Command Economy

Why study command?

The command system creates initial conditions for transition
Legacies from command critical for transition
Path dependence
Two types of legacies
Structural
The result of past investments and other decisions
Enterprises, locational choices
Institutional
Behavioral patterns
How to reverse past decisions
Start with the analysis of command system
Command Economy
Attempt to replace markets
The command principle strives to fully and effectively replace
the operation of market forces in the key industrial and
developmental sectors of the economy, and render the
remaining (peripheral) markets manipulable and subordinate
to political direction.
Two Basic Imperatives
Growth
Control
3 Key Purposes
1. maximum resource mobilization towards urgent and
over-riding national objectives, e.g. rapid
industrialization or the prosecution of war;
Used by many countries in wartime
2. radical transformation of the socio-economic system
in a collectivist direction based on ideological tenets
and power-political imperatives; and
3. not the least, as an answer to the disorganization of a
market economy through price control, possibly
occasioned by inflationary pressure arising from (1)
and/or (2).
Basic Features of the STE
state-ownership of the means of production
centralized control by means of an administered system
of planning in physical terms.
The system replaces the market with a set of directives from
the center to the production units throughout the economy.
These directives are commands, not suggestions. They are
directives that have the force of law, and subordinates are
responsible for fulfilling them, even if the plans are not
feasible.
The absence of markets implies loss of information
about opportunity cost
absence of private property, except for households
STE
STE created by Stalin in 1928
Exported to Eastern Europe after WW2
Imported by China after 1949
Yugoslavia mutates in mid-50s
Self-management
North Korea, Vietnam, Cuba are
underdeveloped examples of command
economies
Basic Feature Continued, Implications
soft-budget constraints
chronic sellers market
emphasis on heavy industry
gigantomania
dynamic incentives problems
state control of investment
restrictions on entry, no exit

Soc i ali st
Countri es
a
Capi tali st
Countri es
b
Total Manufac turi ng
Average employment per firm 197 80
Percentage of those employed
in firms with more than 500 workers 66 32
Texti le Industry
Average employment per firm 355 81
Percentage of those employed
in firms with more than 500 workers 75 17
Ferrous Metals
Average employment per firm 2,542 350
Percentage of those employed
in firms with more than 500 workers 95 79
Mac hi nery
Average employment per firm 253 82
Percentage of those employed
in firms with more than 500 workers 61 28
Chemi c als
Average employment per firm 325 104
Percentage of those employed
in firms with more than 500 workers 79 35
Food Proc essi ng
Average employment per firm 103 65
Percentage of those employed
in firms with more than 500 workers 39 16
Sourc e: Ehrlich (1985)
a
Sample, including Czechoslovakia, GDR, Hungary, and Poland.
b
Sample, including Austria, Belgium, France, Italy, Japan, and Sweden
0-100 100-500 500 and more
West Germany 14.1 23.9 62
France 22.5 24.9 52.6
Italy 32.3 27.3 40.4
GDR 1 11.1 87.9
Czechoslovakia 0.1 3.4 96.5
Hungary 4.5 16.3 79.3
Poland 1.4 18.2 80.4
source: OECD data for West Germany, France and Italy are for 1987,
and for the other countries are for 1989.
Distribution of Employment by Size
Structural Differences
Agriculture Industry Services
OECD (1991)
8 richest countries 5.5 29.8 64.7
8 middle countries 5.8 30.4 63.9
8 poorest countries 17.9 29.5 52.6
Centrally Planned
Economies (1998)
GDR 10 44.1 45.9
Czechoslovakia 11.6 46.8 41.6
Hungary 17.5 36.1 46.4
Poland 27.2 36.3 36.4
Ownership
Not just commanding heights
In the Soviet Union, for example,
the state and collective sectors accounted for some 88% of
the value added in agriculture; controlled 98% of retail trade,
and owned 75% of urban housing space
The industrial sector was exclusively state owned.
In 1985, for example, 91% of employment was in state enterprises,
and another 6% was in kolkhozy.
The extensive control of retail trade means that the smallest
shops were state owned.
But key factor is hierarchical control
Sample Hierarchy
Consumer
Goods
Defense
Chemical
Plant #3
Chemical
Plant
#2
Chemical
Plant
#1
Chemicals
Coke Plant
#2
Coke Plant
#1
Coke Trust Rolling Mills
Steel Plant
#2
Steel Plant
#1
Steel Trust
Ferrous
Metals
Central
Planning
Board
Old Gosplan (currently Duma)
Hierarchy
Only vertical information flows
But there are informal horizontal flows
Only at the top of the hierarchy can opportunity cost be assessed
Lower level agents cannot assess tradeoffs
Implies subordinate control crucial
Bureaucracy must exercise full control and discretion
But subordinates have their own interests, which implies:
Incentive problems
Need for monitoring systems (police, party, banks)
Corruption
Fundamental issue: how to get agents to reveal information and
follow orders
Soviet Growth Model
Mechanism for extensive growth
Paradoxical attitude towards time
planners have a very low discount rate -- they are willing to sacrifice lots
of current consumption for future consumption
On the other hand, haste implies that they want to industrialize fast. So
they cut corners, and ignore side effects and other costs.
Diabetes example
Key point
Haste sowed the seeds of the barriers to longer-term performance.
In that sense, the rapid growth in output of the first couple of five year
plans represent borrowing from future performance.
Balloon payment
Key defect of the SGM is that output growth is pursued without
regard for the opportunity cost of that growth
E.g., environmental mess
Extensive vs Intensive Growth
Suppose that output is given by

