Cultural Transmission and the Pendulum of Economic Systems: The Case of Communism

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1 Culural Transmission and he Pendulum of Economic Sysems: The Case of Communism Eienne Farvaque Alexander Mihailov Alireza Naghavi May 2012 Absrac This paper aims o explain he rise and fall of communism by exploring he inerplay beween economic incenives and social preferences ransmied by ideology. We inroduce inequaliy-averse and ine ciency-averse agens and analyze heir conflic hrough he ineracion beween leaders wih economic power and followers wih ideological deerminaion. The socioeconomic dynamics of our model generae a pendulum-like swich from markes o a cenrally-planned economy abolishing privae ownership, and back o resoring marke incenives. The grand experimen of communism is hus characerized o have led o he discovery of a rade-o beween equaliy and e ciency a he scale of alernaive economic sysems. While our focus is on he long-run ransiions from capialism o communism and back observed in he course of he 20-h cenury, he model also derives condiions under which each of he sysems can remain sable. Key words: capialism; communism; inequaliy; ine ciency; ideology ransmission; economic ransiions JEL classificaion codes: C72, D31, D63, D74, D83, P51 Universié du Havre (and Skema Business School), Faculé des A aires Inernaionales, 25 rue Philippe Lebon, BP 1123, Le Havre Cedex, France; Eienne.Farvaque@univ-lehavre.fr. Universiy of Reading, Deparmen of Economics, Whieknighs, Reading RG6 6AA, Unied Kingdom; a.mihailov@reading.ac.uk. Universiy of Bologna, Deparmen of Economics, Piazza Scaravilli 2, Bologna 40126, Ialy; alireza.naghavi@unibo.i. We hank Daron Acemoglu, Toke Aid, Sephen Broadberry, Mark Casson, Ron Davies, Rumen Dobrinsky, Oded Galor, John Harwick, Nigar Hashimzade, Huber Kempf, Giuseppe Pignaaro, Mahias Thönig, Cédric Tille, as well as he audiences of several conferences, workshops and seminars whose feedbacks proved essenial. Mihailov acknowledges funding from he Universiy of Reading Board for Research in he Social Sciences (Projec E , ). The responsibiliy for any errors and misinerpreaions remains our own. 1

2 Culural Transmission and he Pendulum of Economic Sysems 2 February 1848: The Communiss disdain o conceal heir views and aims. They openly declare ha heir ends can be aained only by he forcible overhrow of all exising social condiions. Le he ruling classes remble a a Communisic revoluion. The prolearians have nohing o lose bu heir chains. They have a world o win. Karl Marx and Frederick Engels, Manifeso of he Communis Pary. 1 Sepember 2010: There were many odd hings abou my recen Havana sopover [...] bu one of he mos unusual was Fidel Casro s level of selfreflecion. [...] I asked him if he believed he Cuban model was sill somehing worh exporing. The Cuban model doesn even work for us anymore, he said. Je rey Goldberg, Fidel: Cuban Model Doesn Even Work for Us Anymore, The Alanic. 2 1 Inroducion Communism was he grand experimen of he 20-h cenury. I also seems o have been is grand illusion. In erms of uopian vision, radical implemenaion and socioeconomic impac, communism has lef a lasing mark in hisory. Is rise and fall as a possible alernaive o capialism is a complex and muli-faceed heme, inerpreed from di eren heoreical and mehodological perspecives in social sciences. Works from many disciplines, going beyond poliics and economics, have ried o porray or, more ambiiously, explain he various manifesaions of communism across he map of he world from nascen and milian hrough maure and oppressive ino sagnaing and decaying. So why anoher aemp o reconsider he key driving mechanisms behind he genesis of he revoluionary communis projec and he gradual mass disillusionmen wih is realiies? This paper aims o sudy how he economic sysem a ecs he evoluion of beliefs and preferences hrough he endogenous socializaion e ors of he various social classes. Can his lead o cycles in economic sysems, if a sysem gradually builds opposiion o iself? To analyze hese quesions, we rely on economic heory o examine he ineracive dynamics of economic incenives and social preferences hrough culural ransmission. In wha follows, we build a racable model o formalize he role of socioeconomic facors in he process ha led o he rise of communism via a forced revoluion and naionalizaion of capial, as well as is reversal back o markes. In essence, his grand experimen has led o a rade-o beween equaliy and e ciency in erms of produciviy and saving a he scale of alernaive economic sysems. 3 Our heoreical accoun of he rise and fall of communism, from he revoluionary enhusiasm of Marx and Engels hrough he disillusionmen of Casro quoed above, is framed as a sylized game of class sruggle involving economic decisions and ransmission of ideology across generaions. This is along he lines of Norh (2005), who inerpres he experience wih communism in Russia as a sory of perceived realiy! beliefs! insiuions! policies! alered 1 Chaper IV. Posiion of he Communiss in Relaion o he Various Exising Opposiion Paries, ranslaed by Samuel Moore in cooperaion wih Frederick Engels, 1888, hp:// 2 hp:// 3 For insance, Sreon (1976) wries: Equaliies can always be ill-designed, or enforced by oppressive mehods. When hey are, hey may reduce produciviy, as well as freedom. Some communis counries have flaened heir margin for skill or hard work oo far, wih apparenly bad e ec on economy e ciency.

