7. Wages and Employment in the Transition to a Market Economy

Georg Winckler
Published Date:
September 1992
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I. Introduction

The scale of the reform agenda in the erstwhile socialist economies and the complementary nature of policy changes make the ordering of reforms peculiarly complex. Yet it is not difficult to understand that certain basic features of the inherited system—the presence ex ante of socialized ownership, full employment, restricted labor mobility, and de facto wage indexation—necessarily imply that drastic reforms in the labor market area must feature prominently and at an early stage in any viable reform program. To a certain extent, this is not a matter of choice. The question turns rather on ensuring the compatibility of interventions over particular time horizons.

Reforming governments characteristically seek to establish a commitment to prudent macroeconomic policies, among which restrictive fiscal targets figure prominently. Achieving these targets in turn will reflect their ability to enforce hard budget constraints on the socialized enterprises and thereby simultaneously tolerate unemployment. However, if it is believed that structural features will promote myopic or short-run behavior by workers and managers, the government is faced with the task of balancing its desire for demonstrating its commitment to a more passive role in the economy with maintaining direct controls over wages and possibly employment decisions.

This paper concentrates on the implications of those inherited wage-setting rules and ownership arrangements for wage bargaining and policy in the transition. Several tensions in the system are given prominence. In the first place, wage and employment decisions have to be set in a context of a departure from full employment and where any trade-off between wages and employment is only partially or perversely perceived by agents. In effect, by imposing unemployment on the system through repudiation of the soft budget constraint, the reforming government attempts to teach workers and managers that behind it all lies a Phillips curve. Yet while this implies initial tolerance, if not stimulation, of unemployment on the part of the government, fiscal and political constraints will tend to place bounds on this tolerance, possibly leading agents to believe that adherence to announced policy will be weakened and loosening of stabilization measures pursued.

Second, the extent of worker participation or influence in management decisions requires appropriate analytical treatment when tracing the likely outcomes of bargaining between government and firms and of wage bargaining within the firm. Insofar as the firm is worker managed, this tends to give rise to a joint maximization problem over wages and employment. It also has important implications for the likely wage and employment outcome once uncertainty over ownership rights is introduced.

Third, the government faces a dilemma with regard to its wage policy. On the one hand, given low wage dispersion and inadequate relative returns to skills, wage controls can tend to dilute incentives for firms to expand while also conserving a suboptimal wage structure. However, if the structure of current ownership is conducive to capital depletion and maximization of labor rents, as is commonly asserted,2 a centralized wage policy would be critical for restraining inflationary pressures, avoiding a lower capital stock and ultimately lower aggregate employment, as well as the emergence of classical unemployment derived from excessive real wage claims. In this light, the appropriate question concerns the design of the wage policy, its incidence, and its degree of permanence.

In Section II we provide a summary discussion of the main features of wage setting in various types of socialist economies. These initial conditions are shown to be critical in shaping the labor market policies of a reforming government moving to a market-based system. We draw on recent Polish experience since January 1990, highlighting the behavior of wages and employment during the initial phase of the stabilization program. In Section III we set up our basic model of a worker-controlled firm (WCF) and develop a one-period policy game between the government and the WCF. Section IV discusses the implications of a number of simple tax rules for the WCF’s wage and employment decisions. Section V explicitly accounts for uncertainty over ownership rights and models this uncertainty in a two-period context. We indicate some possible means by which decapitalization of the firm can be avoided.

II. Wage Determination Under Socialism

In this section, we lay out the range of initial conditions from which more accelerated episodes of reforms have commenced. We focus on the wage-setting framework and outline in very stylized form the manner in which wage bargaining arose in these systems. For clarity of exposition, a simple distinction between three types of regimes—the centrally planned economy (CPE); the partially reformed socialist economy (PRE); and a market-based economy—is drawn.3

Centrally Planned and Partially Reformed Regimes

In the case of the CPE and the PRE, certain common features hold. Full employment is a given. Excess aggregate demand for labor predominates alongside selective labor shortages. Further, no evident association exists between output and prices with no endogenous mechanism of equilibration in the system. Prices are largely administered and explicitly follow a cost-plus routine. The full employment regimes tend also to be associated with low mobility exacerbated by infrastructural constraints, particularly housing.4 In both systems, wage levels tend to be low with minimal dispersion, thereby distorting the intertemporal accumulation of skills. Labor allocation and sorting largely occurs independently of prices.

It would seem reasonable to assume that in the controlled economy wages could be considered exogenous. This is incorrect.5 In the CPE world of vertical controls and exhaustion of labor reserves, the planner generally had recourse to piece rates to motivate workers and to circumvent the monitoring problem. Managers of enterprises were effectively transmission belts and lacked autonomy in negotiating wages. The wage bill of enterprises, comprising base wages plus piece rate adjustments, was the control variable employed by the planner.6

In the more decentralized world of the PRE vertical controls were relaxed, and greater autonomy to enterprises and managers was granted. In Hungary and Poland this was also associated with the transformation of the majority of enterprises into management by workers’ councils. Wages were generally explicitly associated with productivity or profitability indicators.

Decentralization opened up a number of tensions with regard to wage policy. Enterprises faced distorted prices that complicated simple association of warranted wage growth with profitability or productivity indicators. Soft budget constraints and the redistribution of profits through the budget generated perverse incentives for enterprises and generally subverted the association between wage distribution and performance at the plant or industry level.7 The absence of a hard budget constraint and the explicit use of cost-plus pricing required that the government continue to regulate wages through centrally given norms to avoid wage drift and cost-side inflationary pressures. Average wages in the dominant socialized sector remained characterized by low dispersion.8 In both CPE and PRE regimes social cash and kind transfers and subsidies further tended to equalize gross household income and net personal income. In Hungary, for example, where social income expanded to around 49 percent of total household income for the period 1980-90, the Gini coefficient for gross household income at the end of the period fell from 0.29 for main wage earnings to 0.23 when social income and taxes were included.9

The emergence of more complex bargaining behavior in the PRE turned around the interaction between managers, workers, and government. Enterprise managers were motivated through bonus payments that associated their wages with performance or synthetic indicators. By imposing an appropriate incentive structure, the government hoped to engage workers and managers in a cooperative bargain over wages and effort. For the most part, this structure was given through tax policy conditioned on the wage, either on the level, or, at times, on the rate of growth.10 Wages paid out above an announced norm were taxed by the government. Most commonly a tax (t) was levied on that share of the wage bill above the warranted amount (wn). This implied in terms of cost per employee:

This tax formula would have been fiscally neutral only if a rebate or subsidy per employee had been offered.11 A rebate or subsidy was obviously not applied in the full employment regime, as an explicit objective of tax-based wage policy was to motivate labor shedding by enterprises.

Experience with applying an exogenous incentive structure and regulating wage development by tax-based wage policies was very mixed and generally disappointing. In general, it would be appropriate to see workers and managers playing cooperatively against the government. Noncooperative settings invariably prevailed when, as in Poland, there was no underlying agreement over the distribution of resources in the economy. While the broad rule appears to have been an indexation of wages to prices, the ability to enforce wage norms through tax policy varied widely.12

The Market-Based Regime: Poland, 1990/91

Central to the regime change is the tolerance of unemployment and the gradual emergence of a Phillips curve. Additionally, labor allocation is meant to be largely market driven within the constraints imposed by limitations on mobility and plant-specific nonwage benefits. Partial wage liberalization is likely to occur. In this section, we concentrate on the recent Polish stabilization experience, focusing on the way in which wages are determined once unemployment is tolerated and the Government signals a repudiation of the soft budget constraint and of accommodating monetary policy.

The broad features of the Polish stabilization program are covered elsewhere.13 In this context, it suffices to underline the use of wages, together with the exchange rate, as a nominal anchor to the stabilization in the context of a radical trade opening and the associated, if incomplete, importation of a new relative price structure.

Wages were controlled at the outset of the program to arrest the development of a price-wage spiral. In the first four months wages could be adjusted in relation to inflation by a coefficient significantly lower than one, except for July.14 Centralized control on wages was carried over and justified mainly in terms of dampening inflation, given the ownership structure, uncertainty over the scale of restructuring, and the cost-plus pricing routine followed by producers.

The outcome of the program in its first year can be summarized as follows:

  • Real wages fell by 31 percent over the full year;15
  • Output in the socialized sector fell by 25 percent;
  • Employment fell much less than output, and productivity therefore dropped by about 20 percent;
  • Unemployment rose from almost zero to over 6 percent of the labor force on a rising trend;
  • Inflation was 250 percent over the year, with a monthly rate of 6 percent by early 1991;
  • Sizable budget and trade surpluses were generated.

The first year has been characterized by stagnation of output and persistent inflation. Real wages proved to be highly flexible downward in response to the initial shock to the economy, while employment dropped only marginally in the first two months of 1990 despite a steep decline in output. After March real wages began to increase while employment continued to decline. As a result, in the second half of 1990, a rapid increase in real wages together with a rapid increase in unemployment can be observed.

Overall, the behavior of wages, employment, and productivity during 1990 seems to have reflected a generalized recession more than a shake-out of the economy associated with structural reforms. Indeed, output dropped in every sector of the economy.


