China's State Enterprises: Public Goods, Externalities, and Coase, by Gary H. Jefferson, 1998, The American Economic Review Papers and Proceedings

One central theme in academic research about China is the existence of state ownership in enterprises. State owned enterprises (SOEs henceforth) not necessarily mean lower efficiency. Rather it depends on market structure. In his paper China's State Enterprises Public Goods, Externalities, and Coase (AER P&P, 1998, 99 citations), Gary H. Jefferson studied this question through the lens of Coase theorem (Ronald H Coase, 1960) and public goods.

It is clear that SOEs have negative externalities for the firm itself, the whole economy and non-state sector. The key insight of Coase theorem is the need of clear assignment of property rights and the elimination of transfer costs in order to create an efficient incentive structure. SEOs by definition (owned by all the people), lacks proper incentive structure to monitor the enterprises. SOEs is subject to opportunistic behavior of workers, managers, and local officials, such as stripping by managers, shirking by workers, predatory taxes, fees and bribes levied by local officials, and nonpecuniary benefits for employees and their relatives. A further moral hazard problem is created by the replenishments of SOEs from higher jurisdictions through either direct subsidies or the state banking loans. This could distort resource allocations and diverts investment funds and employment generating opportunities away from non-SOEs. Other theories, including  Armen A. Alchian and Harold Demsetz (1972) and Michael Jensen and William Meckling (1976),  support this “incentive view” of firm ownership structure. 

Will privatization help? How about hardening of the budget constraint (shut down replenishment)? Privatization is neither a necessary nor a sufficient condition. Without an efficient proper-rights market, there is no warrant that assets will be used in a more efficient way than owned publicly. This was the case with Russia’s voucherization. Hardening budget constraints is necessary but not sufficient. Without replenishment, consumption of the resource is rivalrous for small enterprises. This is the case with China's township and village enterprises (TVE), where self-assignment of property rights has evolved. Jefferson et al. (1998) show that China's TVE's generally do enjoy a more coherent set of property rights and more effective monitoring (enterprise autonomy, concentration of internal monitoring authority, and an effective incentive structure) than their state-enterprise counterparts. But large numbers of stakeholders of large public enterprises may not have the same incentives for self-initiate effective property-rights reform, who are more likely to face insurmountable free-rider and coordination difficulties.

The crux lies in an efficient property-rights market, implying costless information, search, entry and exits, transparency and ease of contracting. Once a world in which property rights are not clearly assigned and exchange is costly or impossible is transformed into a Coasian property-rights market in which rights are clearly assigned and transaction costs are low, the opportunity cost of state ownership becomes well defined. It is well defined in the sense that parties who employ assets more efficiently than existing owners will value them more highly and compensate existing public owners with the explicit price in the property-rights market. The remaining question is whether the total social value of the assets is completely captured by the explicit market price.

This is the exact situation in China, from a position in the late 1970s to the post reform stage. For example, approximately 150 municipal-based property-rights transaction centers were established throughout China, which plays an important role in merge and acquisition industry. Another example is decentralized assignment of property rights of SOEs to subnational jurisdictions, which plausibly combines public ownership with a vibrant property-rights market. The most successful outcome of the reform is reducing entry restrictions, representing a diverse technological and institutional mix of state, urban collective, township, village, foreign and domestic joint-venture, shareholding, cooperative, individual, and privately owned enterprises. 

The author summarized property-right markets with the following conclusion.

In China and elsewhere, emerging property-rights markets perform three functions: to motivate the efficient monitoring of industrial assets to avoid the "tragedy of the commons" and costly macroeconomic externalities; to mediate the restructuring and exit of unsuccessful enterprises, both public and private; and to select sustainable forms of corporate governance that are able to withstand mounting competition within the industrial systems of transition economies. China's emerging property-rights market has begun to perform these functions.

Reference

Alchian, Armen A. and Demsetz, Harold. "Production, Information Costs, and Economic Organization." American Economic Re view, December 1972, 62(5), pp. 777- 95.

Coase, Ronald H. "The Problem of Social Cost." Journal of Law and Economics, October 1960, 3, pp. 1-44.

Jefferson, Gary H.; Lu, Mai and Zhao, John Z. Y. "Reforming Property Rights in Chinese Industry," in G. Jefferson and I. Singh, eds., Reform, ownership, and performance in Chinese industry. New York: Oxford University Press, 1998.

Jefferson, Gary H, “China's State Enterprises: Public Goods, Externalities, and Coase.” The American Economic Review, Vol. 88, No. 2, Papers and Proceedings of the Hundred and Tenth Annual Meeting of the American Economic Association (May, 1998), pp. 428-432.

Jensen, Michael and Meckling, William. "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure." Journal of Financial Economics, October 1976, 3(4), pp. 306-60.