Knowledge that Transforms

Mark A. Satterthwaite, Hugo Sonnenschein; Strategy-Proof Allocation Mechanisms at Differentiable Points, The Review of Economic Studies, Volume 48, Issue 4

Every good economics textbook contains the cliche that market prices provide signals which facilitate the allocation of resources to their best use. In a world not subject to random shocks, consumers and producers when faced with competitive prices need look no further than their own preferences or production technology to be able to make a decision. They need give no thought to the tastes, endowments or technology of other agents. However, in a world subject to random shocks, this is no longer the case. Agents are faced with the problem of forecasting future states of nature and more importantly of forecasting the impact of these states on the actions of other agents. Rational expectations theories provide a model of how agents make those forecasts. In a world subject to random shocks, it will be the case that agents acquire (or at least attempt to acquire) information about the future realization of the shocks. It will, in general, be the case that different agents have access to different information. The fact that information is dispersed throughout the economy has the potential to cause a misallocation of resources relative to what would be the case if all agents knew everything. An efficient allocation of resources will in general require the transfer of information from consumers who have some information about their future demands to producers who can take current actions to mitigate avoidable scarcities or surpluses. Though many classical and neo-classical writers emphasize the informational role of prices, the standard Marshallian or Walrasian model of competitive equilibrium does not involve prices transferring information across traders. The purpose of this paper is to show that rational expectations models are radically different from Walrasian models in an economy where traders have diverse information. This is demonstrated by showing that unlike what occurs in a Walrasian equilibrium of an economy with heterogeneous information, if there is a complete set of insurance markets and utility is additively separable over time, then there exists a rational expectations equilibrium which gives consumers the same allocation as if each consumer has access to all of the economy's information. This implies that, under the above assumptions, a central planner with all the economy's information could not Pareto dominate the competitive allocation achieved when traders have diverse information and rational expectations. This paper makes no attempt to survey the literature on rational expectations. The reader is referred to Shiller (1978), Barro (1981) for a survey of macroeconomics and rational expectations, and Radner (1980) for a survey of the microeconomics and mathematical theory of rational expectations. This paper will, however, try to outline the evolution of the rational expectations concept from a notion of optimal forecasting to a virtually complete departure from the Walrasian model of equilibrium. The rest of this section is devoted to a discussion of pre-rational expectations ideas.

This paper is an attempt at a rigorous (albeit not exceedingly general) analysis of the diffusion of new technology. In particular, consider an industry composed of two firms, each using the current best-practice technology. The firms are assumed to be operating at Nash equilibrium output levels, generating a market price (given demand) and profit allocations. When a cost-reducing innovation is announced, each firm must determine when (if ever) to adopt it, based in part upon the discounted cost of implementing the new technology, and in part upon the behavior of the rival firm. If either firm adopts before the other, it can expect to make substantial profits at the expense of the other firm. On the other hand, the discounted sum of purchase price and adjustment costs may decline with the lengthening of the adjustment period as various quasi-fixed factors become more easily variable. Therefore, although waiting costs the firm more in terms of foregone profits, it may save money on the cost of purchasing the new technology. Thus the firm must weigh the costs and benefits of delaying adoption, as well as take account of its rival's strategic behavior.

Jonathan Eaton, Mark Gersovitz; Debt with Potential Repudiation: Theoretical and Empirical Analysis, The Review of Economic Studies, Volume 48, Issue 2, 1