3 Farvaque, Mihailov and Naghavi (May 2012) 3 perceived realiy and on and on (p. 4). 4 The model also shows condiions under which communism remains sable ha can explain he persisence and he success of he Chinese social marke economy. While he chain of logic by Norh is framed along purely descripive argumenaion in he radiion of he new insiuional economics, i is cerainly compaible wih a learning perspecive formalized in works such as Pikey (1995) and Buera e al. (2011). Recen evidence has however uncovered he role of indocrinaion (Alesina and Fuchs- Schündeln, 2007) and hisory (Roland, 2009) in his phenomenon. Ineresingly, recen empirical sudies also provide direc evidence on he inergeneraional ransmission of beliefs and culural resilience. These include Paacchini and Zenou (2011) on religion, and Klasing (2011) and Dohmen e al. (2012) on aiudes owards risk and rus and how hey inerac wih changes in insiuions. We herefore emphasize he role of socializaion and he ransmission of preferences, social norms, and beliefs, following a srand of lieraure semming from Bisin and Verdier (2001) ha explores he role of inergeneraional ransmission of aiudes o explain he persisence of socioeconomic saus across generaions. 5 Our goal is o show how his same mechanism can paradoxically lead o a pendulum-like swing beween economic sysems. Only few heoreical works focus on he inerrelaion beween he inergeneraional ransmission of ideological preferences and insiuional change. The closes o our work is Döpke and Ziliboi (2008), which sudies he role of he inergeneraional ransmission of ase for leisure and paience in he success of insiuional changes brough abou by he indusrial revoluion. Also, Sain-Paul (2010) analyzes he impac of he evoluion of beliefs abou he workings of he marke economy on ideological bias in he sociey and poliical reform. The incenive srucure under he wo economic sysems is capured in our model by he (mis)alignmen of ownership and conrol. This is in line wih he large lieraure on he key weaknesses of socialism: one srand dealing wih he pervasive problems arising from he sof budge consrains of socialis enerprises (e.g., Kornai, 1980) wha Roemer (2008) labels lack of incenives ; anoher poining o he overambiious ask of cenral planning, given dispersed and local informaion, o ensure beer allocaive decisions han markes (e.g., von Hayek, 1940, 1945) wha Roemer (2008) labels lack of coordinaion. Our approach highlighs hese wo familiar disadvanages of a communis economy a heir crucial link, he ineremporal opimizaion decision, a which he (mis)alignmen of ownership and conrol manifess iself. The choice of consumpion and accumulaion ou of one s own wealh given he signals of compeiive markes and locally relevan informaion under capialism susains e ciency bu generaes inequaliy. Delegaing his choice o an egaliarian planner forces equaliy by revoluion bu erodes economic e ciency, hus making everyone equal in heir povery. 6 In his paper, we combine he above lines of hough and use he ransmission and evoluion of preferences o shed ligh on he dynamics of regime swiches across economic sysems. We devise a non-cooperaive game beween agen ypes ha akes place in every period of an overlapping-generaions (OLG) framework o demonsrae how he equilibrium sraegies drive he long-run socioeconomic dynamics and can generae such 4 This view somewha depars from earlier seminal works on communism versus capialism, and relaed sudies on he comparaive e ciency of he wo sysems. Among many ohers, see Lange (1956 [1936]), von Hayek (1940, 1945), Tinbergen (1960), Lancaser (1973), Kornai (1980), Roemer (1980, 1985). 5 See Bisin and Verdier (2010) for a horough survey of he lieraure on culural ransmission and socializaion ha followed. 6 Noe ha we ignore neiher ha inequaliies were de faco exising in communis counries, nor ha hey were creaing resenmen (see, e.g., Joo, 2005, for an accoun). However, considering explicily he nomenklaura would only complicae he model wihou changing he subsance of he resuls (in e ec, only acceleraing he swing back from plan o marke).

4 Culural Transmission and he Pendulum of Economic Sysems 4 pendulum-like swich from markes o an egaliarian economy abolishing privae ownership, and back o rebuilding marke incenives o susain sociey. We focus on a large region of he world where capialism was less developed and, perhaps more imporanly, any democraizaion of he sociey was avoided or much delayed. In paricular, we model wo ypes of agens, inequaliy-averse and ine ciency-averse ones, responding o economic incenives and ransmiing heir values as hey are a eced by evolving economic oucomes. We firs show how capial accumulaion by he minoriy elie and he resuling inequaliy leads o increasing social disconen over ime and, evenually, he overhrow of he sysem. We hen show how a cenrally-planned sysem aimed a equaliy also fades away due o misalignmen of individual incenives and aggregae arges, lower well-being and he gradual redirecion of ideas owards a marke sysem. The economic lieraure, and he lieraure on communism or social evoluion more generally, has no provided so far a consisen heory on he insiuional change experienced by he Sovie Union and is saellie counries in Easern Europe hroughou he 20-h cenury accouning for boh hese ransiions. In his consiss he conribuion of our sylized bu hisory-based formal analysis of he rise and fall of communism and he condiions under which i remains sable. We suppor our resuls and he underlying assumpions by providing a number of relaed hisorical (anecdoal and empirical) evidence in he relevan world regions. In so doing, we focus on he bifurcaion of he ransiion pah observed in Russia and China. The ransmission dynamics of our model also mach some of he findings of Alesina and Fuchs-Schündeln (2007), who explore he possibiliy of a feedback e ec from communism on preferences by assessing he dynamics of suppor for sae inervenion among individuals in Eas Germany compared o hose in Wes Germany. Looking a he preferences of di eren age groups afer he reunificaion, hey find sae suppor o be higher in some areas for he age group whose older generaion lived mos of heir lives before he sar of communism. Suppor hen decisively fell from one generaion o he nex for subsequen age groups who lived under communism. 7 We also presen and discuss evidence on he incenive problem faced in cenrally planned economies compared o hose in which agens were free o choose oupu arges as well as means o mee hem. Among ohers, Bergson (1991) provides figures on he remarkably lower oupu and consumpion per worker in he USSR compared o he res of he world. The paper is organized as follows. In he nex secion we consruc our model, presening he ypes of agens, heir objecives, consrains, ideological conflic, and he ransmission of heir beliefs across generaions. Secion 3 hen solves he opimizaion problems of he agen ypes and he von Sackelberg game hey play every period. Secion 4 derives he inergeneraional dynamics and highlighs he resuling economic oucomes in erms of regime ransiions or sabiliy. Secion 5 siuaes our heory in hisorical conex, jusifying he key assumpions we employ in our model. The las secion concludes by summarizing he insighs from our model and draws parallels beween our findings and he relaed lieraure. 2 The Model 2.1 Economic Sysems, Agen Types and Conflic We consider wo economic sysems under which sociey can evolve: one is based on he marke (capialis), denoed by M, andheoheronanegaliarianplanner(communis), denoed by E. True o he hisorical genesis of communis ideas, our analysis begins wih a marke-based sysem founded upon propery righs over he means of pro- 7 See Alesina and Fuchs-Schündeln (2007): Figure 1, p

