Modeling Private Sector Development

5.1 Issues to be Addressed by the Model

In the past 26 years between 1978 and 2004, the PRC has successfully carried out reform and opening policies and achieved a nearly 9% average annual economic growth rate. Through reform and opening, it has also successfully developed a prosperous private sector and became a member of the World Trade Organization (WTO) in 2001. These two important events demonstrate that the PRC has transformed itself from a socialist planned economy to a market oriented one. The observation above gives us a general profile of the Chinese private sector, describing how it has developed and what bottlenecks are currently hindering its further development. More specifically,

• The number of private enterprises increased rapidly. From 1989 to 2003, the number of private enterprises grew from 90,000 to more than 3 million, up nearly 33.3 times, and the number of individual business increased from 12.47 million to 23.53 million, nearly doubling during the same period. The number of foreign enterprises increased from 16,000 in 1989 to more than 226,000 in 2003, up nearly 14 times. In contrast to the rapid growth of the private sector, the number of SOEs and collective enterprises fell from 1.55 million in 1992 to 1.05 million in 2003 and from 4.16 million to 1.63 million, respectively.
• The number of employees in private enterprises is relatively small and is decreasing. In 1989 on average about 18 workers were employed in each private enterprise, but by 2003 this number had gone down to 14. During the same period, the average number of employees for SOEs was relatively stable, fluctuating within a narrow range between 49 and 56, except for 1992 when it registered a high figure of 76 employees. In 2003 the average number of employees for SOEs was 65. It should also be noted that most small-medium sized SOEs have been privatized.
• Private enterprises face high transaction costs including high administration approval costs and other costs such as costs for entrance.
• The most important driving forces for the PRC economy are private sector development and SOE reform, in particular the privatization of existing SOEs.
• There are other macroeconomic phenomena to be looked into. For example, why did the 'township-village' enterprises (TVEs), which were once considered new creatures by the PRC, moving toward disappearance after their temporary heyday in the 1980s? Why did SOEs under the contract responsibility system follow the same destiny? Why has the PRC gone through such a long process of inflation? Are these factors related to the behavior of enterprises? Why have most SOEs suffered from losses and huge nonperforming loans? Is there any reasonable explanation? Do different types of enterprises have the same economic efficiency or not?

To address these issues, we discuss the objectives of enterprises in Section 5.2, and based on those observations, try to make some assumptions that can be helpful in simplifying the issues presented. Secondly, based on the model, some propositions on the determination of output, investment and employment in the course of privatization are obtained in Section 5.3. Thirdly, also based on the model, we discuss the determination of a firm¡¯s residual profit and its implications to the banking sector in Section 5.4. In Section 5.5 we discuss how the number and size of private enterprises in the PRC is determined. Finally, we summarize the finding of this chapter and elaborate implications of the model.

5.2 Objectives and Objective Functions of Private Firms in the PRC

There are a number of papers that focus on private sector development in the PRC. Most look into this issue from simple statistical tables or literal descriptions, such as the works by Zhang Houyi, Ming Lizhi, and Liang Chuanyun, 2002 [38], Asian Development Bank, 2003 [2], Stoyan Tenev and Chunlin Zhang, 2002 [29]; only a few provide a general theoretical framework. In fact, there are few studies either on SOEs or on private companies in the PRC based on mathematical models and the behavioral theory of enterprises. Michael K. Y. Fang, Wai-Ming Ho and Lijing Zhu, 1999 [22] contribute a modeling effort to this issue by introducing a soft constraint assumption. However, since they assume that private enterprises are entities pursuing profit maximization, their model says nothing about institutional changes except for some macroeconomic policy effects.

However, in accordance with the basic principle of economics, the first step for economists in studying firms should be to understand how they behave under specific circumstances. In mature private economies such as the U.S., Western Europe and perhaps Japan,¹⁰ the enterprises are usually "private" and are generally considered to be profit maximization seeking units¹¹. Hence, in those economies, the goal pursued by enterprises is not considered an issue of discussion.

