To develop a positive, economic theory of military spending, this analysis focuses on a game-theoretic, general equilibrium model of international conflict, in which consumption, peaceful investment, and military spending are endogenously determined. The analysis illustrates that when there is repeated interaction between nations, a game of threats and punishments generally will not support a disarmament outcome and that fluctuations in military spending can be an endogenous result of fluctuations in aggregate economic activity. Furthermore, the analysis shows how the relation between aggregate economic activity and military spending qualitatively depends on whether governments are acting opportunistically or cooperatively.
Recent concerns over the effects of the Robinson-Patman Act' and so-called priceprotection policies such as most-favoredcustomer clauses (MFC's)2 on market performance have given economists new reasons to examine the welfare effects of third-degree price discrimination. In order to assess these effects correctly, it is imperative that one understand how price discrimination influences market behavior. Joan Robinson's (1933) work launched the formal inquiry into the welfare effects of third-degree price discrimination. Building on the intuition presented by Arthur Pigou (1932), she showed that, if a monopolist faces two independent linear demand curves, the use of price discrimination will not affect industry output but will reduce welfare. Richard Schmalensee (1981) extends these results to nonlinear demand curves and shows that an increase in total industry output is a necessary condition for price discrimination to be welfare improving. Hal Varian (1985) broadens these results by deriving upper and lower bounds on the welfare change due to the use of price discrimination. He shows that these results can be applied to markets in which there are nonzero cross price effects. All of this work examines how the ability of a monopolist to price-discriminate will affect the market outcome when all other characteristics of the market are treated as exogenous. Recently, two lines of research have extended this inquiry beyond the case of a monopolist in a market with exogenously fixed parameters. The first line considers the case of oligopoly. The work of Charles Holt and David Scheffman (1985) and Thomas Cooper (1986) has shown that restrictions on price discrimination imposed by the use of MFC's can facilitate collusion between oligopolists attempting to restrict output. This implies that third-degree price discrimination can be welfare-improving. The second line of research shows that price discrimination by a firm can affect nonprice decisions made by other market participants, thus affecting the market outcome. Michael Katz (1987) presents a model in which a large firm's ability to vertically integrate backward into the production of an input allows it to obtain a lower per-unit price from the supplier of the input than can be obtained by smaller firms without this ability. He shows that third-degree price discrimination reduces welfare unless it prevents inefficient backward integration. DeGraba (1987) shows that the use or nonuse of price discrimination by a national firm can affect nonprice decisions made by local firms that compete with the national firm. In this situation, third-degree price discrimination is welfare-reducing, because it induces local firms to produce a product that is overly differentiated from the product of the national firm. In all of the work cited above, price discrimination is important when sellers set prices in separate markets or charge different prices to different customers in the same market. The following analysis (which can be considered a contribution to the second line of research) suggests that price discrimination can be important even when a seller faces a single market in which all customers are identical. The intuition behind this result is that nonprice decisions made by downstream producers (such as the choice of technology) can be affected by the use or *Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853. I thank Robert Frank, Robert Smiley, Richard Thaler, and the participants of the JGSM applied microeconomics workshop for their helpful comments. 'See William Baldwin (1987 pp. 438-40) for a good summary of the debate. 2See John Kwoka and Lawrence White (1989 pp. 196-7).
This paper argues that default plays an important positive role in the economy. If markets are incomplete and traders are only able to enter into contracts that they will be able to execute regardless of future events, contingent contracting may be severely restricted. Moreover, opening new markets may not relieve these restrictions. Default promotes efficiency in a way that opening new markets does not by making it possible for traders to enter into contracts that they will be able to execute with high probability but not with certainty.
It appears that speculative asset prices tend to show excess volatility relative to simple present value efficient markets models, and that prices are partly forecastable as tending to returning to mean, appropriately defined.' But what does this tell us about how speculative prices are determined? Are there in prices, and if so, how do they behave? The question has arisen recently whether there is really room for fads in speculative prices. Whether or not speculative prices are too volatile, if stock prices are highly correlated with dividends we might conclude that the movements in stock prices are driven by fundamentals, not fads. A question of longer standing is whether fads models that entail feedback from price change to price change are consistent with the observed approximate random walk price behavior, that is, rather low serial correlation of short-run price changes. We can also ask whether the feedback models are consistent with the observed relation of stock prices to dividends and earnings.
The overshooting theory of exchange rates seems ideally designed to explain some important aspects of the movement of the dollar in recent years. Over the period 1981-1984, for example, when real interest rates in the United States rose above those among trading partners (presumably due to shifts in the monetary/fiscal policy mix), the dollar appreciated strongly. It was the higher rates of return that made U.S. assets more attractive to international investors and caused the dollar to appreciate. The overshooting theory would say that, as of 1984 for example, the value of the dollar was so far above its long-run equilibrium that expectations of future depreciation were sufficient to offset the higher nominal interest rate in the minds of international investors. (Figure 1 shows the correlation of the real interest differential with the real value of the dollar, since exchange rates began to float in 1973.)