In Douglas North, ed. Transforming Post-Communist Political 
Economies. National Resource Council/ National Academy of 
Sciences.1998, 133-156. 
RESTRUCTURING PRODUCTION WITHOUT 
MARKET INFRASTRUCTURE 
Judith Thornton 
Department of Economics 
University of Washington 
The aim of economic reform is to provide a framework of laws and 
institutions that will further freedom and prosperity. In pursuit of this 
aim, the reforming economies have attempted to privatize firms, 
liberalize markets, deregulate access to markets, and redirect the role of 
the government to the provision of economic and social infrastructure 
and the securing of individual rights. Several of the East European and 
Baltic countries are succeeding in building a healthy private sector and 
reorienting economic activity to the world market. However, although 
Russia and many of the republics of the former Soviet Union have 
pursued privatization with no less vigor, still a successful restructuring 
of production continues to elude them. In 1996, the level of real gross 
domestic product in the Commonwealth of Independent States was only 
52 percent of 1989, according to official data.1 
Creation of Markets 
What does economic reform mean? There are many difficult steps 
in this process. Creation of markets is a crucial first step. Central 
planning implied not only reliance on administrative mechanisms to 
direct resources to centrally-determined tasks but also use of sanctions 
to restrict diversion of resources to unplanned ends, however valuable in 
the informal economy these uses appeared to be. The widespread 
emergence of black or gray markets for goods and the importance of 
1 European Bank for Reconstruction and Development. Transition Report 1996, 112. 
1
barter both signaled the costs these systems faced from the absence of 
legal alternatives to planned allocations and assignments. After 
economic reform, as the structure of domestic production adjusts to 
consumer preferences and world market opportunities, labor and capital 
markets must play an essential role in directing resources to higher value 
activities. 
Emergence of Private Producers 
Reform implies the emergence of non-state producers which face 
hard budget constraints and competition. Private producers will bear 
risks, reap the benefits and costs of their activities, and, thus, have 
incentives to move resources from lower-value to higher-value uses. In 
the reform economies, a population of competitive producers can emerge 
from the privatization and restructuring of existing state producers, from 
new domestic entrants to the market, and from an inflow of foreign 
capital and management. An opening of domestic markets to 
international trade will bring the discipline of market competition as 
well. 
Creation of a non-state sector implies a termination of the state's 
monopoly on ownership of productive resources and the emergence of 
private owners. Private ownership can bring together the control and 
cash flow rights to resources, improving incentives, while creation of 
capital markets can lower the costs of seeking investment finance. But 
establishment of property rights requires legal, financial, and 
administrative infrastructure to define and enforce ownership rights. It 
implies a significant redefinition of the role of the state, which is no 
longer the owner and allocator of resources and capital, but is rather the 
means for providing social infrastructure and public goods. 
Redefining the Role of the State 
Thus, most importantly, reform implies the creation of a separate 
tax-based state with the capacity to supply social infrastructure and 
public goods. A separation of government revenue from ownership of 
capital provides greater transparency in both the capital market and in 
the public sector. Government taxes and subsidies become explicit in 
the government budget rather than implicit in government prices and 
2
allocations. If the central function of the administrative state was 
ownership and control, then the central functions of the market-oriented 
state are provision of a) institutional infrastructure, b) social insurance, 
and c) public goods. 
So the role of the state is very different in the planned and market 
economies. In the pre-reform era, state controls supplanted much of the 
institutional infrastructure of a market economy, overriding contract law 
with administrative practice. Thus, elimination of state control involves 
rebuilding rule of law and the capacity to enforce a framework of rules of 
the game. It involves rebuilding a capacity to manage the macroeconomy 
by means of monetary and financial policies, to establish independent 
financial institutions, and to provide public goods and a social safety 
net. Restructuring of government may involve building local 
governments with the capacity to provide local public goods and agencies 
at all levels that provide more public services and less regulation. 
Changing the Structure of Production and Attracting Investment 
Initial reform policies--liberalization, stabilization, and 
privatization--have set the East European transition economies well on 
the road to integration with Europe. But successful implementation of 
each of these policies assumes the existence of supporting institutions 
and minimum levels of governmental administrative capacity. Where 
such infrastructure is lacking--notably in the republics of the former 
Soviet Union--the desired policy results have been harder to achieve. 
The second stage of economic reform involves a still more difficult 
process, the reallocation of labor and capital from subsidized state 
sectors to expanding export and consumer-oriented sectors. Eastern 
Europe has had considerable success in mobilizing domestic saving and 
in attracting foreign investment, while Russia and the CIS continue to 
suffer capital flight. The collapse of the former Soviet Union left these 
countries with a highly uneconomic dispersion of production facilities. 
