Showing papers in "The Review of Economic Studies in 1996"

A Theory of Collective Reputations (with applications to the persistence of corruption and to firm quality)

Abstract: The paper is a first attempt at modelling the idea of group reputation as an aggregate of individual reputations A member's current incentives are affected by his past behaviour and, because his track record is observed only with noise, by the group's past behaviour as well The paper thus studies the joint dynamics of individual and collective reputations and derives the existence of stereotypes from history dependence rather than from a multiplicity of equilibria or from the existence of a common trait as is usually done in the literature It shows that new members of an organization may suffer from an original sin of their elders long after the latter are gone, and it derives necessary and sufficient conditions under which group reputations can be rebuilt Last, the paper applies the theory to analyse when a large firm can maintain a reputation for quality 1 COLLECTIVE REPUTATIONS Collective reputations play an important role in economics and the social sciences Countries, ethnic, racial or religious groups are known to be hard-working, honest, corrupt, hospitable or belligerent Some firms enjoy substantial rents from their reputations for producing high-quality products Some departments are reported to treat their faculty or students fairly The paper is a first attempt at modelling the idea of group reputation as an aggregate of individual reputations A member's current incentives are affected by her past behaviour and, because her track record is observed only with noise, by the group's past behaviour as well The paper studies the joint dynamics of individual and collective reputations in a model in which current generations are progressively replaced by new ones, and derives the existence of stereotypes from history dependence rather than from a multiplicity of equilibria or from the existence of a common trait as is usually done in the literature (see Section 2 for a detailed comparison with the literature) It shows that new members of an organization may suffer from an original sin of their elders long after the latter are gone, and it derives necessary and sufficient conditions under which group reputations can be rebuilt Last, the paper applies the theory to analyse when a large firm can maintain a reputation for quality Let us spell out the building blocks of our theory in more detail: (a) A group's reputation is only as good as that of its members Each member is characterized by individual traits such as talent, diligence or honesty Past individual behaviour conveys information about these traits and generates individual reputations

Electoral Competition and Special Interest Politics

Abstract: have fixed positions on some issues, but vary their positions on others in order to attract votes and campaign contributions. In this context, we examine whether special interest groups are governed by an electoral motive or an influence in their campaign giving, and how their contributions affect the equilibrium platforms. We show that each party is induced to behave as if it were maximizing a weighted sum of the aggregate welfares of informed voters and members of special interest groups. The party that is expected to win a majority of seats caters more to the special interests.

Equity and Efficiency in Human Capital Investment: The Local Connection

Abstract: A general model of community formation and human capital accumulation with social spillovers and decentralized school funding is used to analyse the causes of economic segregation and its consequences for equity and efficiency. Significant polarization arises from minor differences in endowments, preferences or access to capital markets. This makes income inequality more persistent across generations, but the same need not be true for wealth. Equilibrium stratification tends to be excessive, resulting in low aggregate surplus. Whether state equalization of school resources can remedy these problems hinges on how purchased, social and family inputs interact in education and in mobility decisions.

Intra-firm Bargaining under Non-binding Contracts

Abstract: We present a new methodology for studying the problem of intra-firm bargaining, based on the notion that contracts cannot commit the firm and its agents to wages and employment. We develop and analyse a general non-cooperative multilateral bargaining framework between the firm and its employees and consider outcomes which are immune to renegotiations by any party. Equilibrium firm profits are characterizable as both a weighted average of a neo-classical (non-bargaining) firm's profits and a generalization of Shapley value for a corresponding cooperative game. Furthermore, the resulting payoffs induce economically significant distortions in the firm's input and organizational-design decisions.

Useful Modifications to Some Unit Root Tests with Dependent Errors and Their Local Asymptotic Properties

Abstract: Many unit root tests have distorted sizes when the root of the error process is close to the unit circle. This paper analyses the properties of the Phillips-Perron tests and some of their variants in the problematic parameter space. We use local asymptotic analyses to explain why the Phillips-Perron tests suffer from severe size distortions regardless of the choice of the spectral density estimator but that the modified statistics show dramatic improvements in size when used in conjunction with a particular formulation an autoregressive spectral density estimator. We explain why kernel based spectral density estimators aggravate the size problem in the Phillips-Perron tests and yield no size improvement to the modified statistics. The local asymptotic power of the modified statistics are also evaluated. These modified statistics are recommended as being useful in empirical work since they are free of the size problems which have plagued many unit root tests, and they retain respectable power.

