Economics of Shortage
The soft budget constraint: why state firms never run out of money and never allocate well.
Summary
Kornai published this two-volume work in 1979 and it established the analytical framework for understanding socialist economies from inside.
His method was to build a positive theory of how the system actually behaved rather than to compare it against an ideal. The observation he starts from is that shortage in these economies is not occasional but permanent and general, appearing across consumer goods, intermediate inputs, capital goods and labour simultaneously, which no explanation based on planning errors can account for.
His explanation is the soft budget constraint, the concept this book introduced. A state firm that loses money is not permitted to fail. It receives subsidies, additional credit, tax relief or a price adjustment. Because the firm knows this, its budget does not constrain its behaviour. It therefore demands inputs and investment without limit, since acquiring more is always better and the cost is not borne by the firm. Aggregate demand for inputs consequently exceeds supply regardless of the price level or the plan.
The consequences follow mechanically. Firms hoard inputs and labour against future shortage, which worsens the shortage. Firms integrate vertically to secure their own supply, which reduces specialisation and efficiency. Buyers accept whatever is available rather than what they want, which he calls forced substitution. Sellers face no competitive pressure, so quality deteriorates and customer responsiveness disappears. Queuing and rationing allocate what price cannot. Investment hunger produces projects started and not completed.
He also shows why partial reform fails: introducing market signals while the budget constraint remains soft means the signals are ignored.
The work is long, formal and written under censorship, which required care in how the argument was stated. The soft budget constraint has since been applied far beyond socialist economies, to state enterprises, to banks expecting rescue and to any organisation whose losses are covered by someone else.
Key takeaways 7
- Shortage in socialist economies was permanent and general rather than occasional, which no planning error explanation accounts for.
- A firm whose losses are always covered treats its budget as soft, so it demands inputs and investment without limit.
- Aggregate input demand consequently exceeds supply regardless of the price level or the quality of the plan.
- Firms hoard inputs and labour against future shortage, which makes the shortage worse.
- Firms integrate vertically to secure their own supply, which reduces specialisation across the whole economy.
- A permanent sellers' market eliminates any incentive for quality improvement or customer responsiveness.
- Introducing market signals while the budget constraint remains soft means the signals are received and ignored.
Who should read it
Economists and analysts who want the original theory of the soft budget constraint, which applies wherever an organisation expects its losses to be covered.
Where it sits in the reference 2
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