Showing papers in "Quarterly Journal of Economics in 1986"
TL;DR: In this paper, the optimal timing of investment in an irreversible project where the benefits from the project and the investment cost follow continuous-time stochastic processes was studied, and an explicit formula for the value of the option to invest was derived, assuming that the option is valued by risk-averse investors who are well diversified.
Abstract: This paper studies the optimal timing of investment in an irreversible project where the benefits from the project and the investment cost follow continuous-time stochastic processes. The optimal investment rule and an explicit formula for the value of the option to invest are derived, assuming that the option is valued by risk-averse investors who are well diversified. The same analysis is applied to the scrapping decision. Simulations show that this option value can be significant, and that for reasonable parameter values it is optimal to wait until benefits are twice the investment costs.
2,927 citations
TL;DR: In this article, the authors consider a more general class of auctions, in which bidders name a "menu" of offers for various possible actions (allocations) available to the auctioneer.
Abstract: In many examples of competitive bidding (e.g., government construction contracting) the relevant object is either partially divisible or ill-defined, in contrast to much of the recent theoretical work on auctions. In this paper we consider a more general class of auctions, in which bidders name a "menu" of offers for various possible actions (allocations) available to the auctioneer. We focus upon "first-price" menu auctions under the assumption of complete information, and show that, for an attractive refinement of the set of Nash Equilibria, an efficient action always results. Our model also has application to situations of economic influence, in which interested parties independently attempt to influence a decision-maker's action.
1,319 citations
TL;DR: In this article, the authors present a simple, general framework for analyzing externalities in economies with incomplete markets and imperfect infonnation, and identify the pecuniary effects of these externalities that net out, simplifying the problem of determining when tax interventions are Pareto improving.
Abstract: This paper presents a simple, general framework for analyzing externalities in economies with incomplete markets and imperfect infonnation. By identifying the pecuniary effects of these externalities that net out, the paper simplifies the problem of determining when tax interventions are Pareto improving. The approach indicates that such tax interventions almost always exist and that equilibria in situations of imperfect information are rarely constrained Pareto optima. It can also lead to simple tests, based on readily observable indicators of the efficacy of particular tax policies in situations involving adverse selection, signaling, moral hazard, incomplete contingent claims markets, and queue rationing equilibria. Traditional discussions of externalities have emphasized the distinction between technological externalities, in which the action of one individual or firm directly affects the utility or profit ofanother, and pecuniary externalities, in which one individual's or firm's actions affect another only through effects on prices. While the presence of technological externalities imply, in general, that a competitive equilibrium may not be Pareto efficient, pecuniary externalities hy themselves are not a source of inefficiency. The fact that prices change has, of course important consequences: there are both distributional and allocational effects. But, the distribution effects "net" out: gains for example, hy firms whose prices increase—are precisely offset by losses—e.g., to individuals who must pay higher prices. And, there are no welfare losses from the allocation effects as long as the price changes involved are small: if firms are maximizing profits and individuals are maximizing utility, both facing prices that correctly refiect opportunity costs, then standard envelope theorem arguments imply that changes in profits or utility induced by changes in allocations (resulting from any small change in prices) are negligible.
1,160 citations
TL;DR: The authors analyzed the welfare effects of trade and industrial policy under oligopoly, and characterized optimal intervention under a variety of assumptions about market structure and conduct, concluding that free trade is optimal.
Abstract: We analyze the welfare effects of trade and industrial policy under oligopoly, and characterize optimal intervention under a variety of assumptions about market structure and conduct. When all output is exported, optimal policy with a single home firm depends on the difference between foreign firms' actual responses to the home firm's actions and the responses that the home firm conjectures. A subsidy often is indicated for Cournot behavior, but a tax generally is optimal if firms engage in Bertrand competition. If conjectures are "consistent," free trade is optimal. With domestic consumption, intervention can raise national welfare by reducing the deviation of price from marginal cost.
951 citations
TL;DR: In this article, the authors show that the optimal wage contract is an option of the value of the manager's human capital for insurance reasons and that consequently rationing of capital is often required to counterbalance the resulting incentive to overinvest.
