Showing papers in "The Review of Economic Studies in 1991"

Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations.

Abstract: This paper presents specification tests that are applicable after estimating a dynamic model from panel data by the generalized method of moments (GMM), and studies the practical performance of these procedures using both generated and real data. Our GMM estimator optimally exploits all the linear moment restrictions that follow from the assumption of no serial correlation in the errors, in an equation which contains individual effects, lagged dependent variables and no strictly exogenous variables. We propose a test of serial correlation based on the GMM residuals and compare this with Sargan tests of over-identifying restrictions and Hausman specification tests.

Financial Intermediation and Endogenous Growth

Abstract: An endogenous growth model with multiple assets is developed. Agents who face random future liquidity needs accumulate capital and a liquid, but unproductive asset. The effects of introducing financial intermediation into this environment are considered. Conditions are provided under which the introduction of intermediaries shifts the composition of savings toward capital, causing intermediation to be growth promoting. In addition, intermediaries generally reduce socially unnecessary capital liquidation, again tending to promote growth.

Quality Ladders in the Theory of Growth

Abstract: We develop a model of repeated product improvements in a continuum of sectors. Each product follows a stochastic progression up a quality ladder. Progress is not uniform across sectors, so an equilibrium distribution of qualities evolves over time. But the rate of aggregate growth is constant. The growth rate responds to profit incentives in the R&D sector. We explore the welfare properties of our model. Then we relate our approach to an alternative one that views product innovation as a process of generating an ever-expanding range of horizontally differentiated products. Finally, we apply the model to issues of resource accumulation and international trade.

Yield Spreads and Interest Rate Movements: A Bird's Eye View

Abstract: This paper examines postwar U.S. term structure data and finds that for almost any combination of maturities between one month and ten years, a high yield spread between a longer-term and a shorter-term interest rate forecasts rising shorter-term interest rates over the long term, but a declining yield on the longer-term bond over the short term. This pattern is inconsistent with the expectations theory of the term structure, but is consistent with a model in which the spread is proportional to the value implied by the expectations theory.

Estimating Long-run Economic Equilibria

Abstract: with stochastic trends. An asymptotic theory is provided to analyze a menu of currently existing estimators of cointegrated systems. We study in detail the single-equation ECM (SEECM) approach of Hendry. Our theoretical results lead to prescriptions for empirical work, such as specifying SEECM's nonlinearly and including lagged equilibrium relationships rather than lagged differences of the dependent variable as covariates. Simulations support these prescriptions, and point to problems of overfitting not encountered in the semiparametric approach of Phillips and Hansen (1990).

Intra-Day and Inter-Market Volatility in Foreign Exchange Rates

Abstract: Four foreign exchange spot rate series, recorded on an hourly basis for a six-month period in 1986 are examined. A seasonal GARCH model is developed to describe the time-dependent volatility apparent in the percentage nominal return of each currency. Hourly patterns in volatility are found to be remarkably similar across currencies and appear to be related to the opening and closing of the worlds major markets. Robust LM tests designed to deal with the extreme leptokurtosis in the data fails to uncover any evidence of misspecification or the presence of volatility spillover effects between the currencies or across markets.

Mean reversion in stock prices? a reappraisal of the empirical evidence

Abstract: The paper re-examines the empirical evidence for mean-reverting behaviour in stock prices. Comparison of data before and after World War II shows that mean reversion is entirely a pre-war phenomenon. Using randomization methods to calculate significance levels, we find that the full sample evidence for mean reversion is weaker than previously indicated by Monte Carlo methods under a Normal assumption. Further, the switch to mean-averting behaviour after the war is about to be too strong to be compatible with sampling variation. We interpret these findings as evidence of a fundamental change in the stock returns process and conjecture that it may be due to the resolution of the uncertainties of the 1930's and 1940's.

Joint Projects without Commitment

Abstract: This paper concerns the pattern of contributions to a joint project when commitments and enforceable contracts are not available. We analyse a game in which partners alternate in making contributions to the project until the project is completed. Contributions are sunk when they are made. The game has a unique subgame perfect equilibrium path, which is inefficient in the sense that socially desirable projects may not be completed. By contrast, in a "subscription game" in which the cost of the contribution is borne only if and when the contributions committed to the project cover its cost, the outcome is efficient.