However, for an economy in transition such as the PRC, the simple assumption of profit maximization may not be necessarily reasonable because of strong government intervention. In fact, one of the purposes of economic reform of China is to remove obstacles that make enterprises depart from profit maximization.

In the PRC, whether the economic growth rate is high or low is directly linked to the motivation of local government officials. Local government officials can use their power to force enterprises to produce more than the market equilibrium level. This is evidently corruption, as it involves using public power to seek self-interest, such as the achievement of promotion. The GDP is usually a very important factor in the promotion of local government officials. In order to win promotion, government officials might make great efforts to realize their personal objectives by manipulating the enterprises under their administration. In some cases they even falsify economic data and inflate them compared to the real figures. There is a well-known phrase, "the number produces the official and the official produces the number; the bigger the number, the bigger the official." This vividly describes the important role played by economic growth in the promotion of government officials. There are also many other reasons why enterprises deviate from profit maximization objectives. For example, they may blindly try to enlarge their market share, marketization may be imperfect, or managers may place more emphasis on their personal interests or workers' welfare. Our argument that PRC enterprises are not necessarily profitmaximizing units coincides with the idea of evolutionary economics, which argues that enterprises are profit-seeking units, rather than profit maximization units.

This idea is also supported by a survey conducted by the Institute of Economics, Chinese Academy of Social Sciences (CASS). The survey was carried out in the year 2000 to investigate how the performance and behavior of various types of enterprises in the PRC evolved. Considering the diversity of reform models as discussed in Chapter 2, and to reflect the effect of economic reform on SOEs, collective enterprises and private enterprises, a total of 451 enterprises were surveyed. 184 enterprises are selected in Jiangsu province, where 83 are in Wuxi, 58 in Yancheng and 43 in Hangzhou. 130 enterprises are from Zhengzhou of Henan province and 137 from Jiangmen of Guangdong province. Each was asked to describe their objectives in seven steps. The seven choices were: (1) Value added maximization, (2) Market share maximization, (3) Profit maximization, (4) Sales revenue maximization, (5) Enlargement of firm scale, (6) Maximization of employees¡¯ wealth, and (7) Others.

The survey asked the firms which of the above choices was the primary objective, which was second, third, and so on. The outcome of the survey (see Table 5.1 [PDF 66KB | 1 page]) shows that the number of enterprises choosing value-added maximization as the first place was 40, or 9%. The number of enterprises choosing value added maximization in second, third, fourth, fifth and sixth place was 11%, 17%, 18%, 18% and 17% respectively. Forty-five, or 10% of enterprises, did not choose value added maximization as their objective. A similar outcome can be seen for other choices. From the table, we also find that the enterprises choosing profit maximization (Goal 3) as a first choice made up the largest proportion, 53%, followed by market share (Goal 4), sales revenue, value added, enlargement of firm size and employees¡¯ welfare, with 19%, 12%, 9%, 6%, 2% and 0.2% respectively.

Table 5.2 [PDF 64KB | 1 page] shows that all of the partnership enterprises in type 7 primarily pursue profit maximization. However there is a lack of generality due to the limited number of samples. All other types of enterprises have a relatively stable proportion of enterprises pursuing profit maximization as the first choice, ranging from 47% to 57%.

The outcomes of the table give us at least two hints. First, many enterprises in the PRC, regardless of whether they are private or state-owned and under reform, are not pure profit maximization entities. In addition to profit maximization, they also give attention to other goals such as market share, value added and sales revenue. Second, toward the year 2000, after experiencing the so-called "Zhua Da Fang Xiao" reform, SOEs and collective enterprises have grown close to private enterprises in their choice of objectives. In other words, small and medium sized SOEs have basically completed their transition process.

The objectives of the surveyed firms can be classified into three main categories. The first closely relates to the scale of the firm, and includes factors such as value added, market share, sales revenue, and enlargement of firm scale. The second category represents the efficiency of the enterprise or returns on capital and manager's ability, and includes factors such as profit maximization. The third category relates to the wealth of employees, such as maximization of workers' welfare. The survey shows that profit maximization is not the sole objective for PRC enterprises. This outcome helps us to develop an objective function for PRC enterprises.

