Knowledge that Transforms

Why did the stock market decline so much in the early 1970's and remain low until the early 1980's? We argue that it was because information technology arrived on the scene and the stock-market incumbents of the day were not ready to implement it. Instead, new firms would bring in the new technology after the mid-1980's. Investors foresaw this in the early 1970's and stock prices fell right away. In our model, new capital destroys old capital, but with a lag. The prospect of this causes the value of the old capital to fall right away. (JEL G12, O16, O33)

Research in Economic Education: Five New Initiatives by Michael K. Salemi, John J. Siegfried, Kim Sosin, William B. Walstad and Michael Watts. Published in volume 91, issue 2, pages 440-445 of American Economic Review, May 2001

Recent studies have shown that the dynamics of firms (growth, job reallocation, and exit) are negatively correlated with the initial size of the firm and its age. In this paper we analyze whether financial factors, in addition to technological differences, are important in generating these dynamics. We introduce financial-market frictions in a basic model of industry dynamics with persistent shocks and show that the combination of persistent shocks and financial frictions can account for the simultaneous dependence of firm dynamics on size (once we control for age) and on age (once we control for size). (JEL D21, G3, L2)

As Edwin Leuven and Hessel Oosterbeek (2001) point out, rather than performing the comparative statics analysis on the effect of increasing uncertainty, my original study limited the analysis to degenerate cases and refrained from inferring a possible monotonic relationship between uncertainties and the share ratio (Hashimoto, 1981 pp. 479–80). Leuven and Oosterbeek do not dispute my conclusions for degenerate cases. Donald O. Parsons (1986 p. 826) later asserted such a monotonic relationship without reporting a comparative statics analysis. Leuven and Oosterbeek use a uniform distribution of productivity to dispute Parsons’ assertion. Hashimoto and Jeong-Geon Lee (1994) reached a similar conclusion to theirs. Given the Hashimoto-Lee comparative statics analysis, I view the most significant contribution of Leuven-Oosterbeek to be not so much their comparative statics as their explicit formulation to account for what has become known in the literature as enforceability of contracts. In the 1981 paper I was concerned with the enforceability issues, so I adopted a certaintyequivalent approach to the fixed-wage formulation in the face of double informational asymmetry between the employer and worker. I then focused on the Becker-type share determination of specific human-capital returns (Gary S. Becker, 1962). Leuven and Oosterbeek directly formulate the enforceability of employment contracts in terms of a fixed wage rather than in terms of the sharing ratio. By considering the enforceability (or the incentive compatibility) issues in a fuller perspective, I conclude that the certainty-equivalent formulation I adopted in my 1981 model has an internal infirmity. In my opinion, this infirmity is a point that a serious Comment on Hashimoto (1981) should underscore. I do not think that Leuven and Oosterbeek’s Comment (2001) is sufficiently articulate or structured to highlight this point. Space does not permit a full discussion, so let me remark briefly on an important point that Leuven and Oosterbeek should have highlighted, but did not. The explicit and direct determination of the incentive-compatible fixed wage w leads me to conclude that the joint maximand is not the unconditional expectation Ev (s) 2 Ey(s), as I originally formulated; rather it is the conditional expectation Estay(v (s) 2 y(s)), conditional on both parties not separating. In the latter formulation, the determination of the fixed wage w implies an ex ante determination of the share parameter to be a 5 {Estay(w 2 y(s))}/{Estay(v(s) 2 y(s))}, which is equivalent to Leuven and Oosterbeek’s definition of a. In spite of the difference in formulation between Leuven-Oosterbeek and Hashimoto-Lee, the two studies obtain essentially the same comparative statics results. This is because both formulations rely on incentive-compatibility conditions for separation decisions where the forces at work are basically the same. Thus, Leuven and Oosterbeek confirm the accuracy of the degenerate results reported in Hashimoto (1981). For nondegenerate cases, the comparative statics are generally ambiguous. Using a uniform distribution, Leuven and Oosterbeek do find that the optimal wage decreases with the uncertainty in the market and increases with the uncertainty in the firm (p. 345). These findings are equivalent to what Hashimoto and Lee (1994) found: that the optimal share ratio decreases with the uncertainty in the outside productivity and increases with the uncertainty in the inside productivity. The Leuven-Oosterbeek Comment contributes a technical advance, but it retains the essential economic logic * Department of Economics, 410 Arps Hall, Ohio State University, 1945 North High Street, Columbus, OH 43210. I am grateful to Hajime Miyazaki for extensive discussions that elucidated theoretical issues in modeling information asymmetric employment relations and for improving the exposition, and to Teresa Schoellner for her very competent research assistance. However, I bear full responsibility for any remaining shortcomings. 1 Further analytical details are available upon request.