Everybody was in the wrong place and doing the wrong thing. In 
consequence, the social dislocation resulting from redirection of 
production adds to already-high levels of economic risk and inhibits 
further the modest inflow of investment. Given the failure of these 
economies to attract domestic and foreign investment, a top priority of 
3
future policy must be the creation of a more attractive environment for 
private investment. 
Initial Conditions and State Dependence 
The task of restructuring production is hampered by initial 
conditions. The Soviet Union shared with Eastern Europe a 
bureaucratic power structure controlled by a Communist party and 
oriented toward the maintenance of political power. Why then, have 
Soviet political institutions served as a more serious impediment to 
restructuring than similar institutions in Eastern Europe? 
One difference between the Soviet Union and Eastern Europe is 
the immense size of the Soviet economy and high degree of centralization 
of its government system. The sheer size of the Soviet government meant 
that the resources at stake in government decisions were enormous, 
creating significant incentives for individuals in the decision-making 
hierarchy to attempt to influence decisions by lobbying and by distorting 
the information on which decisions would be based. Local interests took 
advantage of long bureaucratic channels between local and central levels 
and their control of information to supply biased reports. 
Good decision-making requires accurate information about the 
options available and about the likely consequences of each choice-- 
information that is best obtained directly from people on the spot who 
can seek out alternatives, gather evidence, and forecast consequences. 
But opening a decision process to participation by individuals with a 
stake in it increases the resources devoted to lobbying, and these 
lobbying costs are greatest when a decision redistributes a large amount 
of wealth. So lobbying costs must be balanced against the increased 
information that lobbying provides.2 
One way to reduce rent-seeking is to limit the distributional 
implications of decisions, a step which may also sharply reduce the 
bureaucracy's capacity to adjust to changed circumstances. Another is 
to limit communication by denying individuals in the hierarchy access to 
2 On these points, see Paul Milgrom, "Employment Contracts, Influence Activities and 
Efficient Organization Design," Journal of Political Economy, Vo. 96 (1988), 42-60 and 
Paul Milgrom and John Roberts, "Bargaining and Influence Costs and the Organization 
of Economic Activity," Perspectives on Positive Political Economy, J. Alt and K. Shepsle, 
eds. (Cambridge, Ma: Cambridge University Press, 1990), 57-89. 
4
the information they would need to politic effectively, a step which 
reduces the accountability of top level decision makers and may reduce 
the information on which central decision makers base their own 
judgments. 
Decentralization limits influence activities by eliminating the 
central authority altogether, but decentralization when there are no 
markets leaves decentralized actors without effective means of 
coordination. The informal economy is a product of this need for 
horizontal links. Consider, then, the structure of inherited government 
institutions described by Richard Ericson in the Journal of Economic 
Perspectives:3
1) A hierarchical structure of authority in which all 
choices must be made, and all conflicts resolved, in 
principle, at a level superior to all sides of the issue, with 
sole vertical accountability for actions and outcomes; 
2) Rigid, highly centralized planning of production 
and distribution; 
3) A commitment to maximal resource utilization, 
implying tautness and pressure in planning; 
4) Formal rationing--that is, administrative allocation 
in physical or quasi-physical terms of producers' goods and 
services; 
5) Exhaustive price control, yielding multiple and 
contradictory systems of centrally fixed, inflexible prices; 
capability (either financial or physical) in the system, and in 
particular the lack of a true money; 
relationships and the inability of any subordinate to alter 
any of these relationships legally; 
norms, indices, and parameters of plan assignments, 
6) The lack of any liquidity or flexible response 
7) The lack of legal alternatives to assigned economic 
8) Absolute and arbitrary control by superiors of the 
performance evaluation, and rewards; 
9) Incentives that are geared to meeting the plans and 
desires of evaluating superiors, and not to the economic 
consequences of decisions taken at levels below the very top. 
From features 7) and 8) comes the perception, described in James 
Leitzel, "Evasion in Transitional Russia; An Extended Outline" (this 
volume), that it was impossible to operate legally in the Soviet economy. 
3 Richard Ericson, "The Classical Soviet-Type Economy: Nature of the System and 
Implications for Reform," Journal of Economic Perspectives, Vol. 5, No. 4 (Fall 1991) 11-27. 