5 Farvaque, Mihailov and Naghavi (May 2012) 5 ducion and he corresponding privae incenives o capial accumulaion. Our ineres is in a paricular region ha a some poin in ime splis apar and experimens wih communism. Is oal adul populaion is normalized o 1. There are wo ypes of agens in he iniial capialis sociey. The large majoriy are born wihou inheriing capial: hey are he workers. They are unprivileged in he sense ha hey can only sell heir labor force in he marke in order o subsis, as Marx argued. Being he have-nos, hey care abou inequaliy in he capialis sociey, whose vicim hey are by birh. We call hem inequaliy-averse agens and denoe heir ype as A. A minoriy of agens are born wih inheried capial: hey are he capialiss. They exrac rens from heir privae capial, and care abou he relaive ine ciency beween he wo sysems. We call hem ine ciency-averse agens and denoe heir ype as B. 8 Iniially, ypes (A and B) and classes (workers and capial owners) coincide, by definiion. In a convenional way, his can be inerpreed in erms of he class sruggle beween capial and labor. However, over ime preference ypes evolve, so ha class and preference ype diverge. We consider an OLG model, where agens live for wo periods. During childhood (in he firs period of life), hey are socialized acquiring a paricular ype when hey become adul. When maure (in he second period of life), hey perform acive economic and ideological roles in he sociey, and die a he end of he period, invesing any capial wealh hey have accumulaed. Under boh sysems, M and E, economic power belongs o he preference ype who decides upon and enforces he ineremporal allocaion beween capial accumulaion and consumpion. The oher preference ype can hen only ry o change he economic sysem hrough ideological influence. We denoe he degree of srengh of each ype relaive o he oher by he conflic funcion q ( ) and 1 q ( ), respecivelyforypes A and B in any period, andmeasureibyanindex,0 <q ( ) < 1. More precisely, his index can be defined o be some increasing funcion of he relaive inensiy of he preference iself (social resenmen or ideological deerminaion), 0 <m < 1, and he relaive size (or fracion) of each preference ype in he oal adul populaion, 0 <n < 1: 0 <q (m,n ) < 1, > 0 > 0. I also capures he probabiliy of a regime shif in any period. 2.2 Preferences The uiliy of agen i for i = A, B under each sysem j = M,E akes he form U i (c i j,,b i j,+1, +1, +1, i )=c i j, + b i j,+1 E i [ +1, +1 ] i 2 2, (1) wih c i j, denoing individual consumpion levels, bi j,+1 income in he subsequen period achieved from savings by individuals under marke and he sae under communism, and 0 < <1 he discoun facor assumed o be idenical for all agens. 9 The hird erm generally represens he disuiliy in erms of relaive saus wih respec o oher individuals or he oher sysem, depending on he agen s ype. More precisely, E A [ +1 ] and E B [ +1 ] are he expeced regime-dependen inequaliy and ine ciency E A [ +1 ] = q +1 ln E,+1 +(1 q +1 )ln M,+1, (2) E B [ +1 ] = q +1 ln E,+1 +(1 q +1 )ln M,+1, (3) 8 See also Fehr and Schmid (1999, 2000) and Olcina and Peñarrubia (2004) for alernaive explanaions of he agen ypes. 9 I will be made clear below ha he same resuls obain boh qualiaively and quaniaively if he beques erm b i j,+1 is replaced by nex-period consumpion c i j,+1.

6 Culural Transmission and he Pendulum of Economic Sysems 6 where j,+1 measures income of ype B relaive o A, or inequaliy wihin he sociey as perceived a, and j,+1 he relaive e ciency of individual opimizaion under free marke over a cenrally-planned economy in erms of produciviy and poenial growh possibiliies as perceived a. Noe ha communism forcefully proclaims complee equaliy in he sociey, E =1,yieldingln E =0. Similarly, ine ciency is iniially normalized under capialism, M =1,andsoln M =0. M, and E, will be defined furher below. The relaive srengh of he preference ypes, q +1,deerminesheprobabiliy of a regime change in period +1.Finally,uiliydependsoncoslysocializaion e or funcions i, wih 0 i 1, obediscussedinsecion2.5. The uiliy funcion places a rade-o beween capial accumulaion and he risk ha he group wih a di eren ideology akes conrol of he sociey. For capialiss, his implies alruisic bequess o heir o spring versus he possibiliy of he laer living in alesse ciensysem.foranegaliarianplanner,herade-o arisesbeweenbuilding capial in order o maximize oupu from one generaion o he nex, and losing he cenralized sysem o an unequal sociey. 2.3 Producion and Income We consider a one-secor real model where a single good is produced using a consanreurns-o-scale linear echnology. The oupu produced a ime in regime j is H j, = A j [ K j, + j, (1 )L] (4) for j = M,E and depends on wo producive facors, capial K j, depreciaing fully during and labor L supplied inelasically by households. Toal facor produciviy (TFP) under each regime is denoed by A j. Labor-augmening produciviy is measured by j, (c) and is deermined by he incenives of workers. We approximae hese incenives by maerial well-being based on consumpion in workers families. Furhermore, 0 (c) > 0 represens he incenive of workers as a funcion of consumpion, and 00 (c) < 0 implies ha produciviy gains are decreasing. The relaive imporance of capial and labor in producing oupu are denoed by and 1, respecively.undercompeiive facor markes, reurns o labor and capial can hen be wrien as w M, = A M (1 ) M, and r M, = A M. Boh facor reurns are j-indexed, because of he poenially di eren produciviy levels under he wo sysems. We consider a subsisence consumpion level c, never reached by he A ype so ha only capial owners can inves. In he marke sysem, income of capial owners and workers in each period is respecively where s B 1 is savings in he previous period, and y B M, = r M, s B 1 = A M s B 1, (5) y A M, = w M, = A M (1 ) M,. (6) Under communism, as capial is naionalized and capialiss are deprived of heir ownership, invesmen decisions are no longer individual bu made by he egaliarian planner. As a consequence, individual income becomes a cenralized allocaion of an

