Showing papers in "The American Economic Review in 1986"

Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers

Abstract: The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows—more cash than profitable investment opportunities. The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why “diversification” programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidationmotivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.

Efficiency Wage Models of the Labor Market: Equilibrium Unemployment as a Worker Discipline Device

Abstract: Involuntary unemployment appears to be a persistent feature of many modem labor markets. The presence of such unemployment raises the question of why wages do not fall to clear labor markets. In this paper we show how the information structure of employer-employee relationships, in particular the inability of employers to costlessly observe workers' on-the-job effort, can explain involuntary unemployment' as an equilibrium phenomenon. Indeed, we show that imperfect monitoring necessitates unemployment in equilibrium. The intuition behind our result is simple. Under the conventional competitive paradigm, in which all workers receive the market wage and there is no unemployment, the worst that can happen to a worker who shirks on the job is that he is fired. Since he can immediately be rehired, however, he pays no penalty for his misdemeanor. With imperfect monitoring and full employment, therefore, workers will choose to shirk. To induce its workers not to shirk, the firm attempts to pay more than the "going wage"; then, if a worker is caught shirking and is fired, he will pay a penalty. If it pays one firm to raise its wage, however, it will pay all firms to raise their wages. When they all raise their wages, the incentive not to shirk again disappears. But as all firms raise their wages, their demand for labor decreases, and unemployment results. With unemployment, even if all firms pay the same wages, a worker has an incentive not to shirk. For, if he is fired, an individual will not immediately obtain another job. The equilibrium unemployment rate must be sufficiently large that it pays workers to work rather than to take the risk of being caught shirking. The idea that the threat of firing a worker is a method of discipline is not novel. Guillermo Calvo (1981) studied a static model which involves equilibrium unemployment.2 No previous studies have treated general market equilibrium with dynamics, however, or studied the welfare properties of such unemployment equilibria. One key contribution of this paper is that the punishment associated with being fired is endogenous, as it depends on the equilibrium rate of unemployment. Our analysis thus goes beyond studies of information and incentives within organizations (such as Armen Alchian and Harold Demsetz, 1972, and the more recent and growing literature on worker-firm relations as a principal-agent problem) to inquire about the equilibrium conditions in markets with these informational features. The paper closest in spirit to ours is Steven Salop (1979) in which firms reduce turnover costs when they raise wages; here the savings from higher wages are on monitoring costs (or, at the same level of monitoring, from increased output due to increased effort). As in the Salop paper, the unemployment in this paper is definitely involuntary, and not of the standard search theory type (Peter Diamond, 1981, for example). Workers have perfect information about all job opportunities in our model, and unemployed workers strictly prefer to work at wages less than the prevailing market wage (rather than to remain unemployed); there are no vacancies. *Woodrow Wilson School of Public and International Affairs, and Department of Economics, respectively, Princeton University, Princeton, NJ 08540. We thank Peter Diamond, Gene Grossman, Ed Lazear, Steve Salop, and Mike Veall for helpful comments. Financial support from the National Science Foundation is appreciated. 'By involuntary unemployment we mean a situation where an unemployed worker is willing to work for less than the wage received by an equally skilled employed worker, yet no job offers are forthcoming. 2In his 1979 paper, Calvo surveyed a variety of models of unemployment, including his hierarchical firm model (also with Stanislaw Wellisz, 1979). There are a number of important differences between that work and this paper, including the specification of the monitoring technology.

Fairness as a Constraint on Profit Seeking: Entitlements in the Market

Abstract: Community standards of fairness for the setting of prices and wages were elicited by telephone surveys. In customer or labor markets it isacceptable for a firm to raise prices (or cut wages) when profits arethreatened, and to maintain prices when costs diminish. It is unfair toexploit shifts in demand by raising prices or cutting wages. Several market anomalies are explained by assuming that these standards of fairness influence the behavior of firms. Copyright 1986 by American Economic Association.

Technological Opportunity and Spillovers of R&D: Evidence from Firms' Patents, Profits, and Market Value

Abstract: This paper quantifies the effects of exogenous variations in the state of technology (technological opportunity) and of the R&D of other firms (spillovers of R&D) on the productivity of firms' R&D. The R&D productivity is increased by the R&D of "technological neighbors," though neighbors' R&D lowers the profits and market value of low-R&D-intensity firms. Firms are shown to adjust the technological composition of their R&D in response to technological opportunity. Copyright 1986 by American Economic Association.

Productivity Growth, Convergence, and Welfare: What the Long-Run Data Show

Abstract: Maddison's 1870-1979 data are analyzed, showing the historically unprecedented growth in productivity, gross domestic product per capita and exports and the remarkable convergence of productivities of industrialized market economies, with convergence apparently shared by planned economies but not less developed countries. Productivity lag's relation to "deindustrialization," unemployment, and balance of payments is examined. The data are shown to suggest a tempered view of the slowdown in U.S. productivity growth and its lag behind other countries.

