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International Monetary Fund, Washington D.C. 20431. In particular Manuel Guitian, Jan van Houten, Ashok Lahiri, Dubravko Mihaljek and Richard Quandt provided perceptive comments; all errors are, of course, the responsibility of the author.
Holzmann (1991) provides evidence of the extent to which loss-making enterprises in Eastern Europe were supported by the state; during the 1980s, a period of putative reforms in some countries, budgetary subsidies alone were typically almost 10 percent of GDP. Budgatary support by the European Communities for the agricultural sector averaged 0.6 of members' GDP during the 1980s (European Economy, 1990).
Decreasing returns to scale in the aggregate production function of the atomistic sector could be introduced with little effect on the qualitative results.
Time subscripts have be dropped whenever ambiguity is not thereby created.
There is no conceptual difficulty in introducing more explicit dynamics. For instance, if exp(ỹt) is replaced; throughout by Pt=Pt-1 exp(ỹt), where ỹt remains an i.i.d. normal random variable, expected future operating profits; become; negative when current operating profits are negative.
The term Φ' must be positive because it describes a distribution function, ρ is the positive discount factor and V1 is positive if the firm is worth operating. Assume that the term in square brackets in (4) is negative, which implies that exp(σ2/2)f' < w. But if expected profits are positive, exp(σ2)f > [wx+C]. Hence w/[wx+C] > f '/f. which leads to a contradiction of the assumption.
Note that dΦ2/dx = dΦ1/dx.[wx + C]/[f 'exp(σ2/2)], which allows simplification of the derivative of (6) with respect to x.
In this model a tax on wage income is non-distortionary because the labor supply is fixed.
The model does not rely in any very important way on the specification of the costs associated with the firm being left to fail.
The (shadow) reservation wage v reflects whatever cost or benefit arises from being idle.
As by assumption the government does not care about distribution and taxes are non-distortionary, the transfer from the rest of society to the loss-maker does not itself enter into the welfare calculation.
If, contrary to the assumption here, the firm is not replaced if it ever has to shut, the W(t+1) - Γ(t+1) in equation (10) would be replaced with wxρ/[l-ρ], which is the discounted value of production when only the competitive sector produces. Then subsidizing loss-makers is still the only credible policy if ρx[w-v] is large enough.
An analogy can be made with schemes that make deviation from a preannounced monetary policy automatically costly to the government itself, perhaps through its effect on the government's portfolio of nominal and indexed bonds (see Persson, Persson and Svensson, (1987)).
In the model of this paper the government could also achieve the first best solution by taxing input use by the firm and always subsidizing loss-makers. However, such an approach would create new distortions if the firm's technology is known imperfectly or if taxes have to be uniform across industries.
A liquidity constraint is less likely to bind on a labor managed firm than on a profit maximizer because the latter must treat the return to labor as a contractual obligation. When bankruptcy is possible, a labor managed firm will typically have the longer time horizon.
However, since in the model here the government is indifferent about the distribution of income, there is no reason here why the unemployed themselves should receive the compensation.