LOS CINCO MOSQUETEROS

neoclassical situation. However, in an economy with chronic shortage, the firm's initial demand will not be fulfilled. Suppose P is acceptable, but A is not instantaneously available. The firm now has two choices: queuing and forced substitution. Queuing is a special case of waiting and involves costs. The firm may not be willing to wait, because the waiting cost may be too high. The alternative is to proceed with forced substitution. If this happens, initial demand is revised.

Figure 2.5 The Shopping Algorithm

Queuing time acceptable? —K Yes Price acceptable? Queue Consume No _{Substitution better} Uian waiting? Wait Yes Substitute No

4

The neoclassical demand model requires that observed demand be consistent with initial demand. However, in the shortage economy, observed demand usually differs from initial demand. If the neoclassical model is applied to the revised (observed) demand, the derived estimates are likely to be biased.

Shortage is a relative concept. In an economy where the market mechanism is missing, shortage develops. Shortage may be reduced or eliminated altogether using the price mechanism (Hare 1989). Therefore, a key issue to be addressed is whether the development of a fibre market in recent years has essentially eliminated physical shortages of fibres in China.

Under the highly centralised system of pre-reform China, there was no fibre market. Inputs were allocated through national planning and prices played virtually no

role in resource allocation; they were used merely for accounting purposes. Economic reform initiated in the industrial sector since the mid 1980s together with earlier reform in the rural sector has led to a significant decline in the role of the state in the production, supply and marketing of agricultural and industrial products. The market is now increasingly used as a way of allocating resources.

The introduction of the dual price system is of particular importance to resource allocation. Much discussion has focused on how the dual price system operates in China and its likely effects on resource allocation. According to Diao (1987), the two-tier price system permits the coexistence of two prices for the same commodity, one the list price set by the state and the other the fluctuating market price determined by market forces or agreed upon by the parties engaged in the transaction. The proportion of inputs and output that changes hands under the state plan is allocated, purchased, sold or distributed at prices set by the state. Any output in excess of the quota set in the state plan is sold at the market price. In this context, nearly all previous studies point to the high marginal effect of prices prevailing on the free market (among them, Jefferson and Xu 1991; Martin 1992; McMillan and Naughton 1991; Sicular 1988; Wu and Zhao

1987; Diao 1987; Byrd 1987; Tisdell 1993). This means that when incremental input or output decisions are made, what matters to the decision-makers is the market price and not the state price."^

One implication for the present study of the development of the dual price system is that physical shortage should in theory be eliminated, because any excess demand will be cleared at the price prevailing on the secondary market. This point can be illustrated with the help of a simple supply and demand curve analysis (Figure 2.6).

In Figure 2.6, S and D represent respectively the supply and demand curves of a commodity. In a t>'pical planning system, the state sets a quota Q^ for producers paying a price P^. Consumer price is set at for quantity Q^- Excess demand, or what we call physical shortage, thus exists between Q^ and However, if a secondary market is allowed, the free market price will be driven up to P^ for the quantity produced and

consumed at Q^. This price has no distorting effect since it does not affect resource allocation, though it does generate a revenue transfer (Martin 1992).

Figure 2.6 Supply and Demand in a Dual Price System

Price

Pc

Ps

s ~e ~c

Quantity

The last condition, which is not essential but which will affect the degree of price responsiveness, is associated with budget constraint. Standard microeconomic theory stipulates that two effects result from a change in prices: an income effect and a substitution effect. Kornai (1980) argues that under soft budget constraint "the income effect does not materialise"(1980, p. 325). This point is illustrated in Figure 2.7. Suppose a firm uses two inputs to produce output Q. Given the initial budget constraint BQ, the cost-minimising point for producing Q g i s A . At point A, demand for X is x^ and demand for Y is y^. When the price of X increases, the budget constraint shifts inward to BJ with a new equihbrium found at Ay. At Ay, demand for Y has increased from y^ to yj and that for X has decreased from XQ to X2. The corresponding Marshallian demand curve for X (D^) is shown in the lower diagram.

Figure 2.7 Shift in Firm's Demand Curve in Response to a Change in Softness of Budget Constraint

Movement from the initial cost-minimi sing point A to the new point A j can be seen as comprising two separate effects. The substitution effect is depicted as a movement from point A to point C on the initial isoquant Q^. The price increase would, however, create a loss of purchasing power and a consequent movement to a lower isoquant. This is the income effect.^ In the diagram, the substitution effect is represented by the distance between and X/ and the income effect by the distance between X j and

In contrast to a market economy, budget constraint in planned economies is typically soft. This means that budget constraint is not binding. Suppose that, following

an increase in price, the budget constraint line shifts outward to, say, B^ due to subsidies