The rise in unemployment, though substantial and significantly more rapid than in other reforming economies,16 was not associated with a single bankruptcy in 1990, even though mass layoffs increased in the latter part of the year and accounted for roughly a third of cumulative unemployment over the year.17 It is important to note that the fall in output in the socialized sector (25 percent) exceeded the drop in employment (14 percent), implying not only a fall in productivity but overmanning that was likely to continue.

Sectoral data consistently show output falling more than employment (see Table 1). Moreover, the variability of output across sectors (measured by the coefficient of variation in Table 1) was twice as large as that of employment. Overall, the dominant strategy appears to have been to reduce output rather than employment.18 Flows into unemployment have consequently to be further related to new entrants, some possible labor supply effects, and the inducement to register as unemployed created by a fairly generous replacement ratio.19

Wages and Wage Policy

The sharp and programmed fall in economy-wide real wages disguises a rather more complex set of developments. First, after March 1990, real consumer and producer wages rose significantly, falling again only in December (Chart 1). By November real wages were barely 20 percent below the average for 1989 and above the level in January 1989, not taking into account differences in effective purchasing power over these periods owing to the elimination of shortages. Second, wages and profits moved inversely after March (Chart 1). Sectoral data (Table 1) do, however, show profits and wages moving together, but this can largely be ascribed to price changes rather than to productivity growth. Product wages exhibit far greater variance than consumer wages. Real wages also exhibit greater variance across sectors than employment.

Table 1.Poland: Sectoral Data, January-December 19901(jan.-Dec. 1989=100)
EmploymentProductivityProductionProducer PricesReal ProfitsProduct WageConsumer WageNominal Wages
Ferrous metallurgy94.4088.0383.101,098.1117.955.274.7519.6
Nonferrous metallurgy97.2078.5076.301,090.6113.751.372.9507.6
Metal products90.6079.2571.80836.575.664.367.5470.0
Precision instruments89.7092.7583.20650.160.880.965.7457.1
Transport equipment91.5080.7773.90885.070.463.868.7477.9
Electrical-technical engineering and electronics92.0085.5478.70734.657.470.965.5456.0
Chemical industry93.9080.1975.30938.98O. 659.168.2474.7
Building materials93.2082.4076.80892.191.960.667.6470.8
Class and glass products94.6076.5372.40873.058.362.567.0466.2
Pottery and china97.0076.3974.10734.151.772.466.3465.0
Wood and wood products89.8084.1975.60730.735.473.966.0459.6
Pa per and pa per products92.3083.7577.30949.870.558.867.7471.1
Textile products88.9066.9359.50638.121.378.061.8429.8
Wearing apparel89.2077.8069.40496.827.497.762.1431.9
Leather products90.1073.5866.30565.317.684.660.3419.8
Food industry98.2075.6674.30727.652.082.266.0459.2
Unweighted averages93.2680.8975.44858.280.066.567.2468.0
Standard deviation3.706.036.33204.663.913.43.826.8
Coefficient of variation, in percent3.967.458.3923.879.920.25.75.7

Owing to unavailability of data on producer prices by sectors for December 1990, the product wage refers to January-November.

Owing to unavailability of data on producer prices by sectors for December 1990, the product wage refers to January-November.

Throughout 1990 wages were centrally regulated, except for private sector wages. The mechanism of enforcement was a tax on wage bill increases in excess of levels given by the monthly coefficient or norm (n). The norm was inflation in a given month times a coefficient usually less than one.20 The wage bill tax took the following form:

with a very steep progressivity in tax rates.

Designed in this way the tax was not neutral vis-à-vis employment nor vis-à-vis the composition of the labor force within an enterprise. The monthly indexation rule also imparted inertia to the inflationary process. A particular feature of the scheme was the ability of enterprises to carry over wages from month to month when actual wage payments fell below the norm. Actual wages fell below the norm in the first six months of the program. Thereafter the accumulated surplus was drawn down, with wages consistently exceeding the norm. Only in November and December were accumulated wage norms exceeded, resulting in substantial tax penalties being incurred by enterprises. In this regard, wages barely anchored the stabilization at all, except at the end of the year.

The factors behind stronger wage growth in the second half of 1990 are difficult to pin down. The relative buoyancy of profit margins and some relaxation of credit policy in the third quarter of 1990 suggest some ability to pay on the part of enterprises.21 At the same time, it would be logical to assume that workers would test the government’s resolve to hold down wages, particularly given the relatively gradual increase in unemployment. The fact that firms were willing to pay taxes on excess wage increases, at rates above 100 percent, supports this argument. In principle, the tax on the wage bill might explain the phenomenon of rising real wages and declining employment during the second half of 1990.

Chart 1.Poland: Production, Prices, and Labor Market

1 Socialized sectors

2 Profit ratio equals net profits/total costs

For 1991 the wage tax has been modified. First, to eliminate the pro-unemployment bias and constraints on expanding firms, the average wage rather than the wage bill is subject to regulation. Second, a monthly indexation scheme has been retained.22 Third, wage expansion has been explicitly associated with the enterprise profit ratio. Fourth, private firms can set wages free of government regulation, while firms that are about to be privatized—“commercialized entities”—are partially exempted from excess wage taxation.23

By linking permissible wage growth to a firm’s profit ratio (nominal profits plus wages over wages) the new policy has the clear disadvantage of allowing wage growth to depend on the price that the enterprise can charge.24 This can be an invitation to exploit market power, particularly if it is believed that workers will attempt to maximize short-term wage growth.25 Additionally, a monthly indexation arrangement retains inertia and ensures that the system remains very sensitive to price shocks. This is particularly problematic in the Polish context, still subject to large temporary shocks to inflation, such the increase in administrative prices in January 1991. An alternative approach would be to lengthen the indexation period but this would obviously depend on the Government’s ability to enforce a longer constant wage ceiling.

In common with heterodox stabilization experiences elsewhere, wage restraint in Poland was fairly effective at the outset of the program.26 The problems start when controls are weakened or made-more flexible. These problems are more acute for former socialist economies precisely because of the ownership structure and worker participation in decision making. This structure has further implieations for whether centralized wage control policies can be seen as short-term devices to restrain cost-push inflationary pressures or are likely to respond over a more protracted period to the institutional particularities of such regimes.27

III. Wage and Employment Decisions in the Worker-Controlled Firm

We start from the stylized institutional features of a market-based regime. There is a dominant socialized sector in which workers’ councils control the firm and whose interference in management is non-trivial. Henceforth, we refer to such firms as worker-controlled firms (WCFs).

The Worker-Controlled Firm

The implications of active participation of workers in management have been extensively explored elsewhere, particularly in the Yugoslav context.28 Labor-managed firms have been widely characterized as maximizing income per worker rather than profits, so that the value of the marginal product of labor does not equate the wage rate but rather income per worker.29 If this was so, it could readily be shown that employment would be lower, that there would be a tendency to substitute capital for labor, and that there would be an inverse relationship between price and output changes. However, the robustness of these results has been questioned. For instance, distinguishing between short- and long-run membership can generate a positive short-run output supply curve.30 Further, in a static setting, optimal employment, given by the employment equating the marginal revenue product of labor with the lowest-paid worker member, can be shown to deviate relatively mildly from employment in a conventional profit-maximizing firm.31 Empirical work has also emphasized the importance of exogenously given rules and policies.32

Our objectives are more restrictive. We assume—at least initially—that the WCF operates in a market environment. There is, however, uncertainty as to consistency in government behavior, particularly with regard to enforcing a hard budget constraint on firms. Moreover, there is uncertainty over ownership and the degree to which WCFs will be carried over into future periods. These issues are explored further below. For our purposes, worker control can be treated as equivalent to a powerful trade union presence where wages and employment are subject to joint maximization.33 In contrast with the classical labor-managed firm, the WCF also cares about employment and accordingly maximizes the expected utility of the representative worker in the firm. Assuming further that there is a random selection of workers among those that are laid off and that they subsequently receive unemployment benefit, this allows us to view the WCF as a limited case for an efficient bargain model of the type commonly implemented for capitalist firms. However, in the WCF workers will be constrained by the firm’s profit level and not directly by the labor demand curve, and the wage will therefore equate the average product of labor. The point on the contract curve that is picked will not result from bargaining, as in a conventional firm.

We assume that the workers maximize the expected utility of a representative worker over prospects of employment at the contract wage as against unemployment with a fall-back income. The latter is given by unemployment benefits (B). All current workers or members (M) receive equal treatment and those who will be eventually unemployed are randomly selected among members. The workers’ or union’s utility function is

The production function F(L) is assumed to have positive but decreasing returns:

In the WCF, the union maximizes its utility (equation 2) with respect to wages and employment subject to a zero-profit constraint;34

where ϵ is a price or productivity shock if the price is normalized to one. We set M constant and equal to one.

From the first-order conditions we obtain


Equation (3) is for the contract curve, while equation (4) gives the “rent sharing” rule that, in the case of the WCF, involves the workers appropriating all revenues.

