This paper presents a strategic theory of contract renegotiation. In this theory, suboptimal contracts are put in place initially to protect one party against undesirable a ctions by another party and are renegotiated once the danger is past. The authors develop a model to establish the cases in which simple contracts cannot achieve desirable outcomes, so that only a complicated contract or renegotiation will serve. Unlike most previous accounts of contract renegotiation, this theory does not rely on exogenous uncertainty to motivate renegotiation.

Contemporary economic theory has all but completed burial of idea that market discrimination explains racial wage differentials or differences in general pecuniary accomplishments across ethnic groups under competitive conditions. We need only await eulogy. Interment began with failure of model premised on employers' taste for discrimination. The preferences of employers for members of one group over another could not sustain wage differentials under competition if individuals from each group were equally able. Although initial argument was made under assumptions of neoclassical perfect competition, it was beaten back by Austrian process view of competition (see Israel Kirzner, 1973). A latent reservoir of alert entrepreneurs presumably would seize profit opportunities generated by discriminatory wage gap, drive discriminating employers from market, and erode wage differentials. Valiant efforts emerged subsequently to raise from dead idea that competition might eliminate market discrimination. These efforts involved development of market discrimination models under states of affairs characteristic of neoclassical imperfect competition or so-called discrimination. Neither case precluded possibility of ingenious entrepreneurship nor the entrepreneurial capacity to smell profits (Kirzner, p. 229). As a result, in neither case could existence of wage or earnings differentials be maintained by employer decisions. In first case, inventive entrepreneur could circumvent or bring down barrier that was source of imperfection. Similarly, in second case clever entrepreneur could devise procedures for overcoming existing informational discrepancies that might exist about abilities of members of each of ascriptively distinct groups (see Darity, 1982). The application of Austrian process view of competition to problem of racial and ethnic wage differences stripped market discrimination of its analytic significance. However, empirical persistence of such wage differentials in U.S. economy is well established. The demise of theory of market discrimination under competitive conditions has led to increasing use of human capital explanation for differences in economic achievement across ascriptively distinct groups. After many years and scores of statistical studies that revealed that convergence in observable human capital characteristics-especially years of formal education-did not lead to anticipated abolition of black-white wage gaps (see Williams, 1984), there is now a shift underway that identifies source of alleged human capital differences as unobservable cultural differences between ascriptively distinct groups. Cultural variation is accorded primacy in explaining ethnic and racial differences in economic achievement. In light of death of market discrimination explanation, culturalogical explanation is given added force by observation that certain ethnic groups (Japanese and Jewish Americans, to name but two) have managed to succeed despite discrimination (see Barry Chiswick, 1983a, b). The themes of culture and competition thus are focus of this essay. We first provide substantive and historical critiques of new cultural variant of human capital theory. Second, we argue that existence of ongoing market discrimination can be revived by employing an alternative *University of North Carolina, Chapel Hill, NC 27514, and University of Texas, Austin, TX 78712, respectively. We are grateful to Art Goldsmith, Bobbie Horn, Steve Steib, and David Swinton for helpful comments. Research support was provided by Southern Center for Public Policy Studies at Clark College in Atlanta.

Based on data from 32 countries over the period 1996–2010, this paper is the first to assess the relationship between financial innovation, on the one hand, and bank growth and fragility, as well as economic growth, on the other hand. We find that different measures of financial innovation, capturing both a broad concept and specific innovations, are associated with faster bank growth, but also higher bank fragility and worse bank performance during the recent crisis. These effects are stronger in countries with larger securities markets and more restrictive regulatory frameworks. In spite of these seemingly ambiguous findings, our evidence points to a positive net effect of financial innovation on economic growth: financial innovation is associated with higher growth in countries and industries with better growth opportunities.

Statistical arbitrage strategies are typically based on models of returns. We introduce a new statistical arbitrage strategy based on dynamic factor models of prices. Our objective in this paper is to exploit the mean-reverting properties of prices reported in the literature. We do so because, to capture the same information using a return-based factor model, a much larger number of lags would be needed, leading to inaccurate parameter estimation. To empirically test the relative performance of return-based and price-based models, we construct portfolios (long-short, long-only, and equally weighted) based on the forecasts generated by two dynamic factor models. Using the stock of companies included in the S&P 500 index for constructing portfolios, the empirical analysis statistically tests the relative forecasting performance using the Diebold–Mariano framework and performing the test for statistical arbitrage proposed by Hogan et al. (2004). Our results show that prices allow for significantly more accurate forecasts than returns and pass the test for statistical arbitrage. We attribute this finding to the mean-reverting properties of stock prices. The high level of forecasting accuracy using price-based factor models has important theoretical and practical implications.

