Knowledge that Transforms

Do observed contracts have the properties predicted by the principal-agent model with moral hazard in contract theory? This paper tests the predictions of such an agency model in the context of sharecropping in North India. The most well-known explanation for sharecropping is based on the principal-agent model with a trade-off between risk and incentives. Even though sharecropping contracts are quite prevalent in rural areas of developing countries, there is very little evidence on factors determining the instruments used to provide incentives in such contracts. Using information in the data giving rise to exogenous variation in technology across regions, this paper tests for the effect of cultivation technology on the incentive structure of share contracts as predicted by the agency model. Existing empirical evidence on sharecropping seems to indicate that yield on sharecropped plots is lower than on owner-operated plots, i.e., there is an incentive problem or moral hazard (Radwan A. Shaban, 1987; Jean-Jacques Laffont and Mohamed S. Matoussi, 1995). There is some informal evidence that landowners use various mechanisms to improve efficiency in sharecropping by participating in cost sharing and by repeating contracts. Robert M. Townsend and Rolf A. Mueller (1994) examine the nature of these mechanisms in detail but their data do not permit econometric tests. More generally, though the principal-agent model has been widely studied there is little existing empirical evidence for it. Michael C. Jensen and Kevin J. Murphy (1990) find that executive compensation is only weakly sensitive to firm performance. In recent work Rajesh K. Aggarwal and Andrew A. Samwick (1999) find that executive’s pay-performance sensitivity is decreasing in the volatility of firm’s performance. However, their results are sensitive to the inclusion of other characteristics of the firms in the regressions. As Pierre A. Chiappori and Bernard Salanie (2003) note in a recent survey, empirical work on contract theory using nonexperimental data needs to be careful in adequately correcting for underlying heterogeneity across agents. Otherwise the parameters of interest would be hard to interpret if such heterogeneity affects contract choice. For example, Douglas W. Allen and Dean Lueck (1995) find no role for risk in the choice between share contract and fixed rent contracts but they do not take the heterogeneity across agents into account. In a recent paper addressing the issue of heterogeneity across agents, Ackerberg and Botticini (2002) find a significant role for risk in the choice between share contract and fixed rent contract. After correcting for endogenous matching between landowners and tenants, they find that wealthier tenants are more likely to be in fixed rent contracts. In this paper, we are able to address such estimation issues and check for the robustness of our results regarding the relationship between technology and the design of share contracts * Department of Economics, Pennsylvania State University, University Park, PA 16801 (e-mail: [email protected]). This paper derives from related work done earlier in my dissertation. I am grateful to two anonymous referees for very helpful suggestions. I thank James Heckman, Lars Stole, Robert Townsend, Kala Krishna, and seminar participants for useful comments. Financial support from the Andrew Mellon Foundation for both rounds of fieldwork is gratefully acknowledged. Any errors remain my own. 1 See Nirvikar Singh (1991) for a survey of various theories of sharecropping including Steven N. Cheung (1969), C. H. Hanumantha Rao (1971), Joseph E. Stiglitz (1974), David Newbery and Stiglitz (1979), Avishay Braverman and Stiglitz (1982), Mukesh Eswaran and Ashok Kotwal (1985), and Sudhir Shetty (1988). A common feature of the different theories is an emphasis on uncertainty and asymmetric information. 2 An exception is Daniel A. Ackerberg and Maristella Botticini (2002). Ackerberg and Botticini differ from our paper in that they examine the role of tenant’s risk aversion in the choice between fixed rental contract and share contract—they do not examine share contracts per se. 3 See John E. Core and Wayne Guay (2000).

In a recent article in this journal, B. D. McCullough and H. D. Vinod (2003; hereafter MV) argue that checking the condition number of the Hessian should be a standard part of checking the validity of any estimates obtained via nonlinear optimization. While we think that looking at the condition number of the Hessian is a good idea, we argue that the issue is not as straightforward as claimed by MV. To illustrate our point, we show that MV reached the wrong conclusion about the validity of the Ron Shachar and Barry Nalebuff (1999) solution. In Sections I–III of their article, MV note that it is possible for a well-coded log-likelihood program to declare convergence when some of the parameters are not identified for the given data set. Furthermore, MV make several important recommendations including that researchers check that

Pulled Away or Pushed Out? Explaining the Decline of Teacher Aptitude in the United States by Caroline M. Hoxby and Andrew Leigh. Published in volume 94, issue 2, pages 236-240 of American Economic Review, May 2004

An important challenge in the crime literature is to isolate causal effects of police on crime. Following a terrorist attack on the main Jewish center in Buenos Aires, Argentina, in July 1994, all Jewish institutions received police protection. Thus, this hideous event induced a geographical allocation of police forces that can be presumed exogenous in a crime regression. Using data on the location of car thefts before and after the attack, we find a large deterrent effect of observable police on crime. The effect is local, with no appreciable impact outside the narrow area in which the police are deployed.

The Employment Consequences of Wrongful-Discharge Laws: Large, Small, or None at All? by David H. Autor, John J. Donohue and Stewart J. Schwab. Published in volume 94, issue 2, pages 440-446 of American Economic Review, May 2004

This paper develops a measure of U.S. monetary policy shocks for the period 1969–1996 that is relatively free of endogenous and anticipatory movements. Quantitative and narrative records are used to infer the Federal Reserve's intentions for the federal funds rate around FOMC meetings. This series is regressed on the Federal Reserve's internal forecasts to derive a measure free of systematic responses to information about future developments. Estimates using the new measure indicate that policy has large, relatively rapid, and statistically significant effects on both output and inflation. The effects are substantially stronger and quicker than those obtained using conventional indicators.

In 1954 the United States Supreme Court ruled that separate schools for black and white children were “inherently unequal.” This paper studies whether the desegregation plans of the next 30 years benefited black and white students in desegregated school districts. Data from the 1970 and 1980 censuses suggest desegregation plans of the 1970's reduced high school dropout rates of blacks by two to three percentage points during this decade. No significant change is observed among whites. The results are robust to controls for family income, parental education, and state- and region-specific trends, as well as to tests for selective migration.

Prospect theory, loss aversion, mental accounts, hyperbolic discounting, cues, and the endowment effect can all be seen as examples of situationalism -- the view that people isolate decisions and overweight immediate aspects of the situation relative to longer term concerns. But outside of the laboratory, emotionally-powerful situational factors -- frames, social influence, mental accounts -- are almost always endogenous and often the result of self-interested entrepreneurs. As such, laboratory work and, indeed, psychology more generally, gives us little guidance as to market outcomes. Economics provides a stronger basis for understanding the supply of emotionally-relevant situational variables. Paradoxically situationalism actually increases the relative importance of economics.

Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates? by Harald Hau and Hélène Rey. Published in volume 94, issue 2, pages 126-133 of American Economic Review, May 2004

This paper examines the robustness of explanatory variables in cross-country economic growth regressions. It introduces and employs a novel approach, Bayesian Averaging of Classical Estimates (BACE), which constructs estimates by averaging OLS coefficients across models. The weights given to individual regressions have a Bayesian justification similar to the Schwarz model selection criterion. Of 67 explanatory variables we find 18 to be significantly and robustly partially correlated with long-term growth and another three variables to be marginally related. The strongest evidence is for the relative price of investment, primary school enrollment, and the initial level of real GDP per capita.