Chart 2 is a standard diagram in wage-employment space contrasting the non-Pareto optimal outcome on the labor demand curve and efficient bargains given by the tangency of the firm’s isoprofit curves and the workers’ or union’s indifference curves. The locus of the points of tangency defines the contract curve. The isoprofit curves have a positive slope until the wage equates the marginal revenue product of employment, Fʹ(L). The lowest point on the labor demand curve, D, is the competitive equilibrium. This can be thought of as that point where the workers have no bargaining power and where B is the supply price of labor or the reservation wage. The contract curve emanates from this point and slopes upward thereafter, given w ≥ w* (the competitive wage), w ≥ ϵFʹ(L). Any point along the contract curve above D implies a wage above the marginal revenue product of labor. This illustrates the nature of the solution to “efficient bargaining.” The solution is efficient for the firm and the given set of members; it is however inefficient from a social point of view as there is excessive employment. The model seems to accord well with the “stylized” fact of overmanning and labor hoarding in socialist economies. The outer point E on the contract curve is that given by the tangency of the zero isoprofit curve and the workers’ indifference curve. It can be seen as that point at which the workers appropriate the maximum rent above the reservation wage subject to the slope of the zero isoprofit curve and thus the zero-profit condition.

In the literature on market economies, the precise point on the contract curve is generally undetermined. Most authors have opted for a Nash-Zeuthen-Harsanyi solution to the bargaining problem. This maximizes the product of the gains from a contract subject to the respective bargaining powers and threat points of the parties to the contract.35 The threat points and union size are given exogenously. Further assumptions are that the threat point for profit earners is equal to zero, that profit earners are risk neutral and their utility linear in profits, and that there is a representative worker.36 In this setting, with ε=1, the maximization over w and L, under the constraint that L is smaller than total membership, is as follows:

Chart 2.Optimal Wage-Employment Setting

From the first-order conditions we obtain

Equation (6) gives the contract curve, while equation (7) indicates the specific point on the contract curve resulting from the solution to the Nash bargain. The latter takes the form of a sharing rule and means that under a cooperative solution the wage would equal the mean of the marginal and average products of labor.37 A more general formulation of the sharing rule, without assuming either a zero threat point for profit earners or risk neutrality, would be38

with δ measuring the relative bargaining power of the union.

Raising the workers’ bargaining power or threat point would obviously imply that average productivity will matter more than marginal productivity in the determination of the wage. In the case of the WCF, going to the zero profit point on the contract curve will be equivalent to setting wages and employment on the average revenue product of labor curve.39

Chart 3 illustrates the wage-employment outcome associated with equation (8).40 Wages in the WCF will be on the average product of labor curve at a point such as D. The classical labor-managed firm, which does not care about employment, will set wages at E, that point giving the maximum feasible wage per worker. A competitive firm will set wages equal to the reservation wage, B. Employment will be on the labor demand curve, F’(L), for the labor-managed firm and the competitive firm, but this will not be so for the WCF. For the latter, wages will be above those for the competitive firm, but lower than for the classical labor-managed firm. The highest employment level is associated with the WCF.

We can now trace through the likely implications for the wage and employment of various shocks. Two types of shocks have been studied in the context of the present model.41 One involves a shock to the labor market, such as an increase in unemployment benefits, the other a change in goods markets, such as an adverse demand shock. A productivity shock will be equivalent to the demand shock. An increase in unemployment benefits will shift the contract curve up to the left. This clearly implies that at any level of employment, wages on the new contract curve will be higher. An adverse product market shock would also induce a shift to the left (northwest) of the contract curve, implying a lower level of employment at any given wage. With risk-neutral workers (that is, a linear utility function) real wages are independent of product market shocks. Wages would thus be rigid in the face of changed product market conditions. If labor and goods market shocks occur simultaneously—as happens in Polish-type stabilization programs—employment will decline, while the effect on wages will be unclear. Introducing considerations of membership size obviously modifies the result and would generally make wages flexible. In particular, if current members discount the future, the prospect of unemployment in the next period motivates a real wage fall.

Chart 3.Wage-Employment Outcome in a WCF

Having set out the basic model, we now provide a series of extensions that explicitly associate the response of the WCF to government policy and policy instruments, particularly subsidies and tax-based wage rules.

A Simple Policy Game

In much of the existing policy game literature it is worth noting that the choice of raising output above the natural rate can generally be attributed to labor market rigidities. However, in the transitional economy, no player knows where the natural rate lies—there is a learning process under way—and a simple model in which inflation and output enter the utility function and where the economic causality and trade-offs are obvious has little to offer.42 Structural change and the “noise” associated with that change obscure conventional, emerging relationships. At the same time, political and institutional complexities make modeling more difficult.

In the reforming economy, the government starts necessarily with low credibility. Agents not only are uncertain with regard to the characteristics of the government but also have imperfect information regarding exogenous shocks to the system.43 If credibility is a state variable that is time dependent, the larger is the departure from steady-state values at the outset, the larger and possibly more protracted is the likely demonstration effect. This can partially explain why a reforming government may wish to supercorrect the first period—and actually prefer output losses—with the size of that correction testifying to the policymaker’s adherence to announced goals.44

It is clear that to acquire credibility a reforming government of the Polish variety has to convince agents that it is in effect a wolf, but not in sheep’s clothing. In particular, the government seeks to impose a hard budget constraint on producers and hence will not resort to deficit financing. The government deals with organized labor via a trade union or worker-managers.45 It seeks to shock enterprise managers and workers into behaving like true profit-maximizers. It may choose to use tolerance of bankruptcy as an instrument for demonstrating its resolve. It will correspondingly accept that unemployment is above any implicit target level.46 But agents will seek to test the government’s tolerance of output and employment losses and, implicitly, its ability to enforce a hard budget constraint on firms. Such discontinuity in preference could be seen as recourse to stabilization policy and would hence give rise to discontinuity in the indifference curves of the union. This motivates the use of subsidies as a policy or stabilization instrument in the subsection below.

This tension is evident once a fiscal policy target is introduced. That target encompasses the hard budget constraint insofar as subsidies to firms to cover operating losses directly show up in the budget. Moreover, we can assume that unemployment benefit is paid to workers and is financed through the budget. Thus, fiscal balance depends on enforcing the hard budget constraint, while enforcing the hard budget constraint implies increased unemployment and hence a call on budgetary resources for financing the unemployment system. We allude to this tension below.

Single-Period Policy Game

We now motivate a simple game in noncooperative and cooperative settings over the minimum time period in which a policy rule can be applied. We present solutions with Nash and Stackelberg equilibria. We assume a closed economy with WCFs and a government. Individual workers are risk neutral, u(W) = W. Union membership is constant and set equal to one. No taxes are levied. The WCF maximizes the utility function in equation (9) subject to the zero-profit constraint in equation (10) with respect to employment and wages.

The only difference from the basic model in the first subsection above is that subsidies (S) now enter the zero-profit constraint. Subsidies are positively associated with employment and/or the wage.

The government has the following simple utility function:

The parameter β represents the government’s trade-off between employment and paying subsidies.47 A high β implies that the government is strongly averse to departures from fiscal balance. We assume that the government adopts the following rule for the payment of subsidies:

The government is assumed to condition its policy on output so that subsidies are paid as a fraction of firms’ output.48

At this stage, unemployment benefits, B, are assumed exogenous, and the total payment of benefits (l-L)B does not enter the government’s utility function.49

Finally, we use a Cobb Douglas production function with decreasing returns to scale. We write F(L) as

The Nash Equilibrium

The WCF maximizes its utility taking the government’s choice of s as given. Consequently, equation (9) is maximized with respect to W and L subject to equation (10) and the subsidy rule in equation (12). The firm’s reaction curve is 50

The union’s choice of employment as a function of the subsidy parameter is given by equation (15), where an increased subsidy parameter, s, will always be associated with increased employment.

The government knows the zero-profit constraint of the WCF but in this setting can only influence employment, taking wages as given.51 The government’s reaction curve is hence found by maximizing its utility in equation (12) with respect to s, subject to the subsidy rule in equation (13) and the zero-profit constraint (equation (11)). The government reacts to a given W by the choice of s implicitly given by equation (16) below:

In (s, W) space the government’s reaction curve will be downward sloping, since dW/ds < 0. The government’s choice of s as a function of the employment level is implicitly given by equation (17) below.

If a/B <β<1/(1–a)(a/B), there exists a unique Nash equilibrium (with S ≥ 0), which is stable. That equilibrium implies a subsidy parameter sNE, an employment level LNE, and a wage WNE:

s > 0 implies payment of positive subsidies to the firm, a soft budget constraint.52 The employment in the NE (LNE) is greater than if no subsidies are paid (L0), that is, LNE ≥ L0. The wage is B/a, since the union’s choice of wage does not depend on the subsidy parameter. An increase in β lowers both sNE and LNE. Emphasizing fiscal balance will be associated with lower subsidies and employment.

These points are graphically presented in Chart 4.

The intersection between the reaction curves in the upper panel is the Nash equilibrium. Subsidies are on the horizontal, and wages on the vertical, axis. In the lower panel the curves show the optimal relationship between employment and the subsidy parameter for, respectively, the union (equation (15)) and the government (equation (17)). The intersection between these curves represents the subsidy parameter and employment for the Nash equilibrium. An increase of β will lead to a horizontal shift of the government’s reaction curve to the left (and likewise for the curve for equation (17)) and hence lead to lower employment.

The Stackelberg Equilibrium with the Government as Leader53

We now assume that the government sets its subsidy parameter before the WCF sets the wage and employment. The government acts as a Stackelberg leader maximizing its utility taking into account the firm’s reaction to its policy s.

