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The Elgar Companion to Public Economics

Empirical Public Economics

Edited by Attiat F. Ott and Richard J. Cebula

Attiat Ott and Richard Cebula have recognised the need to present, in an accessible and straightforward way, the voluminous literature in the public economics arena. Advances in econometric techniques and the spillover of knowledge from other disciplines made it difficult, not only for students but also for lecturers, to accurately find the information they need.
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Chapter 5: Soft Budget Constraint and Hard Budget Constraint: Who is Bailing Out Whom and Why?

Attiat F. Ott and Nirupama Devaraj


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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