The Effects of Reforming the Chinese Dual-Track Price System

effect on the CPI through the induced change in the market price. Let e_p denote
price elasticity of demand and e_m the income elasticity of demand. Our next
proposition gives the efforts of reform of DTP on the CPI.

Proposition 2 If X is normal and its supply is non-decreasing in price p, tran-
sitional policy inflates the CPI, i.e., ^ddp > 0 > ddp.

We therefore have a paradoxical situation: when the government raises the
controlled price, the CPI is pushed up but the market equilibrium price is reduced.
The effects of a higher level of p, with x constant, are illustrated in Figure 3, in
which the supply of X is also fixed (we assume that p < p throughout). As in Figure
2, the household is at equilibrium point E initially. When p is raised the plan-track
segment of the budget line, the downward-sloping line from point B (0, 1), rotates
clockwise about point B. Assuming momentarily that p is unchanged, the budget
line becomes BCD, the sharpness of the kink having been reduced. The household
consumes at point F on CD, which, given that X is normal, is to the left of E. As
there is now an excess supply of X, its market price p falls; i.e., the right-hand
portion of the budget line rotates anti-clockwise around point C. Given that the
quantity of X supplied is unchanged, the rotation occurs until the quantity of X
demanded is at its original level. The new solution is at point G. Recall that the
average price of X in the original situation was minus the slope of BE. Thus, it

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