5
The truth of this view, even today, tells us that CIS governments have 
transformed themselves far less and in less desirable directions than 
have their privatized firms. In Central Asia, much of the familiar 
governmental authority over production remains, the elaborate patronage 
systems transmuted into their monetary equivalents. In Russia, where 
republican agencies held almost no authority in the Soviet era (since 
producers dealt directly with their Soviet-level ministries,) the Russian 
government is simultaneously bloated and disintegrating. Many 
Federation agencies are effectively privatized by corruption resulting from 
the fierce competition for ownership and control of Russia's vast 
resource wealth. 
Restructuring the Socialist Firm 
If the centralized Soviet Ministry was a feudal barony, then the 
enterprise subordinate to it was a principality. Stephen Kotkin's 
depiction of the Magnitogorsk Works in Steeltown, USSR is instructive:4 
Forty-three kilometers around, the Magnitogorsk 
Works, a dense mass of smokestacks, pipes, cranes, and 
railroad track, consists of 130 shops, many of which are as 
large as whole factories. "Steel plant" would be an 
inadequate description of the complex formed by an orecrushing 
and ore-enriching plant, a coke and chemical byproducts 
plant, 10 gigantic blast furnaces, 34 open-hearth 
ovens, and dozens of rolling and finishing mills. The 
Magnitogorsk Works produces more steel each year than 
Canada or Czechoslovakia and almost as much as Great 
Britain. 
The metallurgical complex dominates city life in every 
way. The works owns apartment buildings in the city 
housing two hundred thousand people, eighty-five children's 
institutions, several hospitals, a number of nearby resort 
complexes, and an entire agricultural system of state farms 
and greenhouses in the surrounding countryside. It 
manages its own food service, which serves hundreds of 
thousands of meals a day. It owns and operates the city's 
mass transit system, ferrying its employees and those of 
every other enterprise to and from work. 
4 Stephen Kotkin. Steeltown, USSR; Soviet Society in the Gorbachev Era. Berkeley: 
University of California Press, 1991, 1. 
6
Ivan Romazan, the director of the Magnitogorsk Works, oversaw 
not only production but also the political administration of almost all 
social life in the city. Through his influence in the Moscow Ministry, he 
was responsible for assuring delivery of the centrally-allocated resources 
to everyone from the mayor to the plant managers. Through his role in 
the Communist Party nomenklatura, he selected these managers in a 
system where one's position in the bureaucracy constituted one's primary 
wealth. 
A restructuring of the Magnitogorsk Works involves more than 
privatizing a firm that employs 60,000 workers. It means creating an 
institutional framework for civil society in a city of 440,000 people. 
Worse still, it may mean creating the labor and housing markets to allow 
a considerable part of that population to leave "the largest assemblage of 
obsolete equipment in the country" for a city with better prospects. 
The Role of Institutions 
What are the institutions whose absence impedes adjustment? 
First and foremost, they are property rights and markets. But what 
impedes the exercise of property rights and contracting in markets? The 
hurdles are lack of legal institutions, financial institutions, public goods 
such as law and order and physical infrastructure, and government 
administrative capacity. 
Institutions are sets of formal and informal rules that constrain 
behavior in society. According to Douglass C. North, writing in 
Institutions, Institutional Change and Economic Performance, "Institutions 
reduce uncertainty by providing a structure to everyday life."5 
Institutions provide a framework within which individuals seek to 
coordinate their separate activities. They provide information and 
incentives and define terms of access to membership. 
The institutional framework of society includes both the formal 
and informal "rules of the game" as well as the resulting organizations 
that people create and within which they interact to reach their 
individual and collective goals. Formal rules, such as laws and 
contracts, define the rules of the game and give people the rights and 
5 
Douglass C. North. Institutions, Institutional Change and Economic Performance. 
Cambridge University Press, 1991, p. 3. 
7
mechanisms to enforce the rules. Informal rules of the game depict the 
expectations that individuals hold as to the uncertain consequences of 
actions and events. Informal rules take into account the real-world 
costs of negotiating agreements, monitoring compliance, and enforcing 
sanctions. 
