Knowledge that Transforms

Recently several economists (Richard Thaler, 1980; Jack Knetsch and J. A. Sinden, 1984), following suggestions of psychologists (Daniel Kahneman and Amos Tversky, 1979), have argued that current economic models of consumer behavior fail to explain observed asymmetries in how individuals respond to gain vs. losses in perceived entitlements. Attention to their arguments is increasing because they relate to many current policy issues-especially those associated with undesirable land uses. Most of the papers suggesting this limitation with the conventional economic framework have been motivated by the large differences between the estimates of willingness to pay vs. willingness to accept as measures of the change in individual well-being that would result from a change in the conditions of access to (or the quality of) a commodity.' In this paper we report the first evidence of a sizable property rights effect using only willingness-to-pay measures. This change is potentially important because both the recent appraisal of contingent valuation surveys (see Ronald Cummings et al.. 1986), an important source of the available empirical evidence, and laboratory experiments suggest that individuals may have difficulty in dealing with the concept of compensation. This is especially true when there is no opportunity for individuals to learn about transactions that involve compensation through experience. Based on a contingent valuation survey of households in suburban Boston, we found that respondents bid significantly more to reduce risk than they indicated they were willing to pay to avoid an equivalent risk increase. While our findings support suggestions that changes in the implied entitlements (to safety) can lead to large differences in welfare measures for risk changes, several of these earlier arguments would have implied that individuals were willing to pay more to avoid a risk increase-the opposite to our results. Thus, these differences imply that the determinants of individuals' valuations for risk changes are more complex than past studies have acknowledged.

The road to welfare reform increasingly appears to be one of the rockier paths the United States has traversed. Indeed, by all outward appearances it is not even clear whether the current path runs uphill or downhill. As far as work incentives in the welfare system are concerned, economists of all political persuasions, from Milton Friedman to James Tobin, have agreed that the uphill direction is that which leads to lower tax rates (i.e., lower benefit-reduction rates). However, as with free trade, the near unanimity of opinion among economists has, strangely, only occasionally persuaded a majority of the nation's representatives to vote to go uphill. The legislative history so illustrates. From 1935, when the Aid to Families with Dependent Children (AFDC) program was enacted, to the 1967 Social Security Amendments, the tax rate in the program was 100 percent-that is, benefits were reduced by one dollar for every extra dollar earned. With the 1967 Amendments, Congress lowered the tax rate to 67 percent, and, in the heady atmosphere of the 1960's, it was expected that further progress in this direction would be made and that the tax rate would be lowered further. Indeed, the Family Assistance Plan subsequently proposed by President Nixon would have lowered tax rates; however, the legislation passed the House but not the Senate. The Ford Administration considered welfare reform proposals internally but never proposed legislation, while the Carter Administration proposed a massive welfare reform plan that met with no legislative success. Welfare reform was finally achieved in 1981 when the Omnibus Budget Reconciliation Act (OBRA) was enacted. But OBRA increased the tax rate back to 100 percent, the level prevailing prior to 1967. In retrospect, it appears that 1967 marked the end, not the beginning, of legislative progress on work incentives in the welfare system. In this paper I shall report the results of recent research that complicates the issue considerably by questioning whether lower tax rates do in fact provide work incentives. The findings themselves seesaw not unlike the path of welfare reform itself. First, on a theoretical basis, it appears that lower tax rates in a welfare program do not necessarily increase labor supply in the low-income population as a whole, contrary to the conventional wisdom. In fact, it also appears that members of the Reagan Administration were aware of this all along, well in advance of the economics profession. This theoretical ambiguity has fairly fundamental implications for the work-incentive issue in welfare reform. Second, nevertheless, the empirical resolution of the ambiguity provided by existing econometric estimates in the labor supply literature and by estimates of the effect of AFDC on labor supply indicates that a lower tax rate would indeed increase labor supply in the low-income population as a whole, and that a higher tax rate would decrease it. Thus the conventional wisdom is correct even though based upon an incorrect tDiscussants: Henry Aaron, The Brookings Institution and University of Maryland; Harold Watts, Columbia University; Edward Gramlich, University of Michigan.