Then the growth rate of output is given by


Thus growth occurs either thru growth of inputs (more K
and/or more L) or technological change (growth in A)
Extensive growth is the former, intensive growth is the latter
Growth thru greater efficiency in use of inputs
Extensive growth is growth thru accumulation of inputs
Consumption Paths
Whose utility is being maximized?
Households versus planners objectives
Planners willing to defer present consumption versus
future consumption
Planners combine haste with patience
Their haste for fast growth with publics patience for
deferred consumption
High rate of time preference on part of owners, cost
paid for by public
Aral Sea
Soviet Growth Model (cont.)
Growth implies maximize investment
How? Via control of consumption
State is sole employer => monopsony
Let be the subsistence level of consumption
Then is aggregate consumption.
Let be aggregate consumption
Then investment is maximized, for given level of K,
by choosing L so that
What if ?
c

L c

) , ( L K F Y =
c F
L

=
L L <
*
Industrialization Strategy
Heavy industry
Maximize investment
Collectivization
Surplus labor argument
Transfer from rural to urban
State control over resources
But peasant response
Output growth versus welfare
USSR, Inc.
Soviet economy as a single corporation
The corporation owns a large stock of natural
resources,
has no outside shareholders
(so that all "profits" can be retained for investment)
hires labor
Moreover, as a monopsonist in the labor market, USSR Inc.
can minimize the expenditure on labor.
Transactions between enterprises are merely transfer
prices between "divisions."
The exceptions are purchase of labor and engagement
in foreign trade.
Exceptions
Labor is allocated partly by choice
State determines demand, but labor is supplied
Though vagrancy is a crime full employment
Foreign Trade controlled by FTM
FTM trades with ROW
Intermediary between producers and ROW
Insulates domestic prices from world prices
Purchases (sells) goods at state prices and sells (buys)
at world prices
Haste
Command system is good at mobilizing
achieving specific objectives
Extensive growth
Growth through accumulation of inputs
It is bad at assessing costs and tradeoffs
May be important for intensive growth
Growth via greater efficiency
Crucial Role of Resource Abundance
Delay in reaching BoP constraint
Growth Problems
Over time growth rates decline in all STEs
Despite continued growth in capital-worker
Why?
Failure to transition to intensive growth
Extensive growth trap
Inability to substitute capital for labor
Innovation Problems
The system worked best when the fruit was low-
hanging
mobilization
Soviet Growth Rates Decline
Intensive vs Extensive Growth
Start with
Then the growth rate of output can be written as:



Intensive growth means high

Extensive growth means accumulation
But notice that as capital accumulates, increases
What happens to rate of return?

