Market Transition and the Firm: Institutional Change and Income Inequality in Urban China

This paper examines how the rise of a market economy in urban China redefines the rules governing economic activities and affects on earnings inequality. We identify three causal mechanisms linked to institutional change that are transforming the firm's employment practices: the higher marginal productivity of a private enterprise economy relative to state-owned enterprises, competition by firms for skilled and semi-skilled labor following emergence of labor markets and the end of state monopoly on labor allocation, and increased emphasis on merit-based reward systems in firms. Analyses of survey data from urban China show how these three causal mechanisms stemming from the transition to a market economy contribute to new patterns of earnings differentiation that increase income returns to human capital and private-sector entrepreneurship.

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