Knowledge that Transforms

Are stock prices determined by fundamentals or can “bubbles” exist? An important issue in this debate concerns the circumstances in which deviations from fundamentals are consistent with rational behaviour. When there is asymmetric information between investors and portfolio managers, portfolio managers have an incentive to churn; their trades are not motivated by changes in information, liquidity needs or risk sharing but rather by a desire to profit at the expense of the investors that hire them. As a result, assets can trade at prices which do not reflect their fundamentals and bubbles can exist.

Suppose that a seller and a buyer have private valuations for a good, and that their respective utilities from a trading mechanism are given by us and ub. (These utilities are determined by the valuation for the good, by whether a trade occurs, and by the price which is paid.) Consider the problem of maximizing E[λus + (1 − λ)ub] for some weight λ in the unit interval. It is shown in this article that, if λ is sufficiently close to zero or one, then the maximum value of this objective function attainable by a static revelation mechanism can be arbitrarily closely approximated by equilibria of the sequential bargaining games in which only a single player makes offers. That is, the welfare bound implied by the revelation principle is virtually attainable in offer/counteroffer bargaining. The main condition needed for this result is a monotone-hazard-rate assumption about the distribution of types. A class of examples is presented in which the result holds for all λ (i.e. the entire ex ante Pareto frontier).

This paper examines optimal monetary policy under uncertainty in a context in which policymakers are able to make credible policy commitments. The authors study an optimal taxation problem of minimizing the social cost of financing a stochastic and exogenous level of government transfers. Since, in the basic model, the welfare costs of inflation derive only from expected inflation, the optimal monetary policy is highly responsive to the state of nature. In a benchmark case in which all shocks are transitory, the optimal policy calls for loading all the variability of government transfers on the shoulders of the inflation tax. Copyright 1993 by The Review of Economic Studies Limited.

This paper extends the analysis of transactions cost models of vertical integration to multilateral settings. Its main focus is on supply assurance concerns which arise when several downstream firms are competing for inputs in limited supply. Integration reduces supply assurance concerns for an integrating firm but it may increase them for others. Therefore, to explain the scope of any firm, one must consider the overall network of production and distribution relations. Three fundamental questions are addressed: (1) What are the effects of different integration structures?; (2) What are the determinants of the socially efficient integration structures?; (3) In what way do equilibrium integration structures differ from socially efficient structures?

Infrequency of purchase models are alternatives to those derived from the classical "utility maximization with binding non-negativity constraints" scheme for modelling purchases that occur at random dates. An extension of those models is proposed that takes into account additional information about the exact number of times households purchased during the survey period. Various methods of estimation are described and an empirical illustration is presented with data drawn from the French Food Expenditure Survey (INSEE).

Aggregate cost uncertainty, arising from real shocks or unanticipated inflation, reduces the informativeness of prices by scrambling relative and aggregate variations. But when agents can acquire additional information, such increased noise may in fact lead them to become better informed, and price competition will intensify. We examine these issues in a model of search with learning, where consumers search optimally from an unknown price distribution while firms price optimally given consumers' search rules. We show that the decisive factor in whether inflation variability increases or reduces the incentive to search, and thereby market efficiency, is the size of informational costs.

The possibility of sunspot equilibria and endogenous cycles are explored in a two-sector overlapping-generations model with entry. It is shown that if prospective entrants act oligopolistically as producers but competitively as consumers then a strategic complementarity between the entry decisions of agents across sectors and across time may arise. If the complementarity is sufficiently strong, the economy will have multiple, Pareto-ranked steady states. Stationary sunspot equilibria can then be constructed as a randomization between allocations in the neighbourhood of the multiple steady states providing a source of aggregate fluctuations.

We develop a theory of general equilibrium with endogenous debt limits in the form of individual rationality constraints similar to those in the dynamic consistency literature. If an agent defaults on a contract, he can be excluded from future contingent claims markets trading and can have his assets seized. He cannot be excluded from spot markets trading, however, and he has some private endowments that cannot be seized. All information is publicly held and common knowledge, and there is a complete set of contingent claims markets. Since there is complete information, an agent cannot enter into a contract in which he would have an incentive to default in some state. In general there is only partial insurance: variations in consumption may be imperfectly correlated across agents; interest rates may be lower than they would be without constraints; and equilibria may be Pareto ranked.

This paper develops a new method for estimating the structural parameters of (discrete choice) dynamic programming problems. The method reduces the computational burden of estimating such models. We show the valuation functions characterizing the expected future utility associated with the choices often can be represented as an easily computed function of the state variables, structural parameters, and the probabilities of choosing alternative actions for states which are feasible in the future. Under certain conditions, nonparametric estimators of these probabilities can be formed from sample information on the relative frequencies of observed choices using observations with the same (or similar) state variables. Substituting the estimators for the true conditional choice probabilities in formulating optimal decision rules, we establish the consistency and asymptotic normality of the resulting structural parameter estimators. To illustrate our new method, we estimate a dynamic model of parental contraceptive choice and fertility using data from the National Fertility Survey.

When firms face menu costs, the relation between their output and money is highly non-linear. At the aggregate level, however, this needs not be so. In this paper we study the dynamic behaviour of a menu-cost economy where firms are heterogeneous in the shocks they perceive, and the demands and adjustment costs they face. In this context we (i) generalize the Caplin and Spulber (1987) steady-state monetary-neutrality result; (ii) show that uniqueness of equilibria depends not only on the degree of strategic complementarities but also on the degree of dispersion of firms' positions in their price-cycle; (iii) characterize the path of output outside the steady state and show that as strategic complementarities become more important, expansions become longer and smoother than contractions; and (iv) show that the potential impact of monetary shocks is an increasing function of the distance of the economy from its steady state, but that an uninformed policy maker will have no effect on output on average.