DP1619 Optimal Restructuring Under a Political Constraint: A General Equilibrium Approach

Author(s): Vivek Dehejia
Publication Date: April 1997
Keyword(s): General Equilibrium, Gradualism, Political Economy, Second-best Theory, Shock Therapy, Structural Adjustment, Transition Economies
JEL(s): F11, F13
Programme Areas: Transition Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1619

This paper considers the generalized second-best analytics of optimal restructuring under a political constraint, building on the modelling approach in Dehejia (1997). It is shown that the second-best optimum entails administering the terms-of-trade shock fully at the initiation of the reform, just as in shock therapy, but that this must be supplemented with interventions in domestic factor markets. The effects of these interventions are to speed up the exit of the politically affected factor, labour, and to retard the exit of the other factor, capital, both of which serve to prop-up the wages of workers in the declining sector and hence address the political constraint. The results are in the spirit of the neoclassical theory of distortions and welfare: the optimal intervention targets the affected margin directly, in consonance with the ?targeting? principle of Bhagwati-Ramaswami-Johnson.