The bureaucratic Soviet system eliminated markets and created 
poorly defined property rights. In contemporary Russia, the property 
rights individuals enjoy still are poorly defined (in the case of land) or 
costly to enforce. If, as Maxim Boycko, Andrei Shleifer, and Robert 
Vishny argue in Privatizing Russia, political control of economic activity 
in the Soviet era created an inefficient division of control rights and cash 
flow rights to property, then weak legal and administrative infrastructure 
in contemporary Russia still leaves citizens with scant means to resolve 
agency problems in governance of firms and facing expropriation of 
income by the competing authorities of the tax inspectorate and (for 
small business) the mafiya.6 
Businesses in Russia do seek strategies to operate in the absence 
of institutional infrastructure. They build "reputation capital" to operate 
in a system founded on relationships. They use the relationship system 
to gain access to resources and wealth that remain under political 
control and keep out potential competitors by political regulation. They 
attempt to design self-enforcing arrangements to support agreements and 
investment in the absence of third-party enforcement. They attempt to 
create long-run incentives to forego short-run opportunism. Where 
appropriate, they use reliable third parties to vouch for the quality of 
their prospective performance. They create private enforcement 
institutions.7 
The economic development of Asia shows that some countries, 
such as China, have achieved rising standards of living in the absence of 
formal legal infrastructure by relying on relationship systems. But 
Russia does not appear have this option. Russia is unlikely to attract 
the levels of domestic and foreign investment it needs for structural 
6 
Maxim Boycko, Andrei Shleifer, and Robert Vishny. Privatizing Russia, Cambridge, Ma.: 
MIT Press, 1995, 19-46. 
7 Judith Thornton and Nadezhda Mikheeva, " The Strategies of Foreign and Foreign- 
Assisted Firms in the Russian Far East; Alternatives to Missing Infrastructure," 
Comparative Economic Studies (forthcoming). 
8
change unless it does considerably more to build the institutional 
infrastructure of a market system. 
The Role of Property Rights 
Property rights are a key institution. As is true of all institutions, 
it is de facto and not de jure property rights that will determine people's 
incentives to act and will shape the organizations that they establish. 
Property rights are rules of the game that may be defined by formal laws 
or administrative practices or may be codified in informal custom. These 
rules of the game define the forms that competition for resources may 
take in society. 
Consider two individuals, A (with an endowment of wine) and B 
(with an endowment of cheese). What institutional arrangements would 
allow both individuals to consume both commodities? Clearly, voluntary 
exchange would facilitate transactions theat are both mutual and 
voluntary, but the form that transfers from one party to another will 
take depends, in part, on whether each individual respects the other's 
property rights. If property rights were not protected, A could steal B's 
cheese, transferring ownership from one to the other without 
compensation. In a world where B had to incur high costs to protect 
herself from theft, the value of her property would be much reduced. 
Alternatively, A could threaten B with violence. In this case, A has 
transferred property rights to B's person from B to himself, but he allows 
B to purchase back the rights to her person with an appropriate amount 
of cheese. 
If the private protection of property is costly, then individual 
incentives to produce and maintain resources will be reduced. Further, 
the resources available for productive use will be reduced by the diversion 
of resouces to attempts to capture wealth or to prevent such capture. 
When property rights to valuable income streams are not defined and 
enforced, then individuals have an incentive to spend real resources to 
9
capture such rights. Such a competition will tend to dissipate (or, with 
uncertainty, more than dissipate) the value of ownership after the fact.8 
Private ownership means that an owner can control the use of an 
asset and exclude others from using it, that one has the right to enjoy 
benefit or income and the right to transfer. Ownership also implies the 
responsibility to bear the costs of one's actions. Gaining these rights of 
ownership, individuals have incentives to create and maintain productive 
assets.
Private ownership concentrates the benefits and costs of actions 
more directly on the person responsible for them and it allows 
individuals to specialize in management of assets and in bearing the 
risks associated with uncertain outcomes. A decision-maker who 
receives the benefits and bears the cost of decisions will face incentives 
to increase the value of endowment or will bear the costs of failure to do 
so. Private owners who receive the gains from moving resources to higher 
value uses will have incentives to create institutional arrangements 
supporting such transactions. Thus, resource owners have incentives to 
create market institutions. 
Moreover, differences in initial endowments and tastes for risk and 
incentives to enjoy specialization and economies of scale will lead 
individuals to establish institutional arrangements that allow them to 
partition property rights in a variety of different ways. If the 
institutional framework allows, an owner may choose to farm her land 
herself or to hire a tenant to till the fields under her direction in 
exchange for a fixed wage. She may lease her fields to the tenant in 
exchange for a fixed payment, leaving him free to select crops and choose 
his own level of effort or she may share the control rights and the 
returns in a multiplicity of different contractual arrangements. Just as 
competitive markets force out inefficient producers, similarly, 
institutions that allow groups of individuals to enter into a wide variety 
of contractual arrangements will allow them to select among 
contractual forms, resulting in the selection of forms that prove to 
8 For systems with private protection and private capture, see Hirshleifer, Jack, 
"Anarchy and its Breakdown," Journal of Political Economy, Vol 103, No. 1 (February 
1995), 26-52; Grossman, Herschel and Minseong Kim, "Swords or Plowshares? A Theory 
of the Security of Claims to Property," Journal of Political Economy, Vol. 103, No. 6 
(December 1995), 1275-1288. 