Chart 4.Wage-Employment Outcomes in a Policy Game

If 1/B < β ≤ 1/(1-a)(1/B), subsidy parameter sSg, employment LSg, and wages WSg are similar in this Stackelberg equilibrium to the solutions for the Nash equilibrium. This can be grasped from Chart 4. The Stackelberg equilibrium is obtained where an indifference curve is tangent to the firm’s reaction curve. This point can be seen to be where the government’s and the firm’s reaction curves intersect.

The Stackelberg Equilibrium with the WCF as Leader

In this case the WCF is assumed to move first, taking into account the reactions of the government. The firm maximizes its utility with respect to L and W subject to the zero-profit constraint and subject to the subsidy rule in equation (12), and subject to the government’s reaction curve (equation (16) or equation (17)). If 1/B < β < [a2/(1–a)+ 1](1/B), a Stackelberg equilibrium with s ≥ 0 exists and is unique. Denoting the subsidy parameter, the employment and the wage for the Stackelberg equilibrium where the WCF is the leader ssf, Lsf, and Wsf, we have

The subsidy and employment parameters are bigger than for the Nash equilibrium. This occurs because the firm effectively endogenizes the government policy rule and hence the willingness to pay subsidies conditioned on output. But the wage Wsf is lower than for the Nash equilibrium, a function of the downward-sloping government reaction curve. Hence while subsidies and employment increase, the firm will also accept a lower wage.

Concluding Comments

The above results hold for noncooperative settings. A Nash bargaining solution with equal bargaining powers delivers subsidy and employment parameters higher than in any of the noncooperative settings. Wages are found to lie somewhere between the Stackelberg equilibrium with the firm as leader and the Nash equilibrium.54

The very simple policy game presented in this section obviously suffers from not explicitly entering a cost term directly into the government function. A more elaborate treatment, along the lines pursued by Driffill (1985), would be to incorporate a social welfare function in which a cost term, associated with departures from fiscal balance, would figure.55 A more tractable way of presenting the problem in the light of the present model would be to incorporate any negative utility attaching to the government from payment of unemployment benefits. This approach is obviously more restrictive. Writing unemployment benefits (1-L)B, the government’s utility function now reads

Collecting terms, dividing through with (βB+1) and defining Ug/(βB+1) as Ug:

We see that the parameter in front of S has decreased compared to the utility function in equation (11). The obvious intuition is that if the government has a willingness to pay unemployment benefits, it will be associated with a lower weight on budget balance and is likely to imply a higher subsidy parameter. It does not of course capture any of the more complex offsetting effects.

The policy game developed above has clear limitations. Nevertheless, it seeks to formalize a basic dilemma for transitional governments; the trade-off between employment and subsidies, where subsidies are in effect continuation of the soft budget constraint. A cooperative solution can be shown to yield relatively low wages but high employment and hence high subsidies. Both the Nash equilibrium and the Stackelberg setting with the government as leader will deliver higher wages than the cooperative setting, with lower employment and subsidies. When the WCF is the Stackelberg leader it perceives the government rule and endogenizes policy when optimizing. In effect the WCF optimizes against a steeper employment-subsidy curve. Higher employment and subsidies result in a lower wage than with the Nash equilibrium and government Stackelberg settings. Expressed simply, if the WCF understands that the government cares about employment (despite possible announcements to the contrary), this will result in the government offering subsidies to firms and thereby bailing them out. Such subsidies permit higher than warranted employment. It is clear-but is here inadequately developed—that the fiscal costs can be non-trivial. By being unable to execute a hard budget constraint on the WCFs, the credibility of the reform program—and hence the signalling of a regime break—would be undermined.

IV. Tax Rules and the Worker-Controlled Firm

We have already alluded to the widespread use of tax-based incomes policies in partially reformed socialist economies. Their use can be traced to a multiplicity of objectives. They include restraint on the appropriation of labor rents; regulation of labor demand at the firm level; and regulation of effective demand. If the market-based economy lacks fully endogenized restraints on pricing, and ownership remains largely socialized, tax-based incomes policies retain relevance, as recent Polish experience proves.

In this section we provide a summary treatment of tax rules and indicate the likely differing outcomes with respect to employment and wages. We work with the model discussed in Section III. For simplicity, we assume individual workers are risk neutral. The tax enters directly into the zero-profit constraint:

We consider the following four tax rules:56 (1) Wage-bill tax, where the tax is levied on that share of the wage bill (WL) above a preannounced norm. Ω represents the norm so that T = t(WL—Ω), when WL ≥ Ω ≥ 0. This type of tax was widely used in the PRE setting and in Poland in 1990 (see Section II); (2) Wage per worker tax, where wages in excess of a norm (w) are taxed so that: T = tL(W– w), when W ≥ w ≥ 0; (3) Production tax, T = t(F(L)—y), when F(L) ≥ y ≥ 0 and where y is the norm or threshold level; and (4) A lump sum tax, equal to a constant, T = t.

In Table 2 we derive the multipliers from the WCF’s maximization subject to the zero-profit constraint and the particular tax rule.57 Note that the tax parameters are taken as exogenous by the WCF in this arrangement. We distinguish between the tax rule itself and a parameter for the tax norm or threshold. The multipliers in parentheses are for specific functional form for the production function, namely, a semi-Cobb-Douglas;58 those outside parentheses relate to a generic production function with decreasing returns to scale.59

Several results stand out. A wage-bill tax and a production tax have exactly similar effects and clearly result in lower employment and a likely increase in wages. This equivalence is useful to illustrate the negative supply-side implications of the wage-bill tax. This tax rule effectively motivates firms to shed labor—not necessarily a desirable component for a market-based reform economy. Change in the taxable norm (Ω and y) proves neutral vis-à-vis employment, but wages unambiguously increase with an increase in Ω or y.

For the tax per worker, by contrast, an increase in the tax rate clearly lowers wages and raises employment. An increase in the norm (w) leads to higher employment but the impact on wages is ambiguous. This tax rule clearly has an employment bias in sharp contrast to the wage-bill tax. So long as the wage ceiling is above the reservation wage or unemployment benefit, an increase in the ceiling will stimulate employment and reduce wages.

Finally, a lump sum tax merely lowers the wage and is neutral for employment. Note that a lump sum tax is equivalent to a fixed cost, which has been widely studied in the literature on labor-managed firms. It is also a negative subsidy, and can thus be interpreted in connection with the reduction of subsidies that accompanies the shift to a market-based system. Our model indicates that an increase in any type of fixed costs, such as the reduction of subsidies that is a feature of the shift to a market-based system, will lower wages without affecting employment.

Table 2.Effect of Tax Rules on Wages and Employment
Effect of Increase of Parameter t onEffect of Increase in Norm on
Wage-bill tax-(-)?(+)0(0)+(+)
Wage per worker tax?(?)?(?)+(+)?(-)
Production tax-(-)?(+)0(0)+(+)
Lump sum tax0(0)-(-)

V. Ownership Reform and Decapitalization

There is a well-rehearsed set of arguments as to why socialized firms tend to be subject to decapitalization. They run as follows. Workers can only enjoy the benefits of capital if they work in the enterprises where that capital is employed. An absent capital market dilutes the longer-term interest of workers in the firm. Both features will tend to favor an appropriation of those benefits into current earnings. Wage pressure in the system will therefore be severe, subject only to the effectiveness of external restraints, such as tax policy and rules regarding reinvestment.60 Those rules will tend not to bind in more decentralized settings.

While this stylization is extreme and the degree to which market-based restraints are endogenized in the firm will depend on a wide range of factors,61 it is obvious that introducing uncertainty over ownership, through an announced strategy of privatization, could possibly accelerate capital depletion in the transition. If firms are worker controlled and a certain proportion could expect to be privatized in the next period,62 thereby losing access to capital given by the prior ownership form, this might motivate consumption of capital in the current period. By contrast, capital depletion in this period would have negative implications for a firm that remained worker controlled in the next period. From society’s point of view, a lower capital stock in the next period can validate a lower level of employment and hence a possible source of hysteresis. The policy objective then is to reconcile the desire for ownership reform (and the knowledge that this cannot be done overnight) with measures to restrict lowering the capital stock as a function of the uncertainty imparted by prospective ownership reform. We examine this issue in relation to use of tax policy and also to the possible use of vouchers as a means of restricting decapitalization. The overall problem can be couched accessibly in terms of an intertemporal maximization, building upon the basic model developed in Section III.

A Two-Period Model with the Worker-Controlled Firm

We extend our basic model for the WCF (Section III) in a two-period case using a production function with labor and capital as arguments. Risk neutrality for individual workers is assumed. In period 1 the firm is a WCF, while ownership in period 2 is uncertain. We assume that the firm continues as a WCF with the probability q, while being privatized has the probability (1—q).63 Throughout, lower-case subscripts denote the period, i = 1,2.

The Firm Is Worker Controlled

If the firm is worker controlled the union’s utility function is as follows:

The production function is similar in both periods and includes capital (Ki) as well as labor. We also include an exogenous productivity shock (θi > 0):

We assume positive but decreasing marginal returns. For simplicity we assume no depreciation of capital. The firm can sell (and buy) capital at the start of each period at the price pi, i = 1,2, and the WCF has to decide at the start of each period how much capital to sell (or buy) and how much to allocate to production. The WCF pays taxes to the government amounting to Ti, i = 1,2.

