Empirical Public Economics
Edited by Attiat F. Ott and Richard J. Cebula
Chapter 5: Soft Budget Constraint and Hard Budget Constraint: Who is Bailing Out Whom and Why?
Attiat F. Ott and Nirupama Devaraj 1 Introduction The foundation of an economic system rests on its constitutional and institutional structure. Its time path is shaped by its agents and the interplay of its various constituents. The convention is to make a distinction between three types: households, ﬁrms and governments. The role played by one type vis-àvis another depends on the time and space within which such interaction occurs. The interaction can be straightforward – a buyer (household) and a seller (ﬁrm), or complicated – principal–agent relationship. To understand the behavior of any one of these units, the starting point is to assume a utility function (or an objective function) and a budget constraint. The arguments in the utility function may be unit speciﬁc (own activities) or may include spillovers. The budget constraint may be ‘hard’ or ‘soft’. The objective of the unit is to maximize the utility subject to the applicable constraint. The narrative, though common, is incomplete. For one thing one needs to specify the time frame – a one-period versus an inﬁnite or lifetime horizon. Secondly, one needs to identify for each time frame the argument(s) in the budget constraint that could indicate the presence of ‘hardening’ or ‘softening’ of the constraint. This chapter is about the budget constraint, soft as well as hard. Up until the 1980s, the concept of the budget constraint was understood (whether for the household, ﬁrms or government) to convey the equality between expenditures and receipts in a multi-period (in...
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