Knowledge that Transforms

This article develops a dynamic model of retail competition and uses it to study the impact of the expansion of a new national competitor on the structure of urban markets. In order to accommodate substantial heterogeneity (both observed and unobserved) across agents and markets, the article first develops a general framework for estimating and solving dynamic discrete choice models in continuous time that is computationally light and readily applicable to dynamic games. In the proposed framework, players face a standard dynamic discrete choice problem at decision times that occur stochastically. The resulting stochastic-sequential structure naturally admits the use of conditional choice probability methods for estimation and makes it possible to compute counterfactual simulations for relatively high-dimensional games. The model and method are applied to the retail grocery industry, into which Walmart began rapidly expanding in the early 1990s, eventually attaining a dominant position. We find that Walmart's expansion into groceries came mostly at the expense of the large incumbent supermarket chains, rather than the single-store outlets that bore the brunt of its earlier conquest of the broader general merchandise sector. Instead, we find that independent grocers actually thrive when Walmart enters, leading to an overall reduction in market concentration. These competitive effects are strongest in larger markets and those into which Walmart expanded most rapidly, suggesting a diminishing role of scale and a greater emphasis on differentiation in this previously mature industry.

We introduce a model of strategic thinking in games of initial response. Unlike standard models of strategic thinking, in this framework the player's “depth of reasoning” is endogenously determined, and it can be disentangled from his beliefs over his opponent's cognitive bound. In our approach, individuals act as if they follow a cost–benefit analysis. The depth of reasoning is a function of the player's cognitive abilities and his payoffs. The costs are exogenous and represent the game-theoretical sophistication of the player; the benefit instead is related to the game payoffs. Behaviour is in turn determined by the individual's depth of reasoning and his beliefs about the reasoning process of the opponent. Thus, in our framework, payoffs not only affect individual choices in the traditional sense, but they also shape the cognitive process itself. Our model delivers testable implications on players' chosen actions as incentives and opponents change. We then test the model's predictions with an experiment. We administer different treatments that vary beliefs over payoffs and opponents, as well as beliefs over opponents' beliefs. The results of this experiment, which are not accounted for by current models of reasoning in games, strongly support our theory. We also show that the predictions of our model are highly consistent, both qualitatively and quantitatively, with well-known unresolved empirical puzzles. Our approach therefore serves as a novel, unifying framework of strategic thinking that allows for predictions across games.

This article shows that equilibrium unemployment dynamics can significantly increase the efficacy of fiscal policy. In response to a shock that brings the economy into a liquidity trap, an expansion in government spending increases output and causes a fall in the unemployment rate. Since movements in unemployment are persistent, the effects of current spending prevail into the future, leading to an enduring rise in income. As an enduring rise in income boosts private demand, an increase in government spending sets in motion a virtuous employment-spending spiral with large effects on macroeconomic aggregates.

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.

We propose a dynamic framework to study the value of medical innovation in the context of infectious disease. We apply our framework to evaluate an HIV treatment breakthrough known as HAART. The model captures how, in lowering both the expected cost and likelihood of HIV infection, HAART reduced the implicit price of risky sex. Forward-looking agents responded by optimally shifting their behaviour. The model also imposes equilibrium constraints, explicitly capturing how optimal shifts in behaviour affect equilibrium choices by changing both infection probabilities and the ease of finding partners willing to engage in risky sex. Using the estimated model, we conduct counterfactual simulations to compute the value of HAART from the perspective of uninfected agents. This includes the option value of the innovation along with value accruing from changes in sex behaviour in response to HAART introduction. We also calculate the added value of a fully functional vaccine from the perspective of both infected and uninfected agents, where infected agents benefit from a vaccine due to resulting shifts in market equilibrium.

This article measures the economic impacts of social pressure to share income with kin and neighbours in rural Kenyan villages. We conduct a lab experiment in which we randomly vary the observability of investment returns to test whether subjects reduce their income in order to keep it hidden. We find that women adopt an investment strategy that conceals the size of their initial endowment in the experiment, though that strategy reduces their expected earnings. This effect is largest among women with relatives attending the experiment. Parameter estimates suggest that women anticipate that observable income will be “taxed” at a rate above 4%; this effective tax rate nearly doubles when kin can observe income directly. At the village level, we find an association between the willingness to forgo expected return to keep income hidden in the laboratory experiment and worse economic outcomes outside the laboratory.

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.

A growing literature suggests that high-income countries export high-quality goods. Two hypotheses may explain such specialization, with different implications for welfare, inequality, and trade policy. Fajgelbaum et al. formalize the Linder hypothesis that home demand determines the pattern of specialization and, therefore, predict that high-income locations export high-quality products. The factor-proportions model also predicts that skill-abundant, high-income locations export skill-intensive, high-quality products. Prior empirical evidence does not separate these explanations. I develop a model that nests both hypotheses and employ microdata on U.S. manufacturing plants’ shipments and factor inputs to quantify the two mechanisms’ roles in quality specialization across U.S. cities. Home-market demand explains as much of the relationship between income and quality as differences in factor usage.

If individuals own the right to take any action that they please, and are free to contract about behaviour, will outcomes be efficient in all situations? That is, does the Coase theorem hold? We study this classic question through the lens of a non-cooperative model of contract negotiations, considering both compulsory and voluntary participation in negotiations. In either case, we find that all consistent equilibria of the contracting game are efficient in the case of two players. But if participation is voluntary, and there are more than two players, there are situations in which all consistent equilibria are inefficient. Specifically, the provision of public goods tends to be inefficiently low due to strategic abstention from contracting. Free-riding on others' agreements can be avoided if individuals do not own all their actions. When actions involve the use of assets, efficient action ownership may correspond to collective rather than individual asset ownership.

We examine the impact of Chinese import competition on broad measures of technical change—patenting, IT, and TFP—using new panel data across twelve European countries from 1996 to 2007. In particular, we establish that the absolute volume of innovation increases within the firms most affected by Chinese imports in their output markets. We correct for endogeneity using the removal of product-specific quotas following China's entry into the World Trade Organization in 2001. Chinese import competition led to increased technical change within firms and reallocated employment between firms towards more technologically advanced firms. These within and between effects were about equal in magnitude, and account for 14% of European technology upgrading over 2000–7 (and even more when we allow for offshoring to China). Rising Chinese import competition also led to falls in employment and the share of unskilled workers. In contrast to low-wage nations like China, developed countries had no significant effect on innovation.