This paper examines the effects of price liberalization in the former centrally planned economies. To this end, a “search equilibrium” of the commodity market is proposed as an analytical framework, in the tradition of Diamond (1984) and Mortensen (1989). The existing literature interprets price liberalization in transitional economies as the removal of price distortions in a context in which demand and supply schedules do not differ substantially from those in a market economy. This paper is motivated by the observation that, in reality, price liberalization in transitional socialist economies represents only a step toward the introduction of markets. In refuting the assumption that markets are functioning, albeit distorted by “wrong” prices, the paper is able to examine the basic exchange mechanism independently of the institutions and resources that characterize market economies.
The main premise of this paper is that price liberalization in transitional socialist economies could produce substantial output losses unless accompanied by the elimination of existing supply rents because such rents restrict entry and thereby preclude a positive supply response to price liberalization. At the same time, on the demand side, consumers participate less in the search process because of price increases. This paper describes the conditions under which this mechanism could lead the economy to stall at a low-output equilibrium, and points to the added danger that complicated dynamic paths might arise, depending on the features of the trade technology.
It is widely recognized that eliminating supply rents is more difficult and time-consuming for transitional socialist economies than is liberalizing prices. An important conclusion of the model presented in this paper is that policy plays an important role in limiting output losses during the transition period. In particular, a tax-cum-subsidy policy could improve the equilibrium outcome. Policies that encourage consumer participation in the search process—transferring rents from the suppliers to the consumers—could succeed in preventing a low-output equilibrium.