Decision rights, residual claim and performance: A theory of how the Chinese state enterprise reform works

Abstract

This paper is intended to model the process of shifting decision rights and residual claim from the central agent (government) to the inside members of the firm in China, and to analyze how the reform has improved performance of the state-owned enterprises. We show that the bargaining solution between the central agent and the firm is preferred to a one-sided solution, and that managerial discretion of state enterprises can greatly improve efficiency through both its direct incentive effect and indirectly hardening budget constraints. Further improvement of efficiency requires that authority of selecting management is transferred from bureaucrats to capitalists, which implies privatization of the state enterprises. China is already well on its way.