The Soft Budget Constraint and Ways to Harden It

Paper Summary:

This paper examines the soft budget constraint (SBC) as a commitment problem under socialism, presents the Dewatripont and Maskin basic model of the theory behind the SBC, and explains how the SBC can be hardened. Additionally, it closely follows the transition processes in China, as well as several Central and Eastern European Countries by focusing on efficient markets, federalism, demonopolization. The paper ends with a summary of the efficiency outcomes of a hard budget constraint.

From the Paper:

"The soft budget constraint syndrome is an incentive dilemma that has been primarily observed in socialist centrally planned economies, and has created major problems in their transition to the market. The term "soft budget constraint" was coined by Kornai in 1980, and can be summed up as follows: "If the firm acts as a price maker, if the tax system it faces is soft, if it can rely on access to free state grants, if it can get credits and external financial investment on soft terms, then the budget constraint is soft; that is it will not bind the ex ante choices of the firm." Ambrus-Lakatos (1997)"

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