A model of China's economic vertical structure

Xi Li, Xuewen Liu, Zhikun Lu, and Yong Wang

Abstract

We document a prominent yet underappreciated feature of the post-2000 Chinese economy: a vertical structure in which key upstream industries are dominated by state-owned enterprises (SOEs), while downstream industries are largely open to private competition. We develop a general-equilibrium model to analyze how this vertical structure—interacting with industrialization, globalization, and labor abundance—has shaped the Chinese economy. The framework offers new insights into SOE profitability, structural change, resource misallocation, and economic reform. First, upstream SOEs become more profitable as downstream private firms raise their productivity and face greater external demand during industrialization and globalization, helping explain the unprecedented prosperity of SOEs between 2002 and 2007. Second, reducing upstream market power would facilitate labor reallocation from agriculture to non-agricultural sectors, raising GDP and aggregate welfare. Third, preferential credit subsidies to SOEs can improve welfare by alleviating upstream under-supply; consequently, removing these subsidies without dismantling SOE monopoly power could reduce welfare. Quantitative analyses using firm-level data support the theoretical findings. We further show that this vertical structure can arise endogenously as an equilibrium outcome.

Keywords

Vertical structure; Structural change; Chinese economy; State-owned enterprises; Globalization