Showing papers in "Quarterly Journal of Economics in 1989"

Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior

Abstract: This paper develops a model of inefficient managerial behavior in the face of a rational stock market In an effort to mislead the market about their firms' worth, managers forsake good investments so as to boost current earnings. In equilibrium the market is efficient and is not fooled: it correctly conjectures that there will be earnings inflation, and adjusts for this in making inferences. Nonetheless, managers, who take the market's conjectures as fixed, continue to behave myopically. The model is useful in assessing evidence that has been presented in che "myopia" debate. It also yields some novel implications regarding firm structure and the limits of intergation.

The Growth and Failure of U. S. Manufacturing Plants

Abstract: This paper examines the patterns of postentry employment growth and failure for over 200,000 plants that entered the U. S. manufacturing sector in the 1967–1977 period. The postentry patterns of growth and failure vary significantly with observable employer characteristics. Plant failure rates decline with size and age as do the growth rates of nonfailing plants. The expected growth rate of a plant, which depends on the net effect of these two forces, declines with size for plants owned by single-plant firms but increases with size for plants owned by multiplant firms.

Why a Stubborn Conservative would Run a Deficit: Policy with Time-Inconsistent Preferences

Abstract: A conservative government, in favor of a low level of public consumption, knows that it will be replaced by a government in favor of a larger level of public consumption. We show that the resulting level of public consumption is in between the levels the two governments would choose if each were in power both in the present and in the future. In particular, we show that if the conservative government is more stubborn (in a particular sense) than the succeeding government, the conservative government will borrow more than it would had it remained in power in the future.

Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence

Abstract: No one has derived closed-form solutions for consumption with stochastic labor income and constant relative risk aversion utility. A numerical technique is used here to give an accurate approximation to the solution. The resulting consumption function is often dramatically different than the certainty equivalence solution typically used, in which consumption is proportional to the sum of financial wealth and the present value of expected future income. The results help explain three important empirical consumption puzzles: excess sensitivity of consumption to transitory income, high growth of consumption in the presence of a low risk-free interest rate, and underspending of the elderly.

Hysteresis, Import Penetration, and Exchange Rate Pass-Through

Abstract: A competitive industry has established home firms, and foreign firms with entry and exit costs. The real exchange rate follows a Brownian motion. Industry equilibrium is determined using methods of option pricing. Entry requires the operating profit to exceed the interest on the entry cost, and similarly for exit. The middle band of rates without entry or exit yields hysteresis; it is found to be very wide for plausible parameter values. The exchange rate pass-through to domestic prices is found to be close to one in the phases where foreign firms enter or exit, and near zero otherwise.

Multiproduct Monopoly, Commodity Bundling, and Correlation of Values

Abstract: Through what selling strategy can a multiproduct monopolist maximize his profits when his knowledge about individual consumers' preferences is limited? One possibility, extensively studied in the context of a single-good monopoly, is to use quantity-dependent pricing as a means of discriminating among customers with differing tastes (see, for example, Oi [1971] and Maskin and Riley [1984]). An alternative technique for price discrimination, first suggested by Stigler [1968] and analyzed further by Adams and Yellen [1976], is for the monopolist to package two or more products in bundles rather than selling them separately.' Through a series of examples Adams and Yellen illustrate that bundling can serve as a useful price discrimination device, even when all consumers' willingnesses to pay for each of the goods individually are unaffected by whether they are also consuming the other product. A typical example is illustrated in Figure I (adapted from Figure IV in Adams and Yellen), where there are two goods, three consumers (AB,C) who consume at most one unit of each good (with reservation values for each good that are independent of whether the other good is consumed), and zero costs of production. There, a bundle offered at a price of 100 fully extracts all potential surplus, which would be impossible pricing the goods independently. Unfortunately, though, these authors do not provide any general characterization of the circumstances in which bundling is actually a multiproduct monopolist's optimal strategy. Their examples, however (such as Figure I), create the impression that the profitable use of bundling

Persistent Trade Effects of Large Exchange Rate Shocks

Abstract: This paper presents a theoretical basis for the argument that large exchange rate shocks—such as the 1980s dollar cycle—may have persistent effects on trade flows and the equilibrium exchange rate itself. We begin with a partial-equilibrium model in which large exchange rate fluctuations lead to entry or exit decisions that are not reversed when the currency returns to its previous level. Then we develop a simple model of the feedback from hysteresis in trade to the exchange rate itself. Here we see that a large capital inflow, which leads to an initial appreciation, can result in a persistent reduction in the exchange rate consistent with trade balance.