Abstract: The paper shows how career concerns rather than effort aversion can induce a natural incongruity in risk preferences between managers and superiors. A model, based on learning about managerial talent, is developed to study second-best contractual remedies. We show that the optimal wage contract is an option of the value of the manager's human capital for insurance reasons and that consequently rationing of capital is often required to counterbalance the manager's resulting incentive to overinvest. Rationing is strictly superior to price decentralization, offering one reason for the prevalence of centralized capital budgeting procedures.
688 citations
TL;DR: In this paper, the authors compare how much profit an owner of a patent can realize by licensing it to an oligopolistic industry producing a homogeneous product, by means of a fixed fee or a per unit royalty.
Abstract: We compare how much profit an owner of a patented cost-reducing invention can realize by licensing it to an oligopolistic industry producing a homogeneous product, by means of a fixed fee or a per unit royalty. Our analysis is conducted in terms of a noncooperative game involving n + 1 players: the inventor and the n firms. In this game the inventor acts as a Stackelberg leader, and it has a unique subgame perfect equilibrium in pure strategies. It is shown that licensing by means of a fixed fee is superior to licensing by means of a royalty for both the inventor and consumers. Only a "drastic" innovation is licensed to a single producer.
657 citations
TL;DR: In this paper, direct investment is incorporated into a simple general equilibrium model of international trade and the analysis focuses on an attempt to endogenize the internalization decision, arguing that a reasonable approach assumes that arm's length contracts must be "simple" so that "complex" arrangements require internalization.
Abstract: Direct investment is incorporated into a simple general equilibrium model of international trade. The analysis focuses on an attempt to endogenize the internalization decision. It is argued that a reasonable approach assumes that arm's length contracts must be "simple" so that "complex" arrangements require internalization. The model relates direct investment to the degree of underlying uncertainty and to fundamental trade determinants, such as relative factor endowments. The behavior of the model contrasts sharply with that of the Markusen-Helpman model, which takes internalization for granted.
602 citations
TL;DR: In this article, the optimal licensing strategy of a research lab selling to firms who are product market competitors is examined, and the authors show that demands are interdependent and hence the standard price mechanism is not the profit-maximizing licensing strategy.
Abstract: We examine the optimal licensing strategy of a research lab selling to firms who are product market competitors. We consider an independent lab as well as a research joint venture. We show that (1) demands are interdependent and hence the standard price mechanism is not the profit-maximizing licensing strategy; (2) the seller's incentives to develop the innovation may be excessive; (3) the seller's incentives to disseminate the innovation typically are too low; (4) larger ventures are less likely to develop the innovation, and more likely to restrict its dissemination in those cases where development occurs; and (5) a downstream firm that is not a member of the research venture is worse off as a result of the innovation.
529 citations
TL;DR: In this paper, the authors show why this analysis is incomplete and therefore incorrect, and present evidence that appears to be generally consistent with the predictions of the theory of planned obsolescence, showing that oligopolists can generally gain by colluding to reduce durability and increase rentals relative to sales.
Abstract: "Planned Obsolescence" is the production of goods with uneconomically short useful lives so that customers will have to make repeat purchases. However, rational customers will pay for only the present value of the future services of a product. Therefore, profit maximization seemingly implies producing any given flow of services as cheaply as possible, with production involving efficient useful lives. This paper shows why this analysis is incomplete and therefore incorrect. Monopolists are shown to desire uneconomically short useful lives for their goods. Oligopolists have the monopolist's incentive for short lives as well as a second incentive that may either increase or decrease their chosen durability. However, oligopolists can generally gain by colluding to reduce durability and increase rentals relative to sales. Some evidence is presented that appears to be generally consistent with the predictions of the theory.
496 citations
TL;DR: This article showed that prior to the founding of the Federal Reserve System in 1915, the spread between long rates and short rates has substantial predictive power for the path of interest rates; after 1915 the spread contains much less predictive power.