10
reduce the sum of production and transactions costs within the existing 
institutional framework. 
Property rights not only determine the individual's rights to control 
and benefit from use of physical assets, they also define the individual's 
ability to exercise ownership right's in one's own skills and abilities. 
That is, liberty implies the right to own and direct oneself and the fruits 
of one's effort. 
The importance of property rights to our exercise of freedom is 
demonstrated in the case of China. In pre-reform China, political 
authorities held the right to direct individuals to a place of work and to 
define the conditions of their employment. These control rights over 
labor were enforced by a rationing system that gave individuals access to 
rations of basic commodities at their place of employment. But, as soon 
as agricultural reforms created a free market in food, it became much 
easier for workers to move from place to place in search of bertter work 
opportunities, giving them greater de facto property rights over their own 
human capital. 
Moreover, even with little formal change in legal rules of the game, 
the responsibility system gave Chinese households significantly greater 
property rights in agriculture, reflected in increased household control 
over uses of land and income from crops. Similarly, changed contractual 
rights in industry, which gave managers and workers in Chinese town 
and village enterprises increased control over production and rights of 
residual claimancy, improved incentives within town and village 
enterprises and increased competition between them. Thus, the 
economist's understanding of property rights differs from the legal 
definition in that it focuses not on legal ownership but on the de facto 
partitioning of rights, which reflects costs of information and 
enforcement as well as legal rules. 
The Exercise of Ownership to State-Owned Property 
In Privatizing Russia, Maxim Boycko, Andrei Shleifer, and Robert 
Visny attribute the failings of the socialist production system to poorly 
defined property rights inherent in state ownership of wealth. Control 
rights to assets were vested in a political elite that exercised control 
through an administrative bureaucracy. Cash flow rights were assigned 
11
to the citizens, since they would bear the benefits and costs of decisions 
in the level of their standard of living. Officially, returns to capital and 
resources were supposed to be centralized in the Treasury in the form of 
profits, taxes, and charges for resources, but, in practice, administrators 
who enjoyed control rights could assign subsidies and impose costs 
throughout the system in the policies that they pursued. 
Although the institutions of the command system denied 
individuals legal ownership rights to most physical assets (tenancy rights 
to housing were allowed,) they afforded the elite control rights over the 
vast rents generated by administrative allocation. Thus, corruption is a 
commonplace feature of all these systems. In some respects, corruption 
can function like a contract that rewards a decision maker for making an 
efficient decision. However, while corruption allows an allocator to "sell" 
market access at a shadow price reflected in the market for bribes, there 
is no legal way to enforce a bribe contract, so property rights remain 
insecure. Moreover, the recognition by bureaucrats that control of 
access rights is a potential source of rents and of political power creates 
additioinal incentives to impose further regulations and increase the 
sphere of administrative allocation, resulting in a proliferation of 
regulators, each attempting to hold the producer hostage on a different 
margin.9 
Inefficient property rights do much to explain the perverse 
information and incentive features of the command system described by 
Ericson. Ambiguities in the measurement of performance and 
information asymmetries resulting from long hierarchical chains of 
authority intensify enforcement costs.10 The Soviet administrative 
hierarchy presents us with agency relationships writ large. The central 
authorities were linked in a complex hierarchy with managers 
throughout the country. A comparison of enterprise performace across 
regions provided them with one source of information about the level of 
effort in individual firms. 
9 Shleifer, Andrei and Robert Vishny, "Corruption," Quarterly Journal of Economics 
10 
(November,1994), p. 599-618. 
For a model of a single principal with authority over multiple agents, see Steven 
Solnick, "The Brerakdown of Hierarchies in the Soviet Union and China, A 
Neoinstitutional Perspective," World Politics 48 (January 1996) p. 209-238. 
12
In turn, the enterprise manager, an agent, faced multiple 
principals (such as the Party, the Ministerial authorities, the Treasury, 
and the local authorities) whose incentives were likely negate each other. 
