Knowledge that Transforms

Previous research has established that the predictions of game theory are quite sensitive to the assumptions made about the players’ beliefs. We evaluate the severity of this robustness problem by characterizing conditions on the primitives of the model—the players’ beliefs and higher-order beliefs about the payoff-relevant parameters—for the behaviour of a given Harsanyi type to be approximated by the behaviour of (a sequence of) perturbed types. This amounts to providing belief-based characterizations of the strategic topologies of Dekel et al. (2006). We apply our characterizations to a variety of questions concerning robustness to perturbations of higher-order beliefs, including genericity of types that are consistent with a common prior, and we investigate the connections between our notions of robustness and the notion of common p-belief of Monderer and Samet (1989).

Poor heath, large acute and long-term care medical expenses and spousal death are significant drivers of impoverishment among retirees. We document these facts and build a rich overlapping generations model that reproduces them. We use the model to assess the incentive and welfare effects of U.S. Social Security and means-tested social insurance programs, such as Medicaid and food stamp programs, for the aged. We find that U.S. means-tested social insurance programs for retirees provide significant welfare benefits for all newborn. Moreover, when means-tested social insurance benefits are of the scale in the U.S., all newborn prefer that Social Security be removed. Finally, we find that the current scale of means-tested social insurance in the U.S. is about right in the following sense. If we condition on the current Social Security program, the benefits of increasing means-tested social insurance are small or negative.

We study effort and risk-taking behaviour in an economy with a continuum of principal–agent pairs where each agent exerts costly hidden effort. Principals write contracts based on both absolute and relative performance evaluations (APE and RPE, respectively) to make individually optimal risk–return trade-offs but do not take into account their impact on endogenously determined aggregate variables. This results in contractual externalities when these aggregate variables are used as benchmarks in contracts. Contractual externalities have welfare changing effects when principals put too much weight on APE or RPE due to information frictions. Relative to the second best, if the expected productivity is high, risk-averse principals over-incentivize their own agents, triggering a rat race in effort exertion, resulting in over-investment in effort and excessive exposure to industry risks. The opposite occurs when the expected productivity is low, inducing pro-cyclical investment and risk-taking behaviours.

Voters commonly face a choice between competent candidates and those with policy preferences similar to their own. This article explores how electoral rules, such as district magnitude, mediate this trade-off and affect the composition of representative bodies and the quality of policy outcomes. We show formally that anticipation of bargaining over policy causes voters in elections with multiple singlemember districts to prefer candidates with polarized policy positions over more competent candidates. Results from a unique field experiment in Afghanistan are consistent with these predictions. Specifically, representatives selected by elections with a single multi-member district are better educated and exhibit less extreme policy preferences.

We present a Theory of Contracts under costly enforcement in the context of a dynamic relationship between an uninformed buyer and a seller who is privately informed on his persistent cost at the outset. Public enforcement relies on remedies for breach. Private enforcement comes from severing relationships. We first characterize aggregate enforcement constraints ensuring that trading partners do not breach contracts unduly. Whether a long-term contract is enforceable does not depend on the distribution of penalties for breach between the buyer and the seller. While under complete information, the optimal contract would remain stationary, non-stationarity might arise under asymmetric information. Enforcement constraints are time-dependent and easier to satisfy as time passes. Indeed, a high-cost seller may be tempted to trade high volumes at high prices at the beginning of the relationship before breaching the contract later on. Yet, such take-the-money-and-run strategy becomes less attractive as time passes and can be prevented with back loaded payments. The optimal contract thus goes through two different phases. First, quantities and prices increase at the inception of the relationship. Later on, the contract looks more stationary. Long-run screening distortions encapsulate the quality of enforcement, offering de facto a link between the quality of the legal system and contractual performances. / Nous présentons une théorie des contrats avec exécution coûteuse dans le contexte d'une relation dynamique entre un acheteur non informé et un vendeur avec information privée quant à son coût persistant au départ. L’exécution publique des contrats s'appuie sur les recours pour violation. L’exécution privée consiste à de rompre les relations. En premier lieu, nous caractérisons les contraintes d'exécution globale. La possible exécution d’un contrat à long terme ne dépend pas de la distribution des pénalités pour rupture entre l'acheteur et le vendeur. Sous information complète, le contrat optimal resterait stationnaire, alors qu’il pourrait être non stationnaire lorsque l'information est asymétrique. Les contraintes de l'application dépendent du temps et sont plus faciles à satisfaire à mesure que le temps passe. En effet, un vendeur avec des coûts élevés peut être tenté d'échanger de grandes quantités à des prix élevés au début de la relation avant de rompre le contrat par la suite. Pourtant, telle stratégie, prendre l’argent et courir, devient moins attrayante à mesure que le temps passe et peut être évitée. Le contrat optimal passe donc par deux phases différentes. Tout d'abord, les quantités et les prix augmentent lors de la création de la relation. Plus tard, on le contrat semble plus stable. Les distorsions dues au dépistage de long terme signalent, ce qui suggère de facto un lien entre la qualité du système légal et les performances contractuelles.

