Knowledge that Transforms

The equity premium puzzle refers to the empirical fact that stocks have outperformed bonds over the last century by a surprisingly large margin. We offer a new explanation based on two behavioral concepts. First, investors are assumed to be “loss averse,” meaning that they are distinctly more sensitive to losses than to gains. Second, even long-term investors are assumed to evaluate their portfolios frequently. We dub this combination “myopic loss aversion.” Using simulations, we find that the size of the equity premium is consistent with the previously estimated parameters of prospect theory if investors evaluate their portfolios annually.

This paper presents evidence on the long-run trends in U. S. regional specialization and localization and examines which model of regional specialization is most consistent with the data. Regional specialization in the United States rose substantially between 1860 and the turn of the twentieth century, flattened out during the interwar years, and then fell substantially and continuously since the 1930s. The analysis of the long-run trends in U. S. regional specialization and localization supports explanations based on production scale economies and the Heckscher-Ohlin model but is inconsistent with explanations based on external economies.

Using theory, case studies, and cross-country evidence, we investigate the factors behind the concentration of a nation's urban population in a single city. High tariffs, high costs of internal trade, and low levels of international trade increase the degree of concentration. Even more clearly, politics (such as the degree of instability) determines urban primacy. Dictatorships have central cities that are, on average, 50 percent larger than their democratic counterparts. Using information about the timing of city growth, and a series of instruments, we conclude that the predominant causality is from political factors to urban concentration, not from concentration to political change.

We test some propositions about international trade flows that are derived from models of monopolistic competition developed by Elhanan Helpman and Paul Krugman. We investigate whether the volume of trade between OECD countries is consistent with the predictions of a model in which all trade is intraindustry trade in differentiated products. We then repeat the test with non-OECD countries. We also investigate whether the share of intraindustry trade is consistent with a more general theoretical model in which some, but not all, trade is intraindustry trade. Our results lead us to question the apparent empirical success of these models.

Just like economists, voters have conflicting views about redistributive taxation because they estimate its incentive costs differently. We model rational agents as trying to learn from their dynastic income mobility experience the relative importance of effort and predetermined factors in the generation of income inequality and therefore the magnitude of these incentive costs. In the long run, “left-wing dynasties” believing less in individual effort and voting for more redistribution coexist with “right-wing dynasties.” This allows us to explain why individual mobility experience and not only current income matters for political attiitudes and how persistent differences in perceptions about social mobility can generate persistent differences in redistribution across countries.

This paper analyzes the behavior of U. S. governors from 1950 to 1986 to investigate a reputation-building model of political behavior. We argue that differences in the behavior of governors who face a binding term limit and those who are able to run again provides a source of variation in discount rates that can be used to test a political agency model. We find evidence that taxes, spending, and other policy instruments respond to a binding term limit if a Democrat is in office. The result is a fiscal cycle in term-limit states, which lowers state income when the term limit binds.

A monopolistically competitive manufacturing sector produces goods used for final consumption and as intermediates. Intermediate usage creates cost and demand linkages between firms and a tendency for manufacturing agglomeration. How does globalization affect the location of manufacturing and gains from trade? At high transport costs all countries have some manufacturing, but when transport costs fall below a critical value, a core-periphery spontaneously forms, and nations that find themselves in the periphery suffer a decline in real income. At still lower transport costs there is convergence of real incomes, in which peripheral nations gain and core nations may lose.

This paper investigates the link between the trend in the returns to education and foreign competition in concentrated industries. We argue that the impact of foreign competition on the relative wages of less skilled workers depends on the market structure of the industry penetrated. The empirical evidence indicates that employment changes in a small group of trade-impacted concentrated industries can explain not only part of the aggregate rise in wage inequality in the United States, but also some of the differences in the trends in wage inequality across metropolitan areas.

We examine the reduced-form relationship between per capita income and various environmental indicators. Our study covers four types of indicators: urban air pollution, the state of the oxygen regime in river basins, fecal contamination of river basins, and contamination of river basins by heavy metals. We find no evidence that environmental quality deteriorates steadily with economic growth. Rather, for most indicators, economic growth brings an initial phase of deterioration followed by a subsequent phase of improvement. The turning points for the different pollutants vary, but in most cases they come before a country reaches a per capita income of $8000.

This paper examines the determinants of hours worked when employment relationships are influenced by risk-sharing considerations. The environment considered is an extension of the standard symmetric-information risk-sharing model that allows for the possibility of enforcement problems on the part of both the employer and the employee. We show that this class of risk-sharing models unambiguously predicts hours to be influenced by wages only through an income effect. Using data from the PSED, we find evidence in favor of this extended version of the risk-sharing model.