Optimal Investment with Costly Reversibility

Abstract: price and sell capital at a lower price We solve for the optimal investment of a firm that faces costly reversibility under uncertainty and we extend the Jorgensonian concept of the user cost of capital to this case We define and calculate cv and cL as the user costs of capital associated with the purchase and sale of capital, respectively Optimality requires the firm to purchase and sell capital as needed to keep the marginal revenue product of capital in the closed interval [CL, cu] This prescription encompasses the case of irreversible investment as well as the standard neoclassical case of costlessly reversible investment

Implications of Efficient Risk Sharing without Commitment

Abstract: Consumption data generally indicates that consumption risk is not perfectly diversified across individuals. This paper considers if and when imperfect diversification is a feature of efficient allocations in a symmetric information environment without commitment. It shows that if individuals are sufficiently patient, imperfect diversification is always sub-optimal in the long run; however, if individuals are not so patient, imperfect diversification is always optimal. The paper goes on to demonstrate that the way that history matters in an efficient allocation in a symmetricinformation/no-commitment environment can be used to distinguish lack of commitment from other possible rationalizations of imperfect risk sharing, such as efficiency in the presence of asymmetric information.

Vested Interests in a Positive Theory of Stagnation and Growth

Abstract: We study a positive theory of stagnation and growth aimed at understanding the large variations in growth outcomes across actual economies. The theory points to the fundamental role played by vested interests in determining policies which are key to the growth process: some agents seek to prevent the adoption of new technologies. We develop a model of technology adoption, and show how technological innovation may sow the seeds of its own destruction. In particular, we find that the equilibrium is characterized by a long cycle of stagnation and growth. Over this cycle, incumbents are phased out of the economy will new innovation occur. In formalizing our theory we make a methodological contribution by characterizing dynamic voting equilibria when voters must forecast the effects of different current policies on future prices and policy outcomes.

Cooperation in Community Interaction Without Information Flows

Abstract: We study cooperative behavior in communities where the flow of infor- mation regarding past conduct is limited or missing. Players are initially randomly matched with no knowledge of each other's past actions; they endogenously decide whether or not to continue the repeated relationship. There is incomplete infor- mation regarding player types: a subset of the population is myopic, while the remainder have discount factors that permit cooperation, in principle. We define socialize'al equilibriumz in such communities. Such equilibria are characterized by an initial testing phase, followed by cooperation if the test is successful. It is pre- cisely the presence of myopic types that permit cooperation, by raising barriers to entry into new relationships. We examine the implications of increased patience, which takes two forms: an increase in the number of nonmyopic types, and an increase in the discount factor of nonmyopic types. These two notions turn out to have strikingly different implications for the degree of cooperation that can be sustained.

Life-Cycle Economies and Aggregate Fluctuations

Abstract: Do the implications for business cycle issues change when we switch from studying infinitely-lived, representative-agent models to more sophisticated demographic structures with finitely lived agents? This article addresses that question by using a large, overlapping-generations model that is calibrated to U.S. demographic properties, microeconomic evidence, and National Income and Product Accounts. The finding is that the answers obtained are basically the same for the two kinds of models. The article also explores the relative volatility of hours across age groups, an issue that cannot be addressed by using the infinitely-lived, representative-agent abstraction.