The WCF has initially at period 1 a capital stock K. It decides to use K1 for production and sells the rest, worth p1(K–K1). The zero-profit constraint for period 1 can now be expressed as

The zero-profit constraint for period 2 when the firm is still worker controlled is

From expressions (22) and (23) it can be seen that the WCF cannot lend to, or borrow from, sources outside the firm.

Finally, we specify the tax rule as a wage per worker tax (see Section IV).

The Firm Is Privatized

If the firm is privatized, new owners take over in period 2 and there is a regime change. We assume that the decisions taken by the workers in period 1 do not influence the utility of the union in period 2 if the firm is privatized. Further, if the firm is privatized it is not taxed. If the firm is privatized in period 2, the exogenous utility level obtained is U2PR.

The WCF’s Problem

The WCF maximizes its expected utility with respect to the instruments L1, k1, L2, K2, discounting the utility in period 2 with the discount factor δ, 0 < δ ≤ 1.

The utility levels UiWCF, i = 1,2 are found by inserting the tax rules equation (24) into the zero-profit constraints (equation (22) and equation (23)), isolating WiLi, and inserting these into the utility functions equation (21).

The first-order conditions with respect to L1, and K1 are

The interpretation of equation (25) is that the union chooses an employment level and that amount of capital whereby the marginal utility of one extra employee equals B1 (the marginal utility of being unemployed). Equation (26) says that L1 and K1 are chosen so that the marginal utility from keeping one more unit of capital (increased production and value of sales in the next period) equals the utility of selling that unit of capital in this period.

Some Results

We analyze how the exogenous variables influence the amount of capital kept in production in the first period, L1 and K1, where the larger K1, the lower is the extent of decapitalization. L1 and K1 are determined jointly by equation (25) and equation (26). Calculation of the multipliers yields the following results:64

As expected, the higher the probability of the firm remaining worker controlled (q) in period 2, the lower is the extent of decapitalization. Likewise, greater discounting (δ) by the WCF and a higher price of capital in period 2 give positive multipliers, as does a positive productivity shock (θ1)through the higher value of capital stock in period 1. A productivity shock in period 2 is neutral. By contrast, if the price of capital in period 1 is high, this reverses the sign, indicating that the WCF will sell capital in period 1 and hence decapitalize the firm.

Tax Policy

We now consider how a tax rule can be implemented so as to limit any incipient decapitalization. We insert a wage per worker tax where taxation falls on wages above a certain norm, Wi > wi. Distinguishing, as in Section IV, between the tax parameter (t) and the tax norm or threshold (w), the following multipliers can be derived:

Using this tax rule, it emerges that a sufficiently high tax parameter can arrest decapitalization in period 1 but that a higher tax rate in period 2 will promote decapitalization. This is a result of a substitution effect making it more favorable to be paid wages in period 1 than in period 2. Note also that a uniform tax increase for the two periods (dt1= dt2) will reduce decapitalization, dK1/dt1 + dK1/dt2 > 0; if w1 > B1.

An increase of the wage norm in period 1 (w1) increases retained capital while an increase in w2 leaves K1 unchanged. The reason for dK1/dw1 being positive is that the marginal utility of labor has increased. This implies higher employment and also a larger capital stock.

This section makes clear that by using an appropriate tax rule—in this case a wage per worker rule—capital depletion can be restrained. However, this requires a somewhat differentiated tax stance across the two periods. An expected high tax parameter in period 2 will certainly promote capital depletion. The policy challenge is to apply a high tax parameter and wage norm in period 1 relative to those applied in period 2. Clearly, the WCF will retain capital into period 2 only if it believes that it will not be subject to higher taxation in that period.


Pursuing the line of argument developed above, we now consider whether introducing a contingent claim on a specified share of the value of capital of the WCF could induce modified behavior by the WCF, given the uncertainty about ownership in the next period. We consider in particular the case of a voucher handed out to members of the WCF. The value of the voucher, V, is V = αp2K1 if the firm is privatized, 0 if the firm is still worker controlled. α is a constant (α ≥ 0) expressing the fraction of the value of the capital represented by the voucher.

The utility of the union in the case where the firm is privatized can consequently be expressed as

where U2PR is the exogenous utility obtained in the absence of a voucher.

Assuming that the firm pays no taxes if it is privatized, the maximization problem of the WCF can now be written as

The first-order conditions now contain a term for the value of the voucher:

From equation (28) (the first-order condition with respect to K1) it can be seen that a voucher introduces an additional term with positive expected utility from retaining more capital in period 1.

Inserting the voucher results in dK1/dq having an indeterminate sign. This comes about because, although an expected gain for the WCF will result from being able to sell capital in period 2, this will be offset by an expected loss from being unable to cash the voucher.65 However, dK1/dα > 0, so that if the value of the voucher is increased, more capital will be retained in the firm.66

Concluding Comments

In this section we have explored an important issue for the reforming economy: can uncertainty about ownership and associated incentives for decapitalization be mitigated by applying an appropriate tax rule and/or offering a contingent claim on capital to members of the WCF? Given the announcement of impending privatization by reforming governments, a two-period setting seems quite appropriate. The model has some obvious disadvantages. There is no expectation about price and the only uncertainty is with respect to privatization. Equally, we ignore any of the likely wealth effects—and consequent macro-economic implications—as well as the transactions costs and the design issues associated with a voucher scheme. Nevertheless, it is evident that a suitable tax rule—a tax per worker—can dampen tendencies toward capital depletion. This is an important point to the extent that it adjoins the conclusions from Section IV where the wage per worker rule can lead to lower wages and higher employment.

VI. Conclusion

We have attempted in this paper to draw out the implications of the ownership structure and, subsequently, uncertainty about that structure, for wage and employment setting in reforming socialist economies. We have indicated the strong tendencies to excessive employment and wage drift in these systems, in part as a result of the ownership structure and the associated legacy of earlier regimes. Our primary focus has been on the market-based economy, as exemplified by Poland since 1990. Surveying recent developments in Poland, although open unemployment has emerged to a significant degree, it is striking to note the continuing resistance to downward pressure on wages.

In the light of these stylized features, we then set up a series of models that focus on the behavior of the worker-controlled firm. We developed a simple policy game where government policy is conditioned on output through a subsidy instrument. This reflects the characteristic problem faced by reforming governments of whether to enforce a hard budget constraint and hence tolerate higher unemployment or whether to resort to subsidies and associated departures from fiscal targets. We locate, in both cooperative and noncooperative settings, the implications for wages, employment, and subsidies.

Given the commitment to privatization and the resulting uncertainty about future claims on capital, we also developed in a two-period model the conditions under which the WCF will deplete its capital stock, possibly through excessive wage growth. We indicated how an appropriate tax rule—in this case a wage per worker rule—can restrain decapitalization. We also touch lightly on the possible utility of contingent claims on capital, such as vouchers, in offsetting capital depletion promoted by uncertainty over property rights.

Finally, we emphasize the way in which wage tax rules can affect employment and wages and how critical is their design. A wage-bill tax, as used in Poland through 1990, not only lowers employment but will likely raise wages. By contrast, a wage per worker tax will tend to raise employment and lower wages. These effects are likely to be reinforced in a two-sector context where the WCF sector and private firms coexist and where relative wage considerations are important.67 The relevant wage for private sector workers might be the relative wage with respect to the WCF sector. As a consequence the wage set by the WCF will have direct implications for wages in the private sector. This reinforces the point that wage restraint in the WCF is likely to be critical. We therefore conclude that because of the inherited ownership structure and the uncertainty associated with reform, market-based regimes will continue to require centralized controls over wages in the WCF or socialized sector. Unemployment and an expanding private sector alone are unlikely to provide a sufficient restraining mechanism for wages.


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The views expressed in this paper are the authors’ and do not necessarily represent the opinions of the World Bank.


For example, Bulgaria could be classified as a CPE until 1990; Hungary and Poland as PREs up to 1989; and Poland, the former German Democratic Republic, and possibly Hungary as market-based regimes since 1990.


Mayo and Stein (1988) indicate housing and labor market linkages in the case of Poland.


A fuller discussion is contained in Commander and stähr (1991).


Adam (1979) contains a detailed discussion.


Kertesi and Cukor (1987) show that in Hungary short-run tensions in goods markets and with respect to enterprise performance have guided wage policy.


Note, however, that the gap between private and public sector wages tended to expand. See, for example, Falus-Szikra (1986).


The difference for personal net income with and without social income was 0.18 and 0.23, respectively. See World Bank (1991).


A bewildering range of wage tax formulas have been applied; for further details, see Adam (1979) and International Monetary Fund (1989a and 1989b).


A rebate, such as rw =t (w–wn), would have set the cost per worker at w + t(w–wn)–rw, thereby being neutral with regard to employment.


For Hungary and Poland, see Commander and Coricelli (1991).


The initially weak indexation coefficient and the low exchange rate delivered a very low wage level with an average daily wage of under $4.


Measurement is complicated when comparison is made with the shortage regime of 1989 and the fall in the inflation tax on households over this period. It is also not clear what has happened to nonwage components of income: traditionally a large share of household income.


