| Summary: | Given the costs of resource misallocation when prices are set too low, economists have wondered why governments do not raise prices to eliminate shortages altogether. A mathematical model suggests that the “soft budget constraint” common to state-owned firms in socialist economies is the reason that shortages are allowed to persist. Unprofitable state-owned firms are often repeatedly refinanced and survive indefinitely, with increasing investment demands. When households, which have a hard budget constraint, compete with these firms for the same goods, a high market price will exclude many households from receiving consumer goods but will not deter inefficient projects from starting. A lower price leads to input shortages that may discourage managers of bad projects from applying for financing in the first place.
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