7 Farvaque, Mihailov and Naghavi (May 2012) 7 equal share of oupu o each member of he sociey as wages, which are no necessarily equal o he marginal produc of labor: y B E, = y A E, = w E,. (7) Noe ha in his case he whole populaion, including B ypes, forms he working class (c A E, = cb E, = c E, = w E, ). We define perceived income inequaliy arising from saving by capialiss in period as he relaive income from capial versus ha from labor: M,+1 yb M,+1 ym,+1 A = 1 s B M,+1, (8) where imposing he iniial condiion ym,0 B >ya M,0 ypes and becoming a worker. prevens a capialis from swiching 2.4 Savings and E ciency Acapialis,ypeB, chooses individual savings (which we denoe by lowercase s B )o maximize uiliy in (1) given he budge consrain c B + s B y B M,. (9) The iming of evens during he accumulaion process is as follows: he savings of he previous period, s B 1,compriseheprivaecapialsockinhepresenperiod, k M,, which will hen be pu ino producion given (4). The privae yields from capial ownership y B M, = r M,s 1 generaed hrough he producion process are finally divided beween consumpion c B and savings s B (forming he fuure capial sock, k M,+1 ). An egaliarian planner insead maximizes uiliy (1) in he name of he ype A agens under he naional budge consrain C + S H E,. (10) The savings decision by he planner di ers from privae ones in ha aggregae values are considered (which we denoe by uppercase S ). The same iming holds for he accumulaion process under he communis regime: S 1 comprises K, which is used for naional producion along wih labor and yields Y = r E, S 1. Toal oupu, H E,, is hen allocaed beween furher savings, S,andaggregaeconsumpioninhesociey, C,dividedequallyamongallagensviaidenicalwagesassignedoallworkers, w E, = c E,.Noehaundercommunismhereisnomarkepriceofcapial,herefore r E, is he shadow price of capial referred o in period by he planner. We can now define he (inverse) ine ciency index of he communis sysem, E,+1, in erms of perceived relaive growh poenial of he wo regimes by means of savings or capial formaion and labor produciviy E,+1 A MŜ M,+1 A E S E,+1, (11) where S is savings by he egaliarian planner, and Ŝ anoionalvalueofaggregae savings under a free marke sysem referred o by individuals. Hereafer, we normalize M o one as he produciviy ceiling wihou a loss of generaliy. As workers are paid heir marginal produc under markes, hey do no su er he incenives problems ha can occur under communism, discussed in he upcoming secions.

8 Culural Transmission and he Pendulum of Economic Sysems Inergeneraional Transmission of Beliefs We assume ha ype A agens always each a communis ideology o heir children o abolish inequaliy, while ype B agens always each a pro-marke ideology favoring e ciency. 10 This is a firs channel of ransmiing beliefs ha capures he influence on ideology inensiy wihin he family, and corresponds o wha is ermed direc verical ransmission in he lieraure (Bisin and Verdier, 2001, 2010). The evoluion over ime of he relaive degree of ideological deerminaion o change he saus quo, however, is also a eced ouside he family. This second channel, known as oblique ransmission, operaes hrough he influence on ideology inensiy by peers and he broader environmen (see also Sain-Paul, 2010). We assume a seing, where direc verical ransmission acs as a subsiue o oblique ransmission, i.e. parens have less incenives o socialize heir children he more widely dominan are heir rais in he sociey. Socializaion e ors i ( ) a ec he deerminaion of he nex generaion o mobilize in order o change he sysem. Socializaion e or by ype A is generaed by resenmen from inequaliy, A A ( ), andforypeb by he inferior e ciency wih respec o markes B B ( ). The properies of hese socializaion funcions are sandard: i (1) = 0, i 0 ( ) > 0, i 00 ( ) < 0. (12) Propery i (1) = 0 in (12) saes ha socializaion e or is only acivaed upon su erance. 11 The socializaion process of he agens of each ype, A and B, canbesummarized as follows: he ransiion probabiliies a ime, P i",haaparenofypei has a child wih a sronger (") orweaker(#) ideological deerminaion can be wrien as P A" = A +[1 A ]q ; P A# = [1 A ](1 q ); P B" = B +[1 B ](1 q ); P B# = [1 B ]q. (13) Given hese ransiion probabiliies, he relaive srengh of individuals of ype A in period +1is q +1 = q P A" +(1 q )P B# = q +(q q 2 )[ A ( ) B ( )]. (14) The dynamics of he probabiliy of a regime shif are endogenous o he presen economic siuaion and depend on he disuiliy experienced by each ype. The properies of he socializaion funcions imply ha A ( ) =0under communism while B ( ) =0under amarkeeconomy.accordingly,helawofmoionin(14)simplifieso q M,+1 = q M, +(q M, q 2 M,) A (15) 10 Landier e al. (2008) find empirically ha ideological priors maer a lo in aiude formaion. 11 This is a special case of Bisin and Verdier (2001) ha is based solely on resenmen owards he saus quo, i.e. only one agen ype a a ime engages in he ransmission of his preferences. The use of his seing allows us o simplify our noaion, wihou changing our resuls under culural subsiuion. ACournoseingalsoyieldshesameoucomeasresenmenand,hence,e orbyanagenliving under a regime s/he does no suppor is sraegically higher.

9 Farvaque, Mihailov and Naghavi (May 2012) 9 under markes and o q E,+1 = q E, (q E, q 2 E,) B (16) under communism. Thus, in he marke sysem he degree of ideological deerminaion of ype A o change he saus quo, q M,+1,increaseswihanyposiivesocializaione orbyype A, A ( ) > 0. Above he criical value q M, =0.5, hehreaooverhrowhecapialis regime becomes credible. Analogously, in he communis sysem he ideological deerminaion of ype B o change he saus quo increases, i.e. 1 q E,+1 increases, wih any posiive socializaion e or by ype B, B ( ) > 0. Above he criical value 1 q E, =0.5, hehreaoabolishhecommunisregimeasypeb agens promoe marke values becomes credible. 3 Economic Sysems and Ineracion of Agens We consider a sequencing of acions appropriae for boh economic sysems, in which he agen ype who exercises ownership and conrol (economic power) o decide on he spli beween consumpion and savings moves firs. The agen ype who has no ownership and conrol righs can only have socializaion (or ideological) power by insilling beliefs agains he regime in force, ha is, rying o each he nex generaion in favor of his/her own values. The sequence of evens a ime is illusraed in Figure 1 parallel o he process of capial accumulaion in he same period (see Secion 2.4). [Figure 1 abou here] 3.1 Marke-Based Economy In he marke sysem, capialiss boh own he capial sock and conrol he allocaion of heir income beween consumpion and savings, o be invesed and used o produce in he nex period by he nex generaion. In conras, workers do no own and conrol anyhing apar from heir labor force, which hey supply inelasically in he model. I is herefore opimal savings and capial accumulaion wihin he capialis dynasies (where ownership and conrol righs are aligned and e ecive) ha drives he e ciency and susainabiliy of he marke sysem, bu deepens he social inequaliy. Type B agens in his case are he firs movers in a von Sackelberg leadership game and decide on savings, while aking ino consideraion in heir maximizaion problem he socializaion reacion of ype A agens o he inequaliy caused by heir own savings. Saring wih ype A agens (he working class), hey ake savings as fixed and maximize heir uiliy using (1): max A UM, A ( ) =c A M, E A [ +1 ] {z } (1 q +1)ln M,+1 ( A ) 2, 2 where we have subsiued for E A [ +1 ] from (2) afer noing ha ln E =0.Replacing for M,+1 from (8) and for q M,+1 from (15), he opimizaion problem becomes: max A c A M, 1 q + q (1 q ) A ln 1 sb ( A ) 2. 2 The firs-order condiion yields he opimal reacion of ype A as follower:

