LG and bank: from favoring SOEs and TVEs, to favoring PEs.
Given the institutional environment, the local governments choose effort levels to allocate
in helping the TVE and PE get loans, and chooses output targets and minimum employment
levels. Then, given the credit, output-target, and minimum employment levels, TVEs and
PEs choose their constrained profit maximizing output, labor, and material input decisions.
Let Ej (I) represent the loan secured by the LG for the type-j enterprise given institutional
environment I.Herej =1, 2 indexes enterprise type with 1 representing the TVE, and 2
representing the PE.
2.1 TVE and PE Preferences
Let f (l, m, K) represent TVE and PE’s output technology, where l is labor input, m is
material input, and K is physical/fixed capital. Without any local government interfer-
ence and perfect capital markets, the TVE and PE are assumed to choose labor and vari-
able/intermediate inputs to maximize profit subject to the technology f (∙). Let
π = ,max {PYj - wlj - rmj : Yj ≤ f(j,mj,K)}, (1)
lj,mj,Yj
j =1, 2. Here Yj represents the output level produced by enterprise-j , lj and mj represents
the respective labor and material input demanded by that enterprise, and Kj represents
the enterprise’s endowment of physical capital. The parameter p is the price of output, w
is the wage rate, and r is the price of material inputs. Solving the maximization problem
(1), we get the profit maximizing level of labor, material input, and output (l*,m*,γ*} =
(l∙(Kj),m'(Ki),Y∙(Kj)), j = 1,2.
With LG interference, the PE or TVE might be induced to choose input and output
levels that deviate from the profit maximizing levels (l*,m*,γ*} . Also, poorly functioning
credit markets could lead to credit allocations that constrain profit opportunities. Under
expenditure, output-target, and minimum-labor constraints, the firms’ constrained profit
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