Knowledge that Transforms

Stock-Market Participation, Intertemporal Substitution, and Risk-Aversion by Annette Vissing-Jørgensen and Orazio P. Attanasio. Published in volume 93, issue 2, pages 383-391 of American Economic Review, May 2003

Measuring Unilateral Market Power in Wholesale Electricity Markets: The California Market, 1998-2000 by Frank A. Wolak. Published in volume 93, issue 2, pages 425-430 of American Economic Review, May 2003

The widespread public and political impetus, in the United States and elsewhere, to revamp social security to incorporate some form of individual accounts creates a time of opportunity. It is a time when people want to see the better exploitation of the available trade-off between risk and return and a time to reconsider the foundations of the social-security system so that it can much better serve its intended purpose as a manager of risks. As I argue in my new book, The New Financial Order: Risk in the 21st Century (Shiller, 2003), the time when we redesign social security ought to be a time when we carefully consider the fundamental intergenerational risk-management problem and define choices in individual accounts that reflect the true problem. It is also a time when we must make creative use of insights from behavioral economics that have emerged over the years. Finally, it is a time for an expanded exploitation of our new electronic information technology. We should not miss this opportunity. This means we must work now toward solving a complex constrained optimization problem where the objective is to maximize a social welfare function involving all generations and the constraints reflect the varying degrees of individual optimization ability, psychological underpinnings of human behavior, and modem information technology.

In spite of significant institutional and macroeconomic reforms over the last decade or two, capital flows to developing economies remain highly volatile. In 1996, net private capital flows to emerging markets reached US$230 billion; by 1997 these flows had been cut in half; by 1998 halved again; and after a mild recovery during 1999, flows fell in 2000 and 2001 to slightly over one-tenth the level of 1996. With the exception of developing Asia, 2002 does not look much rosier (see International Monetary Fund, 2002 p. 12 [table 1.3]). The economic, political, and social costs of these large swings in capital flows are enormous. The most vivid examples are seen in the economies that experience deep crises, including (since 1997) Thailand, Indonesia, Malaysia, Korea, Russia, Brazil, Turkey, and Argentina. While in many instances there are important domestic deficiencies behind these reversals, there is also a well-founded sense that international financial markets often exacerbate the problem. It is not surprising, then, that as with the debt crisis of the early 1980’s and the Mexican crisis of the 1990’s this new wave of crises has led to innumerable calls for deep reform to these markets. Nowhere is this more apparent than in the design of new “rules of engagement” for the International Monetary Fund. The important work of multiple official and unofficial commissions, leveraged by its own rethinking, promises to transform this institution from the ground up. In a nutshell, most experts agree that the International Monetary Fund should be much more focused, transparent, predictable, and quick in its interventions, and its role limited to surveillance (pre-crisis) and lenderof-last-resort/bankruptcy-court (during crises) activities. This seems right. I believe, however, that by focusing almost exclusively on the needs of countries undergoing deep crises (highly illiquid and “bankrupt” economies) these reform proposals have left unaddressed a significant fraction of the costs associated with capital-flows reversals. An important share of these costs are borne by countries that experience deep contractions but do not undergo full-blown crises, and much of the cost experienced by those countries that do fall into deep crises is experienced well before the open crisis phase develops. Often, the latter is just the final stage of a prolonged and politically thorny economic period of sharply reduced access to international capital markets. Surely, the anticipation of more orderly resolution and access to a few credit lines, should the open crisis phase arrive, would (by backward induction) eliminate some of the costs that precede these events as well. But this benefit is indirect only and relies on a chain of reasoning that requires more rationality and trust in the new system † Discussants: Stanley Fischer, Citigroup; Allan Meltzer, Carnegie Mellon University; Jeffrey Sachs, Columbia University; Nicholas Stern, World Bank.

Impact of Immigration on Prenatal Care Use and Birth Weight: Evidence from California in the 1990's by Catalina Amuedo-Dorantes and Kusum Mundra. Published in volume 93, issue 2, pages 242-246 of American Economic Review, May 2003

Over the last 20 years the wage-education relationships in the United States and Germany have evolved very differently, while the education compositions of employment have evolved in a parallel fashion. In this paper, we show how these patterns shed light on the nature of recent technological change and highlight the importance of taking into account movements in the ratio of human capital to physical capital when examining changes in the returns to skill. Our analysis indicates that the United States could have prevented the increase in wage inequality observed in the 1980's by a faster accumulation of physical capital.

The classical economic approach to policy analysis assumes that people always respond optimally to the costs and benefits of their available choices. A great deal of evidence suggests, however, that in some contexts people make errors that lead them not to behave in their own best interests. Economic policy prescriptions might change once we recognize that humans are humanly rational rather than superhumanly rational, and in particular it may be fruitful for economists to study the possible advantages of paternalistic policies that help people make better choices. We propose an approach for studying optimal paternalism that follows naturally from standard assumptions and methods of economic theory: Write down assumptions about the distribution of rational and irrational types of agents, about the available policy instruments, and about the government’s information about agents, and then investigate which policies achieve the most efficient outcomes. In other words, economists ought to treat the analysis of optimal paternalism as a mechanism-design problem when some agents might be boundedly rational. This approach has many advantages. First and foremost, by explicitly addressing when and how people do and don’t pursue their own best interests, economists will be better able to contribute to policy debates. To contribute to debates over regulating private financial decisions, we must study

Does Aid Matter? Measuring the Effect of Student Aid on College Attendance and Completion by Susan M. Dynarski. Published in volume 93, issue 1, pages 279-288 of American Economic Review, March 2003

Access to Food and the Biological Standard of Living: Perspectives on the Nutritional Status of Native Americans by John Komlos. Published in volume 93, issue 1, pages 252-255 of American Economic Review, March 2003

Firms selling multiple quality-differentiated products frequently alter their product lines when a competitor enters the market. We present a model of multiproduct monopoly and duopoly using a general “upgrades” approach that yields a powerful analytical framework. We provide an explanation for the common strategies of using “fighting brands” and of product line “pruning.” The optimal strategy depends on whether entry prompts an incumbent to expand or contract its total output. We also present a general condition that guarantees that a monopolist will sell but a single product. Our model addresses other issues, including intertemporal price discrimination and “damaged goods.”