Knowledge that Transforms

We examine the accuracy and contribution of the Merton distance to default (DD) model, which is based on Merton's (1974) bond pricing model. We compare the model to a “naïve” alternative, which uses the functional form suggested by the Merton model but does not solve the model for an implied probability of default. We find that the naïve predictor performs slightly better in hazard models and in out-of-sample forecasts than both the Merton DD model and a reduced-form model that uses the same inputs. Several other forecasting variables are also important predictors, and fitted values from an expanded hazard model outperform Merton DD default probabilities out of sample. Implied default probabilities from credit default swaps and corporate bond yield spreads are only weakly correlated with Merton DD probabilities after adjusting for agency ratings and bond characteristics. We conclude that while the Merton DD model does not produce a sufficient statistic for the probability of default, its functional form is useful for forecasting defaults.

We study the earning structure and the equilibrium assignment of workers to firms in a model in which workers have social preferences, and skills are perfectly substitutable in production. Firms offer long-term contracts, and we allow for frictions in the labour market in the form of mobility costs. The model delivers specific predictions about the nature of worker flows, about the characteristics of workplace skill segregation, and about wage dispersion both within and across firms. We show that long-term contracts in the presence of social preferences associate within-firm wage dispersion with novel “internal labour market” features such as gradual promotions, productivity-unrelated wage increases, and downward wage flexibility. These three dynamic features lead to productivity-unrelated wage volatility within firms.

In criminal organizations, diffusing information widely throughout the organization might lead to greater internal efficiency (in particular, since these organizations are self-sustaining, through enhancing trust). However, this may come at the cost of leaving the organization more vulnerable to external threats such as law enforcement. We consider the implications of this trade-off and characterize the optimal information structure, rationalizing both “hierarchical” structures and organization in cells. Then, we focus on the role of the external authority, characterize optimal detection strategies, and discuss the implications of different forms of enforcement on the internal structure of the organization and policy. Finally, we discuss a number of applications and extensions.

The timing of elections is flexible in many countries. We study this optimization by first creating a Bayesian learning model of a mean-reverting political support process. We then explore optimal electoral timing, modelling it as a renewable American option with interacting waiting and stopping values. Inter alia, we show that the expected longevity is a convex, then concave, function of the support. Finally, we calibrate our model to the post-1945 Labour-Tory U.K. rivalry. Our story quite well explains when the elections were called. We also show that election options approximately double the expected time in power in the current streak.

Are politicians motivated by policy outcomes or by the perks of office? The answer to this question is central to understanding the behavior of office holders and the policies they produce. Despite the question’s importance, however, the existing literature is not well suited to provide an answer. To shed light on the issue of political motivations I exploit a basic fact: to hold office, one must first win election. By characterizing the types of candidates that succeed in elections, I am able to predict the types that hold office and the policies that are produced. Toward this end, I develop a simple model of two candidate electoral competition in which candidates may be either office or policy motivated. In a second departure from standard formulations, the model incorporates both campaign and post-election behavior of candidates. In this environment I find that office motivated candidates are favored in electoral competition, but that their advantage is limited by the electoral mechanism itself, and policy motivated candidates win a significant fraction of elections. More importantly, I show that the competitive interaction among candidates of different motivations affects the incentives of all candidates — both office and policy motivated — and that this competition affects policy outcomes.

This research argues that the differential effect of international trade on the demand for human capital across countries has been a major determinant of the distribution of income and population across the globe. In developed countries the gains from trade have been directed towards investment in education and growth in income per capita, whereas a significant portion of these gains in less developed economies have been channeled towards population growth. Cross-country regressions establish that indeed trade has positive effects on fertility and negative effects on education in non-OECD economies, while inducing fertility decline and human capital formation in OECD economies.

This paper considers structural non-parametric random utility models for continuous choice variables with unobserved heterogeneity. We provide sufficient conditions on random preferences to yield reduced-form systems of non-parametric stochastic demand functions that allow global invertibility between demands and non-separable unobserved heterogeneity. Invertibility is essential for global identification of structural consumer demand models, for the existence of well-specified probability models of choice and for the non-parametric analysis of revealed stochastic preference. We distinguish between new classes of models in which heterogeneity is separable and non-separable in the marginal rates of substitution, respectively.

Commitment failure lies at the core of incomplete contract theory, yet its quantitative significance has rarely been assessed. Using detailed plot-level data from rural Pakistan, we find that non-contractible investment is underprovided on tenanted land, even after controlling for the endogeneity of leasing decisions. Our evidence also indicates that moral hazard in investment effort alone cannot explain this inefficiency. Instead, imperfect commitment appears to be the driving mechanism, since even plots taken on fixed rent contracts where all the rent is paid upfront receive lower investment than owner-cultivated plots. We further show that a considerable portion of the variation in tenancy duration, and hence in the security of tenure, is due to heterogeneity across landlords. One interpretation of this finding is that landlord reputation is important in mitigating hold-up.

We study the formation of a ruling coalition in non-democratic societies where institutions do not enable political commitments. Each individual is endowed with a level of political power. The ruling coalition consists of a subset of the individuals in the society and decides the distribution of resources. A ruling coalition needs to contain enough powerful members to win against any alternative coalition that may challenge it, and it needs to be self-enforcing, in the sense that none of its subcoalitions should be able to secede and become the new ruling coalition. We present both an axiomatic approach that captures these notions and determines a (generically) unique ruling coalition and the analysis of a dynamic game of coalition formation that encompasses these ideas. We establish that the subgame-perfect equilibria of the coalition formation game coincide with the set of ruling coalitions resulting from the axiomatic approach. A key insight of our analysis is that a coalition is made self-enforcing by the failure of its winning subcoalitions to be self-enforcing. This is most simply illustrated by the following example: with “majority rule”, two-person coalitions are generically not self-enforcing and consequently, three-person coalitions are self-enforcing (unless one player is disproportionately powerful). We also characterize the structure of ruling coalitions. For example, we determine the conditions under which ruling coalitions are robust to small changes in the distribution of power and when they are fragile. We also show that when the distribution of power across individuals is relatively equal and there is majoritarian voting, only certain sizes of coalitions (e.g. with majority rule, coalitions of size 1, 3, 7, 15, etc.) can be the ruling coalition.

This paper shows how record-value theory, a branch of statistics that deals with the timing and magnitude of extreme values in sequences of random variables, can be used to nonparametrically identify the offer distribution of wages workers face.Using NLSY wage data, I show that the data supports the hypothesis that the wage offer distribution is Pareto but rejects that it is lognormal.In addition, I show that my approach can be used to construct a bound on the return to job-specific human capital.Using the same NLSY data, I find that job-specific human capital plays only a minor role in the wage growth of the workers in my sample.Instead, wage growth among the young workers in my sample appears to be driven primarily by the accumulation of general human capital as well as on-the-job search.