Abstract: We reexamine the expectations theory of the term structure using data at the short end of the maturity spectrum. We find that prior to the founding of the Federal Reserve System in 1915, the spread between long rates and short rates has substantial predictive power for the path of interest rates; after 1915, however, the spread contains much less predictive power. We then show that the short rate is approximately a random walk after the founding of the Fed but not before. This latter fact, coupled with even slight variation in the term premium, can explain the observed change in 1915 in the performance of the expectations theory. We suggest that the random walk character of the short rate may be attributable to the Federal Reserve's commitment to stabilizing interest rates.
438 citations
TL;DR: This article developed a model in which people can only work together if they "speak" the same language and in which it is costly to learn a second language, but if interaction is required, the cost will be borne by the minority.
Abstract: Any advanced industrial society is composed of a number of speech communities with different verbal and nonverbal languages. In particular, in the United States blacks and whites and men and women have sharply differing methods of speaking and listening. This paper develops a model in which people can only work together if they "speak" the same language and in which it is costly to learn a second language. The competitive market will tend to minimize communication through segregation, but if interaction is required, the cost will be borne by the minority. A number of nontrivial predictions are derived from the model.
TL;DR: In this article, the allocation of credit in a market in which borrowers have greater information concerning their own riskiness than do lenders is examined and the authors suggest a role for government as the lender of last resort.
Abstract: This paper examines the allocation of credit in a market in which borrowers have greater information concerning their own riskiness than do lenders. It illustrates that (1) the allocation of credit is inefficient and at times can be improved by government intervention, and (2) small changes in the exogenous risk-free interest rate can cause large (discontinuous) changes in the allocation of credit and the efficiency of the market equilibrium. These conclusions suggests a role for government as the lender of last resort.
TL;DR: In this paper, the authors restate Hart's definition of large group monopolistic competition, distinguish it from oligopolistic competition and raise the question of whether there are reasonable circumstances that give rise to true monopoly competition as defined.
Abstract: The paper restates Hart's [1985a, 1985b] definition of large group monopolistic competition, distinguishes it from oligopolistic competition, and raises the question of whether there are reasonable circumstances that give rise to true monopolistic competition as defined. The purpose is to show that consumers' imperfect information may create conditions that will turn an otherwise oligopolistic market into a truly monopolistically competitive one.
TL;DR: In this paper, a model of the dynamically interrelated demand for capital and labor is specified and estimated, and the estimates are of first-order conditions of the firm's problem rather than of the closed-form decision rules.
Abstract: A model of the dynamically interrelated demand for capital and labor is specified and estimated. The estimates are of the first-order conditions of the firm's problem rather than of the closed-form decision rules. This use of the first-order conditions allows a random rate of return and a flexible specification of the technology. The estimates do not imply the very slow rates of adjustment displayed in other, related estimates of the demand for capital. Because adjustment is estimated to be rapid, there is, contrary to the standard view, scope for factor prices to affect investment at relatively high frequencies.
TL;DR: The production smoothing model of inventory behavior has a long and venerable history and theoretical foundations that seem very strong as discussed by the authors. Yet certain overwhelming facts seem not only to defy explanation within the PSA framework, but also to argue that the basic idea of PSA is all wrong.
Abstract: The production smoothing model of inventory behavior has a long and venerable history and theoretical foundations that seem very strong. Yet certain overwhelming facts seem not only to defy explanation within the production smoothing framework, but actually to argue that the basic idea of production smoothing is all wrong. Most prominent among these is the fact that the variance of detrended production exceeds the variance of detrended sales. This paper first documents the stylized facts. Then it derives the production smoothing model rigorously and explains how the model can be amended to make it consistent with the facts. Finally, it reviews the theoretical and empirical evidence and tries to draw some tentative conclusions.
TL;DR: In this article, the authors argue that overlapping games can provide a natural theory of long-lived organizations and show that participation in organizations of infinite duration changes the incentives of agents with finite lives, and will induce more cooperation than a static model would predict.
Abstract: This paper argues that overlapping games can provide a natural theory of long-lived organizations. It shows that participation in organizations of infinite duration changes the incentives of agents with finite lives, and will induce more cooperation than a static model would predict. After developing the general theory, we apply it to the description of career paths in organizations and show that it can be optimal to give the youngest workers the most arduous tasks.
