Knowledge that Transforms

Oliver Hart delivered his Prize Lecture on 8 December 2016 at the Aula Magna, Stockholm University.

This paper shows how to identify and estimate, using standard semi-parametric techniques, a class of dynamic games with perfect monitoring, that have been at the frontier of recent research in political economy. The empirical analysis provides novel quantitative insights into the trade-off that voters face between ideology and ability, the differences in ability and ideology among parties and states, and the differences in preferences between political candidates and voters. We analyze the consequences of term limits and quantify their relative importance. Specifically, we characterize conditions under which term limits improve voters' welfare. (JEL C57, C73, D72)

Contrary to standard search models predictions, past studies have not found a positive effect of unemployment insurance (UI) on reemployment wages. We estimate a positive UI wage effect exploiting an age-based regression discontinuity design in Austria. A search model incorporating duration dependence predicts two countervailing forces: UI induces workers to seek higher-wage jobs, but reduces wages by lengthening unemployment. Matching-function heterogeneity plausibly generates a negative relationship between the UI unemployment-duration and wage effects, which holds empirically in our sample and across studies, reconciling disparate wage-effect estimates. Empirically, UI raises wages by improving reemployment firm quality and attenuating wage drops. (JEL J31, J64, J65)

This paper establishes a new fact about the compositional changes in the pool of unemployed over the US business cycle. Using microdata from the Current Population Survey for the years 1962–2012, it documents that in recessions the pool of unemployed shifts toward workers with high wages in their previous job and that these shifts are driven by the high cyclicality of separations for high-wage workers. The paper finds that standard theories of wage setting and unemployment have difficulty in explaining these patterns and evaluates a number of alternative theories that do better in accounting for the new fact. (JEL E24, E32, J31, J63, J64)

A strategy is obviously dominant if, for any deviation, at any information set where both strategies first diverge, the best outcome under the deviation is no better than the worst outcome under the dominant strategy. A mechanism is obviously strategy-proof (OSP) if it has an equilibrium in obviously dominant strategies. This has a behavioral interpretation: a strategy is obviously dominant if and only if a cognitively limited agent can recognize it as weakly dominant. It also has a classical interpretation: a choice rule is OSP-implementable if and only if it can be carried out by a social planner under a particular regime of partial commitment. (JEL D11, D44, D82)

We develop a version of Afriat's theorem that is applicable in a variety of choice environments beyond the setting of classical consumer theory. This allows us to devise tests for rationalizability in environments where the set of alternatives is not the positive orthant of a Euclidean space and where the rationalizing utility function is required to satisfy properties appropriate to that environment. We show that our results are applicable, amongst others, to choice data on lotteries, contingent consumption, and intertemporal consumption. (JEL D11, D81)

Chetty, Friedman, and Rockoff (2014a, b) study value-added (VA) measures of teacher effectiveness. CFR (2014a) exploits teacher switching as a quasi-experiment, concluding that student sorting creates negligible bias in VA scores. CFR (2014b) finds VA scores are useful proxies for teachers' effects on students' long-run outcomes. I successfully reproduce each in North Carolina data. But I find that the quasi-experiment is invalid, as teacher switching is correlated with changes in student preparedness. Adjusting for this, I find moderate bias in VA scores, perhaps 10–35 percent as large, in variance terms, as teachers' causal effects. Long-run results are sensitive to controls and cannot support strong conclusions. (JEL H75, I21, J45)

We estimate a model of illicit drugs markets using data on purchases of crack cocaine. Buyers are searching for high-quality drugs, but they determine drugs' quality (i.e., their purity) only after consuming them. Hence, sellers can rip off first-time buyers or can offer higher-quality drugs to induce buyers to purchase from them again. In equilibrium, a distribution of qualities persists. The estimated model implies that if drugs were legalized, in which case purity could be regulated and hence observable, the average purity of drugs would increase by approximately 20 percent and the dispersion would decrease by approximately 80 percent. Moreover, increasing penalties may raise the purity and affordability of the drugs traded by increasing sellers’ relative profitability of targeting loyal buyers versus first-time buyers.

We show that policy uncertainty about how the rising public debt will be stabilized accounts for the lack of deflation in the US economy at the zero lower bound. We first estimate a Markov-switching VAR to highlight that a zero-lower-bound regime captures most of the comovements during the Great Recession: a deep recession, no deflation, and large fiscal imbalances. We then show that a microfounded model that features policy uncertainty accounts for these stylized facts. Finally, we highlight that policy uncertainty arises at the zero lower bound because of a trade-off between mitigating the recession and preserving long-run macroeconomic stability. (JEL E31, E32, E52, E62, G01, H63)

We estimate the causal effect of sovereign default on the equity returns of Argentine firms. We identify this effect by exploiting changes in the probability of Argentine sovereign default induced by legal rulings in the case of NML Capital, Ltd. v. Republic of Argentina. We find that a 10 percent increase in the probability of default causes a 6 percent decline in the value of Argentine equities and a 1 percent depreciation of a measure of the exchange rate. We examine the channels through which a sovereign default may affect the economy. (JEL D22, F31, F34, G32, O14, O16, O19)