Optimal Learning by Experimentation

Abstract: This paper considers a problem of optimal learning by experimentation by a single decision maker. Most of the analysis is concerned with the characterisation of limit beliefs and actions. We take a two-stage approach to this problem: first, understand the case where the agent's payoff function is deterministic; then, address the additional issues arising when noise is present. Our analysis indicates that local properties of the payoff function (such as smoothness) are crucial in determining whether the agent eventually attains the true maximum payoff or not. The paper also makes a limited attempt at characterising optimal experimentation strategies.

Computing Multi-Period, Information-Constrained Optima

Abstract: This paper presents a detailed theoretical derivation and justification for methods used to compute solutions to a multi-period (including infinite-period), continuum-agent, unobservedeffort economy. Actual solutions are displayed illustrating cross-sectional variability in consumption and labour effort in the population at a point in time and variability for a typical individual over time. The optimal tradeoff between insurance and incentives is explored and the issue of excess variability is addressed by consideration of the analogue full-information economy and various restricted-contracting regimes.

Incomplete Contracts, Specific Investments, and Risk Sharing

Abstract: An optimal contract design problem is considered. Contracts which are incomplete and simple are used to investigate the extent to which constrained revisions can mitigate inefficiencies resulting from contractual incompleteness. An optimal contract is characterized in two cases. First, when a contract is being used to facilitate trade between two risk-neutral parties who must make relationship-specific investments, it is possible to implement the first-best by a simple contract. Second, when a contract is being used to share risk, it is generally not possible to implement the first-best. When one party is risk neutral, however, it is possible to implement the first-best by assigning all the ex post decision rights to that party.

Risk-Bearing and the Theory of Income Distribution

Abstract: This paper develops the stochastic theory of distribution with a dynamic model which focuses on the role of incomplete insurance in generating inequality. Unlike previous work, our approach takes explicit account of the reason for market incompleteness in modeling agents' behaviour; in particular, the amount of risk borne is endogenous. Using a model of growth with altruism in which agents are risk-averse and there is moral hazard, we show that lineage wealth follows a Markov process which converges globally to an ergodic distribution; this also represents the long-run population distribution of wealth. We discuss the role of particular assumptions, such as availability of production loans and unboundedness of utility, in yielding the qualitative properties of the distribution of wealth, the choice of "occupation", and the prevention of poverty traps.

The Volume and Composition of Trade Between Rich and Poor Countries

Abstract: North-South trade is studied in a model of vertical product differentiation. The South produces a low-quality spectrum of goods and the North a high-quality spectrum. An increase in the South's population lowers its relative wage, expands the spectrum of Southern goods at the top, and shifts the Northern spectrum upward. An increase in Northern labour productivity raises its relative wage. If the increase is neutral or export-biased, then the South's terms of trade improve, the spectrum of Northern products expands, the spectrum of Southern products contracts, and the volume of trade grows. If it is biased against Northern exports, these effects are reversed. Similar results hold for neutral increases in Southern productivity. New goods are typically developed, first produced, and first consumed in the most advanced countries, and only later produced and consumed in less advanced countries. A number of explanations have been suggested for this pattern, the product cycle. In his classic article, Vernon (1966) stressed that the demand for certain types of consumer goods, especially labour-saving goods, is greatest in high-income countries, and that familiarity with the tastes of potential buyers is a critical factor in successful product innovation. In his view, proximity to the product market is the key factor. More recently, Krugman (1979), Dollar (1986), Jensen and Thursby (1986, 1987), and Grossman and Helpman (1989) have put forward an explanation based on a techno- logical advantage in the advanced countries in carrying out R&D. They assume that innovation can take place only in the more advanced region, hereafter called the North, and that reverse engineering is required in the less-developed region, the South, before a new good can be produced there. Preferences over product varieties are taken to be homothetic and symmetric, so the model is one of horizontal product differentiation. North-South trade is motivated by a preference for diversity, and growth is represented by an increase in the total number of varieties available. This model captures many interesting aspects of the development and diffusion of new products, but it also has some unsatisfactory features. First, consumption patterns are the same in both regions. Because preferences are homothetic, Northerners simply consume proportionately more (per capita) of each variety. This is clearly at odds with the fact, stressed by Vernon, that new goods are not typically consumed in the South until later in the cycle. Second, old goods are never dropped from production. Because