These principals were the primary claimants to surpluses generated by 
the enterprise, and they also were likely to bail out losses, taking on 
much of the risk the enterprise faced. While, in theory, the enterprise 
manager had few control rights over resources, in practice, his control 
over information and his ability to trade off unmeasured dimensions of 
performance against measured performance indicators could give him 
substantial benefits of ownership. On the other hand, as central 
authority deteriorated in the 80s and as nominal price controls created 
increasing excess demand, Boycko, Shleifer, and Visny report that 
managers more and more frequently had to bribe allocators to gain 
access to supplies.11 
How does an economy's institutional framework influence the 
forms of governance of organizations? In a market system, there are few 
legal constraints on the form that organizations adopt (with the 
exception of slavery.) Individuals will attempt to choose arrangements 
that reduce the costs of governance in order to minimize the sum of 
production and transaction costs. They will trade off agency costs 
against the resource costs of preventing agency problems. 
In an administrative bureaucracy, in which bureaucrats have 
control, but not cash flow rights, to assets, the state is likely to impose 
many regulatory constraints on the activities of mid-level bureaucrats 
and agents and to undertake considerable monitoring in order to prevent 
diversion of resources from centrally-set goals. Since control of 
information is a valuable asset, which determines the distribution of 
rents, both bureaucrats and managers may have incentives to choose 
institutional forms that conceal information about rents--that increase, 
rather than reduce, information costs. Moreover, if the political elite, as 
principals, gain security by their ability to monitor decision makers at 
lower levels in the hierarchy to prevent challenges to their authority, 
then the state system will not necessarily have incentives to reduce 
11 Maxim Boycko, Andrei Shleifer, and Robert Vishny. Privatizing Russia, p 43. 
13
monitoring costs either. With collusion, there will also be costs of 
monitoring the monitors. 
In the state bureaucracy, both principals and agents have 
incentives to seek arrangements that give them control of information 
influencing the division of income. For example, low-cost producers will 
seek to conceal their true profits in order to retain a larger share, while 
government principals may seek to hide the true value of centralized 
resource rents from both enterprises and regional authorities who enjoy 
some de facto control rights to local resources. Since agents have 
incentives to divert resources from joint activities to their separate 
benefit, the authorities will attempt to create strong restrictions to local 
initiative. So, in sum, state-owned institutions burden citizens with an 
inefficient partitioning of property rights and deny them governance 
mechanisms that would allow them to contract around inefficiencies. 
Creeping Capitalism 
What are the possible paths to efficient ownership? Attempts to 
improve performance by establishing an efficient bureaucracy, by 
corporatizing public enterprises, or by institutionalizing corruption all 
fail to bring control rights and cash flow rights to property together. 
Attempts to decentralize control over state production without 
establishing horizontal market links will disorganize existing 
administrative means of coordination. Allowing decentralization without 
establishing a legal framework for private ownership is likely to create de 
facto opportunities to gain access to rents leading to a drain of resources 
from the state-controlled sector of the economy to the informal or illegal 
sector. In Poland's Protracted Transition, Kazimierz Poznanski refers to 
this process as "creeping capitalism."12 
From the very beginning, a total shift of control to the 
centre proved to be impractical, this because of lack of 
information...Control over vital information has allowed 
lower level actors to carve niches of private-choice for 
themselves. These could be used to make adjustments that 
actually helped to meet directives set by the centre but also 
hurt them. In both cases, such independent adjustments 
12 Kazimierz Poznanski. Poland's Protracted Transition. Cambridge: Cambridge 
University Press, 1997, p. 276-277. 
14
provided lower-level agents with the opportunity for making 
private gains. 
With time these informal spheres of free action have 
gained ground, this process, to a degree, being helped by 
official reforms. Those communist-era systemic reforms that 
delegated authority down the decision-pyramid, even if 
short-lived, were conducive to such expansion. Any reversals 
in the reform course were helpful because they brought in an 
element of confusion that served lower-level agents to hide 
their activities. Personal incentives to work outside of 
official directives--the central plan--increased further with a 
decline in the level of coercion. With the practice of 
subverting the system for personal gain reaching all layers of 
the system, including the centre, interest in applying 
coercion has subsided. And when in use, coercion was 
increasingly applied for extracting personal gains as well. 
As the government began issuing trading concessions and production 
permits to members of the political elite, says Poznanski, a system of socalled 
political capitalism emerged in Poland where political power was 
used to acquire private wealth and where the political system provided 
party bosses, state officials, and the police force with protection. The 
alternative to political capitalism is legal private property. 