L
K
Two Explanations of Slowdown
TFP growth declines due to increased complexity of the
economy
Difficulty with diffusing innovation
Low elasticity of substitution
K/L increase due to high savings rate and limits to growth in labor force
If substitution is difficult output growth is reduced
Note that this is organizational, not technological
No entry, limited exit
Input-output conservatism in planning
Extensive growth and natural resources
Energy was underpriced and over-utilized
when prices are liberalized many industries are producing negative value
added
Price System
Prices unrelated to social costs
Socially necessary costs
Average not marginal
Non-existent charges for rent and capital
Raw materials underpriced
Costs of production were thus calculated based on an incomplete
enumeration of costs.
Prices biased based on user
Circus mirror effect
Does it matter?
USSR, Inc., => transfer pricing
But illusion about sources of value
Implications for transition
Price System (cont.,)
Why have prices in a planned economy?
an accounting device
Monitoring of plan performance
Related question, why have money?
Active and passive money
Soft-budget constraint (Kornai)
If budget constraints are not binding a resource constraint
must eventually be reached
Implies that shortage is an equilibrium phenomenon in STEs
Leads to sellers markets

SBC
Dynamic Commitment problem
Subsidy available ex post not ex ante
Effort costly for manager, bonus for fulfillment is B


Effort is sufficiently costly so
If effort is low, Y = 0 with no bailout, Y R with bailout
If low effort manager must be bailed out because low output
is bad for planner
Manager knows this so he supplies low effort

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

Dynamic Incentives Problems
Planning from the achieved level

Enterprise exploits hidden information
Agents must be induced to reveal information
Simple 2-person game
Enterprise director can tell the truth or lie
Planner can issue a feasible or a taut plan

1
) 1 (

+ =
t t
Y Y u
Preferences
Directors preferences:

Planners preferences:

Illustrative payoff matrix




Equilibrium: both lie

Bonus Function
To get director to reveal information planner
implements a bonus function



But why pay to overfulfill?
Need for extra resources to meet shortages
Increase effort
Canonical Bonus Function
B
q
More on the Bonus Function
Solves static problem
Assume that effort is required to produce more
output
Moral hazard
But that this differs depending on productivity
Hidden information (adverse selection)
Then preferences depend on the nature of the
enterprise

Canonical Bonus Function
B q ( )
B
q

q
B
0
B B
0
+
U
H
U
L
q
1
Canonical Bonus Function
Generates separation
If no bonus for overfulfillment, then pooling
Sets up the dynamic incentives problem
Fulfillment today risks fulfillment tomorrow
Consequences
Need for a safety factor
Ratchet effect
Taxing high performance
Dynamic Problem
Let be utility for fulfilling the plan for the
high productivity enterprise
Current gain from overfulfilling is:

Loss from revealing information is

Then director must compare

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

Shchekino Experiment
Planning experiment
Planners commit not to change targets for 5 years
Enterprise can keep costs savings
Labor productivity rose so fast, 52% in first year,
planners reneged
Changed plan targets 7 times in 10 years
Another plant 17 times in 5 years
Inability of planners to commit
Ratchet Effect
More severe the greater is
Time horizon
Utility loss
And the smaller is
The discount rate
Leads to reduced incentives to perform and
innovate
Alexeev and weightlifting records
Slow diffusion of innovations

Result
Who said this?




Yuri Andropov, General Secretary, CPUSSR
Top officials know the problem, cant solve it
Lack of Observability
Inflated reports simulation is commonplace
Difficulty of monitoring
Occasional audits show this:
Enron, Global Crossing, Stock options
Similar problems occur in corporations
Directors and managers engage in simulation
simulation of performance to achieve bonuses
Simulate earnings to benefit from options
Incomplete information necessary but not sufficient
it is also necessary that rewards be skewed toward the present,
especially if those costs can be shifted on to others in the future.
Much harder to keep simulations hidden in markets
Need to hide losses, but Soviet pricing does not reveal losses
Vasily Alexeev
Date of First Adoption versus Diffusion
(proportion of output produced in 1982)
Structure of Command Economy
Imperative is microbalance
Planning by material balances
Feasibility, not optimality
Iterative process of vertical information flows
Basic idea
Sources = uses, good by good
For good j we have:



Where does come from?
The input requests from other enterprises
Where does this come from?
j
X

Material Balances, cont.