In our study, the typical planned economy is treated as an extreme case. In accordance with the above observation, we assume that the planned economy is a form of one firm-country system, meaning that the whole country is made up of only one firm. The amount produced by the firm is determined by the central government, based on a production function. Since there is no market in the planned economy, there is also no market price. Therefore price is not a constraint for the central government. However, since resources are scarce, as in any other society, the planned economy also faces resources constraints, such as capital and labor. So-called state-owned firms are regarded as production branches. What to produce, how to produce and how much to produce are all determined under the central government plan. As a result, resources are used so long as they are available by the government, which pursues high economic growth.

The other extreme case is the neoclassical market economy. Under this system, it is usually assumed that private companies take pure profit maximization as their final objective. This kind of enterprise, regardless of whether it exists in the real world, can be assumed as a standard for the purpose of comparison.

According to our survey, SOEs and non-SOEs in the PRC appear to have multiple objectives. For the sake of simplicity, we assume that the objective function of these enterprises is a function of value added (output) and profit, or for simplification, a function of a weighted average of value added (output) and profit.

Below, we set up a simple model, and then based on it, discuss the impacts of objective choice, entrance costs faced by enterprises on the demand for labor, investment, and profits and total product. Secondly, we identify the factors affecting the development of the private sector, and how they influence private sector development. Thirdly, based the above analysis, we address the issues of how to develop private enterprises in the future.

There are two standard ways to analyze the objectives and development of private firms. One is to assume that a firm has production technology with a constant return to scale, and also to assume constant marginal costs and an independent output level (Solow, 1994 [26]). Using this approach we cannot say anything about the size and number of firms, since at equilibrium, any industry configuration is possible, and there is no distinction between many small firms producing each n Q and one big firm producingQ according to the ideas of Christina Gathmann ¹² (2001 [8]). Another feature of the model is that it does not deal with the issue of how much income is attributable to the technology level and how much to the manager's talent. This contradicts the reality that managers get more money than average workers.

Another way to analyze the development of firm is that all firms in the market are engaged in production with the same technology. Therefore, each firm faces the same cost curve. If we take the standard case of a U-shaped average cost curve, the production level of all firms is equal; this is also obviously different from what we actually observe.

To examine the development of private sector in the PRC, we follow the modeling methods of Christina Gathmann, 2001 [8], which combine Lucas¡¯s (Lucas, 1978 [18]) model of firm size with entrepreneurial talent, Luc Laeven and Christopher Woodruff (2004 [17]) with not only entrepreneurial talent but also the quality of legal system when determining optimal size of firms, and Fabiano Schivardi and Roobeto Torrini, 2004 [9], which investigated the role of employment protection legislation (EPL) in determining firm size distribution. All of them assume that enterprises face a decreasing return to scale¹³ . Therefore, each enterprise is assumed to have a residual profit (income) after income is distributed among labor and capital. This residual profit pays for the manager¡¯s talent or technological level.

In addition, as stated in Chapter 4, people face considerable constraints, including the lack of credit and excessive administration process, in starting up private enterprises. To represent the impediment faced by private enterprises, we introduce a proxy variable called "entrance cost" denoted by C into the model to represent all transaction cost other than labor and capital costs. Under a planned economy, the entrance cost can be unlimitedly high, so that a private enterprise cannot be established in some sectors. With the progress of reform in the PRC, the entrance cost may fall, making it easier for entrepreneurs to build more private enterprises.

