Transition and the output fall

We present a model to explain why in the transition economies of Central an d Eastern Europe an important output fall has been associated with price li beralization. Its key ingredients are search frictions and Williamsonian re lation-specific investment, implying that new investments are made only aft er having found a new long-term partner. When all firms search for new part ners, output may fall because of three effects: a) disruption of previous p roduction links, b) a fall in investment, and c) capital depreciation due t o the absence of replacement investment. We show that forms of gradual libe ralization like the Chinese 'dualtrack' price liberalization may avoid the transitory output fall.