Incremental Reform and Distortions in China’s Product and Factor Markets

The purpose of reform is to reduce distortions in the economic system and enhance efficiency. However, along with incremental partial reforms, local governments or individuals often have the chance to capture the rent inherent in the gradual transition process. Young (2000) warned that this rent-seeking behavior might lead to increasing market fragmentation. Empirical studies have shown the opposite in the product market. In this paper we argue that as the rent from the product market has been squeezed out due to deepening reforms, rent-seeking behavior may have shifted to other sectors, in particular to the capital market. The key is to conduct further reforms in the capital market to squeeze out rent seeking opportunities as those from the product and labor markets have been squeezed out earlier.