Knowledge that Transforms

Academics, consultants, and practitioners have long advocated bringing the market inside the firm. For example, in the 1950s and 1960s economists proposed that the transfer-pricing problem should be solved by charging market prices for internal transactions. Similarly, in the 1980s, financial economists suggested that the capital-allocation problem should be solved by charging the external cost of capital for internal investments. And wave after wave of organizational restructuring has advocated radical decentralization, empowerment, “intrapreneurship, ” and the like—in short, making employees feel like owners. Proponents of making transactions within firms more market-like often seem to ignore the factors that brought these transactions inside firms in the first place. But Bengt Holmstrom and Paul Milgrom (1991, 1994), Holmstrom and Jean Tirole (1991), and Holmstrom (1999) [hereafter collectively HMT] remind us that in some cases integration is efficient precisely because it eliminates market incentives. In such cases, bringing the market inside the firm would clearly be undesirable. In this paper we show that bringing the market inside the firm is often not feasible, even if it would be desirable. More precisely, if some aspects of the market transaction are non-contractible (as we define below) then it is impossible to replicate spot-market payoffs inside a firm. This result would be trivial if the firm’s only instruments were court-enforceable contracts: it is impossible (by definition) for such contracts to replicate payoffs that were non-contractible in a spot market. Our

Even among households with similar socioeconomic characteristics, saving and wealth vary considerably. Life-cycle models attribute this variation to differences in time preference rates, risk tolerance, exposure to uncertainty, relative tastes for work and leisure at advanced ages, and income replacement rates. These factors have testable implications concerning the relation between accumulated wealth and the shape of the consumption profile. Using the Panel Study of Income Dynamics and the Consumer Expenditure Survey, we find little support for these implications. The data are instead consistent with “rule of thumb,” “mental accounting,” or hyperbolic discounting theories of wealth accumulation. (JEL D1, D91, E21)

This paper shows that a small amount of individual-level money illusion may cause considerable aggregate nominal inertia after a negative nominal shock. In addition, our results indicate that negative and positive nominal shocks have asymmetric effects because of money illusion. While nominal inertia is quite substantial and long lasting after a negative shock, it is rather small after a positive shock. (JEL C92, E32, E52)

Should the proportion of risky assets in the risky part of an investor’s portfolio depend on the investor’s risk aversion? According to basic financial theory, in particular the mutual-fund separation theorem with a riskless asset, the answer is no. The theorem states that rational investors should divide their assets between a riskless asset and a risky mutual fund, the composition of which is the same for all investors. Risk aversion affects only the allocation between the riskless asset and the fund. However, Niko Canner et al. (1997), CMW hereafter, observed that popular investment advice does not conform to this theory. They reported the stocks, bonds, and cash allocations recommended by four advisors for conservative, moderate, and aggressive investors. As shown in Table 1, which is reproduced from CMW, the advisors recommend a bond/stock ratio that varies directly with risk aversion. For example, Fidelity recommends a bond/stock ratio of 1.50 for a “conservative” (more riskaverse) investor, a ratio of 1.00 for a “moderate” (less risk-averse) investor, and a ratio of 0.46 for an “aggressive” (still less risk-averse) investor. The inconsistency between such advice and the separation theorem is called an asset allocation puzzle by CMW. They attempted to solve the puzzle by relaxing key assumptions in the theory, but finally reached a negative conclusion: “Although we cannot rule out the possibility that popular advice is consistent with some model of rational behavior, we have so far been unable to find such a model” (p. 181). However, they suggested that consideration of intertemporal trading might help resolve the puzzle. In the present paper, we provide theoretical support for the popular advice. The two key insights are that the investor’s horizon may exceed the maturity of the cash asset and that the investor rebalances the portfolio as time passes. If the investor’s horizon exceeds the maturity of cash, which might be a money-market security with maturity of one to six months, then cash is not the riskless asset as is commonly assumed in the basic theory. In a theory allowing portfolio rebalancing, as opposed to a buy-and-hold framework, it is not unreasonable to assume that the investor can synthesize a riskless asset (a zero-coupon bond maturing at the horizon) using a bond fund and cash. Then bonds will be both in the (synthetic) riskless asset and in the risky mutual fund and we show that in this case the theoretical bond/stock ratio varies directly with risk aversion for any hyperbolic absolute risk aversion (HARA) investor. As an example of the type of results that a specific model can produce, we provide a continuous-time model with closed-form solutions, which produces theoretical bond/stock ratios similar to the popular advice. The present paper is organized as follows: in the next section, we analyze the popular advice in terms of the theory of mutual-fund separation of David Cass and Joseph E. Stiglitz (1970). We show that this theory is relevant both in static and dynamic frameworks and use it to analyze the popular advice in complete and incomplete markets. In Section II, we analyze the popular advice in the context of Robert C. Merton’s (1971) continuous-time statement of mutualfund separation and present an illustrative model in which a CRRA investor makes continuous-time portfolio decisions under interest rate and stock price uncertainty. In Section III, numerical results are compared with the popular advice. Section IV is a conclusion. * Bajeux-Besnainou: Department of Finance, School of Business and Public Management, George Washington University, 2023 G Street NW, Washington, DC 20052; Jordan: National Economic Research Associates, 1255 23rd Street NW, Washington, DC 20037; Portait: CNAM and ESSEC, Finance Chair CNAM, 2 Rue Conte, Paris, France. This research was supported by a grant from the Institute for Quantitative Investment Research. We thank two anonymous referees for their comments. 1 HARA functions include quadratic utility, which is one way of justifying mean-variance preferences, and constant relative risk aversion (CRRA) utility. Both quadratic and CRRA utility were considered in the CMW analysis.

