We develop an approach to asset pricing in incomplete markets that bridges the gap between the two fundamental approaches in finance: model‐based pricing and pricing by no arbitrage. We strengthen the absence of arbtrage assumption by precluding investment opportunities whose attractiveness to a benchmark investor exceeds a specified threshold. In our framework, the attractiveness of an investment opportunity is measured by the gain‐loss ratio. We show that a restriction on the maximum gain‐loss ratio is equivalent to a restriction on the ratio of the maximum to minimum values of the pricing kernel. By limiting the maximum gainloss ratio, we can restrict the admissible set of pricing kernels, which in turn allows us to restrict the set of prices that can be assigned to assets. We illustrate our methodology by computing price bounds for call options in a Black‐Scholes economy without intermediate trading. When we vary the maximum permitted gainloss ratio, these bounds can range from the exact prices implied by a model‐based pricing approach to the loose price bounds implied by the no‐arbitrage approach.
We examine the contracts used to compensate the managers of the seven dual‐purpose investment companies that existed between 1967 and 1985 to determine whether financial incentives in fluence real behavior in the predicted way. The compensation contracts for these funds provided explicit incentives for the production of both capital gains and current income. We model the behavior that an expected compensation‐maximizing agent would exhibit when faced with such contracts and derive several testable implications. Our empirical results are consistent with the theoretical predictions, and so we are able to use this relatively clean setting to contribute to the growing literature concerned with determining the impact of incentive contracts on behavior. A unique and interesting aspect of this study is that the nature of these organizations allows us to provide evidence that the market understood and priced the behavior induced by these contracts.
This paper develops a Ricardian model of trade in which goods are indexed according to priority and higher‐indexed goods are consumed only by richer households. South (North) has a comparative advantage in lower‐ (higher‐) indexed goods and, hence, specializes in goods with lower (higher) income elasticities of demand. Product cycles and a southern terms‐of‐trade deterioration result from faster population growth and uniform productivity growth in South and a global productivity improvement. South’s domestic income redistribution policy can improve its terms of trade so much that every household in South may be better off, at the expense of North.
One often wants to value a risky payoff by reference to prices of other assets rather than by exploiting full‐fledged economic models. However, this approach breaks down if one cannot find a perfect replicating portfolio. We impose weak economic restriction to derive usefully tight bounds on asset prices in this situation. The bounds assume that investors would want to buy assets with high Sharpe ratios‐“good deals”‐as well as pure arbitrage opportunities. We show how to calculate the price bounds in one‐period, multiperiod, and continuous‐time contexts. We show that the multiperiod problem can be solved recursively as a sequence of one‐period problems. We calculate bounds in option pricing examples including infrequent trading and an option written on a nontraded event, and we use the bounds to explore the economic significance of option pricing predictions. We find that much variation in S&P 500, index option prices over time and across strike prices fits within the bounds.
We explore sequential voting in symmetric two‐option environments. We show that the (informative) symmetric equilibria of the simultancous voting game are also equilibria in any sequential voting structure. In unanimity games, (essentially) the whole set of equilibria is the same in all sequential structures. We also explore the relationship between simultaneous and sequential voting in other contexts. We illustrate several instances in which sequential voting does no better at aggregating information than simultaneous voting. The inability of the sequential structure to use additional information in voting models is distinct from that in the herd‐cascade literature.
This study seeks to establish the empirical importance of price dispersion due to costly consumer search by examining retail prices for prescription drugs. Posted prices in two geographically distinct markets are shown to vary considerably across pharmacies within the same market, even after one controls for variation due to pharmacy differences. Pharmacy heterogeneity accounts for at most one‐third of the observed price dispersion. The empirical analysis hinges on the observation that consumers’ incentives to price‐shop depend on characteristics of the drug therapy. Cross‐sectional patterns in price distributions across drugs are consistent with the predictions of a search model: prices for repeatedly purchased prescriptions (for which the expected benefits of search are highest) exhibit significant reductions in both dispersion and price‐cost margins.
To offer a possible interpretation for recent empirical findings on earnings growth, this paper constructs a simple model with endogenous human capital investment, a distribution of natural abilities, and unbiased technological progress. The model predicts that in the long run, average earnings within any education group will grow more slowly than average wages overall. It also predicts that average earnings in high‐education groups ultimately will rise relative to average earnings in low‐education groups. In the model, these processes do not imply secular increases in the degree of inequality in the overall cross‐sectional distribution of earnings.
This paper develops a simple model to analyze the dual‐track approach to market liberalization as a mechanism for implementing efficient Pareto‐improving economic reform, that is, reform achieving efficiency without creating losers. The approach, based on the continued enforcement of the existing plan while simultaneously liberalizing the market, can be understood as a method for making implicit lump‐sum transfers to compensate potential losers of the reform. The model highlights the critical roles of enforcement of the plan for achieving Pareto improvement and full liberalization of the market track for achieving efficiency. We examine how the dual‐track approach has worked in product and labor market liberalization in China.