Information Externalities in the Labour Market and the Duration of Unemployment

Abstract: A matching model is analysed in which firms imperfectly test workers prior to hiring them. If (some) firms hire only workers who pass the test, there is an informational externality; unemployment duration is a signal of productivity. In equilibrium, if it is profitable for a firm to test, it is also profitable for it to condition its hiring decision on duration, hiring those whose duration is less than a critical value. This testing equilibrium is inefficient, with too much testing and too low a critical duration value. Sensitivity analysis of the latter suggests explanations for the dependence of re-employment probabilities on duration and the instability of the U- V curve.

Consistent Nonparametric Entropy-Based Testing

Abstract: form the test statistic. In order to obtain a normal null limiting distribution, a form of weighting is employed. The test is also shown to be consistent against a class of alternatives. The exposition focusses on testing for serial independence in time series, with a small application to testing the random walk hypothesis for exchange rate series, and tests of some other hypotheses of econometric interest are briefly described. This paper proposes a new class of tests for nonparametric hypotheses, with special reference to the problem of testing for independence in time series in the presence of a nonparametric marginal distribution under the null. The critical region of the tests is the upper tail of the distribution of an estimate of the Kullback-Leibler information criterion, whose desirable properties make it convenient to describe in a reasonably comprehensible fashion some of the consistent directions. A test is consistent against one direction of departure from the null hypothesis if the probability of rejection approaches one no matter how small the departure in that direction. For continuous distributions, two random variables Y and Z are independent if and only if their joint probability density f(y, z) equals the product of the marginal densities g(y) and h(z) for all y, z; our test for independence is consistent wherever f(y, z) deviates from g(y)h(z) by even small amounts on a set of arbitrarily small non-zero measure, providing some regularity conditions hold. It will be helpful to briefly introduce the Kullback-Leibler information criterion and describe some of its properties. Following definitions of the entropy of a distribution by Shannon (1948), Wiener (1948), a measure of information for discriminating between two hypotheses was proposed by Kullback and Leibler (1951). Let X be a p-vector-valued random variable with absolutely continuous distribution function. Consider the hypotheses HI: pdf(X) = f(x) H2: pdf(X) = g(x). The mean information for discrimination between HI and H2 per observation from f is

Learning from Coarse Information: Biased Contests and Career Profiles

Abstract: An organization's promotion decision between two workers is modelled as a problem of boundedly-rational learning about ability. The decision-maker can bias noisy rank-order contests sequentially, thereby changing the information they convey. The optimal final-period bias favours the "leader", reinforcing his likely ability advantage. When optimally biased rank-order information is a sufficient statistic for cardinal information, the leader is favoured in every period. In other environments, bias in early periods may (i) favour the early loser, (ii) be optimal even when the workers are equally rated, and (iii) reduce the favoured worker's promotion chances. This paper presents a model of boundedly-rational learning by an organization. The aims are to represent in a simple form the costs of gathering, processing, or transmitting information and to analyse their implications for the procedures selected to handle information, as well as for the decisions actually made. Like other recent work on the internal organization of firms, this work explores to what extent organizational structure and behaviour, as well as organizational performance, can be explained by adaptation to the costs associated with information.' In the learning model we formulate, the decision-maker not only selects a rule specifying what action to take as a function of his observations but also chooses, sequentially, the information partitions generating those observations. This general problem is interpreted in the context of an organization which needs to make an important promotion decision and which attempts to maximize the value of the information generated during the observation periods that precede the decision. One of the motivations for this analysis was the finding by organizational sociologists that earnings and promotions in the later stages of a worker's career are strongly correlated with earnings and promotions in the early stages (Kanter (1977), Rosenbaum (1984)). Later success is positively associated with early success, even when one controls for the effect of observable characteristics likely to affect performance, such as education. One obvious source of this correlation is differences in ability that persist over time and that are not captured by the observable covariates. In this paper, we focus on differences in ability which are initially unobservable by organizations and their workers, as well as by researchers. We present a simple model of an organization trying to learn about differences in ability and show

