the employee whenever his marginal benefit from doing so is lower than the market wage
rate. As a result, the overall quantity actually consumed in the two tracks is the result of
the behavior of those buyers with a marginal willingness to pay larger than Pe. Similarly,
for a given Pe, the total quantity actually produced in the two tracks will be generated only
by those producers with a marginal cost lower than Pe. This implies that in equilibrium the
free-market price must be at the level where the marginal cost equals the marginal willingness
to pay, independently of the original government policy.
We summarize our observations in the following Lemma, which reproduces Proposition
1 in Lau, Qian, and Roland (2000):
Lemma 1 Regardless of the first period government policy, dual track liberalization attains
the first best allocation in the second period. Moreover, the equilibrium price in the market
track is the same as the competitive equilibrium price.
4 Expectations and Intertemporal Arbitrage
In a dynamic context, the first period allocation depends on the private agents’ expectations
about the second period reform. Translating the static discussion of Lau, Qian, and Roland
(2000) to our dynamic framework, we allow the reform to be anticipated, while in their
analysis the liberalization comes as a “surprise”, so that the first period outcome is not
affected by the ensuing liberalization. If the reform is anticipated, private agents are induced
to strategically modify their behavior in the first period in order to take advantage of new
arbitrage opportunities. These opportunities arise because dual track liberalization creates
two tracks in the second period, and agents who have engaged in transactions in the first
period are entitled to exchange in the regulated track in the second period. Since the prices
prevailing in the two tracks may very well differ, agents will attempt to take advantage of
such differences by modifying their first period behavior. We refer to these activities as
inter-temporal arbitrage. For instance, if workers realize that they can lock up the Union-set
wage rate in the second period by entering a labor contract in the first period, they will be
more willing to supply their labor services if the Union-set wage rate is substantially higher
than the market rate in the second period. And the opposite is true for employers.
Figure 1 illustrates how inter-temporal arbitrage alters the agents’ first-period behavior
in a closed economy. S0 and D0 represent the first period “strategic” supply and demand