lecture 6. meritocracy and yardstick competition

Lecture 6. Meritocracy and Yardstick competition.

Introduction.

• While fiscal decentralization gives instruments to pursue growth, the incentives work well if local authorities can get rents from higher growth via expanded revenues.

• However, better growth performance may also lead to faster promotion within the government bureaucracy.

• Meritocracy has always been an important component of Chinese administration (with fluctuations).

Yardstick competition

• Meritocracy makes use of yardstick competition (Lazear and Rosen, 1981; Holmström, 1982; Nalebuff and Stiglitz, 1983)

• Yardstick competititon used a lot in China. Different provincial governments were ranked according to different measures of performance and this played a role for promotion of bureaucrats. Similar principle used for airline companies and divisions of different agencies.

• Maskin et al. (1999) show that yardstick competition works well in a M-form organizational structure (regional organization) compared to U-form (functional organization).

Yardstick competition

• Assume two regions A and B and two industries 1 and 2. The performance of region r has the following form:

• Rr = er + r

• er denotes unobservable effort by bureaucrat in region r

• r denotes shock. A and B are jointly normally distributed with E(r)=0, variances 2

A, 2B and covariance AB.

Yardstick competition

• Similarly, define for industry:

• Ri = ei + i

• 1 and 2 are jointly normally distributed with E(i)=0, variances 2

1, 22 and covariance 12.

• The utility of a regional bureaucrat is U[w(RA,RB)]-g(er), g’ > 0, g” > 0, g’” > 0

• Define similarly the utility of a bureaucrat heading a functional ministryU[w(R1,R2)]-g(ei)

Yardstick competition

• If Var(A B) < Var(1 2) , then managerA can be given better incentives than manager 1.

• Managers A and B can be given better incentives than 1 and 2 if the following hold:min{ Var(A B), Var(B A) } < min {Var(1 2), Var(2 1)}max{ Var(A B), Var(B A) } < max {Var(1 2), Var(2 1)}

• Intuition is the same as moral hazard. Better incentives can be given if less noise (here conditional noise) since insurance motive less important.

Yardstick competition.• Proposition more easily derived with

specific functional form. • Assume U[wr(RA,RB)]= -e exp{- rwr(RA,RB)}• Assume linear incentive schemes in

regions and industries: • wA(RA,RB)=aA + bARA + cARB

• wB(RA,RB)=aB + bBRA + cBRB

• w1(R1,R2)=a1 + b1R1 + c1R2

• w2(R1,R2)=a2 + b2R1 + c2R2

Using certainty equivalent expression for U(wr) : E(wr)-1/2 rvar(wr) where r is constant absolute risk aversion derived from functional form of U:

U[wr(RA,RB)]-g(er)=

breA+creB-g(er)-1/2 r(br2A

2+cr2B

2+2brcrAB)

We can derive similar expression for i. Assume the principal is risk neutral and maximizes payoff of Managers A and B net of incentive payments:

E(RA)+ E(RB)-wA(RA,RB)-wB(RA,RB)= (1-bA-bB)eA +(1-cA-cB)eB-aA-aB

• An efficient contract maximizes the joint payoff of principal and managers:

• (er,br,cr)chosen to Max eA-g(eA)-1/2r(bA

2A2+cA

2B2+2bAcAAB)

+ eB-g(eB)-1/2r(bB2A

2+cB2B

2+2bBcBAB)• If effort were observable, first best would be g’(er)= 1 but

it is not observable. • Managers will maximize their utility, yielding bA=g’(eA),

cB=g’(eB)• Replacing bA in the objective function, we get the

following f.o.c. for eA and cA :• 1-g’(eA)=r[g’(eA)A

2 + cA2B] g”(eA)

• cA = -g’(eA) B/B2

• Plugging the expression for cA in the f.o.c. for eA, we get• 1-g’(eA)=r[g’(eA) g”(eA)[A

2 -B/B2]

• =r[g’(eA) g”(eA)Var(A / B) (since A and B are jointly normally distributed)

• Denoting VarAB = Var(A / B) and differenciating expression for f.o.c. w.r.t. eA, we get

0)"'"("

"'22

gggrVg

gg

dV

de

ABAB

A

A higher conditional variance will thus lower incentives for effort. Yardstick competition works better when lower conditional variance.

Yardstick competition

• Maskin et al. (1999) give evidence that conditional variances of regional shocks are smaller than conditional variances of industrial shocks. Moreover, yardstick competition is effective for promotion.

• Sample of 520 SOE’s from 1986 to 1991. Industrial and regional partition.

