Russia Growth Diagnostics (7): Market Structure and Competition

< Part 6: Taxation and Laws

Thirty years ago the entire Russian economy was managed by the state. Some estimates of the current state presence reach 50% of GDP, and this makes the current market structure a likely source of inefficiencies. Let’s see if it is.

Industrial Organization

Over the last 15 years, Russia transformed several state-owned industries according to a simple rule: take an industry and separate it into a natural monopoly and firms that will compete with each other. After the separation, the state retains control over the natural monopoly and privatizes the rest. This was done for electricity, railroads, utilities, and oil. Maybe not so competitive in details, newly created firms are separate business entities and have to think about profit.

The state retained control over certain industries. The Russian government is a monopolist in banking and gas production, although this doesn’t imply the textbook behavior with prices above and supply below competitive equilibrium. I already discussed banking in the post on finance and just restate here that the industry is open for new competitors, including foreign banks.

The third interesting part is the industries where the state consolidated assets, instead of privatizing them. The newly created “state corporations” manage state assets in the defense industry, nuclear energy, and hi-tech. They don’t have many competitors in these markets.

Regional economies may lack local competition. This includes company towns with a single major employer, former state enterprises that have been privatized by geographical clusters, and other peculiarities of an economy in transition.

Government procurement is the last suspect for distorted competition. Technically, it should be the most efficient market, where each pen is bought from an auction. In practice, this system involves collusions and incentives to spend more. Still, it’s difficult to separate trivial corruption from attempts to overcome formalism. Though the price isn’t the only criterion in procurement auctions, ex ante requirements to the bidders are incomplete and leave space for price dumping by incompetent firms. Is this procurement system a constraint in general? Yes, in the sense that private firms would be better at picking suppliers.

I haven’t discussed privately owned sectors, like retail and cellular, but they would benefit from the same things the state sector would. Namely, an independent and powerful agency that protects competition on the ongoing basis, not just at the moment when the state privatizes assets. Secondly, government price setting, including price ceilings for natural monopolies, is based on some arbitrary factors, rather than economic principles. Of course, government uses some ad-hoc models, but until these models remain secret, government pricing casts doubts.

Industrial Policy

By “industrial policy” I mean incentives for reallocating resources to productive industries. This smells anti-market sentiments, but it isn’t. Many markets have already been distorted (not just by government), and these distortions are costly. Hsieh and Klenow (2011) estimate a 50% productivity gain for China and India if these countries moved resources into more productive industries.

An overview of Russian productivity growth from Kaitila (2015):

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The total factor productivity (TFP) depends on the economy-wide factors and allocation of inputs across firms. The economy-wide factors are all those things I discussed in the previous posts. Here I take on the distribution of inputs, mostly physical capital and labor.

McKinsey (2009) review productivity in Russia from a business perspective. Academic sources are listed in the table above, and I also recommend Bessonova (2007, in Russian). Most sources reach a similar conclusion: high dispersion of productivity within industries, which means that unproductive firms survive. In a hypothetical market economy, unproductive firms don’t live long before they lose capital and employees. Something keeps them afloat in Russia, and it retards TFP growth.

Variety, Complexity, and Innovations

This section is due to HRV’s discussion of product diversification in economic development. Hausmann and Hidalgo (2011) and Klinger and Lederman (2006) use trade data for tests. Trade data underestimates the diversification of the Russian economy because Russia is a big domestic market and its export mostly consists of commodities. Anyway, here’re the numbers:

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The primary industries dominate export, but implications are unclear. First, there’re currency appreciation and other distortions caused by high commodity prices. Second, productivity of the entire economy may be insufficient to compete under current exchange rates. It means that developing new industries wouldn’t diversify export.

Does the economy need some domestic diversification? If the economy desperately needed some intermediate inputs, it would exhaust the trade surplus. But the trade balance is positive, and import consists mostly of consumer goods, not of important or innovative capital goods.

Overall, creating new productive industries is a good idea, but it’s called venture investing. And few investors are good at this trade.

Summary

Industrial policy and competition restrain growth. But they are the free lunch: an opportunity to get more output using the same inputs. Meanwhile, the inputs, capital and labor, won’t come to Russia in the nearest future. So this lunch is more desirable than policies aimed at investments and labor participation.

Alibaba, The State

Alibaba is sort of doing fine after the IPO. But what does it do? It replaces the state.

Roughly, if a firm picks a supplier, it wants supplies to be fine and to arrive in time. The supplier, in turn, want to make sure that the client pays as agreed.

Now, there are two ways to provide it for sure. Option A is the threat of legal actions if things went terribly wrong. Option B is to avoid bad partners at all. The state offers both options. It has licensing and regulators to prevent very bad companies from operating in the market. And the state also has a more traditional function of bashing bad businesses for violating the law.

Obviously, Alibaba is not the British East India Company—it cannot apply violence freely. But it does offer an alternative to government regulations, especially in countries where governments are not trusted. The website routinely offers inspections and secure payments. It encourages buyers to leave feedbacks. As a matter of punishment, it can ban businesses from the marketplace.

Alibaba reduces the risk, which would otherwise require more resources to meet. Though private inspections, insurance, and feedbacks have been there for centuries, IT technologies made them extremely centralized and embedded in a single company. The state also implies a monopoly—and online marketplaces have it! Amazon, eBay, and Alibaba have no strong competitors in their respective markets.

Does this replacement for weak governance affect economic development? Possibly. Alibaba is an international trade hub. Normally, small and medium enterprises are reluctant to deal with international partners due to uncertainty. For example, the World Bank points at political risks:

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Those investors who actually work in emerging markets estimate the risk as being three times lower than that by investors who don’t consider investing in emerging markets at all. Uninformed investors overstate risks and stay away from what can be a perfectly normal market.

Many of the B2B transactions mediated by Alibaba might not have happened at all without the relevant information. For one reason, the baseline risk is high as governments in emerging markets are reluctant to prosecute local crooks. For another, western mass media cover these markets biasedly. Someone who read the Financial Times throughout 2014 might have an impression that China is nothing more but corruption, political trials, empty infrastructure, ghost cities, and permanently slowing down economic growth. Even if these materials are not necessarily biased against one country (the media look for a drama everywhere, right?), the readers can’t simply go out in the streets and check how things really are, as for domestic coverage. Therefore, businesses need a middleman who is more motivated than the state and more systematic than the media in helping shoppers in emerging markets.