Learning and Capacity Expansion under Demand Uncertainty

Abstract: A competitive, dynamic model of entry into a new industry is set up and both its positive and normative aspects are studied. The main assumptions are that entry is sequential, that it occurs under imperfect information on the size of the market and that better information becomes available as time goes on. The gradual improvement in information is due to the fact that later waves of entrants are able to observe the profitability of earlier entrants. The major results reported here (under suitable restrictions) are that the equilibrium rate of entry is monotonically decreasing over time, and that-at any given point in time-it is smaller than the socially optimal one. When a new market opens (as a result of a product being newly invented, for instance) or when an existing market starts to expand, uncertainty with respect to its size is likely to prevail. As a result of this uncertainty, entry of firms into such markets typically will occur in waves: some firms will enter initially, while others will wait to see the consequences of that initial entry. If the experience of early entrants is favourable, entry will continue; otherwise entry will cease. Hence, with the introduction of a new product, two phases are associated: the "growth phase", typified by positive operating profits for existing firms and expansion of productive capacity due to entry of new firms, and the "mature phase", typified by erosion of profits and fixed total productive capacity. Empiricists estimating the time-pattern of investments during the growth phase have found an "S-shaped" diffusion curve (see Mansfield (1986), and Gort and Klepper (1982)). The purpose of the present paper is to theoretically characterize these time-patterns and to investigate their welfare properties. Any attempt to model the type of entry described above, must account for differences in both entry dates and resultant earnings. In other words, the theory must explain why the realized earnings of different cohorts of firms are not equal. Often such ex post differences are reconciled by assuming heterogeneity with respect to some latent underlying characteristic ("managerial ability", for instance) and attributing differences in earnings to differences in that characteristic. In this paper, instead, earning differentials are attributable to luck only: ex ante all firms are technologically identical and equally capable of forecasting market prospects and rationally acting upon those forecasts. Ex post, some firms turn out to have entered at the "right time" and are-for that reason-more profitable. The model developed in this paper analyzes a parametric example of a sequential entry problem in which the uncertainty over market size is gradually resolved over time in a Bayesian setting. In an environment of perfect competition and constant returns-toscale, a free-entry equilibrium concept is introduced and the aggregate implications of the time-path of investments are derived. I then compare this (actual) time-path to the optimum. This comparison is interesting because the equilibrium is analysed under the

Analytical Approximations in Models of Hysteresis

Abstract: Decisions made under ongoing uncertainty and costly reversibility entail a range of the state variable where inaction is optimal, which in turn produces hysteresis-permanent effects of temporary shifts. The range is usually defined by non-linear equations that need numerical solutions. In this paper a technique of analytical approximations is developed and applied to two models-menu costs and investment. The resulting explicit solutions help clarify why hysteresis is important even for small irreversibility. In the menu cost model, hysteresis is two orders of magnitude larger than under the Akerlof-Yellen or Mankiw assumptions. When decisions that are costly to reverse are made under conditions of ongoing uncertainty, the optimum policy usually entails a range of inertia. The action should be taken only when the value of the underlying state variable becomes especially favourable, and reversed only when it becomes especially unfavourable. There is an intermediate range over which inaction is optimal. This in turn gives rise to hysteresis. Starting from a value in the range of inertia, if the state variable crosses the action trigger point and then returns to its original level, the action will be taken but not reversed. Thus a temporary change will leave a permanent effect. Numerical solutions for models of irreversible investment show that the range of inaction is remarkably large even when the cost of reversal is small; see Brennan and Schwartz (1985), Constantinides (1986) and Dixit (1989a, b) for examples of this. Unfortunately, the equations tlhat determine the optimum policy are highly non-linear. They do not have analytical solutions. Therefore we lack a clearer and more general understanding of why hysteresis is numerically so important. In this paper I derive analytical approximations for the solutions of more general problems of this kind when the costs of change are small. The idea that small costs of change induce large amounts of inertia has been popularized in the model of Akerlof and Yellen (1985), Mankiw (1985) and others. In these models, second-order small costs of making price changes yield price-stickiness in response to first-order changes in the money supply. This is a simple application of the envelope theorem. But these models are static, and their application to a dynamic reality must assume either permanent shocks or static expectations. When there is ongoing uncertainty, which is rationally expected by the decision-maker, the option value of the status quo enlarges the zone where inaction is optimal. Adding these features to the Mankiw-Akerlof-Yellen (MAY) model, I show that fourth-order small costs of change generate first-order inertia.