The Federal Reserve has been criticized for allowing the base from which it calculates its target growth paths for the monetary aggregatesto drift from year to year in response to past deviations from target.Drift in the base implies that target misses permanently affect the levels of the monetary aggregates. Using a simple theoretical model, this paper shows that the optimal degree of base drift consistent withprice stability depends on the importance of permanent versus transitory income and velocity disturbances. Neither zero base drift nor complete base drift are likely to be compatible with price stability.

In recent years the world economy has been subject to large and unsyncronized changes in fiscal policies, high and volatile real rates of tnterest, large fluctuations in real exchange rates, and significant variations in private-sector spending. This paper reviews some of the key facts characterizing the effects of fiscal policies during the first half of the 1980s and provides a simple analytical framework suitable for the interpretation of these facts. The analytical framework builds on a two-country model of the world economy which is applied to the analysis of the transmission and effects of various changes in the time profile of taxes and of government spending. Generally, the predictions of the model concerning the relation among the intercountry patterns of consumption, long and short-term real rates of interest, real exchange rates and fiscal policies are consistent with the stylized facts.

Studies using the Cobb-Douglas specification blame growth retardation on total factor productivity growth slowdown which set in after 1958. The most comprehensive accounting for the impact of the observable growth determinants (Abram Bergson, 1983) left the decline in total factor productivity growth rate mostly unexplained, and arbitrarily attributed it to technological progress. A number of studies found that the CES production function with a constant rate of growth of the residual fits Soviet industrial data better than the Cobb-Douglas production function (for example, Martin Weitzman, 1970). In this case, postwar growth slowdown is explained (at least for part of the period) by decreasing returns on capital under elasticity of substitution below unity and a rapidly increasing capital-labor ratio. But the estimates of elasticity of substitution and other parameters vary widely across the studies; the implied rate of return on capital in the early 1950's is implausibly high (Bergson, 1979, pp. 117-20; Norman Cameron, 1981, p. 26). Some scholars found elasticity of substitution significantly lower than unity up to the mid-1960's, and close to unity after that (Cameron, p. 36; Ryan Amacher and Darius Conger, 1977, p. 318). Others, in contrast, did not find evidence of a structural break in the sample period (Weitzman, 1983). In some of the latest work, the CES production function with lessthan-unity elasticity of substitution and a constant rate of growth of the residual was found to fit the data no better, or even worse, than the Cobb-Douglas production function with slowing growth of the residual (Weitzman, 1983; Padma Desai, 1985). Thus, production function analysis of the causes of the growth slowdown is inconclusive.

Current discussions of wage norms begin with George Perry's analysis (1980). He argued that the rate of wage change appeared to shift in discrete steps. Although his study concerned aggregate wage adjustments, the union sector has long been identified as the primary source of wage rigidity and hence of wage norms. The stylized explanation for the rigidity of any market price in the efficient contracting literature is the presence of high transaction costs. High transaction costs emanate from the internal rather than the external labor market. These costs make it inefficient to update wages continuously to changing market conditions. Alternatively stated, wage rigidity or norms is a Nash equilibrium for firms under ordinary circumstances (see Costas Azariadis, 1985). The equilibrium position is maintained until the transaction costs of making the change are less than the costs of maintaining the old regime. Once the regime changes, however, the new regime or equilibrium can be a discrete rather than a marginal change from the prior regime. The regime in the unionized sector today is one of concession bargaining. Although concessions have been concentrated in those sectors that have experienced competition in a setting of deregulation and increased international trade, increased competition is more likely to be a consequence of earlier relative wage and cost changes than an exogenous cause of concessions today.' In fact, the common thread that binds together the industries that have exhibited concession bargaining is that they have emerged from a prior regime of significant and prolonged increases in union wage premiums. Indeed, as shown by Peter Linneman and myself, the increases in union wage premiums have caused a statistically significant and quantitatively large decrease in union employment. Concession bargains thus represent a shift in regimes as the parties attempt to deal with the effects of the prior regime of increasing premiums. There is little doubt that the increase in union premiums was related to the supply shocks of the 1970's; that is, while nonunionized wages declined in response to these shocks, union real wages continued to increase. In this sense, the puzzle is why the unionized sector did not shift to lower wage norms during the 1970's and not the presence of concessions today. The expansion of union wage premiums over the past decade cannot be explained by the traditional model of union-nonunion wage differentials. That model states that premiums remain steady over time unless changes occur in the underlying labor demand elasticities (i.e., the Hicks-Marshall conditions change) or the unions' tastes (reflecting the wages-employment tradeoff). Labor markets, however, have become more rather than less competitive in the 1970's as a consequence of deregulation and increasing international trade. In disequilibrium, variation in the union wage premium can occur due to the fixedcontracting periou'. Indeed, union wage rigidity is typically explained by the existence of 3-year contracts that permit only incomplete wage adjustments during the contract period. In this paper, the extent of union wage rigidity is shown to be related to contracting lags, but the lags are not identified with contract expiration and renegotiation dates. Rather, the lags and the resulting wage rigid* Professor of Economics, Law, and Management, University of Pennsylvania, Philadelphia, PA 19104. Costas Azariadis, David Hall, Clyde Summers, Lea Vandervelde, and Susan Wachter provided many helpful suggestions, and Rodrigo Quintanilla and Nancy Zurich provided valuable research assistance. The research was supported by the Institute for Law and Economics, University of Pennsylvania. 'See Peter Linneman and myself (1986) for a discussion of the endogeneity of increased international competition and, to a lesser extent, deregulation.