We also introduce a variable that represents the degree to which an enterprise pays attention to profit maximization. Though many objective choices are presented for consideration, we believe that constructing a final or aggregate objective is helpful in the analysis of enterprise behavior. For the aggregate objective function, we simply assume that it is a weighted average of the multiple choices. For the sake of simplicity, we assume that the objective function of a firm is the function of profit and output:

O = O(π,Y);

We further assume that an enterprise with labor (H) and capital (K) faces labor costs (W) and capital costs (R), and produces output (Y) with Cobb-Douglass technology:

Y = AK^αH^β, α + β < 1;

Following Lucas, 1978 [18], Managers get a residual profit related to ability (A), and firms are assumed to have different sizes and to be controlled by different managers with different managerial abilities. Considering the tax collected by government, the after tax residual profit function is:

π = (1 - τ)AK^αH^β - KR - HW - C¹⁴

Here τ is the tax rate on output. Based on the above assumptions, the maximization problem faced by an enterprise can be written as:

MaxO  K,L	=	O(π,y)
	=	(1 - λ)AKαHβ + λ[(1-τ)AKαHβ - KR - HW - C]
	=	(1 - λτ)AKαHβ - λ(KR + HW + C)

Where, λ is the privatization and marketization variable that represents the extent to which an enterprise pays attentions to profit maximization, or the tendency of an enterprise toward profit maximization¹⁵ . We believe that the assumption made here is suitable for both private enterprises and SOEs in the process of reform. In fact, the objective function can be adjusted with the variable λ to suit the characteristics of both private enterprises and SOEs:

1. When λ = 1,MaxO_K,L = (1 - τ)AK^αH^β - (KR + HW + C), which corresponds to residual profit maximization, the normal or standard pattern of behavior under a mature market economy, such as the U.S. and Japan.
2. When λ = 0,MaxO_K,L = AK^αH^β corresponds to output (value added) maximization. This is what a pure planned economy pursues. In this case, enterprises ignore constraints of factor price and government tax, and demands for both labor and investment are unlimited, notwithstanding the fact that the enterprise will eventually have to face constraints from supply: for example, K < K₀,L < L₀.
3. In general cases, 0 < λ < 1, we have MaxO_K,L = (1 - λτ)AK^αH^β - &lambda(KR + HW + C). This expression reflects what current PRC private enterprises and non-private enterprises are pursuing, namely output maximization and profit maximization. The bigger λ may represent the behavior of non-private enterprises under transformation, which tend to place more emphasis on profit maximization.

We also believe that with the deepening of market-oriented economic reform and the perfection of the legal system, the overall objective of PRC enterprises will move toward profit maximization, which means that λ will increase with the development of the market system and progress of privatization. This is why λ in this paper can be regarded as a variable representing the extent of privatization and marketization in the PRC. Thus, the assumption here is actually suitable for both private enterprises and non-private enterprises.

5.3 Determination of Output, Investment and Employment in the course of Privatization

The first order condition of the problem (4) is

or

Under the first order condition (5) and (6), When λ < 1, then

That is, both capital and labor marginal productivity will be below R¹⁶.

One might argue that enterprises will not be able to survive if investment is pushed to the point where marginal returns are below R, and that at that point, entrepreneurs will lose a capability to service loans and to cover the opportunity cost of capital. In our view, this situation may be connected with the phenomenon of so-called "soft budget constraints." "Soft budget constraints" exist widely in the socialist system, meaning that the supply of funds is softly constrained and the excessive demand for loans is easily satisfied, if enterprises or persons near power groups are able to cooperate well with the government sector. To understand this phenomenon, readers need to grasp the original condition of the PRC economy, i.e. the national government owning almost all assets and tolerating some degrees of loss for macroeconomic efficiency. Taking the state-owned economy as an example, in the initial period of reform all investments were made by the government through appropriating fiscal funds, all profit belonged to the government and losses were compensated by fiscal funds. Consequently a huge budget deficit emerged. Only after the government became unable to bear the losses of state owned enterprises, a policy or reform called "Bo Gai Dai" meaning "replacing government funds for enterprises with bank loans to enterprises" was adopted. This reform succeeded in rescuing fiscal sector from its difficulties. However, since the operating mechanism of firms didn’t change much (due to gradualism) and losses still existed, this reform only transferred the fiscal burden to the banking sector, resulting in a large amount of non-performing loans (over 25% of total bank assets) in the banking sector. Such banks would go bankrupt in a market economy. However, since they are mostly owned and guaranteed by the central government, they could survive for a relatively long time as long as state-owned assets including banking assets are sufficiently large to bear their losses. With the long accumulation of non-performing loans, now it seems that banking sector no longer has the capacity to bear the losses. Furthermore the sector is now under the pressure from WTO accession. As a result, banking sector reform has become an urgent task.