A Necessary and Sufficient Condition for Two-Person Nash Implementation

Abstract: In an important paper, Maskin (1977), it was shown that if an n-person social choice correspondence with n _ 3 satisfies the conditions of monotonicity and no-veto power, then it can be implemented in Nash equilibrium. These conditions are however, not sufficient for the implementation of two-person social choice correspondences. Moreover the condition of no-veto power, which is not a necessary condition for implementation, is unacceptably strong in this environment. In this paper we address the two-person implementation problem and characterize completely the class of implementable social choice correspondences. The two-person problem is an important one in the theory of incentives. It has a bearing on a wide variety of bilateral contracting and negotiating problems.

Search Decisions with Limited Memory

Abstract: This paper concerns a decision problem of an agent, searching to find a low price, whose memory is represented by a partition of the set of possible past prices. The number of elements in the partition is limited. I characterize the optimal partition for the case of a single decision, and then consider memory allocation among several decisions. I consider a case in which a consumer who must allocate a single bit of memory among two decision problems would do better to allocate it exclusively to one of the problems than to use it to convey joint information about both.

Employment Determination in British Industry: Investigations Using Micro-Data

Abstract: This paper derives, and then estimates, a model of employment where unions and firms bargain over wages and possibly employment, and efficiency wage considerations may be important. It illustrates the difficulties associated in interpreting many existing attempts to discriminate between alternative models. The results (based on over 200 U.K. firms) suggest that employment is negatively related to the firm's own wage and the change in the own wage relative to outside opportunities. The latter may be an efficiency wage effect. Various financial factors are also seen to have a significant effect on employment.

Investment under Uncertainty, Irreversibility and the Arrival of Information Over Time

Abstract: In this paper, we consider a risk-neutral competitive firm which is uncertain about the true state of demand. We build upon Arrow by demonstrating that the irreversibility of investment in physical capital together with the anticipation of receiving information and of learning the state of demand lead to (1) cautious investment behaviour and hence, to lower investment levels than otherwise since the firm cannot disinvest if market conditions turn out to be less favourable than currently anticipated; (2) a time-varying risk premium, or marginal "adjustment cost" which is shown to arise endogenously and to be positively related to the investment level and to the anticipation of greater information in the sense of Blackwell (1951, 1953); (3) a gradual adjustment of the capital stock to the desired level, defined as the optimal capital stock corresponding to the true state of demand.

Existence of Steady States with Positive Consumption in the Kiyotaki-Wright Model

Abstract: We prove the general existence of steady states with positive consumption in an N goods and fiat money version of the Kiyotaki-Wright model by admitting mixed strategies. We also show that there always exists a steady state in which everyone accepts a least costly-to-store object. In particular, if fiat money is one such object, then there always exists a monetary steady state. We also establish some other properties of steady states and comment on the relationship between steady states and (incentive) feasible allocations.

Uniqueness of Cournot Equilibrium: New Results From Old Methods

Abstract: This paper provides sufficient conditions for the existence of a unique Cournot equilibrium. Previous uniqueness results have depended on an assumption of non-degeneracy of equilibrium. As we illustrate, this assumption often fails in multi-stage games with proper Cournot subgames. Since our uniqueness results do not depend on this assumption, they are more widely applicable.