TL;DR: In this article, the authors show that the human capital and sorting models can be tested against each other by examining the effects of state compulsory school attendance laws, and that the results are consistent with the predictions of the sorting model.
Abstract: Under the educational sorting hypothesis a state compulsory school attendance law will increase the educational attainment of high-ability workers who are not directly affected hy the law. Under the human capital hypothesis such laws affect only those individuals whose hehavior is directly constrained. We find that compulsory attendance laws do increase enrollment rates in age groups they do not affect directly. Thus, our results contradict the human capital hypothesis and are consistent with the sorting hypothesis. I. INTRODUCTION The last decade has seen considerable debate between supporters of the human capital and sorting models of education. The former assert that the effect of education on wages reflects increased productivity. The latter maintain that it reflects, at least in part, correlation between education and unobserved ability. Workers use education to signal their ability, while employers use education to screen workers. Despite the importance of the debate, no fully convincing tests of the hypotheses have been developed. In fact, many members of the profession maintain (at least privately) that these hypotheses cannot be tested against each other and that the debate must therefore be relegated to the realm of ideology. In this paper we show that the models can be tested against each other by examining the effects of state compulsory school attendance laws. We show that under the human capital hypotheis, such laws will affect the educational attainment only of those who in the absence of the law would have left school prior to the minimum school leaving age. On the other hand, under the sorting hypothesis the effects of the law will percolate through the system, increasing educational attainment even among workers not directly constrained by the law. Our results are consistent with the predictions of the sorting model.
TL;DR: In this paper, a generalization of bargaining theory is presented, where the mechanisms are defined on commodity space and satisfy various axioms that are necessary conditions for "equalizing resources" among a population.
Abstract: If one is an egalitarian, should one try to equalize resources available to agents, or to equalize their welfares? With a suitably general conception of what resources are, these two conceptions cannot be distinguished. An allocation mechanism is defined on a space of economies, and is required to satisfy various axioms that are necessary conditions for "equalizing resources" among a population. The unique mechanism satisfying these axioms on a large domain of economies is the one that allocates commodities so as to equalize utilities of the agents. Methodologically, the theorem is a generalization of bargaining theory because the mechanisms are defined on commodity space.
TL;DR: In this paper, a reward structure that can be utilized in any experimental setting to allow the experimenter to decree beforehand the subjects' preferences for lotteries on experimental outcomes is proposed.
Abstract: In an experimental setting when outcomes are stochastically related to actions, predictions of equilibrium behavior depend not only on the participants' preference orderings of outcomes, but also on their orderings of lotteries on outcomes as well. We introduce and test a reward structure that can be utilized in any experimental setting to allow the experimenter to decree beforehand the subjects' preferences for lotteries on experimental outcomes. We show analytically that the proposed reward structure can induce subjects to behave as if they have the decreed preference function defined on experimental outcomes. Empirical tests using two different choice settings provide evidence to support this ability to control preferences.
TL;DR: This article examined the relationship between product market competition and employment discrimination using an especially constructed data set that links microeconomic data on female employment with measures of market concentration in the banking industry and found that individual market shares are unrelated to female employment, suggesting that the relationship is due primarily to differences across markets rather than individual firms.
Abstract: This paper examines the relationship between product market competition and employment discrimination using an especially constructed data set that links microeconomic data on female employment with measures of market concentration in the banking industry. The use of firm-specific data drawn from this one industry allows estimation of this relationship in a manner that avoids the problems of interindustry differences that have troubled previous studies. The results provide strong support for a negative relationship between market concentration and the relative employment of women. Further, we find that individual market shares are unrelated to female employment, suggesting that the relationship is due primarily to differences across markets rather than individual firms.
TL;DR: In this paper, the authors show that after an increase in aggregate demand, the process of adjustment of nominal prices and nominal wages results from attempts by workers to maintain or increase their real wage and by firms maintaining or increasing their markups of prices over wages.
Abstract: This paper rehabilitates the old wage price spiral. It shows that, after an increase in aggregate demand, the process of adjustment of nominal prices and nominal wages results from attempts by workers to maintain or increase their real wage and by firms to maintain or increase their markups of prices over wages. Under continuous price and wage setting, the process of adjustment would be instantaneous; under staggering of price and wage decisions, the adjustment takes time. The more inflexible real wages and markups are to shifts in demand, the higher is the degree of price level inertia, and the longer lasting are the effects of aggregate demand on output.