Excess Volatility and Predictability of Stock Prices in Autoregressive Dividend Models with Learning

Abstract: To what extent can agents' learning and incomplete information about the "true" underlying model generating stock returns explain findings of excess volatility and predictability of returns in the stock market? In this paper we analyse two models of recursive learning in the stock market when dividends follow a (trend-)stationary autoregressive process. The asymptotic convergence properties of the models are characterized and we decompose the variation in stock prices into rational expectations and recursive learning components with different rates of convergence. A present-value learning rule is found to generate substantial excess volatility in stock prices even in very large samples, and also seems capable of explaining the positive correlation between stock returns and the lagged dividend yield. Self-referential learning, where agents' learning affect the law of motion of the process they are estimating, is shown to generate some additional volatility in stock prices, though of a magnitude much smaller than present value learning

Female Labour Supply and Marital Status Decisions: A Life-Cycle Model

Abstract: This paper studies the interdependence between and the determinants of life-cycle marital status and labour force participation decisions of women. A dynamic utility maximization model is presented and estimated using longitudinal data on women from the Panel Study of Income Dynamics. The MLE method employed, involves solving a dynamic programming problem. Further, a minimum distance estimator is proposed which allows for the incorporation of wage data in a computationally simple way. The estimates are used to predict changes in the life-cycle patterns of employment, marriage and divorce due to differences in education, race, the female's earnings and her (potential) husband's earnings. The estimation results indicate that the utility gains to marriage are decreasing in the female's wage rate and increasing in her (potential) husband's earnings, while the opposite is found for gains to working. Ignoring the endogeneity of marital status decisions is shown to lead to an underestimation of own and husband's wage effects on female labour supply.

Interaction Between Endogenous Human Capital and Technological Change

Abstract: This paper examines how interaction between endogenous human capital accumulation and technological change affects relative wages and economic growth. Private incentives to invest in human capital finance the employment of skilled labour in the education sector, while non-rival technology is a by-product of the education process. The absorption of new technologies into production is skill intensive, creates skill-biased labour demand, and increases the relative wage of skilled to unskilled labour. In contrast to recent models of endogenous growth, higher rates of technological change and growth may be accompanied by a higher relative wage but lower relative supply of skilled labour. Thus the model provides a theoretical foundation for the empirically observed relation between technological change and relative demand, supply and wages of skilled labour. I. INTRODUCTION Rapid change in technology in the 1980's was associated with a sharp rise in the relative wage and a decline in the relative supply of skilled labour. Models of endogenous technological change imply, however, that higher rates of innovation should be associated with more skilled labour and lower relative wages.' These models focus on private incentives to innovate, but assume that human capital is either exogenous or accidental (learning by doing).2 Thus, the literature provides few insights into how endogenous technological change influences private incentives to accumulate human capital through relative wage movements. This paper has two key elements that allow for interaction between endogenous technological change and the relative supply, demand, and wage of skilled labour. First, the two production sectors in the model differ not only in their skill-intensity, but also in technological sophistication. This generates strong skill-biased labour demand and higher relative wages in response to higher rates of technological change. Second, skilled labour is assumed to be an essential input in education, research, and in the absorption of innovations into production. The absorption of bursts in technological change then requires the withdrawal of skilled labour from research and education which subsequently increases the costs of both human capital investment and innovation. We term the resulting leveraging of the future rate of technological change and human capital the absorption effect.

