Knowledge that Transforms

The strength of economic theory is that it can look at the hypothetical rather than merely ex-post rationalize observed behavior. In particular, it can ask the 'what if' question of how changes in model parameters might affect efficiency and social welfare. Based on the answer, it can then suggest welfare-improving policy measures in situations in which privately optimal outcomes are socially inefficient.

The paper presents an incomplete market pricing methodology generating asset price bounds conditional on the absence of attractive investment opportunities in equilibrium. The paper extends and generalises the seminal article of Cochrane and Saá-Requejo who pioneered option pricing based on the absence of arbitrage and high Sharpe Ratios. Our contribution is threefold: We base the equilibrium restrictions on an arbitrary utility function, obtaining the Cochrane and Saá-Requejo analysis as a special case with truncated quadratic utility. We extend the definition of Sharpe Ratio from quadratic utility to the entire family of CRRA utility functions and restate the equilibrium restrictions in terms of Generalised Sharpe Ratios which, unlike the standard Sharpe Ratio, provide a consistent ranking of investment opportunities even when asset returns are highly non-normal. Last but not least, we demonstrate that for Itô processes the Cochrane and Saá-Requejo price bounds are invariant to the choice of the utility function, and that in the limit they tend to a unique price determined by the minimal martingale measure.

This paper examines how the trading behavior of various investors impacts the market reaction to a dividend signal. The dividend signaling model incorporates asymmetric information among traders, firm insiders, and the market. This interaction among market participants explains why not all dividend increases are viewed by the market as good news. The model predicts that the announcement day returns for a dividend increase are inversely related to measures of informed trading and decreasing in the level of buy demand relative to sell demand. Further, the model hypothesizes that more informed trading results in larger dividend increases. Empirical tests confirm these predictions.

The entry‐level market for American gastroenterologists was organized by a centralized clearinghouse from 1986 to 1996. Before, and since, it has been conducted via a decentralized market in which appointment dates have unraveled to well over a year before the start of employment. We find that, both before and after the years in which the centralized clearinghouse was used, gastroenterologists are less mobile and more likely to be employed at the same hospital in which they were internal medicine residents than when the clearinghouse was in use. This suggests that the clearinghouse not only coordinates the timing of appointments but also increases the scope of the market, compared to a decentralized market with early appointments.

Real estate agents typically charge a 6 percent commission, regardless of the price of the house sold. As a consequence, the commission fee from selling a house will differ dramatically across cities depending on the average price of housing, although the effort necessary to match buyers and sellers may not be that different. We use a simple economic model to show that if barriers to entry are low, the entry of real estate agents in cities with high housing prices is socially inefficient. Consistent with our model, we find that when the average price of land in a city increases, (1) the fraction of real estate brokers in a city increases, (2) the productivity of an average real estate agent (houses sold per hour worked) falls, and (3) the real wage of a typical real estate agent remains unchanged. We cannot completely rule out the alternative explanation that these results reflect unmeasured differences in the quality of broker services. However, we present evidence that as the average price of housing in a city increases, there is only a small increase in the amount of time a buyer spends searching for a house, and the average time a house for sale stays on the market falls.

We analyze a simple stochastic environment in which policy makers can be threatened by “nasty” interest groups. In the absence of these groups, the policy maker’s desire for reelection guarantees that good policies are implemented for every realization of the shock. When pressure groups can harass the policy maker, good policies will be chosen for only a subset of states of nature. Hence, honest and able leaders might implement bad policies, and needed reforms could be delayed. In order to make good policies more likely, the public will want to increase the cost of exerting pressure for “nasty groups” and provide rents to those in power. This last result can be used to explain the existence of political parties. They play a role resembling that of the supervisor in the literature on collusion in hierarchical agency. A rational public may also choose to ignore negative media reports on a politician’s personal life and, in general, elect “strong” political leaders. The prevalence of coercive methods of influence helps explain why countries may get to be governed by “inept politicians.”

We consider a simple model of competition under moral hazard with constant return technologies. We consider preferences that are not separable in effort: marginal utility of income is assumed to increase with leisure, especially for high income levels. We show that, in this context, Bertrand competition may result in positive equilibrium profit. This result holds for purely idiosyncratic shocks when only deterministic contracts are considered and extends to unrestricted contract spaces in the presence of aggregate uncertainty. Finally, these findings have important consequences on the definition of an equilibrium. We show that, in this context, a Walrasian general equilibrium à la Prescott‐Townsend may fail to exist: any “equilibrium” must involve rationing.

Using a unique set of banking data containing both originally-reported and subsequently-revised financial variables, we study accounting restatements. Our results indicate the worse a bank's financial condition, the more likely it is for originally-reported data to understate financial losses. Also, we find supervisory exams have an important role in uncovering financial problems and prompting accounting restatements to correct loss underreporting. While revisions are directly related to financial difficulties, exam-based restatements are evident at even the earliest stages of deterioration, indicating substantial accounting misstatements—at both banks and other types of companies—can occur well outside severe business circumstances.

Only recently the debate on bank capital regulation has devoted specific attention to the role that bank loan loss provisions can play as a part of the overall capital regulatory framework. This paper contributes to the ongoing debate by demonstrating empirically that loan loss provisioning needs to be an integral component of capital regulation. We find empirical evidence that many banks around the world delay provisioning for bad loans until too late, when cyclical downturns have already set in, thereby magnifying the impact of the economic cycle on banks' income and capital.