This objective deviation from profit maximization combined with soft budget constraints has a double effect on the economy: on one hand it causes a loss of state-owned assets, and on the other hand it forces the government to reform the economic system toward privatization. Privatization then forces firms to pay more attention to profit maximization and to promote marginal return to capital and cut losses.

By solving (5) and (6), the demand for investment, capital and the demand for labor are

Where, Y_λ, K_λ and H_λ represent the equilibrium solution to the maximization problem of (4) with parameter λ. λ = 1 means that the only thing that enterprises pursue is profit and that no other factors are taken into account. Capital investment, labor demand and output corresponding to 1 = λ , are respectively:

It is easy to show, under 0 < λ ≤ 1 , that

and therefore,

Proposition 1: from equations (13)-(19), we can conclude:

1. In equilibrium, the supply of output, demand for capital investment and demand for labor in 1 < λ are larger than those at 1 = λ. This implies that both private enterprises and SOEs undergoing reform in the PRC invest and employ more than enterprises pursuing profit maximization as their only objective. This may be one of the reasons why the PRC often faces overheated investment and a resulting overheated economy.
2. In equilibrium, the supply of output, demand for capital investment and demand for labor are decreasing functions of tax on output. The higher the tax rate, the lower the output supply, and the lower the demand for investment and labor.

3. Production costs also have an significant influence on output, demand for investment and demand for labor. Output and demand for investment and labor are also decreasing functions of labor and capital costs. This implies that lower labor and capital costs are factors behind the rapid private sector development of the PRC.
4. As the manager's ability increases (the larger A), more workers are hired, greater investment is made and more goods are produced.

We have noted that in the roughly quarter century of reform beginning in 1978, the PRC economy experienced a long period of inflation, which was sometimes called economic overheating. The economic overheating was basically caused by excessive investment dominated by the government. One important reason for this phenomenon is that, as a result of strong government interference and incomplete marketization and privatization, enterprises in the PRC could not pursue profit maximization as their sole objective. Furthermore, soft constraint mechanisms on the supply side pushed actual investment far above the equilibrium of profit maximization, leading to excessive investment and to marginal productivity below the equilibrium of profit maximization. Clearly, this proposition also gives us two other reasons for the rapid development of the private sector, i.e., the lower costs of labor and capital.

5.4 Determination of the Residual Profits of Firms and Their Impact on the Banking Sector

It is well known that a profit maximization-seeking enterprise can efficiently use the resources available to it. However, this is not necessarily true for non-profit maximization-seeking enterprises. We can see from the following that when there is not sufficient marketization or privatization, even if a firm employs more labor and more capital inputs, it might only obtain negative profits.

According to the residual profit function:

It is easy to show that the first term of the right side of the above equation is negative when λ < (α + β) / [1 - (1 - α - β)τ] and then π_λ < 0. In addition, since 0 < &almbda; <= 1 and 1/λ > 1, the partial derivative of residual profit with respect to λ is an increasing function of privatization variable λ due to:

To assure the existence of enterprises¹⁷, it is reasonable to assume that the firm produces a positive residual profit to pay for the manager’s ability. Therefore, a reasonable assumption will be:

¹⁸

in case of 0 < λ ≤ 1. We have

Proposition 2: from the discussion above, we have:

1. When λ is sufficiently small such that

   

   the residual profit will be negative. When λ = 1, residual profit is maximized.

2. Lowering the entrance cost will promote residual profit or income of the enterprise manager.
3. If λ is sufficiently large such that

   

   the manager's ability is positively related to the residual profit. This implies that it is correct to connect the manager's income to the enterprise's residual profit. This conclusion fits well with firm contract theory. If λ is small enough and the capital is financed by bank loans, enterprises might not have sufficient funds to pay back their loan and eventually may go bankrupt if they do not carry out further reform.

