Knowledge that Transforms

risk ; probability ; consumers ; information

It is often argued that the same expenditures on military procurement would produce a more effective defense if larger numbers of less sophisticated (and thus cheaper) weapons were purchased. This paper shows that such a result can occur even if the military derives no private consumption value from technically sophisticated weapons. Rather, the organization of the decision-making process itself can produce this result. This suggests some possible solutions through organizing decision-making in a different fashion.

Perhaps no issue has generated as much controversy among economists in the past decade as the proposition that an increase in the government deficit induces an equal offsetting increase in private saving. The truth of this so-called Ricardian equivalence proposition is central to whether budget deficits reduce capital accumulation, to the feasibility of expansionary tax reductions, and to the effects of Social Security on private saving and aggregate capital accumulation. Although the basic idea that the future tax liabilities associated with government deficits and debt induce individuals to increase their saving has been around since the time of David Ricardo and was treated explicitly by Don Patinkin (1965), Martin Bailey (1971) and Levis Kochin (1974), the current debate was launched by Robert Barro (1974). The voluminous theoretical literature of recent years has shown that complete Ricardian equivalence would be expected to prevail only under very special conditions; see Douglas Bernheim (1987) for an especially useful survey and analysis. But the theoretical restrictiveness of the assumptions required for complete Ricardian equivalence does not constitute a practical refutation. Defenders of Ricardian equivalence can argue that the theory is only an approximation and can claim that, although the stringent conditions required for complete Ricardian equivalence do not hold, the economy's behavior in practice is close to the predictions of Ricardian equivalence. There are two key empirical questions. The first is whether a higher level of taxes (with government spending constant) induces individuals to reduce their spending on consumption as traditional theory holds or has no effect on consumer spending as the Ricardian equivalence proposition predicts. The second deals with the effect of government outlays on goods and services. Although the absence of a negative effect on consumer spending of such government outlays is clearly contrary to the Ricardian equivalence proposition, the existence of a moderate negative effect of government outlays on consumer spending is not in itself evidence in favor of the Ricardian equivalence proposition that individuals increase their saving to finance anticipated debt service. As Feldstein (1982) explained, consumers may correctly believe that a rise in current government spending is a good indicator of a higher level of future government spending. Once a program is launched or budgets increased, the process is unlikely to be reversed. An increase in current government spending is therefore a good indication that future taxes will have to be higher to finance a higher level of future government spending. Individuals may rationally reduce their own spending when government outlays increase without a concurrent increase in taxes because they anticipate higher future taxes to finance higher future government spending even if they give little or no weight to the debt service implications of the current deficit. The strongest direct evidence in favor of Ricardian equivalence is Roger Kormendi's 1983 article in the American Economic Review. He presents consumption regression equations that relate an estimate of consumption' to net national product, wealth, *Martin Feldstein is Professor of Economics at Harvard University and President of the National Bureau of Economic Research. Douglas Elmendorf is Assistant Professor of Economics at Harvard University. We are grateful to Greg Mankiw and Lawrence Summers for comments on an earlier draft. The research reported here is part of the NBER study of the Government Budget and the Private Economy. 'iKormendi defines consumption as the sum of current expenditures on services and nondurables plus 10

A large literature has recently developed which attempts to measure the marginal cost (shadow price) of public funds.' The motivation for much of this literature is the recognition that many of the tax instruments used by governments generate substantial amounts of excess burden (deadweight loss). Jerry A. Hausman (1981), for example, estimates that for an average prime-aged American male with a wage of ten dollars in 1975 the excess burden generated by the federal income tax was over fifty percent of the revenue raised from taxing that individual. One might suspect that such large excess burden estimates would require a change in the way government project costs are calculated in benefit-cost analysis. If the revenue required to finance a project is raised through distortionary taxation, then intuition would suggest that the excess burden generated by the increase in tax rates needed to finance the project should be incorporated into the cost of the project. However, this analysis is not entirely consistent with the theoretical literature on the optimal provision of public goods which are financed by distortionary taxation. When distortionary taxes are used to finance public goods, and the level of public good provision does not affect consumption of the taxed goods, the standard Samuelsonian rule which equates the sum (over consumers) of the marginal rates of substitution between a private good and a public good with the marginal rate of transformation between the two goods must be modified to account for the marginal effect of increases in tax rates on the revenue raised from the existing taxes.2 The intuition behind this result is that we need to correct for indirect leakages from existing government revenue sources when considering an incremental expenditure. If the increase in tax rates needed to finance the project causes a reduction in the revenue raised by the current tax structure, then we need to account for this loss in calculating the cost of the project. It is important to note that this result concerns the values of uncompensated demand elasticities. An example first provided by Atkinson and Stern (1974) illustrates this point. Consider a world where the only tax is on labor earnings, and incremental expenditure on the public good does not affect the demand for leisure. In this case, the marginal rate of transformation will overstate the cost of the public good as long as the uncompensated wage elasticity of labor supply is negative. This is because an increase in the tax rate causes an increase in labor supply, leading to an indirect increase in government revenue. From the excess burden perspective described earlier, this example is very puzzling. It is well known that even if the uncompensated own price elasticity of a good is zero, a tax on that good can still result in a large deadweight loss. We instead need the compensated elasticity to be zero to ensure that there will be no excess burden. However, the *Department of Economics, University of California, Davis, CA 95616. This paper is based on chapter two of my dissertation at the University of Wisconsin-Madison. I wish to thank the members of my dissertation committee, Martin David, Robert Haveman (chair), and Arthur Goldberger, for very helpful advice and comments. I have also benefited from comments by Don Fullerton and Bruce Hamilton. An anonymous referee provided unusually helpful comments and corrected an error in the figure. 1Don Fullerton (1989) provides a recent survey and analysis of this literature. 2This is shown by Anthony Atkinson and Nicholas H. Stern (1974) and David E. Wildasin (1979). The effect of provision of the public good on consumption of the taxed goods must also generally be taken into account.