• Estimate industry-specific and region-specific shocks based on log-linear Cobb-Douglas production function.

• Compare conditional variance under regional and under industrial partition. Find on the basis of pairwise comparison that means of conditional variances higher on basis of industry rather than on basis of region.

Yardstick competition

• Look at provincial representation in CCP Central Committee normalized by provincial population in 1987 compared to 1977 (before reforms started).

• Find that there was a positive correlation between growth ranking and political representation.

Yardstick competition

• Hongbin Li and Li-An Zhou (2005) look at better measure: effect of individual growth performance of provincial leader on speed of promotion but also demotion.

• Promotion within the government administration seen as very desirable and also government career highly desirable among elite.

• China has 31 provincial units in Central Committee representation : 22 provinces, 4 cities (Beijing, Shanghai, Tianjing, Chongqing and 5 autonomous units.

• Since 1978, evaluation of provincial cadres not only based on political loyalty but also on expertise, education and youth.

• Since 1983, retirement of provincial leaders at 65 if not promoted, but not strictly enforced.

Yardstick competition.

• Provincial party secretaries can become members of the State Council, vice-premier or premier, member of Politburo or its standing committee.

• Provincial governor one step below provincial party secretary.

• People can also be “promoted” to honorary positions without power.

• At that level, positions in private sector not as attractive.

Yardstick competition

• Ordered probit model. • Turnover variable y takes values 0 (retirement), 1

(same), 2 promotion. Assume evaluation y* unobserved, y* =x+ where b are coefficients, x economic performance measure and 1, 2 are cutoff points for evaluation. Call cdf of normal distribution.

Yardstick competition

• Data on 254 provincial leaders between 1979 and 1995. Information on career moves, age, education, past work experience. More than 70% of leaders had turnover during that period.

• Average annual turnover rate of 20% (like in US corporations).

• Estimates show that when annual growth rate increases by one standard deviation (0.06) from the mean (.10), the probability of promotion increases by 15% of the average probability of promotion (.75).

• Regressions robust in – Change of weights in average growth rates, – Non linearity in tenure effect– Measurement error in age 65 (year of birth available, not month)

using age 64 and 66. – Differenciating between normal and forced retirement by only

looking at leaders below 65 or sample only before 1983

Decentralization and yardstick competition compared.

• The sole incentive effect of decentralization is that a higher tax base can be in the interest of local government. Implicit argument that local leaders get direct and indirect rents from more tax revenues associated to more economic growth.

• It seems the effect of yardstick competition is very strong as long as a career in the bureaucracy is seen as very attractive for the most brilliant people.

• Decentralization gives local government the policy instruments to respond well to the yardstick competition. So their effects must be seen jointly.

Implications.

• This analysis gives a view of how the specific institutions in China contributed to economic growth.

• It also has implications for further reform.• Picture is one where growth and reform happen not by

simple shrinking of the role of government, leaving room for free markets. Image of a system where the bureaucracy and the organization of government are geared towards growth objectives and market promotion (bird in a very large cage, paraphrasing Chen Yun).

• Meritocracy and decentralization act as substitutes for rule of law and separation of powers.

• The meritocracy that was able to achieve spectacular growth should be able to achieve other objectives such as climate change if a strong political will existed.

Implications• System with mainly accountability from above.

Accountability from below (local elections) only used as instrument of personnel control. Weak accountability at the highest level necessitated mandatory retirement of leaders, good and bad. Substitute for absence of democracy but represents a specific solution to the “succession problem” .

• Breaking the meritocracy and accountability from above (centralized personnel control) are likely to break the engine of growth in the absence of (unlikely) compensating changes.

• The system has however scope for gradual reforms towards separation of party and state, getting gradually rid of the dual power structure. “Parallel” careers possible within the meritocratic system. Also scope for more media freedom and judicial independence.

Dangers in the long run• Strong development of large private firms may reduce

the attraction of a career in the bureaucracy (see however France).

• More leniency towards corruption over time is a nearly inevitable development. The meritocratic system will gradually stop functioning once corruption becomes too strong and the lack of accountability at the highest level cannot over time create enough resistance to counter the expansion of corruption.

• This is not a short term prospect but Chinese history shows that brilliant dynasties could be brought down by corruption.

• A bold “ counterweighing” reform could be election of party chief like “within party primary”.

• Copying Singapore and Hong Kong not so easy. Meritocracy is therefore key.

• External environment will also be a danger (North East Asia, South East Asia, Taiwan, US).