4. The profit of enterprises will decrease if the output tax rises.

5.5 Determination of the Number and Size of Private Enterprises

Let us now turn to how the number and average size of enterprises is determined. In the labor market, each individual has to decide whether to opt to be hired as a worker and earn wages or to run an enterprise and earn additional residual profits. The decision depends on how much the individual can earn in either of the two professions. If one chooses to be a worker one earns wage W; if one chooses to run an enterprise one earns residual profit π_λ¹⁹. The rule therefore is that a person will be a manager if the residual profit owned by the manager π_λ ≤ W²⁰; otherwise, he or she will be a worker. Rewriting this formula, we find:

This formula implies that a manager earns a residual profit that is not smaller than the wage earned by a worker. If all other conditions are equal, we can find the solution of A in the equation:

Assuming that the solution of (25) for A is Ā, which can be called the marginal managerial ability or ability threshold for a person to be a manager. This means that there is a person with ability Ā, who can be called a marginal manager (Christina Gathmann, 2001 [8]), and who is indifferent between being a manager or a worker. In both professions the person will have the same income. Now we can solve for the location of a marginal manager with ability Ā. Still assuming

as before, we have

and

Formula (26) implies that the more attention an enterprise pays to profit (that is, the larger λ), the lower is the marginal manager's ability (that is, the smaller Ā). The logic behind this conclusion is: as an enterprise pays more attention to profit, its residual profit (the part over normal profit "KR") increases (see Proposition 1), and this means that even a person with low managerial ability to run an enterprise can earn residual profits exceeding the wages earned as a worker. Equivalently, the threshold for becoming a manager falls with the progress of privatization and marketization. With the progress of privatization and marketization, government intervention decreases, and more and more people are expected to join the group of managers. This means that more enterprises will be established. This may be one of the reasons why the number of private enterprises in the PRC has risen so quickly.

Formulas (27), (28), (29) and (30) tell us that the marginal manager's ability increases with labor costs, capital costs and entrance costs. Hence, the rapid development of the private sector in the PRC can be at least partly attributed to lower labor and capital costs. Formula (29) also implies that higher costs to entry and uneven treatment of the private sector lead to higher marginal manager's ability, leading to the establishment of fewer private enterprises. The logic behind the conclusions induced from (27), (28), (29) and (30) is almost the same: lower costs, including factor costs, taxes and costs to entry, make the production process more profitable, allowing persons with lower management ability to earn more as managers than as workers. This implies that lower management ability is required for a person to run an enterprise and earn the same profit as before. In other words, the marginal manager's ability is reduced.

If considering the difference of managerial ability "A" among people and also taking account of the learning effect of managerial ability with the progress of privatization and marketization (i.e. managerial ability is assumed to grow with privatization and marketization), it is relevant to assume that managerial ability "A" in a population is a random variable distributing with a continuous probability distribution function F(x;λ)²¹ with parameter λ, representing the probability of a person's managerial ability less than x

and a continuous density function of A

where "f(x;λ)>0" means F(x;λ) is an increasing function of x in light of characteristics of distribution function and means F(x;λ)is a decreasing function of λ. In other words, given the level of managerial ability x, if there is a learning effect, the ratio of people with managerial ability above x will increase with privatization and marketizaiton and the ratio of workers with managerial ability less than x will decrease. It is clear that this result accords with our intuition.

Since the ability of people in the economy follows a probability distribution function F(x;λ), which is an increasing function of x, all people with ability below marginal level Ā in the distribution become workers and those with ability above Ā become managers. Therefore, if the total number of people looking for jobs in the economy is N, the numbers of workers will be N_l = NF(Ā;λ), and the numbers of firms will be N_m = N(1 - F(Ā;λ)). Taking the partial derivatives of N_l and N_m with respect to independent variables, we find:

Formulas (36) and (37) indicate that the number of private enterprises is an increasing function of λ, and the number of workers is a decreasing function of λ(the variable of marketizaiton and privatization). Formulas (38), (39) and (40) indicate that the number of private enterprises is a decreasing function of factor cost R , W and entrance cost C faced by private enterprises. Thus, we have proposition 3.

