# 1. Introduction

1.1 China, Eastern Europe, and the Soviet Union have all embarked on reform of their industrial systems. For the purpose of evaluating industrial economies during the transition, economists and policy-makers require a set of statistical measures and analytical methods that demonstrate the progress of transition enterprises toward mimicking the behavior and performance of profit-maximizing, market-oriented enterprises. This paper formulates and applies an approach for measuring gains in productive efficiency among socialist enterprises in transition.

1.2 Using established theory and micro-level data, the paper evaluates the progress of China's industrial enterprises toward satisfying one of the principal efficiency conditions of a competitive, market economy, namely, the equalization of marginal revenue factor products across enterprises. The approach and resulting measures are of direct use in evaluating critical issues of reform strategy, including China's strategy of evolutionary reform, which contrasts with the rapid, sweeping reforms proposed for the Soviet Union and implemented in Eastern Europe.

13 In his classic article, Farrell distinguishes between two measures of productive inefficiency -- technical inefficiency and price (allocative) inefficiency (Farrell, _1957)._ In a centrally planned economy in which decisions are made by command in the absence of pni,e signals, we expect less productive efficiency than within an economy in which firms profit maximize and operate within competitive product and factor markets. Due to pressures to eliminate gross disparities in factor returns within a competitive economy, we would not expect large differences in levels of technical or allocative inefficiency, since inefficient enterprises would lose money and eventually disappear. Absent externalities, taxes and other factors that can drive a wedge between private and social returns, the equalization of factor returns implies the equality of marginal revenue products.

1.4 Obviously, Chinese enterprises the canonical neoclassical enterprise is not a useful characterization of China's typical state enterprise.' Yet, after more than a decade of reform, wt, expect these enterprises and the economic environment in which they operate to more closely conform to a competitive market economy than they did in the late 1970s, at the outset of the reform program. If reform has had its intended effect, we would expect gains in productive efficiency and the convergence of factor returns. This paper formulates and tests this convergence hypothesis.

_1.5_ During the early stages of China's economic reforms, striking differences existed in factor returns between sectors and across enterprises. One study by Jefferson, Rawski and Zheng (hereafter referred to as JRZ, forthcoming) finds that in 1980, labor's marginal revenue product within state industry was more than twice that within collective industry. Among individual enterprises within the same sectors, differences in factor returns were even more pronounced. Using a sample of 120 state-owned steel enterprises, another study estimates that in 1985 returns to equipment investment varied from a low of 6 percent to a high of 162 percent (Jefferson, 1990). Technical inefficiency was an important source of these divergent factor returns is revealed Firms in the industrial market economies also deviate from the pure neoclassical model, but for comparative purposes, the profit motive and market influences are sufficiently strong to characterize firms in industrial market economies broadly in term of the neoclassical paradigm.