A large importer who places relatively greater weight on future than current oil consumption will import less oil in the future than if it were able to commit itself in advance to future tariffs, and may find itself worse off than if it were unable to impose tariffs at all. Futures markets and storage modify these adverse effects and may avoid the problem of dynamic inconsistency.

This paper develops a model of product patents in which the patent changes the nature of market entry behavior rather than preventing entry entirely. The model incorporates three levels of action, namely, the innovator's patenting decision, the potential entrant's location decision, and possible court action. The analysis demonstrates how the characteristics of the patents system and the enforcement framework can influence rivals' variety choices and, thus, the market equilibrium. It also considers how the system can, in principle, be adjusted to improve social welfare.

Historically, English and Dutch auctions have been used for the exchange of single objects such as works of art or single lots of a good such as produce, fish, or cut flowers. Where these institutions have been used for the exchange of multiple units, such as the Australian wool auction (using English rules), successive lots of the good are sometimes sold sequentially at auction. In some, but not all, instances this is because the goods are not identical, even though the various lots may be close substitutes (see Penny Burns, 1985). Where the goods are accepted universally as being homogeneous, as in the securities markets, multiple units are often commonly auctioned simultaneously. In the securities industry, orders are batched for simultaneous execution in multiple-unit auctions in what are referred to as markets; that is, the security is for auction at a particular point in time. This type of market is used on the stock exchanges of Austria, Belgium, France, Germany, and Israel. Some of these are verbal, and some are sealed bid auctions. Although the U.S. organized exchanges are predominantly continuous rather than call markets (except that call markets are used each day to open trading in each listed security), there is a growing number of exceptions such as the proliferation, since 1984, of Auction Preferred Stock (Goldman, Sachs and Co., October 1984) and Money Market Preferred Stock (Lehman Brothers, July 1984). We now have Dutch Auction Rate Transferable Securities, called DARTS, Stated Rate Auction Preferred Stock, or STRAPS, and many more. After the initial subscription offering of this type of security, the market is called every 49 days to reset the preferred dividend rate using a multiple-unit auction. The exchange of shares and the dividend determination is based on the array of stated dividend rates at which existing holders and potential new holders are willing to sell and/or buy corresponding quantities. The dividend rate and exchange of shares every 49 days is executed using the uniform price or competitive sealed bid mechanism (Vernon L. Smith et al., 1980). The discussion to follow will be confined to this sealed bid form of the call market. Call markets provide temporal consolidation of trade orders or other forms of expressing the desire to buy and sell. By comparison with continuous trading, call markets offer both advantages and disadvantages (Robert A. Schwartz, 1988 pp. 442-6). The cited advantages include low cost of operating the exchange; information aggregation and presumed pricing efficiency; price stability; individual trades, which are thought to have a small impact on price; reduced price uncertainty; and, finally, nondiscriminatory pricing. However, there are offsetting disadvantages: (1) the market is inaccessible except at the time of call; (2) no bid, offer, contract, or price information is available until the results of the call are announced; and (3) there is transaction uncertainty because a submitted bid (offer) may be too low (high) to execute inside the supply-demand cross. These conditions are only partially alleviated if there is a secondary market between calls. These disadvantages may be significant. In September 1988, the Wall Street Journal published an article on the failure of a call market for the auction rate preferred stock *Economic Science Laboratory, University of Arizona, Tucson, Arizona. This material is based upon work supported by the National Science Foundation under grant no. SES-8320121.