Exchange-Rate Hedging: Financial versus Operational Strategies by George Allayannis, Jane Ihrig and James P. Weston. Published in volume 91, issue 2, pages 391-395 of American Economic Review, May 2001

The author discusses the U.S. monetary policy proposed and developed by John B. Taylor (1993) within the context of economic theory and economic welfare.

Market Structure and Racial Earnings: Evidence from Job-Changers by Jacqueline Agesa, Richard U. Agesa and Gary A. Hoover. Published in volume 91, issue 2, pages 169-173 of American Economic Review, May 2001

There exists by now a burgeoning literature concerned with the consequences of a fixed cost of price adjustment. Due to this cost, a monopolistic firm does not necessarily adjust its price even though the current price deviates from the price that would maximize the firm's current profit. As a result, the production generally differs from what it would be in the absence of a menu cost, with the effect of inflation on the average output and welfare under monopolistic competition being ambiguous and depending in a complicated way on the profit and demand functions. 1 However, one strong result holds unambiguously for all profit and demand functions: at low inflation rates, the average output and welfare are above their levels at full price stability where firms charge the static monopoly price.2 The driving force is that discounting makes a firm more concerned with its real profits earlier in a period with a constant nominal price than with its real profits later in the period. In fact, as the inflation rate approaches zero, the firm's initial real price converges to the profit-maximizing real price, while the terminal real price converges to a smaller real price. At low inflation rates, therefore, a firm's price is most of the time below the price that would maximize the current profit. Since output and welfare under monopolistic competition are inversely related to price, average output and welfare are higher than under full price stability. The inevitable conclusion is that the economy benefits from a little bit of inflation. A critical assumption underlying this result is that firms can continuously adjust their production to satisfy demand. So while the menu-cost literature explicitly assumes that there is a small fixed cost incurred at each price adjustment, it also implicitly assumes that it is costless to continuously adjust the quantity of output.3 This is, however, a questionable assumption. There is some empirical evidence indicating the existence of a cost of quantity adjustment, part of which is fixed in that it does not depend on the size of the adjustment.4 The cost of quantity adjustment stems from the need to rearrange and reorganize the factor inputs for the new level of production and includes managerial time and effort. A fixed cost of quantity adjustment rules out any continuous adjustment of the production to satisfy the increasing demand that results from a decreasing real price within a period with a constant nominal price. Under the reasonable assumption that the menu cost does not exceed the fixed cost of quantity adjustment,5 in an inflationary environment a firm chooses to adjust its nomi-

The assumption that nominal price adjustment is costly for firms (there are "menu costs") has generated a stream of important theoretical papers over the last decade or so. 1 In so far as this literature generates asymmetric adjustments, it provides a theoretical underpinning for the (old)Keynesian assumption that nominal prices are more flexible upward than downward. 2Yet, the empirical evidence, while confirming that asymmetri es exist, does not indicate the dominance of any particular form of asymmetry (see Dennis W. Carlton, 1986; Alan S. Blinder, 1991).In this paper we argue that the gap between theory and practice may be the result of the focus of menucost models on specific forms of market structure.Existing menu -cost models are based on the assumption of relatively uncompetitive market structures -monopoly, oligopoly, or monopolistic competition with a fixed number of firms.We widen the scope of the analysis by examining what we call a quasi-competitive industry and demonstrate that it displays a pattern of adjustment quite different from that found in other models.The Keynesian asymmetry is reversed, with nominal price being more flexible downward than upward. 3 We suggest therefore that a relationship exists between market structure and the pattern of nominal price adjustment.Since there is presumably a variety of market structures, this may help explain the inconclusive empirical evidence.We model the most competitive market configuration compatible with menu costs:Bertrand oligopoly in a dynamic setting with free entry.It is assumed that (a) an incumbent in one period can continue to sell at its existing nominal price in the next period without incurring any additional menu cost, whereas an entrant would have to incur a menu cost; and (b) among the firms willing to sell at the lowest price in any given period, one is chosen randomly to sell the