Knowledge that Transforms

This paper considers learning when the distinction between risk and ambiguity matters. It first describes thought experiments, dynamic variants of those provided by Ellsberg, that highlight a sense in which the Bayesian learning model is extreme—it models agents who are implausibly ambitious about what they can learn in complicated environments. The paper then provides a generalization of the Bayesian model that accommodates the intuitive choices in the thought experiments. In particular, the model allows decision-makers' confidence about the environment to change—along with beliefs—as they learn. A portfolio choice application compares the effect of changes in confidence under ambiguity vs. changes in estimation risk under Bayesian learning. The former is shown to induce a trend towards more stock market participation and investment even when the latter does not.

Every new method of trade offers an opportunity for economic agents to compare its costs and benefits relative to the status quo. Such comparison motivates sorting across market segments and reshapes the whole marketplace. The Internet provides an excellent example: it introduces substantial search cost savings over brick and mortar retail stores but imposes new obstacles for sellers to convey quality. Using sports card trading as a case study, we provide empirical evidence on (1) the sorting of product quality between the online and offline segments, (2) the changes for retail outlets after the Internet came into place, and (3) how supporting industries such as professional grading and card manufacturing adapted to take advantage of the new market.

We consider a version of the Solow growth model where technological progress can be investment specific or investment neutral. The labour market is subject to search frictions, and the existing productive units may fail to adopt the most recent technological advances. Technological progress can lead to the destruction of technologically obsolete jobs and cause unemployment. We calibrate the model to replicate the high persistence that characterizes the dynamics of firms' neutral technology and the frequency of firms' capital adjustment. We find that neutral technological advances increase job destruction and job reallocation and reduce aggregate employment. Investment-specific technological advances reduce job destruction, have mild effects on job creation, and are expansionary. Hence, neutral technological progress prompts Schumpeterian creative destruction, while investment-specific technological progress operates essentially as in the standard neoclassical growth model. Using structural VAR models, we provide support to the key dynamic implications of the model.

In a plurality-rule election, a group of voters must coordinate behind one of two challengers in order to defeat a disliked status quo. Departing from existing work, the support for each challenger must be inferred from the private observation of informative signals. The unique equilibrium involves limited strategic voting and incomplete coordination. This is driven by negative feedback: an increase in strategic voting by others reduces the incentives for a voter to act strategically. Strategic-voting incentives are lower in relatively marginal elections, after controlling for the distance from contention of a trailing preferred challenger. A calibration applied to the U.K. General Election of 1997 is consistent with the impact of strategic voting and the reported accuracy of voters' understanding of the electoral situation.

In many preferential trade agreements (PTAs), countries exchange not only reductions in trade barriers but also cooperation in non-trade issues such as labour and environmental standards, intellectual property, etc. We provide a model of PTAs motivated by cooperation in non-trade issues and analyse its implications for global free trade and welfare. We find that such PTAs increase the cost of multilateral tariff reductions and thus cause a stumbling block to global free trade. This occurs because multilateral tariff reductions decrease the threat that can be used in PTAs and thus the surplus that can be extracted from them. By explicitly modelling the interaction between preferential and multilateral negotiations, we derive a testable prediction and provide novel econometric evidence that supports the model's key prediction. The welfare analysis shows that the current World Trade Organization rules allowing this type of PTAs may be optimal for economically large countries, thus the model can predict the rules we observe. We also analyse alternative rules that constitute a Pareto improvement. Copyright 2007, Wiley-Blackwell.

In this paper, different models of vertical relationships between manufacturers and retailers in the supermarket industry are compared. Demand estimates are used to compute price-cost margins for retailers and manufacturers under different supply models when wholesale prices are not observed. The purpose is to identify the set of margins compatible with the margins obtained from estimates of cost and to select the model most consistent with the data among non-nested competing models. The models considered are (1) a simple linear pricing model; (2) a vertically integrated model; and (3) a variety of alternative (strategic) supply scenarios that allow for collusion, non-linear pricing, and strategic behaviour with respect to private label products. Using data on yogurt sold in several stores in a large urban area of the U.S. the results imply that wholesale prices are close to marginal cost and that retailers have pricing power in the vertical chain. This is consistent with non-linear pricing by the manufacturers or high bargaining power of the retailers.

A two-country model of oligopoly in general equilibrium is used to show how changes in market structure accompany the process of trade and capital-market liberalization. The model predicts that bilateral mergers in which low-cost firms buy out higher-cost foreign rivals are profitable under Cournot competition. As a result, trade liberalization can trigger international merger waves, in the process encouraging countries to specialize and trade more in accordance with comparative advantage. With symmetric countries, welfare is likely to rise, though the distribution of income always shifts towards profits.

This paper shows that, with (partial) irreversibility, higher uncertainty reduces the impact effect of demand shocks on investment.Uncertainty increases real option values making firms more cautious when investing or disinvesting.This is confirmed both numerically for a model with a rich mix of adjustment costs, time-varying uncertainty, and aggregation over investment decisions and time, and also empirically for a panel of manufacturing firms.These cautionary effects of uncertainty are large -going from the lower quartile to the upper quartile of the uncertainty distribution typically halves the first year investment response to demand shocks.This implies the responsiveness of firms to any given policy stimulus may be much lower in periods of high uncertainty, such as after major shocks like OPEC I and 9/11.