In Hungary unemployment moved from less than 0.4 percent in January 1990 to around 2 percent of the labor force in January 1991 and is projected to reach between 3.5-4.5 percent by the end of 1991.


Note that for most branches profit margins increased in 1990 as output declined. The stronger-than-expected profit performance of the socialized sector can generally account for the absence of bankruptcies. See Coricelli, de la Calle, and Pinto (1990).


Layoffs have been concentrated in a number of subsectors, principally, retail trade, construction, transportation, engineering, and coal.


The benefits scheme is of indefinite duration with a 70 percent replacement ratio at the start falling to 40 percent after nine months. There is however no indexation above a 30 percent floor. In Hungary the gross replacement ratio similarly ranges from 70 percent unindexed at the outset to 40 percent by the end of the second year. Claims can only be made for up to two years.


The coefficient was 0.3 in January, 0.2 between February and April, 0.6 in May and June, 1 in July, and 0.6 thereafter.


However, positive interest rates would have acted to limit credit-financed wage increases. A simple chain of causality between money and wages is not obvious.


An indexation coefficient of 0.6 for January 1991.


There is an obvious adverse selection problem here.


The tax formula is t[(πt+wt/wt)/(πt-1+wt-1/wt-1).


In theory, monopolies are excluded but whether this will he enforceable another matter.


For experience elsewhere, see Kigucl and Liviatan (1989).


Layard (1991) discusses these points in more detail.


Max r = [pY–(Σpiii+f)]/L rather than Max π = pY-(wL+Σpiii+f) where r = income per worker, Y = output, i = inputs, f = fixed costs, and L = number of workers.


Miyazaki and Neary (1983) show this to hold except over a range of very low prices where the fixed cost burden implied by membership size is too severe.


Spinnewyn and Svejnar (1990), who also emphasize the importance of existing membership size in determining employment and the output response to a price increase.


This contrasts with widely used right-to-manage or monopoly union models where the wage is either bargained or picked by the union and employment is subsequently set unilaterally by the employer; the outcome lies on the labor demand curve. See Oswald (1985) for a summary of this literature.


The firm would fold below this level; in other words, the hard budget constraint binds.


This can be written as Max[(UfUf)θ(UwUw)1θ].


Aoki (1986) has an interesting discussion of these assumptions.


The sharing rule is generated by the cooperative setting and by the assumption of risk neutrality. Note also that the average revenue product curve is downward sloping so that the bargained outcome is at the intersection of the upward-sloping efficiency locus and a downward-sloping locus reflecting bargaining strength (McDonald and Solow, 1981).


Following Aoki (1986).


Precisely because of the institutional arrangement, one can also note that the problem of the firm reneging ex post on the employment associated with this outcome and moving back to the marginal revenue product curve is not an issue.


Chart 3 is adapted from Aoki (1986).


Such as a Barro-Gordon setup with output given by y=yn+(xxe)and a government one-period function, ug(x,xe)=x2+α(yyn),α>0x2+α(xxe).


Note that if the policymaker has no superior information regarding exogenous shocks, a rule-based approach could merely impart greater rigidity to the system.


See Vickers (1986) for a discussion of separating and pooling equilibria in a two-period model.


The union and/or worker-managers could also be seen as being concerned with their credibility as bargainers on the part of workers; especially given the general legacy of subservience to party and state.


This does not necessarily imply that the government accepts output as being above the target level as it may hold that there is such overmanning in the economy that productivity gains can rapidly swamp employment losses.


Only positive subsidies are considered. Note that this implies the fiscal trade-off alluded to above.


Relating subsidies to employment, the wage bill, or an amount independent of W, L, or F(L) would not markedly alter the results.


We will later consider what happens if the payment of unemployment benefits enters the government’s utility function.


Calculations are available from the authors.


This is somewhat ad hoc. One justification could be that the government conditions subsidy policy on output, hence employment. In the later Stackelberg setting with government as leader, wages are no longer taken as given.


s = 0 for β = 1/(1-a)(a/B).


Calculations for both Stackelberg settings are available on request from the authors.


Detailed results are available from the authors.


For example, a social welfare function, v= -(L - L)2–αD2, where the second captures the costs of fiscal imbalance.


More complicated rules—such as those incorporating value-added or productivity—are ignored.


Detailed calculations are available from the authors.


Namely, F(L) = ALa, where A > 0, and 0 < a < 1.


F(0) = 0, F′(L) > 0, F′′(L) < 0.


Hinds (1991) forcefully presents this line of argument.


Privatization could take the form of divestiture or simple closure.


More precisely, q is the union’s point estimate of the firm being a WCF in period 2.


Detailed calculations are available from the authors.


If α=1/(1 +t1), the multiplier dK1/dq = 0, and the firm is indifferent about privatization or continuation as a WCF.


If the value of the voucher equated the value of capital in the firm, then of course decapitalization in this setting would be rendered independent of the probability of privatization.


We intend later to develop a two-sector model incorporating efficiency wage setting in the private sector.


Aleksander Bajt

The paper by Commander, Coricelli, and Stähr is written in the best academic tradition, that is, it bases discussion on a theoretical model that is general enough to provide solutions to many of the most relevant issues of the transition of the ex-socialist economies to modern market economies. I accept the information on the Polish economy, particularly its stabilization efforts since 1989, presented in the first part of the paper, as a convenient introduction to the institutional framework that underlies theoretical modeling. Information on any other socialist economy, from Yugoslavia on the one hand to the former German Democratic Republic on the other, could have served this purpose almost as well.

The authors assume a market setting with firms controlled by the workers. In the process of restructuring, not only in the Yugoslav economy with its 30 years of labor management and in Poland and Hungary with their more recently introduced workers’ councils, but also in other ex-socialist countries, workers are likely to assume positions that are strong enough to allow treating firms as worker-controlled firms.

Starting from the Ward-type model of the Illyrian firm, adjusted to provide for more normal (nonnegative) output and employment responses to price increases, seems only natural in that case. Since wage and employment outcomes are likely to depend on the workers’ relative power position, discussion is cast in terms of the efficient bargaining approach. For the reasons just given, this choice seems to be right. Some reference to the “insiders’” literature (Lindbeck and Snower, 1987) could, perhaps, be useful. Workers’ behavior is constrained by the firm’s profit level rather than directly by the labor demand curve. Uncertainty over government determination to impose financial discipline and privatization of the property structure are the main environmental-institutional variables. By using appropriate utility functions, joint solutions for wages and employment are obtained. Unemployment benefits, subsidies to firms, and taxes are studied as the main exogenous policy variables, and wage-employment equilibria are obtained on suitable assumptions. The depletion of social capital, the impact of contingent claims on property (such as vouchers), and the two-sector (social-private) implications for the same equilibria, using the same policy variables, are also studied.

While the model and the derivation of its results deserve much more attention than can be given in this context (and will very likely follow in academic discussions), they perhaps are not the priority of this seminar. Let me therefore only note that all the results obtained agree with the a priori expectations formed on the basis of the specified assumptions, and that from the policy point of view they all appear plausible. I particularly agree with the most general conclusion that in the transitional period centralized wage controls will be needed to promote employment and growth. The more so since income controls are a frequent tool of stabilization policy in private property economies as well.

My comments are reduced to what I consider the most relevant from the point of view of how labor is treated. On the theoretical level I would prefer a more explicit treatment of the overmanning phenomenon. There can be no doubt that “hidden unemployment,” standing for a zero marginal product of a large fraction of the employed, and thus for a very low productivity of both labor (Bergson, 1987) and, consequently, investment (Bajt, 1988), is a far more fundamental characteristic of socialist economies than the pretty much overdone “shortage” phenomenon (Bajt, 1991). Both the Yugoslav 30 years and the newest Polish experience show that the latter can be most easily overcome.

Low productivity therefore deserves a more “deep” derivation, particularly as improvements in productivity seem to be essential in restructuring socialist economies. The bargaining approach cannot be the whole story. Underlying bargaining is the noncooperative behavior of individual workers in a firm, their breach of contract, free riding, shirking, and the like, which results in lowering labor inputs per worker and in Nash equilibria that are far below production optima accessible under alternative institutional setups (for more information, see Bajt, 1991). By including utility functions for individual workers with labor effort disutility as the relevant argument, and appropriate constraints on information flows (asymmetry), the result is easily obtained. In fact, by including workers’ utility functions with labor effort as an argument it can easily be derived within the original Illyrian model also. The marginal and average product curves shift downward, with their intersections very likely below the capitalist wage level. As more workers are substituted for less effort per worker, the “backward-bending” supply curve disappears, proving that the labor-managed firm is as efficient as the comparable capitalist firm—albeit as only an inefficient one (Bajt, 1988).

From the economic policy view some sorting of the somewhat “neutral” results of the Commander, Coricelli, and stähr model is advisable. That is, with all admiration for it, I prefer here to engage in a discussion of one of the most relevant issues it covers. For it is likely to shape the employment-wages relationship in the transitional period more fatally than any of the usual labor supply and demand factors such as minimum wages, unemployment benefits, or the much-discussed wage bill versus per worker tax issue. The issue is the shocks transmitted to domestic production in general and to the labor market in particular by a substantial reduction of the exchange rate and/or tariff protection (including quantity controls). In a formal sense, these shocks are covered by the Commander, Coricelli, and stähr model in the form of adverse demand shocks to the goods markets (p. 223). Unless such shocks are acknowledged as the real labor market determinant in the transitional period, and successfully countered, the ex-socialist countries are likely to realize that none of the traditional labor market policies, discussed within this model, is able to cope with the unacceptably negative employment-output trends.

