Market Transition and the Firm: Institutional Change and Income Inequality in Urban China Victor Nee and Yang Cao 1 Cornell University and 1 University of North Carolina, Charlotte, USA  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. As systems of interrelated informal and formal rules, institutions are social structures that provide a conduit for social action in shaping the interests of actors and enforcing principal–agent relationships. Thus in departures from state socialism, institutional change entails not simply altering the rules of the game, but fundamentally it involves the realignment of the interests and power of polit- ical and economic actors, whether as individuals or organizations. First, the emergence of a market economy opens new opportunity structures that enable and motivate private entrepreneurs to compete with established state-owned firms. Second, market institutions provide an alternative framework for the pursuit of interests for economic agents. Lastly, as economic agents adapt and compete in the emergent market economy, they institute new economic practices and organizational rules that enable their firms to survive and profit. In sum, we argue that the growth of a market economy alters the structure of incentives for economic actors in facilitating and motivating new pathways for mobility in post-socialist societies, which in turn causes a decline in the significance of politi- cal connections. Management and Organization Review 1:1 23–56 1740-8776 © Blackwell Publishing Ltd 2004. Published by Blackwell Publishing, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.