A recent exchange between George Daly and J. Fred Giertz and Harold Demsetz focused attention on the social efficiency of extortion. Daly and Giertz suggested that extortion could be defined as ... the of obtaining payments from some entity in return for not imposing upon that entity some harmful effect, where the generator of the external effect receives no direct net internal benefit from the act (p. 998). Extortion is, they say, an which merely redistributes income and reduces social welfare by the amount of any transaction costs. It is thus distinguished from legitimate bargaining, which will produce social welfare gains. Demsetz replied to this argument by pointing out that there are many activities which might result in social welfare gains but are, nevertheless, prohibited as extortionary acts. The legality of a threat bears only a very rough relationship to the social utility of the act, and the definition of extortion is therefore rather than economic, according to Demsetz. The difference between these two positions relates to the definition of the extortionary itself. If A demands property from B under threat to accuse B of a crime, extortion has occurred. The which is being threatened may have individual utility to A of equal to or less than zero, as Daly and Giertz correctly point out. There may also be a net gain in social utility either if the threat is of some value to society (for example, it may help deter crime) or if the property transferred is worth more to A than to B (for example, perhaps because of unequal marginal utilities). Thus, an economic interpretation of extortion must be more narrowly defined as the threat to commit an which by itself would not materially benefit the actor alone. Daly and Giertz are correct in postulating the existence of an economic definition of extortion consistent with current legal practice, though wrong in their inferences about its direct social (rather than individual) utility. Demsetz correctly points out that individual acts of extortion may have positive social utility effects, but incorrectly concludes that any definition of extortion must therefore be legalistic. The following discussion indicates that legal theory is broadly consistent with an individual utility interpretation of extortion. It is only the delimitation of the benefits of the threatened extortionary act, not the definition of extortion, which is purely a legalistic question. English criminal law, as embodied in the Larceny Act (1916), specified blackmail (used synonomously with the term extortion) as ... the demanding of any person with menaces, and without reasonable or probable cause, any property or valuable thing .. (see J. W. C. Turner, p. 312). Such menaces include: threats to accuse another of a crime, unlawful violence or restraint, threats to publish and, in general, any threat that ... should produce in any ordinary man such a degree of fear or alarm as would unsettle his mind (Turner, p. 315). The distinction sought in the is whether there is a clear nexus between the threatened and the property demanded, and whether there is value by itself in the threatened, the degree of nexus being one criterion for judging the latter. G. L. Williams' survey of English law on blackmail provides ample evidence of the legal pursuit of this distinction, particularly the emphasis on the private utility of the extortionary itself. He refers to the Dymond case in 1920, which provided the modern English precedent. In this case, a girl who alleged that she had been indecently assaulted wrote to the man in question demanding money under threat of adverse publicity about his moral character. She was convicted of blackmail on the grounds that *Australian Graduate School of Management, University of New South Wales. This note has benefited from comments by an anonymous reviewer and from references supplied by Kenneth Ove.

Lloyd Metzler's Wealth, Saving, and the Rate of Interest has played a useful role in the development of monetary theory. Perhaps most importantly, it has stimulated significant contributions to our understanding of the nature of the classical general equilibrium. Among these contributions are two that I had thought were widely accepted: (i) in order for money prices to be determined they must impinge on some quantity or quantities that are fixed in nominal (money) terms (i.e., money prices must in a sense); and (ii) there is no real balance effect and money is neutral in all-insidemoney, equilibrium systems. Substantial portions of Don Patinkin's Money, Interest, and Prices are devoted to proofs and examples of these propositions.' It is no criticism of Metzler to point out that his seminal work failed to contain all of the refinements and corrections that it inspired. Less understandable has been the failure of several writers to apply the contributions of Patinkin and others to Metzler's representation of the classical framework, with the consequence that we have been exposed to repeated demonstrations of nonclassical results from a so-called classical model. purposes of my earlier paper were to bring Metzler's much used model into the mainstream of contemporary general equilibrium analysis and to derive the implications of that model when, as in other equilibrium systems, trading occurs only at equilibrium prices. I found that classical assumptions, when applied to Metzler's model, lead to standard classical results, such as the neutrality of money. This is true for both the insideand outside-money versions of the model. In addition, because Metzler made inside money proportional to the price level, the application of classical equilibrium trading implies an indeterminate money supply and an indeterminate price level. All of this is familiar to Patinkin's readers. In his opening discussion and equations (1)-(9), Meir Kohn fairly describes my restatement of Metzler's model with equilibrium trading. But he denies the two propositions stated above. His approach is to seek different results by means of an alteration in the assumptions. Instead of following Metzler2 in letting M be endogenous while the central bank exogenously fixes X, he reverses these assumptions by having the central bank fix M and letting X be endogenous. results of this switch, he claims, are that (i) the price level is determinate, and (ii) money is no longer neutral except in the case of the first open market operation. Variations in assumptions often generate variations in results. However, the inability of the central bank to acquire real assets (whose nominal values are proportional to the price level) in exchange for money prevails no matter whether we let M or X be the instrument of policy. Every increase in M causes an increase in P in the same proportion and leaves the central bank in possession of no more real assets than before the monetary injection. indeterminacy of prices in a system in which fixed nominal claims are absent is, it appears, a robust result. These assertions may be demonstrated as follows. Kohn's first open market operation is imposed on his equations (10)-(12) in the three unknown, r, and X: The central bank creates a predetermined sum of dollars M, and uses it to purchase private securities at the equilibrium price P, (p. 1094). He finds that r is not altered by the open market operation while X falls from 1 to X 1 < 1, where (1 X) is the proportion of securities (common stock, i.e., claims on real assets)