Market Making by Price-Setting Firms

Abstract: A model of market making by firms with heterogeneous consumers, suppliers and pricesetting intermediaries is examined. Consumers and suppliers engage in time-consuming search for the best price and discount future returns. There exists a unique symmetric equilibrium pricing strategy. In equilibrium, there are non-degenerate distributions of ask and bid prices that straddle the Walrasian price. As the discount rate goes to zero, the ranges of the bid and ask prices, and the total output approach the Walrasian equilibrium values. As the discount rate becomes large, the ask and bid prices approach the monopoly pricing policies. An increase in the discount rate leads to an increase in the equilibrium number of active firms, profit per firm, the mean spread between ask and bid prices, and the variance of ask and bid prices, while lowering the number of active consumers and suppliers. The model is extended to examine the steady-state market equilibrium with continual entry and exit of consumers and suppliers. In the Walrasian market model, consumers, suppliers and firms are price takers, and the selection of market-clearing prices is ascribed to an exogenous Walrasian auctioneer. In practice however, while some firms act as price takers, many other firms act as price makers, often setting both output prices and input prices to balance their purchases and sales. Certainly, one cannot enter a store or view an advertisement without observing that firms post prices for their products. Furthermore, both large and small companies bid for capital, labour, manufactured inputs, resources, and technology. By setting ask and bid prices, wholesale and retail firms act as intermediaries, coordinate transactions, clear markets, and establish relative prices in the economy, see Spulber (1966). Manufacturing firms often combine production with related market-making activities. These observations suggest that markets are created and operated through the price-setting activities of firms. The question is how the market equilibrium with endogenous price setting by firms differs from the frictionless Walrasian framework. The purpose of this paper is to present a search model that allows an explicit comparison between the market equilibrium with endogenous price-setting by competing intermediaries and the traditional supply and demand model. I examine market-making by pricesetting firms with consumers searching for the lowest ask price and suppliers searching for the highest bid price. Contrary to the "law of one price", and consistent with some search models, the equilibrium with price-setting by firms features non-degenerate distributions of buyer and seller prices. Moreover, trade frictions give firms market power, so that in my model the buy and sell prices offered by a firm are not equal in equilibrium. Instead, market-making firms set buy and sell prices with ranges that are respectively above and below the Walrasian market-clearing price. Furthermore, as a consequence of market frictions, total output lies below the Walrasian output. The market equilibrium is also

Semiparametric Estimation of Regression Models for Panel Data

Abstract: Linear models with error components are widely used to analyse panel data. Some applications of these models require knowledge of the probability densities of the error components. Existing methods handle this requirement by assuming that the densities belong to known parametric families of distributions (typically the normal distribution). This paper shows how to carry out nonparametric estimation of the densities of the error components, thereby avoiding the assumption that the densities belong to known parametric families. The nonparametric estimators are applied to an earnings model using data from the Current Population Survey. The model's transitory error component is not normally distributed. Use of the nonparametric density estimators yields estimates of the probability that individuals with low earnings will become high earners in the future that are much lower than the estimates obtained under the assumption of normally distributed error components.

Polarization and Inefficient Policies

Abstract: of the economy, in this case the costs of producing a public good. The parties each propose a policy, an election is held and the policy of the winning party is implemented. Voters and parties care about the level of the public good and costs. Two kinds of sequential equilibria exist; revealing, where voters learn the true costs and the implemented policy adjusts to costs, and non-revealing. If parties' preferences are polarized only non-revealing equilibria fulfill a refinement criterion like the intuitive criterion. If they are alike only revealing equilibria fulfill this criterion. Thus less political polarization improves information revelation. In electoral democracies, policy-motivated parties are likely to be better informed about the functioning of the economy than are voters. This paper presents a model where two parties, but not voters, are informed about the cost of producing a public good. We study whether an electoral democracy leads to efficient production of the public good given this asymmetry of information. In particular, under which circumstances will the implemented policy (the level of the public good) reflect actual costs? The main result is that the policy will reflect costs if and only if at least one of the parties has preferences which are sufficiently similar to the median voter's. In this sense polarization leads to inefficiency. The public good can be, for instance, infrastructure, medicare or military services. Both a continuum of voters and the parties have preferences over the amount of the good that is provided by the government. The preferences of the two parties are situated on each side of those of the median voter. The costs of providing the good are not precisely known to the voters, who only know the distribution of costs and that they will pay for these costs as taxpayers. On the other hand, the parties know the costs.

Delay and Cycles

Abstract: When the profitability of investment depends on the general level of economic activity, entrepreneurs have an incentive to delay investments during a recession. Endogenous delay thus prolongs the recovery from a recession and heightens the effect of the boom. This paper describes a dynamic model that exhibits both delay and cycles and develops methods for analysing the role of delay in propogating business cycles. A number of interesting characteristics of the cycle are revealed. First, the effect of delay is asymmetric: it lengthens the recovery but not the downturn. Second, delay can increase the amplitude and typically reduces the frequency of the cycle. Third, it can reduce the average level of activity, but it achieves this effect by prolonging the recession rather than by reducing the amplitude of the cycle. The welfare effects of delay are ambiguous, however.