10 Culural Transmission and he Pendulum of Economic Sysems A M, ( A = q (1 q )ln 1 sb, A = q (1 q )ln A =0 1 sb. (17) This equaion delivers a preliminary insigh on he mechanisms ha drive he evoluion from one sysem o anoher. I is easy o see ha an increase in privae savings (by he capialiss) leads o increased socializaion e or by ype A agens. The laer can only expec a growing inequaliy beween he wo ypes of agens, which reinforces heir deerminaion o insill heir values in he nex generaion, and o poenially change he regime. More precisely, he higher he expeced inequaliy, he higher he e or o ransmi heir preferences owards a more equal sociey. Turning o ype B agens, hey move firs by making a decision on he amoun of heir savings: max s B U B M, ( ) = c B M, + y B M,+1 E B [ +1 ] ( B ) 2 s.. c B M, + s B M, y B M,. Noe ha savings by capialiss have no direc negaive exernaliy on aggregae produciviy because he decision is made a an individual level and consumpion by workers c A M, is no a eced by i. Afer a series of subsiuions and omiing he M- subscrip o savings due o he absence of individual savings under communism in our model, we rewrie max s B A M s B 1 +(A M 1) s B q +(q q 2 ) A ln E,+1. Replacing for A wih he opimal reacion of ype A agens from (17) and aking he firs-order condiion yields opimal savings by ype B as leader: B M, ( B = A M 1 q2 (1 q ) 2 s B ln E,+1 =0, s B = q 2 (1 q ) 2 ln E,+1 A M 1, (18) where A M > 1/ mus hold for posiive savings by he capial owners. The las equaion reveals ha increased expeced ine ciency under he alernaive (communis) sysem induces higher accumulaion by capial owners in an e or o furher consolidae he capial sock and, hence, he producive poenial of he marke economy. Savings can also be large when he srengh of he wo ypes are no oo di eren so ha q 2 (1 q ) 2 is near is maximum. Subsiuing (18) back ino (17) o derive he opimal socializaion e or of he ype A in is final form, we ge A = q (1 q )ln 1 sb. (19) Subsiuing A from (19) ino (14), nex-period ideological deerminaion of ype A o change he saus quo becomes q +1 = q + q 2 (1 q ) 2 ln 1 sb. (20)

11 Farvaque, Mihailov and Naghavi (May 2012) 11 I is seen from (20) ha he evoluion of q over ime under a marke sysem is riggered when A > 0. This is rue as long as which holds as long as y B M,0 >ya M,0. M,+1 (s B ) 1 sb > 1, (21) Lemma 1 Given he iniial condiion ym,0 B >ya M,0, opimal individual savings by capial owners s B always increase inequaliy, provoking ype-a workers ino more inensive ransmission of heir social disconen and more e or o insigae a regime change. Proof. See equaion (21) M,+1 > 0 increases B in (19) and q +1 in (20). In sum, capial owners allocae heir income beween consumpion and savings, perpeuaing inequaliy; workers hen reac by choosing heir socializaion e or, which in urn a ecs he ideological deerminaion and srengh of he nex generaion o change he saus quo. 3.2 Cenrally-Planned Economy Under communism, he economic decisions are made by he egaliarian planner, who is of ype A and splis oal consumpion equally across all members of sociey. 12 Afer he naionalizaion following he communis revoluion he sociey, de jure (bu no de faco) owning he capial, delegaes conrol o he egaliarian planner. Individuals do no conrol he choice of aggregae consumpion and invesmen ou of naional income, which is also naional oupu. Thus, under communism, here is misalignmen of ownership and conrol righs creaing ine ciency. We capure and inerpre i in comparing he opimizaion problems under cenral planning (aggregae, hen disaggregaed op-down by equal spli) vis-à-vis he marke (individual, aggregaed boom-up). The egaliarian planner is he firs mover and akes ino consideraion he socializaion reacion of ype B agens o he relaive e ciency of he sysem caused by his cenralized decision. Saring wih ype B agens (marke advocaes), hey ake savings as fixed and maximize: max B UE, B ( ) =c B E, E B [ +1 ] {z } q +1 ln E,+1 ( B ) 2, 2 where we have subsiued for E B [ +1 ] from (3) afer noing ha ln M =0.Replacing for E,+1 from (11) and for q E,+1 from (16), he opimizaion problem becomes: max c B B E, q + q (1 q )( B )! A M Ŝ ln ( B ) 2. A E S E,+1 2 The firs-order condiion hen B E, ( B! A M Ŝ = q (1 q )ln B =0 A E S E,+1!, B A M Ŝ = q (1 q )ln. (22) A E S E,+1 12 This follows our assumpion of inequaliy aversion characerizing ype A agens, o conform wih he preference for equaliy among he hinkers and pioneers of communism. Di eren from maximizing social welfare, i presumes ha he cenral planner himself experiences a disuiliy from inequaliy.