Suppose we all agree that some exchange rate overshooting is advisable to protect domestic activity and employment both in export and in domestic markets. That is, I will bypass experiences like the most recent east German one, where a substantial overvaluation of the east German mark was achieved through the currency union, and also like the Yugoslav one, resulting from a post-stabilization price explosion well above the level consistent with the officially established exchange rate. The question that arises is whether the exchange rate overshooting provides enough protection to prevent socially unacceptable, adverse employment-wage effects that may handicap transition, and whether therefore it has to go hand in hand with trade liberalization. It should not be overlooked that acceptability thresholds have been considerably lowered by the introduction of political pluralism.

There certainly exists a level of undervaluation low enough to protect domestic output and employment. It may turn too inflationary, however. Some combination with tariff protection (and/or import controls) might be preferable. Only tariffs (and/or import controls) allow for differentiation. But a much more fundamental point favoring tariff protection seems to exist. All ex-socialist countries have for many decades been highly autarkic, with production unable to withstand foreign competition on domestic markets. Even the export sectors supported their competitiveness on foreign markets by shedding their junk production on domestic markets, frequently at prices much higher than export prices. Furthermore, particularly in consumer goods, domestic production is uncompetitive simply because it is domestic. The long-accumulated thirst for foreign-made goods calls for enormous discounts to survive on the market. Frequently not even a discount can do it.

Preaching free trade amounts to suicide in such cases. The resulting depressive situation not only produces unbearable social (unemployment) and economic (potential product) losses; it is also not conducive either to capital or to entrepreneurship and hampers normal privatization processes. Through the depressed value of capital, firms become enormously exposed to foreign takeover, which may be unacceptable for political reasons. A decisive advantage of east Germany, compared with other ex-socialist countries, is that this political obstacle does not exist.

A much more viable solution appears to be to start from the traditionally given degree of protection, to relegate the main burden of the linear protection to the exchange rate, and to design a scheme of industry-specific or even product-specific reductions in successive tariff and/or direct import controls over a specified number of years, realistic enough to make progressive improvements in competitiveness on domestic markets both possible and unavoidable. This in no way amounts to painless transition; there is no such thing as painless transition to a modern economic structure. Gradual elimination of nonmarket incomes (state subsidies) alone, necessary to expose firms fully to the market, not only induces real cost reductions but also presses for improvements in competitiveness. Radicals who believe that the best way of learning to swim is to be thrown into the water are probably right. Yet, if somebody constantly holds your head under the water (which is what in the traditionally autarkic economies an instant exposure to free trade amounts to) drowning and not swimming is the real subject of the lecture (on this, see McKinnon, 1991. So, by trying more, you eventually get less, and pay an enormous price also.

The above applies generally, that is, whenever reaching competitiveness in the traditionally autarkic economies is the goal. Often the quest for competitiveness may coincide with other policies that do not necessarily completely mesh with one another. Take stabilization, particularly radical disinflation, for instance, of the Yugoslav and Polish variety, which does not permit any delay.

In the Yugoslav case, the radical disinflation of December 1989 did not merely coincide with import liberalization; rather, import liberalization was included in the program as an efficient support for price stabilization (and against the repeated arguments to the contrary of this writer). This made stabilization a very easy task, similar to an abrupt cut in money supply. It even has an advantage, since, unlike money supply, an invisible hand may be held responsible for the adverse results. Combined with the tightening of monetary reins, which had become necessary for slowing the growth of both prices and wages (with inefficient income controls), the unexpectedly high levels of imports confounded the program designers by stopping inflation overnight. The lowered tariffs and the dismantled direct controls (together with an overvalued dinar) had to bring about adverse activity and employment effects anyway, and expanded imports, particularly of consumer goods, to unbearable levels. Not only was domestic production driven into a state of general bankruptcy, in which lobbying for state subsidies once again emerged, but stabilization itself had to be sacrificed.

The Polish case appears less clear. A stronger overshooting of the exchange rate expanded exports. Does the contracting activity result from tight money (and reductions in wages) alone? The disproportionate contraction in consumer goods production, together with an extreme fall in imports (Winiecki, 1990), may be indicative of a much lesser free trade on the import side than suggested by Sachs (1991). Import controls, perhaps of some invisible kind, may be credited with both. If this was so, Poland may have avoided the trap of trying to kill two birds (inflation and uncompetitiveness) with a single stone, fatal in the case of Yugoslavia, and may have succeeded in preventing too-high employment losses. If not (that is, if tight money and wage reductions were responsible for contraction), production of capital goods may be stronger, compared with consumer goods (Winiecki, 1990), because of credit “instruments” (interfirm indebtedness) that in retail trade have not yet come into use. As these instruments have some upper limits, the original contraction in consumer goods is likely to spread to capital goods production as well. In case wage controls should break down (as seems to be suggested by the fast growth of real wages in 1990), stabilization may fail even in spite of an eventual revival of activity. In that case both Yugoslavia and Poland will have to pursue similar step-by-step stabilization policies in which protection of domestic production beyond the reach of the exchange rate will be equally unavoidable.

Let me finally mention a second most relevant employment-wage aspect of transition. Efforts to narrow the above-mentioned productivity gap can most easily be met by dismissing redundant workers. Without the exchange rate to offset the lower productivity east Germany has no choice here. Should other ex-socialist governments be advised to follow the same path? Both import liberalization and privatization favor this solution. However, national—as distinct from private—productivity does not improve in this way. With production lines destroyed and activity falling, it in fact declines. The cautiousness with import liberalization suggested earlier is indicated here as well. With high activity preserved or even expanding as a result of such policies, dismissals could be fewer and search periods for new jobs shorter. This policy may help a longer-run stabilization, and expansion of private firms as well. Stabilization in a depressed economy is not likely to last, while privatization is reduced to a redistribution process.

Georg Fischer1

The paper by Commander, Coricelli, and stähr looks at the employment and wage-setting behavior of state-owned enterprises in the transition period. Some of these enterprises may soon be privatized, others may remain state property for a longer period. As long as they are in state hands, the government has a responsibility for these firms. This responsibility concerns employment and wages equally. On the wage side, the main problem has been how to control wage increases, and on the employment side, the nature of the problem has changed. Since the early 1980s, governments aimed at giving incentives to firms to reduce labor hoarding. With the transition to a market economy, governments now have to decide to what extent they can cope with rising unemployment.

With the removal of price subsidies, the wage problem has become particularly urgent. Workers hope to receive compensation for the large price increases through higher wages. But full compensation is presently seen as counterproductive, and it is feared that it may lead to an inflationary spiral. The transition governments understand that they cannot assume that managers of state-owned firms will resist workers’ claims but will possibly try to pass on wage increases by raising prices. Governments, therefore, have to assume responsibility and are looking at policies that would control wage increases. Some of the governments have made agreements with the unions on an economically feasible level of compensation, for example, wages should not rise by more than 70 percent of the actual price increases. However, this level was fixed, state-owned firms have to be forced to adhere, and, in order to comply, governments have used traditional incomes policies: increases in the total wage bill above the agreed limit are then subject to a steeply progressive tax with the minimum base starting at 100 percent. When this tax was introduced, it was argued that it would also give an incentive to labor shedding, which was seen desirable. To the extent that labor shortage disappeared, political views on the need for promoting labor shedding changed also. The Polish Government, for example, considered a tax-based income policy scheme giving incentives to limit wage increases but not to reduce employment.

The paper by Commander, Coricelli, and stähr analyzes such a scheme: taxation based not on the total wage bill but on the wage per capita. On the basis of an original, theoretical, and methodological approach, the paper suggests a few highly relevant conclusions.

First, even under the strong assumption that workers control the decision-making process in enterprises and maximize employment in the short term, this new tax would also help to prevent rapid decapitalization of state-owned firms. Such a tax would also have a favorable effect for the forthcoming privatization, particularly if digressively applied. One of the crucial assumptions here is that workers not only control the state-owned firms but also feel that ownership reform may be against their interest. Although workers may be inclined to believe this in the context of all the present uncertainties, we think it is important to develop a broader view on the attitudes and interests of workers regarding structural reform. This issue is discussed further in the latter part of this paper.

Second, the wage per capita tax, as distinct from the wage bill tax, does not encourage labor shedding. This aspect is important as high unemployment may endanger social and political stability. Under certain conditions the wage per capita tax may even stimulate employment. The authors assume that output is a function of employment and will always meet demand allowing for payment of the wage bill. The tax and the hard budget constraint affect only wage increases: as long as firms keep within the allowed wage increase, employment could even be expanded. On the other hand, in the transition economies, output is limited from both the demand and the supply side: the breakdown in trade between countries of the Council for Mutual Economic Assistance (CMEA), changes in consumer preferences, and the fall in the real incomes on the one hand and shortages of energy and raw materials on the other. If this is correct, the policy options for the governments are more complex: expanding or retaining employment in the state enterprises would then require additional subsidies even if the wage guidelines are kept. Conversely, the wage bill tax would not create this problem as it does not encourage expansion at all.

