On the persistence of rationing following liberalization: A theory for economies in transition

Many economic theorists and policy makers argue that a rapid liberalization in which prices are allowed to equilibrate supply and demand is critical for a successful transition in the formerly socialist economies. Yet, despite the advantages of market clearing prices, many local governments in these economies have kept their prices for basic goods low and induced rationing in the state sector. This paper develops a theory explaining why a local government chooses either a low state price that induces rationing or a higher price that clears the market. The theory predicts that a necessary condition for a local government representing its constituents' interests to set a market clearing price is that the private sector is monopolistic. While a market clearing price in the state sector curtails private monopoly power, it also implies that the state price is higher than in the rationing regime. It is shown that a local government's marginal benefit of restraining private monopoly power is higher than the marginal costs of higher state prices when there is an increase in either state sector costs or private capacity. This implies that a local government is more prone to set a market clearing price as its costs increase and as private capacity grows. Furthermore, when there are at least two private firms and the private sector is monopolistic, a local government that sets a market clearing price also stabilizes private sector pricing.