Investment, Capacity Utilization and the Real Business Cycle

Abstract: The present paper adopts the Keynesian view that direct shocks to investment are important for business fluctuations, but incorporates them in a neo-classical framework where the rate of capital ut ...

Installed base and compatibility : innovation, product preannouncements and predation

Abstract: A good is often more valuable to any user, the more others use compatible goods. The authors show that this effect may inhibit innovation. If an installed base exists and transition to a new standard must be gradual, early adopters bear a disproportionate share of transient incompatibility costs. This can produce "excess inertia." The installed base, however, is "stranded" if the new standard is adopted: this may create "excess momentum." These dynamic effects have strategic implications. Temporary price cutting can permanently prevent entry; and product preannouncements can be critical in innovation. These strategic actions have ambiguous welfare effects.

Evaluating the Econometric Evaluations of Training Programs with Experimental Data

Abstract: This paper takes the results of an employment and training program thatwas run as a field experiment, in which the participants were randomlyassigned into a treatment or a control group, and compares these results to the estimates that might have been produced by an econometrician who evaluated the program using the same econometric procedures that have been used in the program evaluation literature. This comparison shows that many of these econometric procedures fail toreplicate the experimentally determined results, and suggests that researchers should be aware of the potential for specification errorsin other nonexperimental evaluations. Copyright 1986 by American Economic Association.

A Supergame-Theoretic Model of Price Wars during Booms

Abstract: theoretical grounds that implicitly colluding oligopolies are likely to behave more competitively in periods of high demand. We then show that, in practice, during those periods, various oligopolistic industries tend to have relatively low prices. The few price wars which have been documented also seem to have taken place during periods of high demand. Finally, we study the possibility that this oligopolistic behavior has macroeconomic consequences. We show that it is possible that the increase in competitiveness that results from a shift in demand towards goods produced by oligopolies may be sufficient to raise the output of all sectors.

Life Cycle, Individual Thrift and the Wealth of Nations

Abstract: This paper provides a review of the theory of the determinants of individual and national thrift that has come to be known as the Life Cycle Hypothesis (LCH) of saving. Applications to some current policy issues are also discussed. Part I deals with the state of the art on the eve of the formulation of the LCH some 30 years ago. Part II sets forth the theoretical foundations of the model in its original formulation and later amendment, calling attention to various implications, distinctive to it and, sometimes, counter-intuitive. It also includes a review of a number of crucial empirical tests, both at the individual and the aggregate level. Part III reviews some applications of LCH to current policy issues, though only in sketchy fashion, as space constraints prevent fuller discussion.(This abstract was borrowed from another version of this item.)

Oligopoly and Financial Structure: The Limited Liability Effect

Abstract: We argue that product markets and financial markets have important linkages. Assuming an oligopoly in which financial and output decisions follow in sequence, we show that limited liability may commit a leveraged firm to a more aggressive output stance. Because firms will have incentives to use financial structure to influence the output market, this demonstrates a new determinant of the debt

Rational and Self-fulfilling Balance-of-Payments Crises

Abstract: Speculative attacks on a pegged exchange rate must sometimes occur ifasset-price paths are to be free of abnormal profit opportunities. Suchattacks are fully rational, as they reflect the market's response to aregime breakdown that is inevitable. The authors shows that under someexpectations about policy, balance-of-payments crises can also be purely self-fulfilling events. In such cases even a permanently viableregime may collapse, and the economy will possess multiple equilibriacorresponding to different subjective assessments of the probability ofa crisis. The behavior of the domestic interest rate will naturally reflect the possibility of a speculative attack. Copyright 1986 by American Economic Association.

Productivity, R&D, and the Basic Research at the Firm Level in the 1970's

Abstract: A new data set for approximately 1,000 largest manufacturing firms inthe United States during 1957-77 is analyzed using a standard production function framework augmented by the addition of RD that the contribution of basic research was significantly higher than its nominal ratio would imply; and that federally financed R&D expenditures had a positive but smaller effect on the productivity growth of these firms than the comparable contribution of privately financed R&D expenditures. Copyright 1986 by American Economic Association.

On the Limitations of Government Borrowing: A Framework for EmpiricalTesting

Abstract: This paper seeks to distinguish empirically between two views on the limitations of government borrowing. According to one view, nothing precludes the government from running a permanent budget deficit, paying interest due on the growing debt load simply by issuing new debt, An alternative perspective holds that creditors would be unwilling to purchase government debt unless the government made a credible commitment to balance its budget in present value terms. We show that distinguishing between these possibilities is mathematically equivalent to testing whether a continuing currency inflation might be fueled by speculation alone or is instead driven solely by economic fundamentals. Empirical tests which have been developed for this economic question lead us to conclude that postwar U.S. deficits are largely consistent with the proposition that the government budget must be balanced in present-value terms.

