Price Liberalization and Output Decline in Transition

In this paper, we attempt to fill the gap in theoretical explanations of a large output decline that took place in the early years of transition process. The prevalent explanations, commonly found under the title of disorganisation, are succesful in explaining output decline in countries of former Soviet Union, but less so for Central and Eastern European countries. The model we develop shares the cause of output decline with disorganisation - price liberalisation, however, the decline takes place only under a set of plausible assumptions: adjustment costs to labor mobility across economic sectors and large benefits to inactivity in a form of either government transfers or reservation wage earned in informal economy. Liberalisation of prices in a form of removal of distortionary taxes creates incentives for labor mobility from a declining sector to inactivity. The decline takes place only in a part of the economy, while the rest of the economy stagnates or slowly grows. Since the model does not have a closed-form solution, we analyze the equilibrium allocation using simulation methods. We also discuss the political economy of reforms and identify the conditions under which rational voters under majoritarian voting rule would support the price liberalisation.