Comparative Advantage, Information and the Allocation of Workers to Tasks: Evidence from an Agricultural Labour Market

Abstract: We use data from an agricultural labour market in which workers receive both time- and piece-rate wages and shift frequently among employers and tasks, to assess the roles of comparative advantage, information problems and preferences in determining the allocation of workers. The estimates which impose minimal structure not implied by economic theory are consistent with a one-factor productivity model, and indicate that information asymmetries are present but workers are sorted according to comparative advantage. In particular, the disproportionate presence of female workers in weeding activities is due not to worker or employer preferences but to comparative advantage and statistical discrimination.

Credit and Money in a Search Model with Divisible Commodities

Abstract: This paper examines the competition between money and credit in a search model with divisible commodities. It is shown that fiat money can be valuable even though it yields a lower rate of return than the coexisting credit. The competition between money and credit increases efficiency. The monetary equilibrium with credit Pareto dominates the monetary equilibrium without credit whenever the two coexist. When a credit is repaid with money, the competition also bounds the purchasing power of money from below by that of credit and so eliminates the weak inefficient monetary equilibrium found in previous search models. With numerical examples, three different monetary equilibria are ranked and the properties of the interest rate are examined.

Strategic Trade Policy Design with Asymmetric Information and Public Contracts

Abstract: This paper examines strategic trade policy under asymmetric information with publicly observable contracts. We analyse both the cases of unilateral and bilateral intervention. We find that the requirement of incentive compatibility undermines the strategic precommitment effect when public funds are costly, even with no restrictions on the form of the policies. Second, when firms sell substitute goods, the introduction of a rival interventionist government may reduce the cost of informational rents to each government. Third, it turns out that under bilateral intervention there exists a continuum of symmetric equilibria with levels of output and corresponding levels of welfare in the exporting countries which can be ranked. The requirement of ex post participation constraints for the firm limits the set of subsidies which can be offered to the firm. In particular, under bilateral intervention, the equilibrium levels of output which are implemented under adverse selection are below their values under ex ante uncertainty, i.e., below the equilibrium levels of output which are achieved when firms sign their contracts before the realization of their costs. Ever since the inception of research on strategic trade policy with the seminal paper by Brander and Spencer (1985), economists have been warning that the informational requirements of rent-shifting policies are enormous and unlikely to be met in practice, because the policy recommendations are highly sensitive to the particularities of the market.' In response, a number of recent papers have begun to address the specific ways that informational failures affect policy, and to modify policy recommendations to take such failures into account. This paper analyses the implications of asymmetric information for strategic trade policy under both unilateral and bilateral intervention. Our complete information benchmark is a simple trade policy designed to shift rents, similar to Brander-Spencer. Two firms are competing in a third country and receive export subsidies from their respective governments. However, we place no restrictions on the form of these export policies. Previous literature has shown that under complete information a large number of outcomes may be sustained as equilibria of delegation games such as this. Moreover, the introduction of uncertainty about the state of nature on the part of both

Policy variability and economic growth

Abstract: This paper explores the effect of policy variability (or frequency of regime switching) on economic growth and welfare. We study a one-sector growth model where investment can be subsidized at either a positive rate or not subsidized at all. We find that the lack of persistence in policies per se need not be welfare reducing and that it is likely to decrease growth. Higher variability implies more frequent changes in consumption and investment. But, by creating a stronger intertemporal link across regimes, variability reduces the fluctuation in investment rates, thus decreasing the magnitude of changes in consumption and increasing welfare.

