Factor Price Distortions and Public Subsidies in East Germany

Hans-Werner Sinn

No 1155, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Economic development in East Germany is not uniform. The building and construction industry is booming but manufacturing industry is stagnating. The paper argues that severe distortions in relative factor prices are the cause of the dichotomous development. These distortions result from excessive wage increases and investment support large enough to make the cost of capital negative for East German industry. The negative cost of capital implies that this factor in fact mutates into an economic good whose `production' the firm tries to increase by using more of other factors. It is suggested that the support for investment be abandoned and that a political compromise be sought, whose aim is to reduce the planned wage rises. The compromise could include an investment wage agreement for insider workers and a distribution of the stock of public housing to prevent workers from suffering wealth losses. It would be a Pareto improvement avoiding the large welfare loss incurred by the policies currently pursued.

Keywords: East Germany; Factor Prices; Subsidies; Transformation (search for similar items in EconPapers)
JEL-codes: D24 H2 P21 (search for similar items in EconPapers)
Date: 1995-05
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Citations: View citations in EconPapers (9)

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