12 Culural Transmission and he Pendulum of Economic Sysems 12 Hence, an increase in he planner s aggregae savings direcly reduces he socializaion e or by ype B agens. This is due o he fac ha, as seen in (11), such an increase is perceived o give a boos o he e ciency of he communis sysem. While his e ec per se could reduce ine ciency, i will be seen below ha he command accumulaion process has an adverse e ec on labor produciviy, leaving he oal e ec of aggregae savings on he relaive e ciency of he communis sysem and he socializaion e or by ype B agens who share he values of capial owners ambiguous. 13 The egaliarian planner as a firs mover maximizes uiliy in he name of he ype A agens aking ino accoun aggregae values. Therefore, he egaliarian planner (no individual capialiss, whose capial has been naionalized) opimally chooses he level of aggregae savings, i.e. naional invesmen. This also deermines he allocaion of oupu o be disribued equally among he oal populaion for consumpion. max S U A E,( ) = C + Y +1 E A [ +1 ] ( A ) 2 2 s.. C + S H E,. Parallel o he marke economy, he planner akes Y +1 as he value of he inergeneraional ransfer in his opimizaion problem using he shadow price of capial r E,+1 (Y +1 = r E,+1 S = A E S ). Aggregae decision making by an egaliarian planner under a communis regime a ecs oal and per capia levels of consumpion, herefore changing produciviy over ime. This is because he naional budge consrain implies C + S = H E,,hais, oupu in he aggregae has o be equal o he sum of consumpion and invesmen in every period. Therefore, each individual ges an idenical consumpion level equal o he assigned allocaion by he planner c E, = H E, S 1 = C. (23) Since allocaion beween saving and consumpion akes place afer producion in each period, consumpion in deermines produciviy in he following period +1. There is an exernaliy caused by produciviy being a funcion of consumpion, which is changing over ime in he new economic sysem. Lemma 2 The budge consrain of an egaliarian planner in (10), C + S = H E,, implies ha higher aggregae savings cu consumpion by he whole populaion. This resuls in a negaive e ec on produciviy E,+1 and makes he laer ime-dependen. Proof. We can conclude from (23) and he properies of E,+1 E, = 0 E,+1 < 0. Afer a series of subsiuions, we obain: max S A E [ S 1 + E, (1 )L] (1 A E )S 1 q (q q 2 ) B ln ( M,+1 ). 13 This ambiguiy resembles hisorical evidence such as ha in Broadberry and Klein (2011), who show Czechoslovakia s comparaive produciviy posiion under he cenral planning regime wih respec o he UK o have iniially improved before falling back o lower levels.

13 Farvaque, Mihailov and Naghavi (May 2012) 13 Replacing for B wih he opimal reacion curve by ype B agens derived in (22) and aking he firs-order condiion A ( ) " # = ( A E 1) + q 2 (1 q ) 2 1 ln ( M,+1 ) 0 E,+1 S E,+1, S 1 =, (24) 1 A E q 2(1 q ) 2 ln ( M,+1 ) + E,+1 where E,+1 represens he perceived lagged semi-elasiciy of labor produciviy in +1 wih respec o consumpion in. In he res of he analysis, we assume imperfec informaion abou he exen o which his value can be observed o analyze he di eren consequences of a cenralized regime. Equaion (24) reveals ha increased expeced inequaliy under he alernaive (marke) sysem induces higher savings by he egaliarian planner in an e or o furher consolidae he capial sock and, hence, he producive poenial of he communis sysem. Savings can also be large when he srengh of he wo ypes is no oo di eren so ha q 2 (1 q ) 2 is near is maximum. In addiion, he planner adjuss savings inversely wih respec o he sensiiviy of labor produciviy o consumpion. Finally, A E < 1/ mus hold o ensure posiive savings by he planner. Lemma 3 If he condiions ha ensure posiive saving a all imes hold under boh sysems, TFP under free marke is necessarily higher han ha under communism: A E < 1 <A M. Proof. Follows direcly from he ineremporal opimizaion problem of he leader in equaions (18) and (24). Subsiuing (24) back ino (22) o derive he opimal socializaion e or of ype B in is final form, we ge! B A M Ŝ = q (1 q )ln A E S. (25) E,+1 And now subsiuing B from (25) ino (14), he nex-period proporion of he populaion in favor of a marke-based sysem becomes! q +1 = q q 2 (1 q ) 2 A M Ŝ ln A E S. (26) E,+1 I immediaely appears from (26) ha he ideological sance of ype A s relaive o ype B s under he communis sysem weakens when B > 0. This is rue as long as E,+1 (S A M Ŝ ) A E S E,+1 > 1, (27) which will urn ou o be he iniial condiion a he momen of he communis revoluion, T,dueodesrucionofsomefracionofhecapialsock(seesecion3.3.1). Perceived ine ciency increases when he direc posiive e ec of aggregae savings S on e ciency of communism relaive o markes is dominaed by is negaive e ec via produciviy in he nex period, E,+1. In words, when he egaliarian planner increases

14 Culural Transmission and he Pendulum of Economic Sysems 14 aggregae savings S o rigger an acceleraion of he accumulaion process and a perceived fall in E,+1,hemusassignalowerconsumpionleveloallworkersaccording o Lemma 2. Since produciviy depends posiively on consumpion in workers families, nex-period worker incenives and herefore produciviy under communism, E,+1,are reduced. If he laer e ec dominaes, ine ciency increases and ype B agens recrui ineremporally by inensifying heir socializaion e or. 14 Lemma 4 Savings by he egaliarian planner increase ine ciency if he indirec negaive e ec on nex period labor produciviy dominaes he direc posiive e ec on e ciency > 0), leading ype B agens ino more proliferaion of marke ideas o insigae ransiion. Proof. Ine ciency in period +1 increases if he direc posiive e ec of saving in on e ciency in +1 is dominaed by is negaive lagged e ec on labor produciviy via a reducion in E,+1 {z } {z }, {z } where we < 0 from Lemma 2. This condiion holds if and only if 0 E,+1 E,+1 > 1 S is rue. The resuls sugges ha he cenral planner faces a rade-o beween building capial hrough saving o ensure oupu growh and causing ine ciency in he subsequen period by reducing labor produciviy. He mus sacrifice consumpion and nex period produciviy o save and increase oupu, which may lead o more disconen in he sociey and an increased probabiliy of ransiion. Solving ou he inequaliy in Lemma 4 and replacing for opimal savings from (24) shows ha in order for he lemma o hold he condiion 1 A E E,+1 > q 2(1 q ) 2 ln ( M,+1 ) + E,+1 (28) mus be saisfied. Condiion (28) suggess ha if he acual lagged impac of saving on labor produciviy is su cienly larger han ha prediced by he cenral planner, savings made a an aggregae level can increase ine ciency. This would be in line wih sylized facs provided in Brixiová and Bulíř (2003)onhow(i)planningauhoriydid no know he rue producion funcion of individual firms and heir capaciy uilizaion, and (ii) firms had vesed ineres o hide his informaion, while he planner possessed only primiive monioring echnology. Knowing his and wihou loss of generaliy, we se E,+1 =0in he remainder of he analysis for he sake of noaion. [Figure 2 abou here] Condiion (28) and hence Lemma 4 is more likely o be saisfied when eiher S or are su cienly large. Savings can be large due o: (i) he planner perceiving E,+1 14 Lindbeck and Nyberg (2006) discuss he disincenive e ecs on work of welfare-sae arrangemens, sressing in paricular ha he negaive e ecs of he poor incenives for work in former socialis counries in Easern Europe also seem o have maerialized wih a ime lag.