TL;DR: In this paper, the authors study asset pricing in a general equilibrium representative agent exchange model and derive closed-form solutions for asset returns without restricting the serial correlation of the log endowment.
Abstract: This paper studies asset pricing in a general equilibrium representative agent exchange model. The assumptions of isoelastic period utility and lognormal endowment allow the derivation of closed-form solutions for asset returns without restricting the serial correlation of the log endowment. Risk premiums on stocks and real bonds are found to be simple functions of relative risk aversion, the variance of the log endowment innovation, and the weights in the moving average representation of the log endowment. The paper analyzes the sign of term premiums, the size of the equity premium, and the effect of taste shocks on asset prices.
TL;DR: In this paper, Asch, Malkiel, and Quandt examined the relationship between the objective probability of winning a race and the probability reflected by the market odds and found that "subjective" and objective probabilities are similar.
Abstract: Racetrack betting is a particularly simple situation in which individuals invest money for an uncertain return. In parimutuel betting, individuals invest in "shares" of the various horses. The prices of the shares are standardized, but the payoffs depend on the amount bet on a particular horse relative to the amount bet on all horses. If bh is the amount bet on horse h and if the racetrack retains a fraction t of all money bet for taxes, expenses, and profit, the payoff per dollar invested on horse h is (1 t)Yibi/bh if the horse wins and zero otherwise. As with the more usual financial instruments, the profitability of "investing" in a particular horse depends on objective factors (the intrinsic ability of the horse, the condition of the track, the skill of the jockey, the qualities of the other horses) and on subjective factors (what other bettors think of the horse, which influences the amount bet on it). Racetrack betting thus shares important characteristics of more general investment markets and, because of the particular simplicity of racetrack betting, permits revealing analyses of risk attitudes and equilibrium. Various aspects of racetrack betting have been studied. Several authors have examined the relationship between the objective probability of winning a race and the probability reflected by the market odds [Baumol, 1965; Rosett, 1977; Ali, 1977; Snyder, 1978; Asch, Malkiel, and Quandt, 1982]. In general, it is found that "subjective" and objective probabilities are similar, but that favorites tend to be underbet and long shots tend to be overbet. Weitzman [1965] analyzed the extent of risk-loving behavior among bettors. Several authors have examined the question of the efficiency of the betting market [Ali, 1979; Hausch, Ziemba, Rubinstein, 1981; Losey and Talbott, 1980; Asch, Malkiel, and Quandt, 1984]. It appears that small amounts of inefficiency exist in betting "to win" and that somewhat larger, profitably exploitable, inefficiencies exist in betting "to place" or "to show" (i.e., to come in second or third).
TL;DR: The authors constructs a model of monopolistic competition where consumers cannot directly verify product quality prior to an initial purchase, and consumers base initial purchases on observed prices, which perfectly signal firms' qualities both in and out of equilibrium.
Abstract: This paper constructs a model of monopolistic competition where consumers cannot directly verify product quality prior to an initial purchase. Instead, consumers base initial purchases on observed prices, which perfectly signal firms' qualities both in and out of equilibrium. Equilibrium quality is less than efficient, but generally bounded away from the minimum quality. With free entry, observable product variety exceeds what would prevail with perfect information. As repeat purchases become large relative to initial purchases, or as firms become small relative to the size of the market, equilibrium product quality rises, and the market converges to the full information equilibrium.
TL;DR: In this paper, a simple general equilibrium model that includes optimizing choices of the frequency of trips to the bank is presented, which is used to analyze the effect of inflation on the capital stock, the interest elasticity of money demand, the optimum quantity of money, and the welfare costs of inflationary finance.
Abstract: This paper presents a simple general equilibrium model that includes optimizing choices of the frequency of trips to the bank. The model is used to analyze the effect of inflation on the capital stock, the interest elasticity of money demand, the optimum quantity of money, and the welfare costs of inflationary finance.
