Liberalization in the former centrally planned economies has led to reductions in output and the emergence of unemployment, but entrepreneurs exploiting new profit opportunities are now drawing resources into more productive employment; aggregate output should continue to rise until full employment is restored at a higher level of output. In Discussion Paper No. 911, Research Fellow Thorvaldur Gylfason develops a two-sector model in which productive resources are initially employed fully but inefficiently, while the relative price of industrial goods is lower in domestic than in world markets, so correspondingly greater resources are devoted to agricultural production. Trade liberalization and domestic price reform reduce agricultural output and allow the emergence of unemployment, until entrepreneurs come to exploit the opportunities created by the rise in the relative price of industrial goods.

Gylfason shows that the output gain from this liberalization is approximately proportional to the square of the initial distortion, while the size of the resulting gain in output increases with the severity of the initial distortion; and the more ambitious the structural adjustment undertaken, the greater the share of the industrial sector in the long run and hence, again, the greater the gain in output. Numerical simulations for the Baltic countries indicate that the permanent proportional static output gains from structural adjustment range from 7% to 40%, so even the lower bound exceeds the Cecchini Report's estimates of the effects of completing the EC single market. For a variant of his model in which efficiency improvements (which may include price reform and trade liberalization as well as privatization, education and even economic stabilization) raise not only the level but also the rate of growth of output, his numerical simulations show that a 25% increase in efficiency or the saving rate increases the annual growth rate from, say, zero to 2.5%, while simultaneous 25% increases in the saving rate and efficiency raise the annual growth rate to 5.6%; per capita output then doubles in less than thirteen years.

Structural Adjustment, Efficiency, and Economic Growth
Thorvaldur Gylfason

Discussion Paper No. 911, May 1994 (IM)