Planners start with a target for sector j:
Enterprise calculates its input needs assuming fixed
coefficients:

So multiply to get needs:


Now planner adds. E.g. for sector 1 (such an equation
for each sector of course):
0
j
X
Schematic
Chemical Plant #3 Chemical Plant #2 Chemical Plant #1
Chemicals
Steel Plant #3 Steel Plant #2 Steel Plant j
Steel
CPB
0
j
X
Material Balances, cont.
Put the sum back into the material balance:


No reason to assume it equals zero.
So adjust output targets:

Now we have a new set of input needs for each enterprise.
For j we have:


And we just repeat the whole process, again, and again


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

Incentives versus Complexity
Mises, Hayek thought central planning problem
was too complex to solve
Lange and Lerner suggested market solutions
Set Q such that MC = P
But this ignores incentives problems
Why would managers follow the rules?
Private information (about actions or conditions) is
valuable
Agents must be induced to reveal this
Command Problems
Detailed planning and the corresponding directives are
often late, are insufficiently detailed, may lack the
requisite information, hence often cannot be effectively
coordinated
Owing to their rigidity they are peculiarly vulnerable to
uncertainty
Planning in a command economy must be largely in
physical terms due to the crucial importance of balance.
The bottom line of the planning process must be available
physical units of required inputs, in appropriate assortment,
quantity and timing, necessitating physical targets for
production and input utilization.
Success indicator problem

Success Indicator Problem
Bonuses are non-synthetic
One linear price schedule produces imbalances
No secondary market
Planners cannot know tradeoffs at each enterprise
Pollution permits
Emphasize priority
Quality problems shifted to users
Because micro-balance is priority
Teaching versus research?
Bonus for retention
Command
Command is good for well-defined measurable
tasks
Build the Atom Bomb
Dont worry about cost = $25.7 billion at current prices
Command is bad at assessing tradeoffs
No prices to measure opportunity cost
Physical indicators lead to success indicator bias
Teaching is harder to measure than research
Shortage
SBC, fixed prices, output fixation => shortage
In production, to avoid wasted resources; full
utilization to achieve growth
In consumption, because planners do not want to
divert output
Of course, flexible prices could eliminate shortage,
but command means dominance over market
Market allocation weakens central control
Implication: Generalized shortage
Shortage
P S

D
Q
P

Excess Demand
*
P
The Big Nail
Problems with Linear Pricing
quality
SW
B
A P
P
quantity
enterprise
1
enterprise
2
Mormon Comparison
Many similarities
Sense of encirclement
Holistic vision of utopia
Virtuous haste
Totalitarian leadership (without terror)
Primacy of collective over individual
Hostility to speculation, private initiative
Insulation and isolation
Need for autarky to conserve foreign exchange
Like the Soviet economy, economy was collectivist,
mobilizational, centrally planned, largely command-managed,
and often redistributional in regard to factors, products, and the
economic surplus.

Mormon comparison, cont.
More similarities
Property owned by church
Capital formation
Via tithes, mostly in kind
Prices as accounting devices, economy demonetized
Frequent reforms
Cooperative forms of organization
Key differences
Voluntary, not coercion
Building on virgin soil
Seeds of Transformation
End of isolation
Immigration of gentile tradesman
Like the second economy of USSR
Railroads lower transportation costs
Raises cost of autarky
Hostile US legislation
Trade leads to corruption and sub-rosa
privatization
Second Economy
Informal economy arises to meet challenges of command
Precisely because command economy cannot achieve balance, and as
terror dissipates
2
nd
economy defined as all production and exchange activity
that meets at least one of two criteria:
1. being directly for private gain;
2. being in some significant respect in knowing contravention of
existing law. See Grossman, 1977, p. 25.
These market-mediated activities are at times supportive,
helping to achieve tolerable micro-balance in the increasingly
complex economy,
but they often are in violation of planned implementation and regime
values.
Second Economy
Brezhnev on second economy
You don't know life. No one lives on wages alone. I remember
in my youth we earned money by unloading railroad freight
cars. So, what did we do? Three crates or bags unloaded and
one for ourselves. That is how everybody lives in [our] country.
Blat markets
2
nd
economy activity necessarily introduces
discretion
Potential for diversion