In recent years, the policy mix-defined as the contemporaneous joint state of monetary and fiscal policy-has conditioned the patterns of the business cycle, set up numerous imbalances in macroeconomic and microeconomic behavior, and is laying the groundwork for future economic performance. Restrictive monetary and fiscal policies produced back-to-back economic downturns in 1980 and 1981-82. From 1982 to 1985, massive fiscal stimulus against a backdrop of monetary growth targeting by the Federal Reserve comprised a loose fiscal-tight money policy mix. Subsequently, an actual and prospective tightening of the federal budget and suspension of monetary growth targeting suggest a shift in the policy mix to a tight fiscal-easier money combination. In this paper, the policy mix of the 1980's first half-in the context of an open economy with flexible exchange rates-is characterized. Some of the important economic and financial effects are identified. Among these are 1) higher nominal and real interest rates than otherwise would have been the case; 2) a strong domestic currency; 3) lower inflation rates; 4) a large and growing trade deficit; 5) an unbalanced composition of economic activity across sectors and industries; and 6) a depressed industrial sector. Some of the changes in economic performance to be expected as the policy mix is shifted in response to the Gramm-Rudman-Hollings balanced-budget statute also are shown. I. Policy Mix Alternatives, the 1980 to 1985 Episode, and the Analytical Framework

In a recent issue of this Review, (1984) Raaj Kumar Sah and Joseph Stiglitz model the impact of shifts in the agriculture-industry terms of trade on industrial accumulation and social welfare.' The intersectoral terms of trade, they note, was a key issue in the Soviet industrialization debate of the 1920's, and continues to be an important issue in contemporary less developed countries. One seemingly surprising implication of the Sah-Stiglitz model is that a shift in the terms of trade against agriculture increases industrial accumulation despite (or rather, because of ) a normal agricultural supply response. In their model, a price-induced decline in marketed agricultural surplus requires depression of industrial wages in order to reequilibrate urban food demand with supply at the lower relative food price. The income and substitution effects of these wage and price changes lower urban consumption demand for industrial goods. Together with agriculture's reduced purchasing power, this lower urban demand leads to the price scissors-induced increase in investable surplus out of industrial production. Thus emerges the strong Sah-Stiglitz result, which they label Preobrazhensky's First Proposition, that the more elastic is agricultural supply response, the more wages must be depressed in equilibrium, and the more effectively plice scissors work to increase accumulation (see their equation (15)). Apparently, the traditional preoccupation with agricultural supply response, including Preobrazhensky's,2 is wrong-headed and backwards. But it is argued here that this result obtains only under rather special labor supply and investable surplus assumptions which conform to neither the constraints of the Soviet industrialization debate, nor to most contemporary less developed countries.3