Vertical Foreclosure and International Trade Policy

Abstract: International differences in the cost of production of a key intermediate product can mean that a domestic firm is dependent on supplies from a foreign vertically integrated firm. This paper considers the incentives for the foreign firm and foreign country to supply the domestic firm when the firms compete in a Cournot or Bertrand market for the final product. The vertical supply decision is significantly affected by domestic supply conditions for the input and a domestic tariff on final product imports. Optimal policy by the exporting country may require a tax on both exports, or a subsidy on both exports. Countries that are dependent on imports of a key intermediate product or raw material from a dominant world supplier are often concerned about the price and the availability of imports. A notable current example involves the computer industry. Japanese suppliers (with the help of the Japanese government) recently restricted the exports of DRAM semiconductors, substantially raising their price.' These suppliers control about 80% of the market for semiconductors and the higher prices and shortage in supply have forced U.S. producers of computers to curtail production and increase prices. Vertically integrated Japanese firms such as Toshiba and N.E.C. have benefitted both from increased profits in the export market for semiconductors and from the improvement in their competitive position in the market for final computers. As this example indicates, the price and availability of imported supplies can depend on both public and private incentives in the exporting country. In this paper, we first examine the private incentives for a vertically integrated firm to export an intermediate product to a higher cost rival, lowering its rival's costs. The exporting firm may choose vertical foreclosure, thus fully cutting off supplies. We then consider the public interest of the exporting country: does the exporting country gain by encouraging the export of the intermediate product, or alternatively, might "government foreclosure" occur? The government is in a position to affect the quantity of exports of both the input and the final product by an appropriate choice of export tax and subsidy policies.

Correlated Demand Shocks and Price Wars During Booms

Abstract: The supergame-theoretic model of price competition (Rotemberg and Saloner (1986)) is re-examined in the case of serially correlated demand shocks. The equilibrium price is shown to exhibit the same counter-cyclical movement as in the i.i.d. case, if the discount factor and the number of firms satisfy certain relationship.

Estimation and Testing of the Union Wage Effect Using Panel Data

Abstract: We present estimates of the union wage effect controlling for unmeasured individual effects, and subject the conventional fixed-effects model to specification tests. For PSID men the union wage effect is 5-8% after controlling for person effects, as opposed to 20% in cross-section. Omnibus tests based on an unrestricted reduced form and instrumental variables tests based on differencing are consistent with conventional models. Tests based on comparing those who enter and leave union coverage provide evidence against the usual model. We find evidence for interactions between union status and other variables even after controlling for person effects.

Market Uncertainty: Correlated and Sunspot Equilibria in Imperfectly Competitive Economies

Abstract: First version received June 1988; final version accepted November 1990 (Eds.) An imperfectly competitive economy is very prone to market uncertainty, including uncertainty about the liquidity (or "thickness") of markets. We show, in particular, that there exist stochastic equilibrium outcomes in nonstochastic market games if (and only if) the endowments are not Pareto optimal. We also provide a link between extrinsic uncertainty arising in games (e.g. correlated equilibria) and extrinsic uncertainty in market economies (e.g. sunspot equilibria). A correlated equilibria to the market game is either a sunspot equilibrium or a non-sunspot equilibrium to the related securities games, but the converse is not true in general.

Stock Market Forecastability and Volatility: A Statistical Appraisal

Abstract: This paper presents and implements statistical tests of stock market forecastability and volatility that are immune from the severe statistical problems of earlier tests. It finds that although the null hypothesis of market efficiency is rejected, the rejections are only marginal. The paper also shows how volatility tests and recent regression tests are closely related, and demonstrates that when finite sample biases are taken into account, regression tests also fail to provide strong evidence of violations of the conventional valuation model.

Impossibility of Strategy-Proof Mechanisms in Economies with Pure Public Goods

Abstract: This paper investigates the structures of strategy-proof mechanisms in general models of economies with pure public goods. Under the assumptions that the set of allocations is a subset of some finite-dimensional Euclidean space and that the admissible preferencees are continuous and convex, I establish that any strategy-proof mechanism is dictatorial whenever the decision problem is of more than one dimension. Furthermore, I establish a similar result when preference relations also satisfy the additional assumption of monotonicity. These results properly extend the Gibbard-Satterthwaite theorem to economies with pure public goods.