Principals often operate on misspecified models of their agents’ preferences. When preferences are such that non-local incentive constraints may bind in the optimum, even slight misspecification of the preferences can lead to large and non-vanishing losses. Instead, we propose a two-step scheme whereby the principal: (1) identifies the model-optimal menu; and (2) modifies prices by offering to share with the agent a fixed proportion of the profit she would receive if an item were sold at the model-optimal price. We show that her loss is bounded and vanishes smoothly as the model converges to the truth. Finally, two-step mechanisms without a sharing rule like (2) will not yield a valid approximation.

In elections with three or more candidates, coordination among like-minded voters is an important problem. We analyse the trade-off between coordination and learning about candidate quality under different temporal election systems in the context of the U.S. presidential primary system. In our model, candidates with different policy positions and qualities compete for the nomination, and voters are uncertain about the candidates' valence. This setup generates two effects: vote splitting ( i.e . several candidates in the same policy position compete for the same voter pool) and voter learning (as the results in earlier elections help voters to update their beliefs on candidate quality). Sequential voting minimizes vote splitting in late districts, but voters may coordinate on a low-quality candidate. Using the parameter estimates obtained from all the Democratic and Republican presidential primaries during 2000–12, we conduct policy experiments such as replacing the current system with a simultaneous system, adopting the reform proposal of the National Association of Secretaries of State, or imposing party rules that lead to candidate withdrawal when prespecified conditions are met.

In U.S. data 1981–2012, unsecured firm credit moves procyclically and tends to lead GDP, while secured firm credit is acyclical; similarly, shocks to unsecured firm credit explain a far larger fraction of output fluctuations than shocks to secured credit. In this article, we develop a tractable dynamic general equilibrium model in which unsecured firm credit arises from self-enforcing borrowing constraints, preventing an efficient capital allocation among heterogeneous firms. Unsecured credit rests on the value that borrowers attach to a good credit reputation which is a forward-looking variable. We argue that self-fulfilling beliefs over future credit conditions naturally generate endogenously persistent business-cycle dynamics. A dynamic complementarity between current and future borrowing limits permits uncorrelated sunspot shocks to unsecured debt to trigger persistent aggregate fluctuations in both secured and unsecured debt, factor productivity, and output. We show that these sunspot shocks are quantitatively important, accounting for around half of output volatility.

We build a heterogeneous agents life cycle model that captures a large number of salient features of individual male labour supply over the life cycle, by education, both along the intensive and extensive margins. The model provides an aggregation theory of individual labour supply, firmly grounded on individual-level micro-evidence, and is used to study the aggregate labour supply responses to changes in the economic environment. We find that the aggregate labour supply elasticity to a transitory wage shock is 1.75, with the extensive margin accounting for 62% of the response. Furthermore, we find that the aggregate labour supply elasticity to a permanent-compensated wage change is 0.44.

We study how the marginal welfare gain from increasing the unemployment insurance (UI) benefit level varies over the business cycle. We do this by estimating how the moral hazard cost and the consumption smoothing benefit of UI vary with labour market conditions, which we identify using variation in the interaction of UI benefit levels with the unemployment rate within U.S. states over time. We find that the moral hazard cost is procyclical, greater when the unemployment rate is relatively low. By contrast, we do not find evidence that the consumption smoothing benefit varies with the unemployment rate. We use these empirical results to estimate the marginal welfare gain, and we find that it is modest on average, but varies positively with the unemployment rate.