The choice of policies to keep unemployment under control by reducing layoffs in the state sector may be even more complex as the extent to which labor is hoarded is still seen as a major obstacle to profitability. Additionally, structural change will lead to fundamental restructuring of these firms. The wage per capita tax, by encouraging low-wage employment, may hinder necessary adjustments, while the wage bill tax encourages labor shedding and may leave some scope for wage differentiation. Commander, Coricelli, and stähr neutralize all these arguments as they assume that productivity in the state sector is fixed and therefore independent of wages. Only after firms have been privatized will wages function as incentives. As it may take a long time to privatize state-owned firms, we do not think this is a sustainable assumption. Therefore the productivity-related pro and con arguments on using taxes on wages to control inflation have to be considered seriously (IMF and others, 1991, Vol. 2, p. 184). This implies that the decisions aimed at keeping unemployment down have to be based on two types of considerations. First, how to maintain social and political stability and to avoid hardship in the short and medium term, and second, the need to encourage structural change in the longer term. Among the options responding to this dilemma are labor market policies.

Layoffs and Labor Market Policies

The underlying problem is whether retaining the employment level in state-owned firms, even if the output is not in demand, is the most appropriate way to keep down unemployment. The usual answer is that the workers not the firms should be supported. To keep enterprises artificially alive is a very costly and, in the end, an inefficient method of helping the workers affected. There is a clear danger that subsidizing firms diverts attention from looking for more durable longer-term solutions. This applies even more to the public authorities involved than to the individual workers. In addition, if a government keeps a specific firm alive, even for very good reasons, political pressures will emerge obliging the state to continue supporting the firm much longer than originally intended or even to subsidize other firms as well.

In an Organization for Economic Cooperation and Development (OECD) framework one would not only argue that keeping firms alive is a costly strategy but also that there are other more productive alternatives to consider: namely, active labor market policy programs and, in particular, a well-functioning placement service, vocational training programs, and enterprise- and job-creation schemes. To implement all these measures a network of employment offices is required (OECD, 1990).

And indeed all the countries of Central and Eastern Europe have adopted new employment laws and have started to build up employment services. They have plans to increase the financial resources devoted to labor market policies and the number of staff employed in placement offices. A network of labor offices has been in place for many years, but they are heavily understaffed and work for low wages with poor equipment and poor working conditions. The objective of these offices was to find workers for the state enterprises that “suffered” from a permanent labor shortage. Firms notified the placement offices of the least skilled vacancies. The employment laws recently adopted in most of the countries give the placement offices much wider objectives, essentially to act as the delivery mechanism for the governments’ employment policies. Consequently, the ministries of labor in these countries plan to raise salaries and to triple staff numbers in one to two years and to quadruple them in two to three years. The staff/employment ratio would then be almost equivalent to the ratio in southern European countries but still well below many other OECD countries. Experience in OECD countries clearly suggests that the establishment of appropriate infrastructure for delivering active labor market policies requires not only resources but also experience acquired over time. While this evidence makes it even more urgent to speed up the establishment of the employment service in these countries, it is difficult to refer to active labor market policies as the answer to the problem.

In view of the deep recession that most of the Eastern and Central European countries are experiencing, another question arises: is it actually clear which enterprises are loss-making in the long term and have to be closed down and what is the level of overmanning? A rapid process of laying off workers may then provoke a staff shortage when production could well pick up again. These are contingencies for which OECD countries use specific measures to allow workers to retain links with their employers, as, for example, the specific use of unemployment insurance during temporary layoffs in North America, short-time work subsidies in Germany, the system of partial unemployment in France, and the Cassa Integrazione in Italy. The reasoning behind these measures is the following: on the one hand, a certain amount of labor hoarding is seen as economically desirable, avoiding the costs of search and training; on the other hand, it is assumed that enterprises may not always be able to finance hoarding costs. Unemployment insurance would therefore provide partial financial support for the workers who remain in employment. In east Germany, the short-time work subsidies are applied very generously: at present more than 25 percent of the labor force are participating in short-time work schemes. The workers remain employed by their companies, working on average less than 50 percent of a normal workweek. Their salaries are partly replaced by a subsidy paid by the federal employment agency.

The phenomenon of firms employing underutilized workers at reduced costs is not unknown in other transition economies: there is ample evidence that workers accept paid, unpaid, part-time, or full-time leave or cuts in wages in order to remain in employment. Such behavior can be seen as rational because (i) there is often no other immediate option available; (ii) the future labor demand is unknown, and therefore many workers believe there is a chance to stay with the firm; and (iii) access to the firm, its premises, and machinery facilitates parallel economic activities. It is also sensible for the workers to remain at least partly attached to their firms: if one eventually has to find new employment, it is clearly advantageous to do so while still employed. OECD experience in the late 1970s and 1980s confirms that unemployment and in particular long-term unemployment has very serious impediments to future employment.

Besides the provision of the short-time work benefit that keeps the income level reasonably high, there is also another important difference between the German case and the others. Workers receiving short-time work benefits are supposed to participate in training programs. It is hoped that they will acquire new skills that will gradually allow them to take on new jobs. Whether the German short-time work proves to be successful in its reallocation function remains to be seen. More recent programs for east Germany have put more emphasis on the training side and on encouraging employees to create businesses. But even these programs keep workers within the framework of their enterprises, thus avoiding major layoffs. As a measure to cushion social disruption and to avoid human resource decay, these measures seem to be effective.

Programs that provide help for the reallocation of workers, by keeping them in employment, may also be worth considering for other transition economies. Such programs may have the advantage of having workers on hand, so that they will be available if the enterprise survives the transition period. However, it should be made clear to all participants that in many cases a change, not only of job but also of enterprise, will be required. Finally, it is important to stress that wide application of these programs will contribute toward low long-term unemployment levels.

However, the latter goal can also be achieved by other options. Major training activities can be provided in existing training institutions if curricula, methods, and equipment are modernized and developed especially for adult training. Public work programs have frequently been suggested, given the catastrophic situation of the infrastructure in these economies. The question arises as to what kind of public work programs are needed to allow workers to develop the urgently needed market-related skills required for the new jobs emerging in the private sector. Evaluation of job-creation programs suggests that those programs that provide both work experience and training achieve reintegration more efficiently than those that focus only on work. Unfortunately, the initial costs of the former are much higher, although the longer-term cost efficiency may also be greater. Caution needs to be taken in regard to public work programs that provide mainly low-paid, unskilled jobs as they may not be successful in promoting reintegration, and participants may be reminded of the previous regime’s policies. Programs to encourage enterprise creation and self employment, although limited in their scope, would be very timely.

Productivity and Workers’ Attitudes

As mentioned above, Commander, Coricelli, and stähr suggest that the state-owned firms are effectively worker controlled. Workers would therefore respond to an announced change in ownership by tending to consume the firm’s capital stock as long as they still have control. These assumptions contrast with other descriptions of the role of workers in firms in a command economy: firms were dominated by a Taylor-type production organization, workers’ opportunities to influence the production programs or methods were nonexistent, and managers and the party committees exercised arbitrary and discriminatory powers. The only strength workers had was based on their high degree of job security and on being characterized as of passive nature. Managers had to motivate workers to fulfill or even better to “overfulfill” the plan, and therefore they compromised on wages. Hence, the passive strength of workers reflects the nature of the command economic system. It would be inappropriate to assume that workers’ interests are by nature so narrow and short term.

Transition has not yet achieved structural reform in the state-owned enterprises. Managers do not yet represent the interests of the owners, and therefore the workers lack a partner for negotiations at the enterprise level, as the only available partner is the government. One could therefore view the tax-based incomes policies as an attempt by the government to force workers to accept partially the interests of the owners and replace the managers. While such a policy may be needed in the short term, in a longer perspective it may be dangerous as it confuses the respective roles of managers and workers. Acknowledging conflicts of interests between workers and employers is the precondition for developing mechanisms that lead to productive solutions. The establishment of representative structures and a network for negotiations and cooperation is essential.

Finally, there is a need to look carefully at the position of workers in regard to enterprise reform: again, if one has only this “passive strength” in mind one may believe that the only way in which the transition to a market economy will increase productivity is by removing job security and thereby strengthening discipline. There are obvious reasons why workers may be interested in enterprise and ownership reform. If the firm is economically sound, many workers will stay with it and are therefore interested in modernization being one of the preconditions for achieving higher wage levels. Ownership reform, in particular privatization, opens access for the individual worker to a new segment of the labor market providing much higher incomes and probably also more prestige. Also, privatization with the participation of foreign capital is particularly attractive because of the high reputation of a job in a “western company” and the fact that it will provide new skills to the workers, giving them wider opportunities elsewhere. With the modernization of production methods and products, work may become more satisfying and interesting. All these elements may motivate workers not only to support the process of modernization and ownership reform but also to increase their work effort. However, the extent to which these elements will actually contribute depends on how modernization is implemented by the new owners or by the new managements. The recent literature (for example, OECD, 1988) on innovation and structural change in OECD countries would certainly support an approach to modernization and increasing productivity, which underlines the importance of active workers’ involvement in the innovation process and of providing human resource development. This last point would stress the need for looking carefully at the role of workers in the transition process.


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The views expressed in this paper are the author’s and do not necessarily represent the opinion of the Organization for Economic Cooperation and Development.

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