction system becomes moe efficient. We then exect both lowe bouns, δ an ε, become lowe as becomes lae oositions 3 an 5. On the othe han, the size of maet,, itself can be assume to be a function of ε. ASSUMTIO 8: The maet size,, is a function of ε. That is: = ε, whee. is continuous, iffeentiable, an ' ε < 0. The eason is that the lae the numbe of local aencies evote thei effot to suot local fims in leal font, the bette the business envionment is ceate; thus, the lae the numbe of new fims will ente emein maets to seve esiual emans, which wee untae io to efom. Let us nomalize the laest numbe of fims in the local maet to unity: [0,]. ROOSITIO 6 Bouwe s Fixe oint Theoem: Une cetain eula conitions, the maet size,, will convee to its lon-tem steay state. 8. Conclusions This ae concens about whethe iffeent tyes of owneshi stuctues can encouae cooeative behaviou uin efom. If the value of iscount factos is 8

19 hih, then cooeative outcome can emee une any owneshi stuctue. An obstacle fo contactual elations in tansition economies is that the value of the iscount facto is low. Ionically, the lowe bouns can be too hih. This is because the ouction system is inefficient. As a esult, eutation mechanism is not as foceful o eictable as in the simle eeate-ame stoy an theefoe not an effective mechanism une any owneshi allocation. To ensue cooeation, aitional evices ae neee to sulement the shaow of the futue. In China s efom, such an aitional evice is continent eleation. It seves to ool incentive constaints, main cooeation incentive comatible. Continent eleation, howeve, can only be imlemente une some secific allocation of owneshi. As emonstate in section 6, ambiuous oety ihts can be moe efficient than ivate ones in tems of infomation. This is because ambiuous oety ihts eveal infomation about fim s income subjecte to tax. This infomation then can be use by the cental ovenment to assess futue efomance of an ovie ewas fo local bueaucats. This continent olicy can otentially alte the ayoff stuctue in favou of cooeation. As a lae numbe of fims entein the maet when time unfols, we shoul exect a new hase of efom is uneway; in which, thee is an incease in the use of fomal institutions to cooinate activities between iffeent oanizations not moelle in this ae. One may seculate that all factos that have woe in favou of ambiuous oety ihts may become insinificant. The ambiuous oety ihts eime aually isaeas in the scene of the contemoay life. This conjectue fits with the fact that a lae numbe of state an townshi-villae enteises have been ivatize ecently in China. Aenix oof of Lemma : Fom the fist oe conitions 4 6, we can see that, if C " is sufficiently lae, the investment level chosen by aent is eceasin in is eceasin in 0 moe eatly than both an 0. Futhemoe, a. We also see that, when the choice of investment is eceasin in 0, so is the faction 0 /. Toethe, these imly becomes smalle when 0 becomes lae. oof of Lemma : By efinition, we have = θ +. Let us fist calculate this execte value fo the case of ivate owneshi ihts: + = θ + C A 4 9

20 0 + / 0, 0 + = A [ + θ ] 0 0 C A3 Let us simlify these fomulas: A = + θ 8 0 C A = A3 = [ + θ ] 0 C Toethe, we have: { ] [ C C = + = θ θ + ]} [ 0 0. oof of Lemma 3 is simila so it is omitte. oof of oosition 5 Recall that equation is: ] [, v V V ε ε δ φ + + = We can ewite it as follows: v V, ε δ φ δε + = Theefoe, we have: v v V, + = δ φ δε But / δ ϕ = s v. This imlies:, s v V ϕ φ δε = Usin the inequality, we then have:

21 ε δε [ ϕ φ, ] > s δ [ φ, ϕ ] Subsequently, ε > s φ, ϕ [ ] δ ϕ φ, omalize δ by δ an tae notice of 9 an 0, we then have: ε s φ, ϕ = Γ δ / δ [ ] ϕ φ, A4 Whee, the function Γ. is a stictly inceasin in its aument. As we can see fom A4, if eithe o inceases, so oes φ,. s φ, ϕ Subsequently, the faction inceases, o equivalently, ε eceases. ϕ φ, We also can see that ε is eceasin in δ / δ, an monotonically inceasin in ϕ s an ϕ. Refeences Ahion, hilie an Tiol, Jean 997. Fomal an Real Authoity in Oanizations, Jounal of olitical conomy, 05, --9. Aow, Kenneth 997. The lace of Institution in the conomy: A Theoetical esective, Mimeo, Stanfo Univesity. Bae, eoe; ibbons, Robet; an Muhy, Kevin 999. Infomal Authoity in Oanizations, The Jounal of Law, conomics, & Oanization, 5,, Benheim, Doulas an Whinston, Michael 990. Multi-Maet Contact an Collusive Behavio, RAD Jounal of conomics,,, --6. Blancha, Olive an Keme, Michael, 997. Disoanization, Quately Jounal of conomics, ovembe, Che, Jiahua an Qian, Yinyi 998. Insecue oety Rihts an ovenment Owneshi of Fims, Quately Jounal of conomics, May, 3, ossman, Sanfo an Hat, Olive 986. The costs an benefits of Owneshi: A Theoy of Vetical an Lateal Inteation, Jounal of olitical conomics, 94, 4, Holmstom, Bent 999. Manaeial Incentive oblems A Dynamic esective, Review of conomic Stuies. 66 6, 69 83

22 Laffont, Jean-Jaques an Tiole, Jean 987. Auctionin Incentive Contacts. Jounal of olitical conomy, 95: Li, Davi 996. A Theoy of Ambiuous oety Rihts in Tansition conomies: The Case of the Chinese on-state Secto Jounal of Comaative conomics 3, --9. Li, Wei 999. A Tale of Two efoms, RAD Jounal of conomics 30, McKinnon 993 The Oe of conomic Libealization: Financial Contol in the Tansition to a Maet conomy, Johns Hoins ess, n eition. McMillan, John 997. Maet in Tansition, in: Kes-Wallis s., Avances in conomics an conometics: Theoy an Alications: Seventh Wol Coness, Cambie: Cambie Univesity ess, McMillan, John an Woouff, Chistohe 999. Disute evention without Couts in Vietnam, Jounal of law, conomics, an Oanization, 5 3, McMillan, John an Woouff, Chistohe 00. The Cental Role of nteeneus in Tansition conomies. Jounal of conomic esectives, 6 3, Halonen, Maija 00, Reutation an The Allocation of Owneshi, The conomic Jounal, July, Qian, Yinyi 994. Refomin Cooate ovenance an Finance in China, in: Aoi, M., Kim s. Cooate ovenance in Tansition conomies, Wol Ban: DI Develoment Stuies. Qian, Yinyi 000. The ocess of China s Maet Tansition : The volutionay, Histoical, an Comaative esectives, Jounal of Institutional an Theoetical conomics, 56, Qian, Yinyi an Rolan, ea 998. Feealism an the Soft Buet Constaint, Ameican conomic Review, 88, 5, Shleife, Anei an Vishny, Robet 993. Coution, The Quately Jounal of conomics, 08 3, Taelis, Steven 00. The Maet fo Reutations as an Incentive Mechanism, Jounal of olitical conomy, 9, Tibout, Chales 956. A ue Theoy of Local xenitues, Jounal of olitical conomics, 64,