How Important Are Idiosyncratic Shocks? Evidence from Labor Supply by Kjetil Storesletten, Chris I. Telmer and Amir Yaron. Published in volume 91, issue 2, pages 413-417 of American Economic Review, May 2001

This paper provides empirical evidence about the effect of unearned income on earnings, consumption, and savings. Using an original survey of people playing the lottery in Massachusetts in the mid-1980's, we analyze the effects of the magnitude of lottery prizes on economic behavior. The critical assumption is that among lottery winners the magnitude of the prize is randomly assigned. We find that unearned income reduces labor earnings, with a marginal propensity to consume leisure of approximately 11 percent, with larger effects for individuals between 55 and 65 years old. After receiving about half their prize, individuals saved about 16 percent. (JEL C81, D12, E21, J22, J26)

Advances in Routing Technologies and Internet Peering Agreements by Stanley Besen, Paul Milgrom, Bridger Mitchell and Padmanabhan Srinagesh. Published in volume 91, issue 2, pages 292-296 of American Economic Review, May 2001

This paper examines the magnitude of informational problems associated with the implementation and interpretation of simple monetary policy rules. Using Taylor's rule as an example, I demonstrate that real-time policy recommendations differ considerably from those obtained with ex post revised data. Further, estimated policy reaction functions based on ex post revised data provide misleading descriptions of historical policy and obscure the behavior suggested by information available to the Federal Reserve in real time. These results indicate that reliance on the information actually available to policy makers in real time is essential for the analysis of monetary policy rules. (JEL E52, E58)

Futures exchanges and other financial intermediaries assume counterparty risks and demand in return guarantees that these counterparties will deliver on their promises. It is often argued that to attract volume, financial intermediaries would settle for excessively low contractual guarantees. In Tano Santos and José Scheinkman (2001) we model financial intermediation in an environment where traders may choose to default, and we examine the characteristics of the equilibrium. In particular, we investigate whether competition implies excessively low standards. We show that in fact, when society punishes default and intermediaries can impose collateral requirements to effectively limit the size of positions, competition leads to a (constrained) optimal amount of contractual guarantees. In Santos and Scheinkman (2001) we assume that exchanges cannot control the size of the positions taken by individuals, but we preclude investors from participating in more than one exchange. This ignores the effect that trading with one financial intermediary may have on the risks faced by other intermediaries. Financial intermediaries typically cannot control the amount of risk that counterparties will take with other intermediaries. In this paper we examine the effect of dropping this exclusivity assumption. We show that the constrained optimum can no longer be implemented as a standard Nash equilibrium with free entry. Nonetheless this allocation is the only one that can be sustained as an anticipatory equilibrium (Charles Wilson (1977)). To break a candidate anticipatory