15 Farvaque, Mihailov and Naghavi (May 2012) 15 inequaliy under an alernaive (marke) regime ln ( M,+1 ) o be high; (ii) TFP A E being large and closer o ha under markes; (iii) he srengh of he wo ypes being no so di eren so ha q 2 +1 (1 q +1) 2 is near is maximum. On he oher hand, he concave naure of labor-augmening produciviy as a funcion of consumpion implies ha he lagged negaive e ec of savings on labor produciviy is large when aggregae consumpion availabiliy C is limied. This can, for example, be due o a large loss of capial caused by revoluion and corresponds o he lef region in Figure 2, where c E, <c. The ambiguiy he cenral planner faces lies hidden in he produciviy funcion. While he negaive dependence of produciviy on lagged consumpion is known, he magniude of his e ec is uncerain, implying ha agens do no have perfec foresigh, alhough hey are e ecively raional in he conex of he game hey play. Wih a highly elasic response of labor produciviy o savings, he planner s choice of savings in he preceding period leads o a lower e ciency, an analogy o he insabiliy of communism in Lemma 4. We inerpre he exen of his elasiciy as he sacrifice ha he populaion of he communis region is willing o endure in he name of an egaliarian sysem, i.e. o wha exen heir working morale is reduced by lower consumpion. This olerance may have o do wih he culural values, social norms, or srong ideological convicion. Thinking along such lines brings in an ineresing parallel wih he cross-culural psychology lieraure ha allows us o compare Russia and Easern Europe wih China and Eas Asia. Hofsede (2001) defines individualism versus collecivism as one of his well-known culural dimensions. In individualisic socieies, people are expeced o pursue individual ineress, whereas in collecive socieies hey are expeced o place collecive ineress over personal ones. Indeed, Russia (esimaed value) and he former Easern block counries score wice as much as China and oher Eas Asian counries on individualism. Such an analogy would, for insance, associae Russia and Easern Europe wih a lower olerance level and place i o he lef of China and Eas Asia in Figure 2. Finally, recalling S = K +1 and subsiuing S ino he producion funcion in (4), we ge an expression for nex period oupu in erms of opimal savings: H E,+1 (S )=A E [ q2 (1 q ) 2 ln ( M,+1 ) 1 A E + E,+1 (1 )L]. (29) I is easy o see ha a srong negaive exernaliy on produciviy in Lemma 4 also prevens producion H E, in (4) from growing over ime. This rules ou he possibiliy of invesmens raising oal oupu over ime and creaing higher consumpion possibiliies. 15 In sum, he egaliarian planner allocaes naional income beween consumpion and savings a he aggregae level, and ype B agens reac by choosing heir socializaion e or o influence he ideology of he nex generaion, hus deermining he proporion of ype B agens in he nex period, 1 q +1. However, if Lemma 4 does no hold, an inelasic negaive response of produciviy o savings across generaions under communism will no undermine i as a susainable economic sysem in he long run. Such a scenario, ulimaely depending on paricular properies and parameers, can hen sabilize communism, delaying or avoiding ransiion o markes. 15 For an insigh on he reduced consumpion opporuniies delivered by communis regimes, see for example Bergson (1991).

16 Culural Transmission and he Pendulum of Economic Sysems Regime Swiches and he Shif of Propery Righs The Momen of Revoluion Before analyzing he dynamics of capial accumulaion, i is helpful o have a closer look a he firs period immediaely following he communis revoluion, T. Aggregaing all capial sock in he hands of he individual capialiss, a proporion 1 n T of he adul populaion, ha has been naionalized a he beginning of T and aking ino accoun he coss of he revoluion in erms of a desroyed fracion of capial, 0 < 1 µ T < 1, we wrie: s B revoluion T 1 = k T ) µ T k T = K T. (30) cos (loss) The lef-hand side of his expression is he capial sock invesed by he individual capialiss jus before he revoluion and aggregaed a he naional level, s B T 1 ; he righ-hand side is he same capial sock afer accouning for he capial losses during he revoluion and he naionalizaion of all he inheried and surviving capial, µ T k T. The laer capial sock, K T, is wha remains for he egaliarian planner o pu ino producion in period T and, obviously, K T <k T. Noe ha produciviy in T does no change, leaving he planner wih unchanged produciviy, M,bualowercapial sock, K T. This resuls in reduced oupu in T relaive o T 1, inducingheplanner o increase savings in his very firs ineremporal allocaion decision. Such a decision could, of course, be moivaed by he need o rebuild he capial base and compensae for he loss from he revoluion, or o cach up wih he res of he world. From hen on, in essence, period T has a lagged e ec on oupu in period T +1 via wo channels: increasing he capial sock, K T +1 = S T,hroughmoresavingsin he preceding period, (i) increases oupu, H T +1, bu also (ii) decreases wages and consumpion ha are equally assigned o all workers as from period T ;hisreduces working morale and, hence, produciviy in he nex period E,T+1 resuling in a lower oupu H T +1.Tosumup,ifLemma4holds,anelasicnegaiveresponseofproduciviy o savings across generaions is ensured and communism is no susainable in he long run The Pos-Communis Transiion Period By symmery, i is also imporan o have a closer look ino he firs period immediaely following he ransiion of he pos-communis sociey back o a marke-based sysem. We assume ha marke ransiion akes place hrough a process of privaizaion of he capial sock in he beginning of period T + N. The capial sock ha has been accumulaed by ha ime, K T +N, is hen allocaed o he new capial owners, who now have o manage i, by a legal change ino propery righs. Hisorically, several ways of ownership ransfer have been applied in pos-communis ransiion economies, from mass privaizaion, via resiuion o he heirs of capialiss wih naionalized facories, o communis nomenklaura grabbing. In our conex, i su ces o assume wihou loss of generaliy ha he new capial owners will be he agens mos eager o ge ino his new role. Such agens may be of boh ypes, as ype A s will be convering fas o ype B s. We assume ha a he beginning of period T + N, jusaferprivaizaion, he new capial owners represen a proporion 1 n T +N of he adul populaion. We also assume ha here will be cerain coss of privaizaion in erms of he lack of enrepreneurial and managerial skills of he new capial owners or because of inheriing ine cien or oudaed enerprises and equipmen. We measure hese coss by a fracion, 0 < 1 µ T +N < 1, of los capial, and we hus wrie:

17 Farvaque, Mihailov and Naghavi (May 2012) 17 ST privaizaion +N 1 = K T +N ) cos (loss) µ T +N K T +N = k B T +N. (31) The lef-hand side of his expression is he opimal savings, S T +N 1,invesedino capial sock, K T +N,byheegaliarianplannerjusprioroheransiionomarkes; i is given direcly a is aggregae naional level (which also coincides in our model, wih a uni mass of adul populaion, wih he per-capia maure-generaion capial sock). The righ-hand side of (31) is he same capial sock afer accouning for he capial losses during he ransiion o markes and he privaizaion of all he inheried and surviving capial, µ T +N K T +N. The laer capial sock, k B T +N,iswharemains, in he aggregae, o be allocaed o he new capial owners and pu ino producion in period T + N, andk B T +N <K T +N. Wih his lower capial sock and produciviy in T + N predeermined by he lagged e ec of savings operaing via consumpion in workers families, E,T+N,oupuinT + N falls relaive o T + N 1. Once he firs period of he reurn o markes elapses, individual decision-making on he spli beween consumpion and savings by he new capial owners eliminaes he negaive exernaliy in he ineremporal opimizaion problem, ypical for communism, we highlighed. This allows higher oupu in he nex period and aligns invesed savings wih individuallyconsisen decisions of capial owners. I also resores he higher level of consumpion characerizing he more e cien marke sysem, ye reinroducing and perpeuaing inequaliy. 4 Inergeneraional Dynamics and Economic Oucomes In his secion, we highligh our principal analyical findings derived from he dynamics of q and he resuling economic oucomes. Tha is, having precedingly analyzed he wihin-period leadership game equilibrium sraegies of our wo agen ypes, we are now well equipped o proceed o he analysis of he feedback from ideological srengh q o sraegies across generaions. Given ha agens only live one period of adulhood, players in he von Sackelberg game change every period. In oher words, he same game is played by he nex generaion, wih he level of srengh q aained by socializaion of agens in he previous period as he iniial condiion. This allows us o observe he law of moion of q and poenial economic ransiions over ime. 4.1 Capialism and he Communis Revoluion We firs consider he dynamics underlying he ransiion from a marke-based o a cenrally-planned economic sysem. We can sae: Proposiion 1 (Communis Revoluion) Suppose ype A is iniially weaker han ype B (q 0 < 0.5). Given A, s B, and he law of moion of q, he opimal savings increase in > 0). This implies ha a higher q M,+1 caused by A will resul in more savings by ype B s in he nex generaion von Sackelberg game +1 > 0). This rend coninues unil q > 0.5 where he hrea of a communis revoluion becomes credible. Proof of Proposiion 1. We derive he e ec of he relaive srengh of workers in some period on he saving behavior of he capial owners in ha B =2q (1 q )(1 2q ) ln E,+1 > 0 if q < A M 1 < 0 if q > 0.5. (32)

18 Culural Transmission and he Pendulum of Economic Sysems 18 Thus, for any low q < > 0. In words, he opimal reacion funcions of he wo ypes in he von Sackelberg game of class sruggle under markes lead o a progressive increase of q unil i surpasses some criical mass. Beyond his hreshold ype A s become su cienly srong and ideologically deermined o represen a credible hrea o overhrow he exising capialis social order. For q > 0.5, a communis revoluion occurs wih probabiliy q ;ifhisdoesnohappen,heopimalsavingsby ype B s, s B, become decreasing in q poenially sabilizing he capialis markeeconomy sysem. Proposiion 1 can be inerpreed as follows: a capialis sysem is only feasible when ype A s are weaker han ype B s (q 0 < 0.5). The mobilizaion of he working class caused by inequaliy increases he ideological moivaion of he nex generaion o overhrow he sysem. This induces more savings by capial owners, bu increases inequaliy, feeding he resenmen of ype A agens. The reinforcing e ec of social resenmen on capial accumulaion and inequaliy could evenually lead he marke sysem owards is fall. Hisorically, his could be relevan o he case of he uprising of he working class in Russia, on which we focus he analysis. Corollary 1 (Sable Capialism) Should a communis revoluion no occur when q > 0.5, a subsanial hrea from srong ype A s revoling induces he leader o accommodae his sraegy in search of a compromise by decreasing savings, s B, miigaing inequaliy and poenially sabilizing he marke sysem. Proof. See he proof of Proposiion 1 The alernaive in Corollary 1 arises because for relaively srong ype A s he probabiliy of a regime change is perceived by ype B s as credible, hus he laer adap heir behavior. An increase in he probabiliy of a regime change (q +1 >q )induces areducionincapialaccumulaionbyypeb s. By reducing income inequaliy and, hence, he ideological deerminaion of ype A s o change he saus quo, such a reacion by capial owners can avoid slipping owards communism. Alhough we do no explicily model redisribuion, a par of he increase in capialiss individual presen consumpion brough abou by lower savings can be hough of as a ransfer o he poor ha akes place when he laer gain su cien srengh. 16 Hisorically, his seems o have been he case of social democracies and he welfare sae, where democraizaion of capialism and redisribuion of income have preserved he marke sysem. 4.2 Communism and he Transiion o Markes We urn o he dynamics underlying he ransiion from a cenrally-planned o a markebased economic sysem in anoher proposiion: Proposiion 2 (Marke Transiion) Suppose ype B is iniially weaker han ype A (q T > 0.5) and Lemma 4 holds. Given B, S and he law of moion of q, he opimal savings increase in 1 < 0). This implies ha a lower q E,+1 caused by B will resul in more savings by he egaliarian planner in he nex generaion von Sackelberg game +1 < 0). This rend coninues unil q < 0.5 where he hrea of a ransiion back o a marke-based economy becomes credible. Proof of Proposiion 2. We derive he e ec of he relaive srengh of marke advocaes in some period on he saving behavior of he egaliarian planner in ha 16 This is a concep similar o Galor and Moav (2006), in which capialiss find i opimal o inves in he human capial of he poor.