Forward Discount Bias: Is It an Exchange Risk Premium?

Abstract: UNIVERSITY OF CALIFORNIA, BERKELEY Department o f Economics Berkeley, California Working Paper 8874 FORWARD DISCOUNT BIAS: IS IT AN EXCHANGE RISK PREMIUM? Kenneth A. F r o o t J e f f r e y A. F r a n k e l June 6, 1988 Key words: forward exchange, exchange r a t e , r i s k premium, r a t i o n a l e x p e c t a t i o n s , survey d a t a . Abstract A common f i n d i n g i s t h a t t h e f o r w a r d d i s c o u n t i s a b i a s e d p r e - d i c t o r o f f u t u r e exchange r a t e changes. We use survey d a t a on exchange r a t e e x p e c t a t i o n s t o decompose t h e b i a s i n t o p o r t i o n s a t t r i b u t a b l e t o t h e r i s k premium and e x p e c t a t i o n a l e r r o r s . None o f t h e b i a s i n our sample r e f l e c t s t h e r i s k premium. We a l s o r e j e c t t h e c l a i m t h a t t h e r i s k premium i s more v a r i a b l e t h a n expected d e p r e c i a t i o n . I n v e s t o r s would do b e t t e r i f t h e y reduced f r a c t i o n a l l y t h e magnitude o f expected d e p r e c i a t i o n . This i s the same r e s u l t t h a t many authors have found with forward market data, but now i t cannot be a t t r i b u t e d t o r i s k . JEL C l a s s i f i c a t i o n :

Efficiency with Costly Information: A Study of Mutual Fund Performance, 1965–1984

Abstract: If information is costly to collect and implement, then it is efficient for trades by informed investors to occur at prices sufficiently different from full-information prices to compensate them for the cost of becoming informed. This notion is tested by evaluating investment performance in the mutual fund industry over a 20-year period. The study finds evidence that is consistent with optimal trading in efficient markets. Risk-adjusted returns in the mutual fund industry, net of fees and expenses, are comparable to returns available in index funds; and portfolio turnover and management fees are unrelated to fund performance.

Trading Volume and Asset Liquidity

Abstract: Since the depth and liquidity of a market depend on the entry decisions of all potential participants, each trader assesses them according to conjectures about entry by others. If trade is equally costly across markets, this externality leads to the concentration of trade on one market. If not, it can produce multiple conjectural equilibria, some where trade concentrates on one market and others where large traders resort to a separate market or to search for a trading partner. While fragmentation is welfare-reducing in the two-market case, no such ranking is possible if it involves off-exchange search.

Income Distribution, Market Size, and Industrialization

Abstract: When world trade is costly, a country can profitably industrialize only if its domestic markets are large enough. In such a country, for increasing returns technologies to break even, sales must be high enough to cover fixed setup costs. We suggest two conditions conducive to industrialization. First, a leading sector, such as agriculture or exports, must grow and provide the source of autonomous demand for manufactures. Second, income generated by this leading sector must be broadly enough distributed that it materializes as demand for a broad range of domestic manufactures. These conditions have been important in several historical growth episodes.

An Outside Option Experiment

Abstract: In the economic modeling of bargaining, outside options have often been naively treated by taking them as the disagreement payoffs in an application of the Nash bargaining solution. The paper contrasts this method of predicting outcomes with that obtained from an analysis of optimal strategic behavior in a natural game theoretic model of the bargaining process. The strategic analysis predicts that the outside options will be irrelevant to the final deal unless a bargainer would then go elsewhere. An experiment is reported which indicates that this prediction performs well in comparison with the conventional predictor.

Veto Threats: Rhetoric in a Bargaining Game

Abstract: A specific bargaining game is studied, motivated by the speech-making, billproposing, and bill-vetoing observed in legislative processes. The game has two players, a chooser and a proposer, with the preferences of the chooser not known to the proposer. The chooser starts the game by talking. Then the proposer proposes an outcome, which the chooser accepts or vetoes. Only two kinds of perfect equilibria exist. In the more interesting kind the chooser tells the proposer which of two sets contains his type. Two proposals are possibly elicited, a compromise proposal and the proposer's favorite proposal. Ironically, only the compromise proposal is ever vetoed.

