Knowledge that Transforms

This paper investigates the forecasting accuracy of bankruptcy hazard rate models for U.S. companies over the time period 1962–1999 using both yearly and monthly observation intervals. The contribution of this paper is multiple-fold. One, using an expanded bankruptcy database we validate the superior forecasting performance of Shumway's (2001) model as opposed to Altman (1968) and Zmijewski (1984). Two, we demonstrate the importance of including industry effects in hazard rate estimation. Industry groupings are shown to significantly affect both the intercept and slope coefficients in the forecasting equations. Three, we extend the hazard rate model to apply to financial firms and monthly observation intervals. Due to data limitations, most of the existing literature employs only yearly observations. We show that bankruptcy prediction is markedly improved using monthly observation intervals. Fourth, consistent with the notion of market efficiency with respect to publicly available information, we demonstrate that accounting variables add little predictive power when market variables are already included in the bankruptcy model.

In this article we develop a model to analyze patent-protected R&D investment projects when there is (imperfect) competition in the development and marketing of the resulting product. The competitive interactions that occur substantially complicate the solution of the problem since the decision maker has to take into account not only the factors that affect her/his own decisions, but also the factors that affect the decisions of the other investors. The real options framework utilized to deal with investments under uncertainty is extended to incorporate the game theoretic concepts required to deal with these interactions. Implementation of the model shows that competition in R&D, in general, not only increases production and reduces prices, but also shortens the time of developing the product and increases the probability of a successful development. These benefits to society are countered by increased total investment costs in R&D and lower aggregate value of the R&D investment projects.

This paper characterizes the optimal securities for venture capital finance in an environment with multiple investment stages and double-sided moral hazard in the relationship between entrepreneurs and venture capitalists. We show that if the conditions relevant for continuation into later stages are verifiable, the optimal security gives the venture capitalist a constant share in the success return of the project over a predetermined set of continuation states. Otherwise, the parties sign an initial start-up contract that is later renegotiated. In this case, in order to minimize the incentive distortions associated with the burden of early financing stages, the optimal start-up security gives a zero payoff in low profitability states and thereafter an increasing share in the success return of the project.

This paper provides a first study of the optimal design of active monitors' exit options in a problem involving a demand for liquidity and costly monitoring of the issuer. Optimal incentives to monitor the issuer may involve restricting the monitor's right to sell her claims on the firm's cash-flow early. But the monitor will then require a liquidity premium for holding such an illiquid claim. In general, therefore, there will be a trade off between incentives and liquidity. The paper highlights a fundamental complementarity between speculative monitoring in financial markets (which increases the informativeness of prices) and active monitoring inside the firm: in financial markets where price discovery is better and securities prices reflect the fundamentals of the issuer better, the incentive cost of greater liquidity may be smaller and active monitoring incentives may be preserved. The paper spells out the conditions under which more or less liquidity is warranted and applies the analysis to shed light on common exit provisions in venture capital financing.

This paper is a theoretical study of rural‐urban migration—urbanization—as it has occurred in many low‐income economies in the postwar period. This process is viewed as a transfer of labor from a traditional, land‐intensive technology to a human capital–intensive technology with an unending potential for growth. The model emphasizes the role of cities as places in which new immigrants can accumulate the skills required by modern production technologies.

In the Anglo-American constitutional tradition, judicial checks and balances are often seen as crucial guarantees of freedom. Hayek distinguishes two ways in which the judiciary provides such checks and balances: judicial independence and constitutional review. We create a new database of constitutional rules in 71 countries that reflect these provisions. We find strong support for the proposition that both judicial independence and constitutional review are associated with greater freedom. Consistent with theory, judicial independence accounts for some of the positive effect of common-law legal origin on measures of economic freedom. The results point to significant benefits of the Anglo-American system of government for freedom. This paper is a radical revision of an earlier paper by the same authors, “The Guarantees

Despite declining group inequality and the rapid expansion of the black middle class in the United States, major urban centers with significant black populations continue to exhibit extreme racial separation. Using a theoretical framework in which individuals care about both the affluence and the racial composition of neighborhoods, we show that lower inequality is consistent with extreme and even rising levels of segregation in cities in which the minority population is large. Our results can help explain why segregation continues to characterize the urban landscape even though survey evidence suggests that individuals favor more integration than they did in the past.

We measure the cost of consumption fluctuations using an approach that does not require the specification of preferences and instead uses asset prices. We measure the marginal cost of consumption fluctuations, the per unit benefit of a marginal reduction in consumption fluctuations expressed as a percentage of lifetime consumption. We find that the gains from eliminating all consumption uncertainty are very large. However, for consumption fluctuations corresponding to business cycle frequencies, we estimate the marginal cost to be between 0.08 percent and 0.49 percent of lifetime consumption.

The evolution of technology causes human capital to become obsolete. We study this phenomenon in an overlapping generations setting, assuming that technology evolves stochastically and that older workers find updating uneconomic. Experience and learning by doing may offer the old some income protection, but technology advance always turns them into has‐beens to some degree. We focus on the determinants (demand elasticities, persistence of technology change, etc.) of the severity of the has‐beens effect. It can be large, even leading to negatively sloped within‐occupation age‐earnings profiles and an occupation dominated by a few young, high‐income workers. Architecture displays the sort of features the theory identifies as magnifying the has‐beens effect, and both anecdotes and some data suggest that the has‐beens effect in architecture is extreme indeed.

I study the interaction between imperfect labor contracts and international trade in a setting in which workers have private information about their own abilities. When an individual’s contribution to firm output can be measured accurately in some activities but not in others, the most able workers select occupations in which their pay most closely reflects their own performance. In a world economy with two otherwise similar countries that have different distributions of talent, the country with the more heterogeneous labor force exports the good that is produced by the most talented individuals. In this country, trade exacerbates the “polarization” of the labor force and often worsens the distribution of income.