Institutional Inertia and the Optimal Pace of Market Reforms∗

In this paper, we study the impact of institutional inertia on the implementation of market-oriented reform programs. We examine the problem of a government who can introduce efficiency-enhancing reforms to increase the rate of economic growth by inducing, via monetary compensations, low productivity workers to exit the sector. In our baseline scenario without institutional inertia, efficiency gains are sufficiently large to permit the introduction of a full market reform program that is accepted by all workers and does not raise a budgetary deficit in any period. In the presence of institutional inertia, the government is required to compensate subsequent generations of workers to allow for institutional changes associated with the expansion of markets. We show that, under some circumstances, the government prefers to introduce a transition reform program that, at least during the first periods of the reform, preserves workers with intermediate productivity levels in the old non-market system and shifts only high productivity workers to the market system.