Service-Induced Campaign Contributions and the Electoral Equilibrium

Abstract: Candidates for office are modeled as promising services, such as support for legislation and intervention in the bureaucracy, to interest groups in exchange for campaign contributions. An electoral equilibrium is characterized in which candidates choose service-contribution offers and interest groups choose whether to contribute. The model provides several explanations of congressional incumbents' success in over 90 percent of their reelection contests: a recognition advantage, a high personal valuation of the office, a lower cost of providing services, and policy alignment with high demand interest groups. The model yields predictions that are consistent with empirical findings on the relation between campaign contributions and election outcomes.

Renegotiation and Information Revelation Over Time: The Case of Optimal Labor Contracts

Abstract: The paper analyzes the issue of commitment in Grossman and Hart's model of optimal labor contracts under asymmetric information about firm profitability. We extend their framework by allowing employment to vary over time, at equidistant intervals. When both parties can precommit ex ante not to renegotiate the contract, this replicates the Grossman-Hart outcome each subperiod. When precommitment is not possible, information revealed through the contract can create Pareto-improving renegotiation opportunities, and the issue of optimal information revelation arises. The paper analyzes the impact of ex post Pareto-improving renegotiations on the optimal contract.

Pricing in a Customer Market

Abstract: In standard pricing models, movements in demand are partially offset by price responses. In a customer market, however, price markups may decrease with high demand. Thus, price may magnify, rather than stabilize, demand movements. I consider a monopolist selling a good of which first-time consumers are uncertain. Repeat customers know that the product works. The monopolist trades the objectives of exploiting past customers and attracting new ones. In a period with many new potential customers, the monopolist gives more weight to attracting and lowers its markup. Last, I examine some evidence on whether expansions are periods with disproportionately many new customers.

The Harm from Insider Trading and Informed Speculation

Abstract: Insider traders and other speculators with private information are able to appropriate some part of the returns to corporate investments made at the expense of other shareholders. As a result, insider trading tends to discourage corporate investment and reduce the efficiency of corporate behavior. In the context of a theoretical model, measures that provide some indication of the sources and extent of the investment reduction are derived.

Limited Rationality and Strategic Complements: The Implications for Macroeconomics

Abstract: This paper considers the implications of heterogeneity in information-processing abilities for macroeconomic models that exhibit "strategic complements." The latter is the same concept that has received much attention in the recent macro literature under the headings Keynesian coordination problems and positive trading externalities. We consider environments in which agents vary in terms of their ability to form expectations, and ask whether it is the "sophisticated" agents or the "naive" agents who have a disproportionately large effect on macroeconomic equilibrium. We find that if macroeconomic interaction exhibits strategic complementarity, then it is the naive agents who have a disproportionate impact.

Monopolistic Competition as a Foundation for Keynesian Macroeconomic Models

Abstract: A general equilibrium macroeconomic model based on monopolistic competition is presented. The model exhibits a traditional multiplier in the short run, but due to free entry, the multiplier disappears in the long run. By construction all agents are fully rational. The Keynesian results are a consequence of the assumption of monopolistic competition, which creates a divergence between optimal private behavior and optimal social behavior.

Bargaining and Strikes

Abstract: Strikes are generally regarded as an important economic phenomenon, and yet good theoretical explanations of them are hard to come by. The difficulty is to understand why rational parties should resort to a wasteful mechanism as a way of distributing the gains from trade. Why could not both parties be made better off by moving to the final distribution of surplus immediately (or if it is uncertain to its certainty equivalent) and sharing the benefits from increased production?

Strikes, Free Riders, and Social Customs

Abstract: In recent years there has been a growing literature on the role of social customs in the labour market. Marsden (1986), for example, has emphasised the importance of group norms and social custom in various labour market contexts. Jones (1984) develops an economic model of conformist behaviour in which an individual's work effort is determined partly by tradition and by the behaviour of other workers. A central theme of the literature is that a rational economic agent does not inhabit a social vacuum and hence that individual behaviour is influenced, to some extent, by the actions of others. The approach promises the possibility of an escape from the free-riders problem, which, as we shall investigate, might have a number of labour market applications. Such a potential has been suggested by a number of writers in different fields. Eiser (1978), writing from a socio-psychological perspective, has stressed the role of social norms in producing cooperative outcomes in the theoretical context of the prisoner’s dilemma. Such an emphasis is consistent with Sen's (1977) argument that the concept of commitment might offer a solution to the free rider problems.