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



Evaluation and Size
2
nd
economy completes the cancerous development of agent
autonomy
Generates undesirable (system perspective) redistribution of
incomes,
although recipients, including many high placed officials, find it very
desirable.
Size
Estimates based on the surveys of Soviet emigrants relate to the second
half of 1970s and range approximately between 10% and 30% of
incomes of urban households.
An alternative set of estimates based on the Soviet-era official family
budget survey data puts the second economy at around 23% of
household income (Kim, 2003).
Could be as large as 12% of GDP in 1979
But double counting
Legacies
Two types
Structural legacies
Institutional legacies
Financial underdevelopment
Absence of rule of law
Khruschev: Whos the Boss: we or the law? We are masters
over the law, not the law over us so we have to change the
law; we have to see to it that it is possible to execute these
speculators.
FTM

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


Distribution of Capital Stocks
Structure by Labor Force
Indicators of Raw Materials and Energy Consumption, 1988

Enterprise Size in US and Russia
0
5
10
15
20
25
30
35
50 to 99 100 to 249 250 to 999 1000 to 9999 GT 10,000
P
e
r
c
e
n
t
Russia US
Hypermilitarization and Climate
Size estimates difficult
Pricing distorts measurement
Cost shifting
Defense burden unsustainable
Locational burden
Interaction with climate problems
Soviet Union got colder in 20
th
century!
Too many people in the wrong places
Big problem for market economy

Location in Russia
Population of Siberia and Far East in 1989: 37 mln (25% of RF total)
Manufacturing employment: 1.8 mln (16% of RF total)
Location in Canada
Population: 85 000. (0.34% of Canadian total) Manufacturing employment:
295people (0.017% of Canadian total)
TPC in Canada, USA, and Russia
Duluth, population = 86,000
0
5
10
15
20
25
2
-
2
-
6
-
1
0
-
1
4
-
1
8
-
2
2
-
2
6
-
3
0
-
3
4
-
3
8
Mean: -11.7
Coldest decile: <-22.1
Duluth January Daily Temperatures, 1994-2002
Omsk, population = 1.2 million
Omsk January Daily Temperatures, 1994-2002
0
5
10
15
20
25
2 -2 -6 -10 -14 -18 -22 -26 -30 -34 -38
Mean: -16.8
Coldest decile: <-27.2
Perm, population = 1.008 million
Perm January Daily Temperatures, 1994-2002
0
5
10
15
20
25
2
-
2
-
6
-
1
0
-
1
4
-
1
8
-
2
2
-
2
6
-
3
0
-
3
4
-
3
8
Mean: -12.5
Coldest decile: <-22.7
Finally, use the
10
How Cold is Cold?
Cold Thresholds in Siberia
Ef fect s on Standard Soviet Machiner y Temp.
( C)
Alloyed st eel components ( ball bearings, etc.) shat ter; s aw fr ames and
ci rc ular s aws stop wor k; al l compr es sor s stop work ; standard steels and
st ruct ures rupt ur e on mass scale
- 35 t o 40
Trestl e cr anes fail; s ome tr actor shoes br eak - 30 to 35
Minimum t emper at ure for use of any standard equipment - 30
Unalloyed steels break; car- engine space, fuel tank s, and oil tank s must be
ins ulated; frost- r esis tant r ubber r equired; non- frost r esi stant convey or belts
and standard pneumatic hos es break ; some cr anes fail
- 25 t o 30
Standard c ompr ess or s with i nter nal c ombus tion engi nes cease to oper ate;
standar d ex cavator hiltbeams br eak; destr uction of some tower c rane
components, dr edgi ng buc kets, and bull doz er blades
- 20
High-carbon steels break; c ar batter ies must be heated; fir st cr iti cal
thr es hold for s tandar d equipment
- 15
Destr uc tion of some standar d metal dr edge components - 10
Internal combustion engines r equir e pr e- start engine heater s - 6
Sour ce: Dogay ev , cited i n Mote.
Internal vs External Inefficiency
Internal inefficiency
Lack of high-powered incentives
Input combinations and X-inefficiency
External inefficiency
Lack of market pricing
allocative
Dynamic inefficiency
Lack of innovation
Legacy of Never-ending Reform
Waves of reform
Why a treadmill?
Rejection of alien organisms
Pitfalls of partial reform
Cooperatives
Supply diversion
Timber and boxcars
Example
Efficient rationing of timber
Plan price = P, excess demand in housing
Cooperatives bid for timber
x units of timber diverted to housing from boxcars