Adverse Selection and Security Design

Abstract: This paper studies the problem of optimal security design by a privately informed entrepreneur. In the context of a simple parametric model, it is shown that the entrepreneur does not find it profitable to float an asset that affords her an informational advantage. The reason is that, with rational, uninformed outside investors, the entrepreneur faces adverse selection in the security market, which prevents her from exploiting her position as an insider. This is true whether or not she has market power in trading the asset. Consider a risk-averse entrepreneur who is contemplating what security to issue. The entrepreneur anticipates that, during subsequent trading in the secondary market, she will have private information on the payoff of her investment, as well as on other risks in the economy. The design of the asset is, therefore, influenced not only by a desire to share risk, but also by informational considerations involving the potential for insider trading profits. This paper studies the problem of optimal security design in the context of a simple parametric model with Gaussian risks and CARA utility. Trading in the secondary market is modelled via the (static) reduced-form concept of rational expectations equilibrium in which uninformed outside investors use market prices to try to infer the private information of the entrepreneur (or insider, as she will sometimes be called). It is shown that the entrepreneur does not find it profitable to float an asset that affords her an informational advantage. An optimal asset entails a fully revealing rational expectations equilibrium' and is perfectly correlated with the issuer's endowment risk. The reason is that, with rational outside investors, the entrepreneur faces adverse selection in the security market, which prevents her from exploiting her position as an insider. She is better off foregoing her informational advantage and concentrating on her hedging motive alone. In the particular setting described in the paper, equity2 is an optimal asset since the entrepreneur has no privileged information regarding its payoff, and it allows efficient risk-sharing. The issue of security design when prices have an informational role to play is just beginning to be researched. Closely related to this paper is the work of Demange and Laroque (1995), who use a competitive rational expectations model with noise traders to analyse the problem posed above. Except for some special cases, however, they are able to get only numerical results. In comparison, the present paper obtains partially revealing equilibria in a model in which all agents are rational. Furthermore, Demange and Laroque

Comparing the Robustness of Trading Systems to Higher Order Uncertainty

Abstract: This paper compares the performance of a decentralized market with that of a dealership market when traders have differential information. Trade occurs as a result of equilibrium actions in a Bayesian game, where uncertainty is captured by a finite state space and information is represented by partitions on this space. In the benchmark case of trade with common knowledge of endowments, the two mechanisms deliver virtually identical outcomes. However, with differential information, the dealership market has strictly higher trading volume, and yields an efficient posttrade allocation in most states. In contrast, the decentralized market suffers from suboptimal trading volume. The reason for this poor performance is the vulnerability of the decentralized market to higher-order uncertainty concerning the fundamentals of the market. Traders may know that mutually beneficial trade is feasible, and perhaps know that they know, and yet a failure of common knowledge that this is so precludes efficient trade. The dealership market is robust to this type of uncertainty.

Redistribution and Non-Consumption Smoothing in an Open Economy

Abstract: This paper presents a model where income distribution and redistributive fiscal policy interact to affect the budget deficit and the pattern of net borrowing of a country. According to the standard representative agent paradigm, a small open economy should smooth consumption by borrowing from (lending to) the rest of the world when its income increases (declines) over time. The simple model of this paper delivers exactly the same predictions in the absence of income dispersion. When income distribution is not degenerate, however, the same model gives rise to a surprising wealth of results. In particular, poor economies with high inequality may exhibit completely counter-intuitive patterns of fiscal policy and external borrowing. The country's production path declines over time, because the more mobile agents leave the country to escape taxation; yet, the country might end up having a budget deficit and borrowing from abroad, thereby reinforcing rather than smoothing the asymmetry in consumption between the two periods. An important feature of this outcome is that it is backed by both the poor and the rich, who gain from the fiscal system at the expense of the middle class.

A Characterization of Game-Theoretic Solutions Which Lead to Impossibility Theorems

Abstract: For some game-theoretic solution concepts, such as dominant strategies, Nash equilibrium, and undominated strategies, only dictatorial social choice functions are implementable on a full domain of preferences with at least three alternatives. For other solution concepts, such as the iterative removal of weakly dominated strategies, undominated Nash equilibrium, and maximin, it is possible to implement non-dictatorial social choice functions. Which aspects of solution concepts accounts for these differences? We answer this question by providing a characterization of solution concepts which lead to impossibility results.

Learning and Convergence to a Full-Information Equilibrium are not Equivalent

Abstract: Support from the Spanish Ministry of Education through grants DGICYT PB90-0132 and PB93-0679 is gratefully acknowledged. Further support for Jun from the CIRIT, Generalitat de Catalunya, is also acknowledged.