Efficient Wage Bargaining as a Repeated Game

Abstract: This paper builds a bridge between the two existing approaches for wage and employment determination in a unionized market: the monopoly union model and the efficient bargaining model. Both fail to capture the dynamic aspects of wage bargaining. When the repeated nature of the wage bargaining process is considered, the equilibria are neither as inefficient as the monopoly union model predicts nor as fully efficient. Rather, the two models can be regarded as particular cases with certain discount rates. We apply our model to issues such as the endgame interpretation of the U. S. steel industry, wage concessions, and featherbedding.

Divergent Expectations as a Cause of Disagreement in Bargaining: Evidence from a Comparison of Arbitration Schemes

Abstract: The fact that settlement rates are much higher, where final-offer arbitration rather than conventional arbitration is the dispute settlement procedure, is used as the basis of a test of the role of divergent and relatively optimistic expectations in causing disagreement in negotiations. Calculations of identical-expectations contract zones using existing estimates of models of arbitrator behavior yield larger identical-expectations contract zones in conventional arbitration than in final-offer arbitration. This evidence clearly suggests that divergent expectations alone are not an adequate explanation of disagreement in labor-management negotiations. A number of alternative explanations for disagreement are suggested and evaluated.

Workers' Trust Funds and the Logic of Wage Profiles

Abstract: This paper defines a concept, a worker's trust fund, which is useful in analyzing optimal age-earnings profiles. The trust fund represents what a worker loses if dismissed from a job for shirking. In considering whether to work or shirk, a worker weighs the potential loss due to forfeiture of the trust fund if caught shirking against the benefits from reduced effort. This concept is used to show that the implicit bonding in upward sloping age-earnings profiles is not a perfect substitute for an explicit up-front performance bond (or employment fee). It is also shown that the second-best optimal earnings profile in the absence of an up-front employment fee pays total compensation in excess of market clearing in a variety of stylized cases.

Price Flexibility, Credit Availability, and Economic Fluctuations: Evidence from the United States, 1894–1909

Abstract: The importance of disturbances in financial markets for real economic activity and the positive association between price level and output movements typically are explained by appeal to a combination of nominal aggregate demand shocks (particularly money-supply shocks) and rigid prices. We argue that this view is inconsistent with evidence for short-run responsiveness of prices and gold flows to nominal disturbances during the pre-World War I gold-standard era. We offer an alternative explanation that connects financial markets and real activity through disturbances to the availability of credit. This approach links comovements in prices and output through real effects in credit markets associated with price-level shocks. Empirical analysis, using monthly data for the pre-World War I period, supports the assumption of rapid price adjustment, and the credit-supply interpretation of the transmission of financial shocks. Disturbances to credit availability, including price shocks, contribute substantially to our empirical explanation of output fluctuations during this period.

Are Prices Too Sticky

Abstract: Nominal price rigidity has a negative externality: rigidity in one firm's price increases the variability of aggregate real spending, which harms all firms. This paper investigates whether this externality is large, which would imply that stabilization policy can be highly beneficial even if the costs of making prices flexible are small. There are three conclusions. First, both the private cost of price rigidity and the externality are second order in the size of fluctuations. Second, the externality can nonetheless be arbitrarily large. Third, in a simple model the externality is small for plausible parameter values.

A Behavioral Explanation for Nominal Wage Rigidity During the Great Depression

Abstract: Nominal wages in manufacturing were left unchanged by the large decline in nominal demand that marked the first two years of the Great Depression This rigidity in nominal wages is explained using the tools of the behavioral theory of the firm The emphasis is on the reasons firms changed their decision rules linking fluctuations in final sales to changes in nominal wages

The Cyclical Behavior of Strategic Inventories

Abstract: This paper presents a model in which inventories are used by a duopoly to deter deviations from an implicitly collusive arrangement. Higher inventories allow firms to punish cheaters more strongly and can thus help to maintain collusion. We show that when demand is high, the incentive to deviate increases so that increases in inventories may be optimal for the duopoly. This rationalizes the observed positive correlation between inventories and sales. In our empirical section we show that, as our model predicts, this correlation is more important in concentrated industries. We also provide several examples where inventories have been a factor in cartel behavior.