Privatization of State Owned Enterprises 
Official privatization of state-owned enterprises proceeded nowhere 
more rapidly than in Russia. The pace of privatization was forced by the 
rapid unofficial privatization of assets that emerged after the 1990 
Russian Law on Enterprises and Entrepreneurial Activity. 
Small-scale privatization began in 1992, as municipal authorities sold 
retail shops, cafes, and service facilities in cash auctions and in 
commercial tenders. 
Then, mass privatization, extending from December 1992 through 
July, 1994, saw 15,000 medium and large-scale enterprises privatized 
through distribution of shares to enterprise employees and through 
voucher auctions. In the process, firms accounting for two-thirds of the 
Russian industrial labor force were privatized and over 50 million 
Russians became shareholders in either privatized enterprises or in the 
investment funds that held equities. 
15
The privatization legislation was a vital first step in codifying 
property rights in productive assets. State enterprises were classified as 
federal, territorial, and municipal. Firms first incorporated, submitting a 
privatization plan, a valuation of assets, and a joint stock charter to the 
regional office of the property committee. 
Simultaneously, vouchers were put on sale from October 1, 1992, 
before privatization auctions began. For a fee of 25 rubles, each Russian 
received one voucher with a denomination of 10,000 rubles. Vouchers 
were bearer documents and could be used to buy shares of the enterprise 
in which the voucher holder worked or to purchase shares at the auction 
of any other enterprise. They could be exchanged for shares of a voucher 
investment fund, sold for cash, or used to pay for housing and small 
scale property. 
Privatization of a firm began with a closed subscription for 
employees and managers of the firm.13 In most firms, employees had the 
right two choose between two options: 
-Option 1. Workers and managers received 25 percent of the firm's 
equity in preferred, nonvoting shares. They also had the option to 
subscribe for another 10 percent of voting equity on favorable terms. In 
addition, enterprise managers had the option of acquiring up to 5 
percent of voting equity at book value, paying with vouchers and cash. 
Managers and workers could sell their stock without constraint. 
-Option 2. Workers and managers could buy 51 percent of the 
voting shares of the enterprise for 1.7 times the book value as of July, 
1992, paying with vouchers (for at least 50 percent) and cash. 
A vote on which option to choose was made at a general meeting, 
with most enterprises opting for option 2. Workers were allowed to use 
enterprise balances in social funds to subscribe to an additional 5 
percent of the firm's stock. 
A portion of the equity remaining after closed subscription was 
then sold by the property committee. The property committee could 
13 Ira Lieberman and Suhail Rahuja, "An Overview of Privatization in Russia," in Ira 
Lieberman, et. al. Russia: Creating Private Enterprises and Efficient Markets. 
Washington: World Bank, 1995, p. 7-33. 
16
choose to sell equity at a voucher auction , at a voucher auction 
combined with a commercial tender, or a voucher auction combined with 
an investment tender. Commercial and investment tenders imposed 
additional investment requirements on prospective purchasers. 
By July, 1994, mass privatization was complete and many 
privatized enterprises had begun to restructure, reducing employment, 
changing their product lines, and divesting enterprise housing and social 
services. However, privatization alone could not render sprawling former 
state-owned giants efficient. 
The division of individual ministries into firms and the boundaries 
of individual firms were determined by political negotiations between 
Moscow and the regions rather than by considerations of economic 
efficiency. All large facilities of the electric power network were 
incorporated in a single monopoly as were the production and 
distribution assets of Gasprom. The oil industry was reconstituted into 
eleven vertically integrated holding companies. On the other hand, 
municipal telephone companies and local railroad warehouses were 
privatized separately although the links connecting them remained state 
owned.
Large enterprises and production units were privatized directly 
from Moscow, while enterprise managers and regional authorities 
bargained for the right to separate local plants from national 
conglomerates by setting up holding companies and offering ministry 
elites blocks of shares in them. 
To minimize outside control, regional elites used regional banks to 
purchase and hold regional assets and acquired shares in other regional 
firms. The resulting pattern of ownership was hybrid with equity divided 
between enterprises workers and management, regional elites, 
institutional investors--usually banks and investment companies--other 
enterprises and holding companies, foreign investors, and state agencies. 
At the end of the first stage of mass privatization, Joseph Blasi 
and his co-authors report in Kremlin Capitalism that insiders--managers 
and workers--owned 65 percent of privatized firms. Management, 
separately, accounted for 25 percent of ownership share; outsiders-- 
17
citizens, firms, investment funds, holding companies, and banks-- 
accounted for 21 percent and the state held 13 percent.14 
In the two years following mass privatization, further shifts in 
ownership occurred. Top managers together retained about 18 percent of 
their firms. Workers retained about 40 percent. The share of outsiders-- 
commercial firms, investment funds, and citizens--rose to 32 percent, on 
average, but majority outsider ownership was concentrated in a small 
number of large firms, many of these export-oriented. The numbers are 
somewhat different if we count ownership structure by number of firms. 