The Rigidity of Prices

Abstract: This paper uses evidence on individual transaction prices to analyze price behavior. The evidence shows that, for many transactions, pricesremain rigid for periods exceeding one year. The rigidity of price ispositively correlated with industry concentration. For several productsthe correlation of price changes across buyers is low. The paper alsoinvestigates the relationship between price rigidity, price change, andthe length of time a buyer and seller have been doing business together. The author interprets the evidence as emphasizing the importance of nonprice rationing and the inadequacy of models in whichprice movements alone clear markets. Copyright 1986 by American Economic Association.

Inventories and the volatility of production

Abstract: A stylized fact associated with inventory behavior is that the variance of production exceeds the variance of sales. This paper presents a model of production decisions with demand uncertainty that incorporates no nnegativity constraints on inventories. Even with no productivity shocks, optimal behavior by the firm is consistent with this stylized fact either if demand exhibits positive serial correlation, or if the firm can backlog excess demand. The reason is that a demand shock affects both the actual inventory level (given unchanged production) and the desired level. Production must replenish the stock and adjust to the new desired level. Copyright 1987 by American Economic Association.

The Persistence of Volatility and Stock Market Fluctuations

Abstract: This paper examines the potential influence of changing volatility in stock market prices on the level of stock market prices. It demonstrates that volatility is only weakly serially correlated, implying that shocks to volatility do not persist. These shocks can therefore have only a small impact on stockmarket prices, since changes in volatility affect expected required rates of return for relatively short intervals. These findings lead us to be skeptical of recent claims that the stock market's poor performance during the 1970's can be explained by volatility-induced increases in risk premia.

Measuring racial discrimination with fair housing audits: caught in the Act.

Abstract: A survey technique called a "fair housing audit" provides a direct measure of racial discrimination in housing. This paper examines the econometric issues raised by audit data, measures the discrimination uncovered by a 1981 Boston study, and tests hypotheses about the causes of discrimination. The estimated level of discrimination is high: Black housing seekers are told about 30 percent fewer available housing units than are whites. The hypothesis tests indicate that the primary cause of this discrimination is that housing agents illegally promote their economic interests by catering to the racial prejudice of their current or potential white customers.

Marriage and divorce: informational constraints and private contracting

Abstract: The relationship between divorce rates in the United States and laws regulating divorce are analyzed using data from a special Current Population Survey undertaken in 1979 with particular reference to the adoption by many states of no-fault divorce laws. The author "utilizes a contract-theoretic framework to examine the impact of both legal and informational constraints on several aspects of the marriage relationship: 1) the probability of divorce; 2) compensation at divorce (i.e. the terms of the divorce settlement); 3) the probability of entering marriage; and 4) incentives for investment in marriage-specific capital." Two different models are developed. The first assumes that ex post information about the value of each spouses opportunites at divorce is symmetric and that since divorce would only occur if the joint benefits outweigh the joint costs the law has no effect on the divorce rate. The second model asserts that the existence of asymmetric information results in a fixed wage marriage contract and that divorce would be higher in states that allow unilateral divorce. The evidence supports the first of these hypotheses. (EXCERPT)

Labor Supply and Marital Separation

Abstract: Panel data are used to estimate the effect of marital separation on labor supply. Female labor supply increases substantially and male labor supply declines marginally, lending support to the theory of specialization within the household. The most interesting finding is that women began to increase their labor supply well before the actualsplit occurs, suggesting either that shocks to labor supply change divorce probabilities or that women with a higher likelihood of divorcework more. This argument is pursued by constructing and estimating a simultaneous model of labor supply and divorce risk. Copyright 1986 by American Economic Association.

Preference Reversals and the Independence Axiom

Abstract: Of all of the paradoxical patterns of behavior reported in laboratory experiments, one of the most perplexing for decision theorists is the preference reversal phenomenon. A subject in a preference reversal experiment is typically given a choice between a lottery with a high probability of winning a modest amount of money, a "P bet," and a lottery with a low probability of winning a large amount of money, a "$ bet." The lowest amount of money for which the subject would willingly sell either of these lotteries is also elicited. The most common "reversal" is for a subject to choose the P bet over the $ bet but to put a higher selling price on the $ bet. Preference reversals were first reported by Harold Lindman (1971) and Sarah Lichtenstein and Paul Slovic (1971). In discussing the psychologists' discovery of such reversals, David Grether and Charles Plott remark: "The inconsistency is deeper than mere lack of transitivity or even stochastic transitivity. It suggests that no optimization principles of any sort lie behind even the simplest of human choices..." (1979, p. 623). This paper offers a simple alternative explanation of documented preference reversals, an explanation that does not require the abandonment of the transitivity assumption.