Proposition 3: if all other conditions are constant, both the number of enterprises and laborers will increase with total employment. The progress of marketization and privatization, and the fall in labor costs, capital costs and entrance costs will cause the number of private enterprises to rise, but the progress of marketization and privatization cause demand for workers to go down.

Now let us look at the determination of average firm size. There are many indicators for measuring firm size; one is the average number of workers per firm, which is attained by measuring the total number of workers in the economy divided by the total number of firms (managers), denoted by S:

By taking derivative of S, we have:

and

Formula (41) expresses the function of how firm size varies with marginal managerial ability and the privatization and marketization parameter λ. (42) Indicates that firm size S is positively related to marginal managerial ability Ā; namely, the higher the marginal managerial ability, the higher the threshold for a person to be a manager, or the harder for a manager to create a firm. The higher threshold for people to establish a firm means that fewer people have management ability higher than Ā. Because the number of managers equals firm number as assumed, fewer enterprises are established.

Formula (43) shows that the deepening of privatization and marketization (that is, the increase in λ) has two effects on firm size. One is threshold effect. That is, privatization and marketization directly lower the threshold for a person to establish an enterprise. The other is learning effect. That is, managerial ability rises with privatization and marketization, making people more likely to start up firms and less likely to be workers. Since both effects make it easier to set up firms, privatization and marketization will lead to more and more new firms being established. On the other side, new firms are usually relatively small, making the average size of enterprises small as well. In the PRC, the average firm size of private enterprises decreased from 18 in 1989 to 14 in 2002; this can be at least partly attributed to the privatization and marketization process. Privatization and marketization increase firm’s profits and lower the threshold or marginal managerial ability (required ability to create an enterprise). We can provide a similar but much easier explanation for (45), (46) and (47): the lower the cost, the more residual profit the manager will earn and the lower will be the ability required for a person to run a profitable enterprise. More people will become managers and more firms will be established. To summarize the above analysis, we obtain the following conclusions from (41)-(47).

Proposition 4: at equilibrium, the average firm size is determined by the marginal manager's ability and "leaning by doing" effect of marketization and privatization. Since marginal managerial ability depends on marketization and privatization, labor costs, capital costs and entrance costs, if every other factor is equal, the threshold to create a new company will fall with the deepening of marketization and privatization, meaning that it becomes easier to create a new company, and the average size of firms will fall. With the fall of entrance, labor and capital costs, the average firm size will decrease as well. Additionally, a learning effect will lift people's managerial ability and mean that fewer will be workers, so the learning effect will also lead to smaller average size of firms.

In addition, under the model there is a managerial ability threshold (marginal level of manager's ability) for creating firms and all firms with a managerial ability over the threshold can survive. In accord with the real world, firms of different sizes can co-exist at the same time. Of course, if the firm's manager's ability falls below the threshold, the firm will die. The difference between firms with different managerial ability can be found in different residual profits and manager's revenue. Only if an individual has more managerial ability than the marginal level can he or she earn more than a worker's wages.

5.6 Implications Derived from the Model

As far as the CASS survey is concerned, it seems that all firms pursue, roughly speaking, three objectives: maximization of profit, sales revenue and market share. Though the behavior difference between firms may be large, we do not see a significant difference in their behavioral patterns among sectors. From the model analysis, we find that enterprises with multiple objectives have larger demand for investment and labor, and tend to produce more output than those with the single objective of profit maximization do. This accords with the objectives of the government sector in pursuing the maximization of economic growth and more employment opportunities. However, enterprises with multiple objectives may be less competitive than those with the single objective of profit maximization, since they earn smaller profits. Even worse, since the marginal productivity of capital is less than its cost, profits tend to become negative, and enterprises may be unable to repay back their loans to the banks. This results in a weakening of the foundation for the existence of the enterprise, or to non-performing loans in the banking sector. In other words, SOEs actually redistribute state-owned assets through negative profits and relatively high salaries that cannot be justified from the real contribution of labor to output. That is why we pointed out previously that the reform of SOEs and collective enterprises itself is, from the very beginning, a privatization process in some sense.