Supply Diversion
Notice that P* is the shadow price of timber
With freedom to sell, timber sector sells q
m
to the housing
(cooperative) sector, cutting back deliveries to the boxcar
sector
Shadow value of timber is now much higher in boxcars
Consumer surplus falls by A in boxcars and rises by C in housing;
note A >> C
Producer surplus in boxcars falls by B = 2C
Notice that the problem arises because the boxcar
industry cannot compete for timber, and the capital in
that sector cannot flow to housing.
The moral of this story is that as the state loses control over
the state sector, diversions make things worse.
But China will be different!
Achievements
Full employment
By law => no unemployment insurance
Soft budget constraint
Free health care
Good at infections, bad at modern diseases
Low income inequality
Gini Coefficient
Ratio of the area between the Lorenz curve and OB, and the whole
area OAB.
Wealth v income, and access to goods

Lorenz Curve
Earnings Distribution, Full-time workers
US Income of Top Decile
Social Uncertainty
Command economy minimizes income shocks
Full employment, socialized medicine
Social insurance is high
Underemployment vs unemployment
Risk taking is low
Institutions to cope with uncertainty in modern
economy are absent
Life Expectancy at Birth, Russia, 195859, 196162,
196364, 19652002

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

An Alternative Factor
Russian Oil & Gas Rents 1970-2005
$0
$50
$100
$150
$200
$250
$300
1970 1975 1980 1985 1990 1995 2000 2005
Real (2005)
USD blns/yr
OIL
GAS
Rents and GDP
70
80
90
100
110
120
130
140
150
160
1970 1975 1980 1985 1990 1995 2000 2005
Russian GDP in 1990
PPP (1970=100)
$0
$50
$100
$150
$200
$250
$300
$350
Oil and Gas Rent
(2005 dollars)
Rents, Addiction
Resource rents postponed day of reckoning
"In sum, the Soviet economic system became what it is in part thanks to
the country's rich resource base, which permitted the planners largely to
ignore the day-to-day discipline of the balance of payments and therefore
also the imperatives of the market place and the pains of real economic
cost. On this basis an elaborate and rigid institutional edifice sprang up.
This economic system thrived for two human generations and achieved
marked successes by its own criteria. But inevitably it hardened and came
to be supported and protected by powerful vested interests [Grossman,
1983: 202].
addiction to rents postponed fundamental reforms, made the
system more fragile
The lesson is that resource abundance, misapplied, can be
addictive
Addiction
Addiction leads to short-time horizon
This leads to an inability to implement reforms.
Three characteristics
tolerance - the need for an increasing amount of the substance to obtain
the same effect
withdrawal - severe unpleasant effects when the addict ceases to use the
substance craving
"willingness to sacrifice all (to the point of self-destructiveness)" in order
to obtain and use the substance.
In Soviet case tolerance arose because windfall was used for
many new activities
defense, East European subsidies and other international adventures
interests created that depend on rents, makes withdrawal painful
where is the methadone for an addicted Soviet economy?
Defense Addiction
Marshal Akhromeev on addiction
Why it was necessary to produce so many weapons?
Akhromeev answered:
"Because at a great cost of many sacrifices we created first-
class factories, no worse than the American ones. Would you
order them to stop work and begin producing cooking pots?"
Shakhnazarov described the "military-industrial mentality" as
a "cancerous growth" that had metastasized to every sphere
of Soviet life
This is an example of addiction. The investment in
factories created interests that were very costly to
reverse.
Aspects of Collapse
Macroeconomic
Budget crisis, inflationary finance
Shortages, stolen hours, more queues
Weaker state lower tax collection
Microeconomic
Misallocation of resources
Lack of property rights
Pseudo privatization
Two Views on Collapse
Essentialists
Essentialists hold that the Soviet system collapsed because it was essentially
abnormal
The nature of the Soviet system made its eventual collapse inevitable and
even predictable
Of course, few made this prediction before the system collapsed. Autopsies
are easier on dead bodies.
Voluntarists
Soviet economy was murdered, or its death was decisively hastened, by
voluntary acts of policy, though the consequences may have been
unintended.
We tend to confer the mantle of inevitability on accomplished facts, and
arguing that what happened did not have to happen is likely to be dismissed
as inventing excuses for the losing side. But the collapse of the Soviet system
was the unintended result of a small number of disastrous decisions by a few
individuals





