Knowledge that Transforms

It is traditional in a discussion piece to organize the material in one of two ways. The writer can either take a historical perspective and attempt to explain how it is we got where we are today and where we are likely to go from here, or the writer can describe the current state of the art, dwelling on particular points of interest or promise in the prevailing research. Having quite recently done both, I thought I would take a somewhat different approach. I would like to try to briefly describe the main characteristics of a neoclassical theory of finance that captures the essential themes of modern finance and relate these characteristics to the general themes of economics. Finance uses the modeling framework constructed in economics but, within this scaffolding, finance has taken a different methodological perspective. It is wrong to characterize finance, or financial economics to be formal, as simply another of the specialty areas of economics-not unlike, for example, labor economics or development economics or public finance. While finance is specialized in its focus on the financial markets, the differences between economics and finance only begin there. The principal distinction is one of methodology rather than of focus. If labor markets behaved like financial markets, the theories of finance would be used to study them. Indeed, the line where financial theoretic analysis leaves off and more conventional patterns of economic reasoning begin is an active research issue.

A theoretical model of deterrence is studied in which the imposition of nonmonetary (as opposed to monetary) sanctions is socially costly. It is therefore desirable that the system of sanctions be designed so that sanctions are imposed infrequently. If courts possess perfect information, the optimal system is such that sanctions are never imposed-all who can be deterred will be--but, realistically, courts' information will be imperfect and sanctions will be imposed.

We consider the following simple model of consumer fraud. Consumers need one of two possible repairs-an expensive repair (denoted E) or an inexpensive repair (denoted I). The exogenous probability that a consumer needs the more costly remedy is r. Each consumer is assumed to know r. An expert can observe with certainty which of the two repairs is needed and can offer to sell either to the consumer. (In a simple extension, we allow for uncertainty with respect to the expert's observation.) We assume that selling the expensive remedy to a consumer who needs only the inexpensive one is more profitable than selling the inexpensive one. Thus, H(EII) > H1(IJI), where H denotes profit and I denotes conditional on needing. The profit functions are increasing in the price of the respective repairs. (For convenience, we suppress the dependence of H on prices in our notation.) We also assume that a consumer prefers to obtain the appropriate repair to the inappropriate one. Thus, u(EIE) > u(IjE) and u(III) > u(EII), where u is the consumer's payoff. Lastly, we assume that the functions u(EjE) and u(E I) are decreasing in the price of the expensive repair and that u(IIE) and u( III) are decreasing in the price of the inexpensive repair. We also assume that u(IIE) is decreasing in the price of the expensive repair since the consumer ultimately buys the expensive repair in this case. (See below for further assumptions regarding the repairs.) We are interested in the equilibrium levels of honesty in this model. How honest is the expert at the equilibrium? Do consumers always follow the expert's advice? Does the level of honesty increase as the interests of the agents become more similar (in a sense to be defined below)? Our assumptions are similar to those in the abstract strategic information transmission models of Vincent Crawford and Joel Sobel (1982), and Jerry Green and Nancy Stokey (1980). We follow the former paper which asks whether the signals sent become less noisy as the agents' preferences become more similar. Despite the similarity of our model to Crawford-Sobel's, we arrive at some different conclusions with respect to the expert's honesty vis-'a-vis the agents' closeness of interests. We explain this in detail in Section III. In addition we allow that the expert may be uncertain about the true state of the world. We also explicitly model the level of expert honesty, which extends Crawford-Sobel. The outline of the paper is as follows. In Section I we provide the details of the model and show that a unique equilibrium exists. Comparative static results and a simple extension (incorporating the assumption of the incompetent expert) are given in Section II. We draw comparisons with CrawfordSobel in Section III. In Section IV we conclude with a brief summary.

The credibility of temporary protection is examined in a simple infinite horizon, perfect information game of timing in which the domestic government uses the threat of future liberalization to induce the domestic firm to invest. All pure strategy subgame-perfect equilibria are cyclical and, surprisingly, one of them implements optimal temporary protection. However, this equilibrium fails to pass another credibility criterion called "renegotiation-proof." The game has a unique stationary subgame-perfect equilibrium in mixed strategies.

Proponents of the new federalism argue that nonprofit organizations and local governments will fully offset federal social service expenditure cutbacks. The author analyzes this proposition as a competitive game in which donations are motivated by private and public good considerations. The author characterizes the response of political-economic equilibrium to exogenous changes in federal expenditures when local voters are cognizant of donor reactions. Partial replacement is the most likely outcome, though others are possible.