Knowledge that Transforms

This paper calculates numerical solutions to the principal-agent problem and compares the results to the stylized facts of CEO compensation. The numerical predictions come from parameterizing the models of Grossman and Hart and of Holmstrom and Milgrom. While the correct incentives for a CEO can greatly enhance a firm's performance, providing such incentives need not be expensive. For many parameter values, CEO compensation need increase only by about $10 for every $1,000 of additional shareholder value; for some values, the amount is 0.003 cents.

The permanent income hypothesis implies that, for any cohort of people born at the same time, inequality in both consumption and income should grow with age. We investigate this prediction using cohort data constructed from 11 years of household survey data from the United States, 22 years from Great Britain, and 14 years from Taiwan. The data show that within-cohort consumption and income inequality measures do indeed increase with age in the three economies and that the rate of increase is similar in all three. According to the permanent income hypothesis, the increase in inequality reflects cumulative differences in the effects of luck on consumption. Other models of intertemporal choice--such as those with strong precautionary motives or liquidity constraints--can limit or even prevent the spread of inequality, as can insurance arrangements that share risk across individuals. The evidence on the spread of inequality can therefore be used to help quantify the extent to which private and social arrangements moderate the impact of risk on the distribution of individual welfare.

This paper studies top executive turnover and compensation, and their relation to firm performance in the largest Japanese and U.S. companies. Japanese executive turnover and compensation are related to earnings, stock returns, and, to a lesser extent, sales performance measures. The fortunes of Japanese top executives, therefore, are positively correlated with stock performance and current cash flows (or with factors contributing to such performance). The relations for the Japanese executives are generally economically and statistically similar to those for their U.S. counterparts. There is some evidence, however, that the fortunes of Japanese executives are more sensitive to low income but less sensitive to stock returns than those of U.S. executives.

This paper describes a contract theory of public finance of college education that explains why everyone pays for the college education of a lucky minority. The contract provides gambles that families desire. Optimizing the contract determines the taxes paid by all members of society, fees paid by those whose children go to college, the fraction of children who are admitted to college, and the quality of college education. Changes in wealth lead to changes in taxes and admissions, but fees and quality are invariant. The practice of using a cutoff level of precollege achievement to determine admission to college is justified by the theory.

We characterize optimal enforcement in a setting in which individuals can select among various levels of some activity, all of which are monitored at the same rate but may be prosecuted and punished at varying rates. For less harmful acts, marginal expected penalties ought to fall short of marginal harms caused. Indeed, some range of very minor acts should be legalized. For more harmful acts, whether marginal expected penalties should fall short of, or exceed, marginal harms depends on the balance between monitoring and prosecution/punishment costs. We also explore how the optimal enforcement policy varies with changes in these costs.

The empirical literature on executive compensation generally fails to specify a model of executive pay on which to base and test hypotheses regarding its determinants. In contrast, this paper analyzes a simple principal-agent model to determine how well it explains variations in CEO incentive pay and salaries. Many findings are consistent with the basic intuition of principal-agent models that compensation is structured to trade off incentives with insurance. However, statistical significance for some of the effects is weak, although the magnitudes are large. Also, there is little evidence of the use of relative performance pay. Nevertheless, while puzzles remain, it seems clear that principal-agent considerations play a role in setting executive compensation.

Focusing on the Southern Bell Telephone Company, we propose a modified version of the predation hypothesis to explain Bell's "natural" monopoly over local telephone service. Southern Bell effectively eliminated competition through a strategy of pricing below cost in response to entry, which deprived competitors of the cash flow required for expansion even if it failed to induce exit; investing in toll lines ahead of demand, isolating independent companies in smaller towns and rural areas, and forcing them to consolidate on favorable terms; and influencing local regulatory policy in large cities to weaken rivals and ultimately to institutionalize the Bell monopoly.

We propose a theory of economic development in which technology adoption and barriers to such adoptions are the focus. The size of these barriers differs across countries and time. The larger these barriers, the greater the investment a firm must make to adopt a more advanced technology. The model is calibrated to the U.S. balanced growth observations and the postwar Japanese development miracle. For this calibrated structure we find that the disparity in technology adoption barriers needed to account for the huge observed income disparity across countries is not implausibly large.

Firm numbers first rise, then later fall, as an industry evolves. This nonmonotonicity is explained using a competitive model in which innovation opportunities fuel entry and relative failure to innovate prompts exit; equilibrium time paths for price and quantity also share features of the data. The model is estimated using data from the U.S. automobile tire industry, a particularly dramatic example of the nonmonotonicity in firm numbers.