Evaluating the effects of optimally distributed public programs: child health and family planning interventions

Abstract: This paper develops and tests an optimizing model determining the distribution of family planning and health subsidies across heterogeneous households and assesses the biases in cross-area estimates of the health effects of such subsidies due to public resource optimization. The model incorporates both health externalities and the endogenous response of the size of the recipient population to program subsidies. Longitudinal data describing child health and publicly provided family planning and health programs in 20 barrios in Laguna Province in the Philippines are used to estimate the effects of such programs on child health and the relationships between the distribution of the programs and preprogram health levels. The impact of a program on a particular childs health status is viewed as dependent upon the childs length of exposure to the program. A basic feature of the model is the presence of health externalities which is shown to be sufficient along with plausible features of household behavior to make selective subsidization of fertility control (either alone or in combination with health investment subsidies) Pareto efficient. The model suggests that subsidization of fertility control is likely to be Pareto efficient in the presence of health or human capital externalities when human capital and family size are gross substitutes and/or when any per child human capital subsidies may substitute for direct subsidies to health investment and an equalizing distribution of the subsidies (the highest family planning subsidies to the lowest health recipient households) is efficient. When both health and family planning subsidies are used fertility control subsidies minimize the subsidy burden for donors and are highest when total subsidy expenditures per child are greatest.

Tests of the Rational Expectations Hypothesis

Abstract: This paper reviews evidence on the structure of anticipation from a number of empirical studies. Jack Muth's "rational expectations hypothesis" is compared with a variety of alternative models, including Ferber's Law, the "implicit expectations" model of Edwin Mills, and Muth's new "errors in the variables" model. The cumulative evidence is of such strength as to compel the suspension of belief in the concept of rational expectations. This implies that it is a mistake to proceed under the maintained hypothesis that expectations are rational; instead, it is necessary to test the sensitivity of empirical and theoretical results to alternative assumptions about the structure by which anticipations are generated. Copyright 1986 by American Economic Association.

Retail Pricing and Clearance Sales

Abstract: Sellers of new products are faced with having to guess demand conditions to set price appropriately. But sellers are able to adjustprice over time and to learn from past mistakes. Additionally, it is not necessary that all goods be sold with certainty. It is sometimes better to set a high price and to risk no sale. This process is modeledto explain retail pricing behavior and the time distribution of transactions. Prices start high and fall as a function of time on theshelf. The initial price and rate of decline can be predicted and depends on thinness of the market, the proportion of customers who are"window shoppers," and other observable characteristics. Copyright 1986 by American Economic Association.

Explaining the Volume of Trade: An Eclectic Approach

Abstract: Divide the world into a capital-abundant North and a labor-abundant South. Subdivide the North into two identical regions, East and West.Modern trade theory predicts intraindustry trade in differentiated manufactured goods between East and West, and traditional interindustry trade based on factor endowments between North and South. But the theory offers no conclusions about the volume of trade , and gives no real role to demand in determining trade flows. The model developed here explains both the volume and the direction of trade by combining nonhomothetic preferences with scale economies and differences in endowments. Copyright 1986 by American Economic Association.

Financial Panics, the Seasonality of the Nominal Interest Rate, and the Founding of the Fed

Abstract: After the founding of the Fed in 1914, the frequency of financial panics and the size of the seasonal movements in nominal interest ratesboth declined substantially. This paper establishes that the Fed, by carrying out the seasonal open market policy that eliminated the seasonal in nominal interest rates, caused the decrease in the frequency of panics. Since seasonal movements are anticipated and financial panics are probably real events, the results show that an anticipated monetary policy had real effects on the economy. Copyright 1986 by American Economic Association.

Taxation of Investment and Savings in a World Economy

Abstract: The equilibrium of capital and equilibrium market prices are derived for a world economy with a unified securities market, mobile capital, no uncertainty, and varying tax rates on different sources of income in each country. The paper then characterizes optimal tax rates for a small country in this setting, focusing on the peculiar incentives created when the before-tax rate of return differs among securities due to differences in their typical tax treatment. Copyright 1986 by American Economic Association.

Golden Parachutes, Shark Repellents, and Hostile Tender Offers

Abstract: A common view of golden parachutes and shark repellents is that they are designed by management to insulate itself from the discipline imposed by the market for corporate control and so are harmful to shareholders. This paper offers an alternative view that these devicesare beneficial to shareholders because they allow better contracting between manager and shareholders. Evidence on the incidence of goldenparachutes and on the compensation-tenure relationship for managers of golden parachute firms supports the alternative view. Copyright 1986 by American Economic Association.