Budget constraint

The concept of soft budget constraints is commonly applied to economies in transition. This theory was originally proposed by János Kornai in 1979. It was used to explain the "economic behavior in socialist economies marked by shortage”.[2] In the socialist transition economy there are soft budget constraint on firms because of subsidies, credit and price support.[3] This theory implies that the survival of a firm depends on financial assistance, especially in a socialist country. The soft budget constraint syndrome usually occurs in the paternalistic role of the State in economic organizations, such as public and private companies and non-profit organizations. János Kornai also highlighted that there are five dimensions to evaluate the post-socialist transition, including fiscal subsidy, soft taxation, soft bank credit (non-performing loans), soft trade credit (the accumulate rears between firms) and wage arrears.[4]

According to the point of view by Cllower [1965],[5] budget constraints are a rational planning assumption with two main attributes. The first is that budget constraints refer to the decision makers' behavioural characteristics --- selling output or acquiring asset income to compensate for spending. This means that adjustment limitation on financial resources are obvious. The second is to impose constraints on prior variables, such as constraints on current actual demand based on expectations of future financial conditions.

The reason for the soft budget constraints is that the excess of expenditure over income will be paid by additional organizations (the State). In addition, the decision maker expects such external financial assistance to be highly probable based on his actions. The further explanation is the more excess spending is covered by external aid, the budget constraints will be more softer.

While low-level demonstrations of budget constraints are often limited to less than two good situations which provide easy graphical representation, it is possible to demonstrate the relationship between multiple goods through a budget constraint.

There are 2 requirements for this case. The first one is that the constraint is not affected if the prices are multiplied by any positive scalar. The second one is that all commodities are desirable and the constraint will always be binding.

In such a case, assuming there are ${\displaystyle n\,}$ goods, called ${\displaystyle x_{i}\,}$ for ${\displaystyle i=1,\dots ,n\,}$, that the price of good ${\displaystyle x_{i}\,}$ is denoted by ${\displaystyle p_{i}\,}$, and if ${\displaystyle \,W\,}$ is the total amount that may be spent, then the budget constraint is:

${\displaystyle \sum _{i=1}^{n}p_{i}x_{i}\leq W.}$

Further, if the consumer spends his income entirely, the budget constraint binds:

${\displaystyle \sum _{i=1}^{n}p_{i}x_{i}=W.}$

In this case, the consumer cannot obtain an additional unit of good ${\displaystyle x_{i}\,}$ without giving up some other good. For example, he could purchase an additional unit of good ${\displaystyle x_{i}\,}$ by giving up ${\displaystyle p_{i}/p_{j}\,}$ units of good ${\displaystyle x_{j}.\,}$

Budget constraints can be expanded outward or contracted inward through borrowing and lending. By borrowing money in a period, usually at an interest rate r, a consumer can choose to forgo consumption in future periods for extra consumption in the borrowing period. Choosing to borrow would expand the budget constraint in this period and contract budget constraints in future periods. Alternatively, consumers can choose to lend their money in the current period, usually at a lending rate l. Lending contracts the budget constraint in the current period but expands budget constraints in future periods.[1] According to behavioral economics, choices on borrowing and lending may also be affected by Present bias. In economics, there are two groups of present biased individuals, sophisticated individuals who are aware of their present bias, and naive individuals who are not aware of their present bias.[11]

• Choice modelling
• Contingent valuation
• Guns versus butter model
• Heckscher–Ohlin theorem on country level budget constraints called resource endowments
• Intertemporal budget constraint
• Isoquant
• Opportunity cost
• Scarcity
• Trade-off
• Paternalism

• Lipsey, Richard G. (1975). An Introduction to Positive Economics (Fourth ed.). Weidenfeld & Nicolson. pp. 214–7. ISBN 0-297-76899-9.
• Kornai, János; Maskin, Eric; Roland, Gérard (2003). "Understanding the Soft Budget Constraint". Journal of Economic Literature. 41 (4): 1095–1136. doi:10.1257/jel.41.4.1095. JSTOR 3217457.
• Vahabi, Mehrdad (2001). "The Soft Budget Constraint : A Theoretical Clarification". Recherches Économiques de Louvain / Louvain Economic Review. 67 (2): 157–195. doi:10.1017/S0770451800055883. JSTOR 40724317. S2CID 152556966.
• Kornai, János (February 1986). "The Soft Budget Constraint". Kyklos. 39 (1): 3–30. doi:10.1111/j.1467-6435.1986.tb01252.x.
• Maskin, Eric; Xu, Chenggang (March 2001). "Soft budget constraint theories: From centralization to the market". The Economics of Transition. 9 (1): 1–27. doi:10.1111/1468-0351.00065. hdl:10722/138701. S2CID 154707861.
• Du, Julan; Li, David D. (March 2007). "The soft budget constraint of banks". Journal of Comparative Economics. 35 (1): 108–135. doi:10.1016/j.jce.2006.11.001.
• Berglöf, Erik; Roland, Gérard (April 1997). "Soft budget constraints and credit crunches in financial transition". European Economic Review. 41 (3–5): 807–817. doi:10.1016/S0014-2921(97)00055-X.