Much recent debate on Eastern Europe has focused on the distinction between firms that are loss-makers at world market prices, but which in principle could become profitable by setting their workers' real wages sufficiently low, and `value subtractors', which can never be profitable even if wages (and returns to capital) are zero. Policy prescriptions for Eastern Europe based on the experiences of Third World and particularly Latin American trade liberalizations tend to assume that the firms concerned are all `loss makers'. In Discussion Paper No. 543, Paul Hare and Research Fellow Gordon Hughes argue that the massive scale of privatization and the history of enormous subsidies to a few key items, which are quite specific to Eastern Europe, increase the likelihood that East European firms are in fact `value subtractors'. Deep distortions due to monopoly, continued subsidies to production and trade- related taxes may result in the closure of the `wrong' firms or the expansion of firms that are really less profitable with their inputs and outputs assessed at world prices. Short-term financial pressures may lead to the closure of firms whose long-term potential is very promising, so banks and industrial ministries need indicators of profitability that reflect firms' longer-term potential in the absence of current distortions.

Hare and Hughes calculate the value added of each industrial branch (at least 89 in each country) at world market prices for Czechoslovakia, Hungary and Poland. They value traded goods directly at world prices and non-traded goods in terms of their primary factor inputs and traded goods i.e. indirectly at world prices. They also calculate domestic resource costs in order to rank branches in order of profitability. They find a very poor correlation between value added at domestic and world prices, with between a fifth and a quarter of manufacturing production exhibiting negative value added at world prices (using 1988-9 data on inputs, outputs and exchange rates), and only small proportions of production with domestic resource costs low enough to be competitive in world markets. The entire food industry `subtracts value' in all three countries, as do the tobacco and leather products industries in Czechoslovakia; iron and steel in Hungary; and basic chemicals, cement and non-ferrous metallurgy in Poland.

Hare and Hughes find clear evidence of significant productivity differences among the three countries, with Polish unit labour costs appearing especially high. Despite recent progress towards the market, distortions remain widespread. They maintain that the region's emerging financial institutions, which have little experience of assessing project profitability systematically, governments concerned to bring their best enterprises and sectors through the difficulties of the transition, and foreign investors including the international financial institutions may all find this methodology useful for assessing East European firms' long-term potential.

Competitiveness and Industrial Restructuring in Czechoslovakia, Hungary and Poland
Paul Hare and Gordon Hughes

Discussion Paper No. 543, April 1991 (IT)