Knowledge that Transforms

This article begins by reviewing the main body of evidence about the effectiveness of resources devoted to schools. It then discusses some of the central implications for policy and for economic research. The implications for educational policy draw heavily on the discussion of the Panel one the Economics of Education Reform (PEER), a group of economists who met over a four-year period to discuss economic aspects of educational investments. Those recommendations are only sketched here, but are detailed in its report, Making Schools Work (Hanushek and others, 1994).

Private Truths, Public Lies is a splendid book. It tackles a long list of interesting and important questions that have been discussed at length, and largely unsuccessfully, by scholars from each of the social sciences. Kuran blends the insights of economics, psychology, sociology, and political science into a behavioral model that moves the discussion forward on many fronts. His may not be the model that many traditional economists might have chosen, but it is one that most can live with.

Statistical significance as used in economics has weak theoretical justification. In particular it merges statistical and substantive significance. The 182 papers using regression analysis in the American Economic Review in the 1980s were tested against 19 criteria for the accepted use of statistical significance. Most, some three-quarters of the papers, did poorly. Likewise, textbooks in econometrics do not distinguish statistical and economic significance. Statistical significance should not be the focus of empirical economics.

This is a nontechnical summary of a much longer study which will appear with the same title in Richard Freeman, Birgitta Swedenborg, and Robert Topel, eds. (forthcoming). I am especially indebted to Henry Ohlsson and Birgitta Swedenborg, and to Stan Engerman, Vic Fuchs, Assar Lindbeck, Stephen Lundgren, and Agnar Sandmo for comments on initial drafts. I alone am responsible for the views expressed here.

Between 1984 and 1995 New Zealand changed from a closed and centrally controlled economy to one of the most open countries in the OECD. The reforms liberalizing the economy were notable for their very comprehensive coverage and innovations that included: performance contracts for senior civil servants and the central bank, legislated constraints on fiscal expenditure decisions backed by accrual accounting, tax neutrality, subsidy-free agriculture, and no industry-specific regulation of competition. Modern microeconomics contributed much to policy design. Economic growth has been vigorous since 1991, but a different sequencing of reforms may have enhanced outcomes.

The tradeoff between an insurer's or medical provider's incentives to select good risks and to produce efficiently is governed by the supply-price analog to the demand-price tradeoff between moral hazard and risk aversion. Under a variety of models the optimum supply price is a mixture of capitation and fee-for-service payments. Empirical literature shows that pure capitation payment leaves strong incentives for selection that are acted upon. The presence of contracting costs in a Rothschild-Stiglitz model means a limited pooling equilibrium can exist and that poor risks will not be at their preferred outcome.

The paper examines the literature that attempts to resolve the equity premium and riskfree rate puzzles. It demonstrates that the puzzles will confront any model of asset prices that relies on three crucial assumptions: preferences have a particular parametric form, asset markets are complete, and asset trade is frictionless. A survey of the literature that relaxes these assumptions reveals that there are now several plausible explanations of the seemingly low riskfree rate, but the large size of the equity premium remains a puzzle.

NEARLY EVERYONE would see the truth as between Hamlet and Puck. Including Hamlet and Puck. Hamlet is feigning madness, and Puck is just being, well, puckish. Model-writing economists, however, tend not to the middle but to the “infinite in faculties” extreme. Although the postulate of unbounded rationality has dominated economic modeling for several decades, the dominance is relaxing. Is this encouraging? Why bounded rationality? In this survey, four reasons are given for incorporating bounded rationality in economic models. First, there is abundant empirical evidence that it is important. Second, models of bounded rationality have proved themselves in a wide range of impressive work. Third, the standard justifications for assuming unbounded rationality are unconvincing; their logic cuts both ways. Fourth, deliberation about an economic decision is a costly activity, and good economics requires that we entertain all costs. These four reasons, or categories of reasons, are developed in the following four sections. Deliberation cost will be a recurring theme. Most references are to the last 15 years, though many earlier works are also cited. A longer version of the survey, including many more references, is available from the author on request.