Was Demise Inevitable?
Productivity growth slowed, but never turned
negative
The odds on overtaking fell
Reforms upset performance
Reforms made the system more fragile
Monitoring costs rose and deterring corruption
became more costly
Erosion of belief in system
So small shocks could lead to collapse
Weakening of Central Control
Critical difficulty for central planning
Brezhnev Communism = Stalinism without terror
Raises the prices of information and action
Loss or resources at center
Agents have two options
Fulfill the plan, F
Dont fulfill the plan, NF
Payoffs depend on whether observed or not
Let be the probability of being observed
t
Stalinist Incentives
Let be the payoff to NF if unobserved
Suppose that and
Then the expected payoffs are




Planners want
Two instruments, detection and punishment
We can plot this
Stalin v Brezhnev
Stalinist system set punishment = - infinity
Lowers cost of detection
Brezhnev system
Cheating is optimal for larger range of
Problem is more severe with greater complexity
Glasnost makes it even worse
Explosion of Second Economy
Loss of central revenue
t
Multiple Equilibria
The same system can have two equilibria
High output
Low output
Consider the producers decision to supply
effort
Depends on gains and penalties
And whether this is observed
Producers Choice of Effort
Producer works hard, if
Gain from working hard > cost
of working hard
If work is hard and
monitoring is strict, then
Gain reward for working hard, avoid
penalty for not working hard, spend
effort working hard
Work hard if reward gained + penalty
avoided > cost of effort
If work is hard and
monitoring is lax, then
Dont work hard
No rewards gained, low effort
supplied
Dictators Choice
Dictator wants to deter stealing
Two key parameters:
Cost of incentives provided
Costs of monitoring
Over time these parameters shift
Complexity raises monitoring costs
Weakening center (decline in oil revenue) raises costs
of providing incentives
High output is no longer an equilibrium
Dictators Decision
Dictator Monitors if
Effort is high, and if Effort is low and if
Cost of monitoring <
value of output stolen +
future output lost
Else, dont monitor Costs of monitoring
< output stolen +
future output loss
Else, dont monitor
Parameter Shift
Evolution of the system led to parameter shift
Complexity raises monitoring costs
Information flow weakens central authority
Value of incentives decreases as their cost rises
Second economy grows
High output is no longer the equilibrium
Reforms weaken the structure
Do not lower monitoring costs
Reforms make defection easier
Cooperatives
Law on state enterprise
Bank Run
Why the sudden collapse?
As center weakens officials defect
Race to cash in on assets
Solnick on the collapse
Key to bank run
Illiquidity
Sudden loss of trust
Solnick
...the image of a "disintegrating" state...is...seriously incomplete.
Soviet institutions did not simply atrophy or dissolve but were
actively pulled apart by officials at all levels seeking to extract
assets that were in any way fungible. Where organizational assets
were more specific to their particular use by the state, as in the
case of draft boards, for example, hierarchical structures proved
more resilient. Where organizational assets were chiefly cash and
buildings, hierarchical breakdown was almost total. At both ends
of the spectrum, the catalysts of state collapse were the agents of
the state itself. Once the bank run was on, these officials were
not merely stealing resources from the state, they were stealing
the state itself."
Shock to Loyalty
Income of an official is
Probability of detection
Strength in numbers
Expected value of defection
Critical value of loyalty
Critical Loyalty Value
n* 1 n
2
Kn y o =
w ) 1 ( t
w
K o
Add Theft
Race to cash in
Each defecting agent steals
Not enough to steal, illiquidity
Official income is now

Output falls faster
Critical value reached sooner
Agents know nothing will be left if

o
The Bank Run Case
n* n' 1 n
2
Kn y o =
w ) 1 ( t
w
K o
| |
2
) 1 ( 1 n n K y o o =
| | o t + w ) 1 (
o + w
Conclusion
Was the collapse a disaster?
Implications for transition
Political and economic collapse
Is this more difficult than just economic reform?
Macroeconomic imbalance
Window of opportunity
Agenda for reform?
No blueprints
Midterm One Results
0
2
4
6
8
10
12
14
40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 100
79.58462 Mean
1.471695 Standard Error
82 Median
89 Mode
12.40072 Standard Deviation
153.7779 Variance
1.166432 Kurtosis
-1.13572 Skewness
57 Range
40 Minimum
97 Maximum
5173 Sum
65 Count
3.01466 Confidence Level(0.950000)