TL;DR: In this article, the authors assume that firms can create new independent divisions more cheaply than potential entrants, who must incur the additional overhead costs of new entry, leading perfectly informed incumbents to preempt all rational entry into their industries.
Abstract: This paper assumes that incumbent firms can create new independent divisions more cheaply than potential entrants, who must incur the additional overhead costs of new entry. The main theoretical result is that such divisionalization ability leads perfectly informed incumbents to preempt all rational entry into their industries. In contrast, existing models of entry deterrence imply that informed incumbents, even those with steadily decreasing average costs, will often allow rational entry. Our result may explain why successful, large-scale entry by firms with no informational advantage is extremely rare. The use of divisions to preempt entry may also explain why large firms in high-profit oligopolies often divisionalize, allowing their divisions to compete freely despite the negative pecuniary externality that each division imposes on others.
TL;DR: In this paper, the authors examined the impact of changes in gasoline price expectations on the market values of used automobiles and used an asset model of automobile valuation to relate year-to-year changes in market values to changes in the present discounted value of gasoline expenses.
Abstract: This paper examines the impact of changes in gasoline price expectations on the market values of used automobiles. An asset model of automobile valuation is used to relate year-to-year changes in market values to changes in the present discounted value of gasoline expenses. Econometric evidence from data covering the years 1972 through 1981 substantially confirms the hypothesis of the model that a gasoline price shock causes relative price changes across automobile types in proportion to the differences in their rates of fuel consumption.
TL;DR: In this paper, the authors derived an expression for the optimal number of firms exploiting a commons when the resulting output is sold in an imperfectly competitive market, and showed that the optimum number depends directly on the elasticity of the input productivity and inversely on the price elasticity.
Abstract: The "problem of the commons" is a frequently cited example of market failure in which exploiters' pursuit of profits does not lead to the attainment of a social or Pareto optimum. In particular, a free-access equilibrium induces an unrestricted number of exploiters or firms to equate the variable input's average product, instead of its marginal product, to the input's real rental rate; hence, the rents of the variable input are driven to zero [Haveman, 1973].1 When the number of firms in a commons is unrestricted, the scarce factor (e.g., the fishery, the hunting ground) is not imputed a rent. A social optimum can be achieved if a single firm exploits a commons and sells its output in a perfectly competitive market [Weitzman, 1974]. The purpose of this note is to derive an expression for the optimal number of firms exploiting a commons when the resulting output is sold in an imperfectly competitive market.2 Since demand inelasticity due to monopoly power leads to overconservation, while an increase in the number of exploiting firms typically leads to underconservation, a finite number of firms for a commons can be found corresponding to a social or Pareto optimum. In particular, the optimum number of firms depends directly on the elasticity of the input productivity and inversely on the price elasticity of market demand.
TL;DR: In this paper, the authors considered a variant of the game of attrition, where one player is perfectly informed about the possible outcome; the other is compelled to deduce the information from the actions of his informed opponent.
Abstract: The essence of the situation to be studied here is this: two players are involved in a conflict that can be resolved in only two possible ways. Each player favors a different outcome. During the bargaining phase, which lasts until some finite time To, each player has the option to concede. If none concedes, the game ends at time T in a way that is known to one of the players from the beginning of the game. The other player is uncertain about the outcome. Time is valuable, but each player prefers to receive his favored outcome at m than to concede immediately. Thus, the game analyzed here is characterized by the asymmetric information about the outcome at the end point, i.e., at time TO. Whereas one player is perfectly informed about the possible outcome; the other is compelled to deduce the information from the actions of his informed opponent. The latter, in turn, can try to exploit his initial advantage by manipulating the flow of information. For example, the informed player may adopt a tough stance in order to create the impression that he is not afraid of forcing the resolution of the conflict at To and thereby builds his reputation.' At the same time, the uninformed player by not conceding can test the opponent's resolve. This brief description suggests that the problem analyzed here is a variant of the game of attrition.2 However, our problem differs from the standard game of attrition in two respects. First, we formulate the game in discrete time, which has important analytic consequences. These are fully developed in Hendricks and Wilson [1985]. Second, and more important perhaps, we study