The model analysis also tells us that the costs of all production factors, including capital, labor, tax and entrance, are important to economic development. As is well known, the PRC has relatively low labor costs and the real interest rate is usually negative. These are important factors contributing to the rapid development of its private sector.

The model helps to explain why the number of private enterprises has increased so rapidly simultaneous with a scaling down of size. The increase in the number of enterprises depends on privatization and marketization, labor and capital costs, entrance costs and the tax rate. The deepening of privatization and marketization, relatively lower labor and capital costs, and falling entrance costs, all contribute to increases in the number of private enterprises.

By considering a more dynamic model, in which manager's ability itself experiences a "learning by doing" process with the progress of marketization and privatization, we conclude that that average firm size is positively related to the marginal manager's ability and negatively related to privatization and marketization. Hence, the decrease in firm size should mostly be attributable to the fall in marginal manager's ability and deepening of privatization and marketization. Since marginal manager's ability is positively related to a variety of costs and negatively related to the deepening of marketization and privatization, the fall of entrance costs and other costs all contribute to decrease of firm size.

The model also provides us with a general framework of development economics. It at least partly helps to explain why the "big bang" reform in Russia brought about widespread collapses of privatized SOEs during a short period of time, and to some extent helps to explain why gradual reform has been somewhat successful in the PRC. According to this model, the development of private enterprises not only depends on privatization and marketizaiton, but also on a variety of other factors, such as capital cost, labor cost, entrance cost, tax and especially the manager's ability. If other conditions are constant, bigger enterprises require higher managerial ability and skill, and thus only firms with appropriate marginal ability can survive in a market economy. If a big firm is run by a manager with low ability, it will lose profits and eventually go bankrupt. The collapse of privatized SOEs in Russia may be attributed to this matching problem. As is well known, in the early period of reform, most private enterprises in Russia were created from the privatization of SOEs through the big bang reform. Those former SOEs were usually very big in size, and therefore they required high managerial ability. However, most of the managers only had experience running enterprises under a planned economy, and had little knowledge about running them under the conditions of a market economy. In other words, they had little ability to manage big private enterprises, and eventually many faced failure.

Unlike the big bang reform in Russia, where the transformation from SOEs to private enterprises was implemented in a very short period of time, the PRC adopted a series of market-oriented measures to encourage the development of private enterprise. Specifically, managers in the newly established enterprises are continuously encouraged to improve their management ability, and in fact some have gained the ability to manage large enterprises. This has helped prepare the conditions for privatizing SOEs through mergers or acquisitions.

Unlike Russia, when the PRC started to privatize its SOEs, it had already created a mass of managers whose ability, skill and market awareness have been improved. In other words, at the cost of government assets, the PRC has trained a mass of high-level managers matching the size of enterprise. In addition, during the course of their development, the newly established private enterprises have not only educated a number of high level managers, but also accumulated a great deal of wealth, which has also paved the way for the privatization of SOEs. In other words, private enterprises have become capable of buying SOEs.

On the other hand, due to the rather high political profile of SOEs in the past (see Chapter 1), the PRC did not privatize its SOEs immediately; leaving their nominal ownership unchanged, it carried out a so-called contract responsibility system. Under these circumstances, the same matching problem as that envisaged under the big bang reform existed. As a result, many SOEs inevitably faced losses. (See Section 4.6) However, unlike in the big bang reform, where individuals took losses, under the gradual reform in the PRC, the government typically absorbed the losses in the early stage of reform. This process quickly eroded state financial resources, including fiscal and banking resource, and state-owned liabilities came increasingly closer to assets. Once the government (including stated-owned banks) becomes unable to absorb the losses incurred by SOEs, the acceleration of privatization reform becomes inevitable. This is the background of the so-called "Zhuan Da Fang Xiao" reforms put forward in 1995.

In conclusion, this model does have strong policy implications. SOEs, TVEs and the banking sector all should actively and continuously carry out market-oriented reforms. Private enterprises need to promote their market awareness, and thereby to transform themselves into pure profitmaximization entities.

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