This study aims to explain the changing pattern of productive efficiency of the Chinese iron and steel industry during the 1980s. By decomposing productive inefficiency into technical, allocative and scale inefficiencies, the effect of market‐oriented reform measures on inefficient resource utilization is empirically tested. A consistent improvement is found in technical efficiency from different sized firms. An improvement in allocative efficiency of investment in upgrading and innovation from different sized firms is also found. Allocative efficiency of working capital was found to have hardly improved which could be largely due to distorted factor markets. Different sized firms exhibited scale inefficiency which could be due to segmented local production and the impact of a two‐tier price system on the distribution of production share among fi