This article explains why decentralization can undermine accountability and answers three questions: what determines if power should be centralized or decentralized when regions are heterogeneous? How many levels of government should there be? How should state borders be drawn? We develop a model of political agency in which voters differ in their ability to monitor rent-seeking politicians. We find that rent extraction is a decreasing and convex function of the share of informed voters, because voter information improves monitoring but also reduces the appeal of holding office. As a result, information heterogeneity pushes toward centralization to reduce rent extraction. Taste heterogeneity pulls instead toward decentralization to match local preferences. Our model thus implies that optimal borders should cluster by tastes but ensure diversity of information. We also find economies of scope in accountability that explain why multiplying government tiers harms efficiency. A single government in charge of many policies has better incentives than many special-purpose governments splitting its budget and responsibilities. Hence, a federal system is desirable only if information varies enough across regions.

Policy choices depend on general values, such as equality, freedom, justice, and welfare. When economists evaluate policies, they focus on their welfare consequences, and they take welfare to be the satisfaction of preferences. Yet most would allow exceptions when preferences are based on obviously false beliefs. Few, for example, would claim that drinking a fatal poison in the mistaken belief that it was water improves a person's welfare. To deny that drinking poison is welfare-enhancing is only good sense, but it creates serious philosophical tensions for the preference-satisfaction view. For one cannot define welfare as the satisfaction of preferences and then admit that satisfying preferences sometimes makes people worse off. Such clear cases are artificial, but the dependence of preferences on unreliable beliefs is a pervasive feature of social life which makes a preference-based standard of welfare generally problematic. Although many kinds of beliefs influence preferences, we shall focus on judgments concerning the probabilities of risky and uncertain outcomes.1

Accounting rates of return are frequently used as indices of monopoly power and market performance by economists and lawyers.' Such a procedure is valid only to the extent that profits are indeed monopoly profits, accounting profits are in fact economic profits, and the accounting rate of return equals the economic rate of return. The large volume of research investigating the profits-concentration relationship uniformly relies on accounting rates of return, such as the ratio of reported profits to total assets or to stockholders' equity as the measure of profitability to be related to concentration.2 Many users of accounting rates of return seem well aware that profits as reported by accountants may not be consistent from firm to firm or industry to industry and may not correspond to economists' definitions of profits. Likewise, they recognize that accountants' statements of assets, hence also stockholders' equity, may fail to correspond to economically acceptable definitions, because accounting practices do not provide for the capitalization of certain activities such as research and development and do not incorporate allowances for inflation. This is to say they are well aware of certain measurement problems which arise in using available accounting information to measure profitability. They seem, however, totally unaware of a much deeper conceptual problem, namely, that accounting rates of return, even if properly and consistently measured, provide almost no information about economic rates of return.3 The economic rate of return on an investment is, of course, that discount rate that equates the present value of its expected net revenue stream to its initial outlay. Putting aside the measurement problems referred to above, it is clear that it is the economic rate of return that is equalized within an industry in long-run industry competitive equilibrium and (after adjustment for risk) equalized everywhere in a competitive economy in long-run equilibrium. It is an economic rate of return (after risk adjustment) above the cost of capital that promotes expansion under competition and is produced by output restriction under monopoly. Thus, the economic rate of return is the only correct measure of the profit rate for purposes of economic analysis.4 Accounting rates of return are useful only insofar as they yield information as to economic rates of return.5 *Fisher is professor of economics, Massachusetts Institute of Technology. McGowan was Vice-President, Charles River Associates. He died on April 7, 1982. This paper is based on work done for Fisher's testimony as a witness for IBM in U.S. v. IBM (69 Civ. 200, U.S. District Court, Southern District of New York). We are indebted to Larry Brownstein, Steven Hendrick, and especially Karen Larson and Leah Hutten for computational and programming assistance. Any errors are our responsibility. 'Aside from U.S. v. IBM, see, for example, Joseph Cooper, p. 15; the various industry studies in Walter Adams; and the discussion in Philip Areeda and Donald Turner, Vol. II, pp. 331-41. 2See the comprehensive reviews of this literature by Leonard Weiss and more recently by F. M. Scherer, pp. 267-95. Additional accounting problems raised by attempting to measure profitability by line of business are discussed extensively in George Benston. 3A referee suggests that even the crudest accounting information tells us IBM is more profitable than American Motors (AMC), but we disagree. Surely accounting information tells us IBM generates more dollars of profits per dollar of assets than does AMC but, as the examples below demonstrate, that information alone does not tell us which firm is more profitable in the sense of having a higher economic rate of return. 4This is literally true only if the cost of capital is first subtracted. In what follows below, we follow the usual empirical practice of measuring all rates of return before such subtraction. sThe existence of a uniquely defined economic rate of return-which we now assume for the theoretical analysis below and which occurs in all the examples-is

The authors analyze how to award a monopoly franchise when the objective is to maximize expected consumers' surplus net of transfer payments to the producer. Potential producers initially possess independent private information about uncertain production costs. Only the chosen producer subsequently observes realized production costs. After awarding the franchise to the producer with the lowest expected costs, prices are optimally set above realized marginal cost. These ex post distortions foster more competitive bidding ex ante. The distortions for any bid-cost pair are invariant to the number of bidders, n, though expected distortions and profits decline with n.