In this case, 65 percent reported majority ownership by all employees, (of 
these, workers had majority ownership in 30.5 percent, managers in 5.4 
percent.) Outsiders had majority ownership of about 20 percent, the 
state had majority ownership in 3 percent, and there was no majority 
owner in 12.8 percent.15 Based on in depth interviews with firms 
employing 2000 or more workers in most regions of Russia, Blasi, 
Kroumova, and Kruse argue that de facto control by top managers is 
considerably larger than these statistics indicate. 
During 1995, the Russian government attempted to sell 136 large 
companies in a round of cash sales, but desire to retain domestic control 
of the shares eventually led to a loans-for-shares agreement between the 
government and several Russian banks. Banks were allowed to organize 
auctions themselves and participate in them as both bidders and 
depostors for bids. In the end, stocks in 12 firms were sold, including 
LUKoil, Surgutneftegas, and Norilsk Nickel. 
At the end of the loans-for-shares "auctions," in which 
only a handful of bidders participated, Russia's banks were 
openly feuding. The banks that organized the auctions 
repeatedly disqualified their competitors and won the bidgs; 
most bids were fairly low; foreigners were completely 
excluded; some banks and companies used front companies 
to bid; and banks that were bidders, auction organizers, and 
bidding competitors helped each other with loan 
guarantees.16 
14 
15 
16 
Joseph Blasi, Maya Kroumova, Douglas Kruse. Kremlin Capitalism; Privatizing the 
Russian Economy. Ithica, N.Y: Cornell University Press, 1997, p. 193. 
Ibid., p 56. 
Ibid., p. 75. 
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In 1996, then, employees of privatized state-owned firms, about 10-15 
percent of the population, owned some 58 percent of their firms. Soveral 
million additional Russians had acquired property in small-scale 
privatization, and about 12 million Russians had acquired ownership of 
their housing. 
Restructuring Existing Firms 
How will privatization lead existing Russian firms to restructure 
themselves? The state-owned Russian firm produced in response to 
government demands, serving a multiplicity of goals other than profits. 
The manager enjoyed considerable leverage from his superior knowledge 
of the firm's true capability and he exercised that leverage by diverting 
resources in directions that served his separate interest. 
The main skill of a successful General Director was his ability to pry 
scarce supplies out of the center, not his knowledge of production, 
marketing, or finance. 
Successful restructuring of the firm, then, means bringing control 
and cash flow rights together by privatization of ownership together with 
the elimination of political capitalism as the primary determinant of 
enterprise success. In the case of large firms, the goal of bringing control 
and cash flow rights together implies the creation of institutions for 
corporate governance. In the absence of institutions supporting 
corporate governance, effective enterprise ownership would have to be 
very concentrated. 
Restructuring implies an end to the social welfare role of the firm 
with a transfer of social overhead capital to households and to the 
municipal government. It requires a firm that produces in response to 
private, rather than government, demand, producing new products that 
can be competitive in an economy that is open to the world market. 
These goods will be produced by a substantially smaller labor force, 
working in a unit that has separated off from a giant Soviet-era 
production complex like Magnitogorsk. Such restructuring is likely to 
require the replacement of most Soviet-era General Directors with new 
managers who have a different mix of skills and face differing incentives, 
including the long-run incentives of ownership. Only when such 
19
substantial restructuring is probable will outside investors be willing to 
risk capital in the privatized firm. 
The restructured firm is operating in a changed environment as 
well. 
Transitional economies are characterized by rapid change in institutional 
rules of the game and in the constraints and opportunities that 
individuals face. The new institutions are intended to reduce 
uncertainty, to improve information about available resources and their 
potential uses, to increase incentives to direct resources productively, 
and, thereby, to give individuals greater control over outcomes that 
influence their well being. However, goals and outcomes often diverge in 
the real world. 
In a transitional economy, members of the society face rapid 
change in relative prices, in the structure of production, consumption, 
and investment and changing expectations about the profitability of 
assets and alternative economic activities. The process of rapid 
institutional change brings with it high levels of economic uncertainty 
together with incentives to use resources to acquire ownership rights 
over valuable assets and to influence the directions of institutional 
change. 
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