THE SOFT BUDGET CONSTRAINT IN THE TRANSITION ECONOMY AND THE PROSPECT OF PRIVATIZATION

The planned economies of Eastern Europe were characterized by a lack of market discipline in that firms were able to extract various kinds of subsidization in order to produce according to the plan. In this paper it is argued that this phenomenon is likely to be carried into the transition economy. The paper sets up a simple one-period model in which a firm sets wages and employment and the government pays subsidies. The possibility appears that the government must pay excessive subsidies without being able to influence the employment significantly. One way to limit the payment of subsidies might be privatization of the state-owned enterprises; however, this carries the risk that the government's ability to stabilize employment might be reduced.