Knowledge that Transforms

I wish to express my appreciation to thefollowingfor their comments and suggestions either in their capacity as the referees of this journal or otherwise: Anthony Atkinson, Zvi Griliches, Martin Bronfenbrenner, Rudolph Blitz, James Buchanan, Milton Friedman, James Meade, Jacob Mincer, Franco Modigliani, Naomi Perlman, John Rawls, Paul Schultz, Gerald Sazama, Joseph Stiglitz, Paul Taubman, Lester Thurow, and Charles Wilson. None of them, however, bears any responsibility for my errors and my appraisal of different theories. I dedicate this paper to the memory of Harry G. Johnson, my teacher, who died at the early age of 53 on 9 May 1977, a few months after we had exchanged correspondence on this survey and had plans for further discussion, especially on the development of his ideas about cultural inheritance. Alas, that was the end.

This essay reviews Lucian A. Bebchuk and Jesse M. Fried's Pay without Performance: The Unfulfilled Promise of Executive Compensation. Bebchuk and Fried criticize the standard view of executive compensation, in which executives negotiate contracts with shareholders that provide incentives that motivate them to maximize the shareholders' welfare. In contrast, Bebchuk and Fried argue that executive compensation is more consistent with executives who control their own boards and who maximize their own compensation subject to an “outrage constraint.” They provide a host of evidence consistent with this alternative viewpoint. The book can be evaluated from both positive and normative perspectives. From a positive perspective, much of the evidence they present, especially about the camouflage and risk-taking aspects of executive compensation systems, is fairly persuasive. However, from a normative perspective, the book conveys the idea that policy changes can dramatically improve executive compensation systems and consequently overall corporate performance. It is unclear to me how effective potential reforms designed to achieve such changes are likely to be in practice.

This paper reviews recent contributions to the economics and economic history of famine. It provides a context for the history of famine in the twentieth century, which is unique. During the century, war and totalitarianism produced more famine deaths than did overpopulation and economic backwardness; yet by its end, economic growth and medical technology had almost eliminated the threat of major famines. Today's high-profile famines are “small” by historical standards. Topics analyzed include the role played by food markets in mitigating or exacerbating famine, the globalization of disaster relief, the enhanced role of human agency and entitlements, distinctive demography of certain twentieth-century famines, and future prospects for “making famine history.”

Geography, flat or not, creates special relationships between buyers and sellers who reside in the same neighborhoods, but Friedman turns this metaphor inside-out by using The World is Flat to warn us of the perils of a relationship-free world in which every economic transaction is contested globally. In his “flat” world, your wages are set in Shanghai. In fact, most of the footloose relationship-free jobs in apparel and footwear and consumer electronics departed the United States several decades ago, and few U.S. workers today feel the force of Chinese and Indian competition, notwithstanding the alarming anecdotes about the outsourcing of intellectual services. Of course, standardization, mechanization, and computerization all work to increase the number of footloose tasks, but innovation and education work in the opposite direction, creating relationship-based activities—like the writing of this review. It may only be personal conceit, but I imagine there is a reason why the Journal of Economic Literature asked me to do this review.

When the quality of a good is at the discretion of the seller, how can buyers assure that the seller provides the mutually efficient level of quality? Contracts that provide a bonus to the seller if the quality is acceptable or impose a penalty on the seller if quality is unacceptable can, in theory, provide efficient incentives. But how are such contracts enforced? While the courts can be used, doing so involves high real costs. Informal enforcement, involving a loss of reputation and future access to the market for any party that defaults on a contract, may often be a better alternative. This paper explores the use of both formal and informal enforcement mechanisms, provides a rationale for a variety of observed market mechanisms, and then generates a number of testable hypotheses.

Recent social experiments have evaluated two reforms of the unemployment insurance (UI) system: reemployment bonuses and job search programs. The bonus experiments show that economic incentives affect the length of UI receipt and provide weak evidence that an earlier return to work does not decrease earnings. The experiments do not show the favorability of a permanent bonus program as they ignore its effect on the number of the claimants. The job search experiments test several more promising reforms. Nearly all of the combinations of services and increased enforcement reduce UI receipt and have favorable cost/benefit analyses. Earnings often increase, though the estimates are imprecise.

Research on the macroeconomic impact of capital account liberalization finds few, if any, robust effects of liberalization on real variables. In contrast to the prevailing wisdom, I argue that the textbook theory of liberalization holds up quite well to a critical reading of this literature. Most papers that find no effect of liberalization on real variables tell us nothing about the empirical validity of the theory because they do not really test it. This paper explains why it is that most studies do not really address the theory they set out to test. It also discusses what is necessary to test the theory and examines papers that have done so. Studies that actually test the theory show that liberalization has significant effects on the cost of capital, investment, and economic growth.

Since Ronald H. Coase's (1937) seminal paper, a rich set of theories has been developed that deal with firm boundaries in vertical or input–output structures. In the last twenty-five years, empirical evidence that can shed light on those theories also has been accumulating. We review the findings of empirical studies that have addressed two main interrelated questions: First, what types of transactions are best brought within the firm and, second, what are the consequences of vertical integration decisions for economic outcomes such as prices, quantities, investment, and profits. Throughout, we highlight areas of potential cross-fertilization and promising areas for future work.

The Stern Review calls for immediate decisive action to stabilize greenhouse gases because “the benefits of strong, early action on climate change outweighs the costs.” The economic analysis supporting this conclusion consists mostly of two basic strands. The first strand is a formal aggregative model that relies for its conclusions primarily upon imposing a very low discount rate. Concerning this discount-rate aspect, I am skeptical of the Review's formal analysis, but this essay points out that we are actually a lot less sure about what interest rate should be used for discounting climate change than is commonly acknowledged. The Review's second basic strand is a more intuitive argument that it might be very important to avoid possibly large uncertainties that are difficult to quantify. Concerning this uncertainty aspect, I argue that it might be recast into sound analytical reasoning that might justify some of the Review's conclusions. The basic issue here is that spending money to slow global warming should perhaps not be conceptualized primarily as being about consumption smoothing as much as being about how much insurance to buy to offset the small change of a ruinous catastrophe that is difficult to compensate by ordinary savings.