Knowledge that Transforms

Prepared under Contract no. EX-76-A-01-2295, Task order 37.

Opportunities for individual learning in multi-period insurance contexts introduce fundamental economic aspects not present in conventional static models. Using a twoperiod model in which there are two states (accident and no accident), it is shown that more precise prior probability assessments lead to increased insurance coverage and reduced self-protection. These dynamic adverse incentive problems can be diminished by merit rating, which has a backwards influence on earlier actions. Self-protection and insurance purchases in the initial period respond in opposite fashion to changes in insurance prices in the second period, the interest rate, and parameters of the prior probability assessment.

This paper presents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory. Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses. In addition, people generally discard components that are shared by all prospects under consideration. This tendency, called the isolation effect, leads to inconsistent preferences when the same choice is presented in different forms. An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights. The value function is normally concave for gains, commonly convex for losses, and is generally steeper for losses than for gains. Decision weights are generally lower than the corresponding probabilities, except in the range of low prob-abilities. Overweighting of low probabilities may contribute to the attractiveness of both insurance and gambling. 1.

[The identifiability of linear dynamic models with autocorrelated errors is considered. Without a priori assuming relative left primeness of the structures, global identifiability conditions in the case of affine cross-equation restrictions and local identifiability conditions in the case of continuously differentiable cross-equation restrictions are derived.]

The purpose of this paper is to indicate the problems connected with the intertemporal comparability of Lorenz curves and Gini indices estimated by standard numerical approaches in the case of the classified empirical income distribution and a growth of individual income at a fixed rate. Collector effects of the higher intervals lead to shifts of the Lorenz curve to the right or to the left; accordingly the Gini index may rise or fall. This class phenomenon occurs although actually nothing has changed in distribution.

THIS PAPER CONSIDERS how certain theoretical results on consistent commodity aggregation can be applied to the problem of the estimation of a complete system of demand equations. The method proposed here builds upon the classic results of Gorman [16], particularly the case he calls perfect price aggregation. These results are well known in the literature on two-stage budgeting but have not been widely applied to problems of empirical demand analysis. This relative neglect of perfect price aggregation is regrettable because several of their features recommend their use in econometric applications. In the perfect price aggregate approach to demand analysis, demand equations are characterized as a two-level system consisting of a system of group expenditure functions and a number of systems of conditional demand functions. This two-level system provides a manageable way of introducing greater detail into a complete system of demand equations. Information about particular commodities may be introduced in the specification of conditional demand functions. As will be discussed below, the two-level system can be estimated by an iterative estimation method in which the maximum number of demand equations which can be estimated is greatly increased over the number found in past estimates of complete systems of demand equations. Even when one is principally interested in estimating group expenditures the perfect price aggregate approach is attractive because the intragroup substitutions due to detailed price changes can affect total group expenditures and this effect is taken into consideration through the computation of the perfect price indices. Thus it may be possible that a perfect price aggregate model will yield better estimates of group expenditures than would an approach which did not explicitly treat aggregation problems. Another pleasing feature of the perfect price aggregate approach to demand analysis is that it avoids the misspecification which results when the commodity

This paper concerns individual choice among from which the individual will later choose a single object. In particular, it concerns relations on opportunity sets which satisfy preference for flexibility, a set is at least as good as all of its subsets, but which may not satisfy revealed preference, the union of two sets may be strictly preferred to each one taken separately. A representation theorem is given which rationalizes such choice behavior as being as if the individual is uncertain about future tastes. IN MANY PROBLEMS of individual choice, the choice is made in more than one stage. At early stages, the individual makes decisions which will constrain the choices that are feasible later. In effect, these early choices amount to choice of a subset of items from which subsequent choice will be made. This paper concerns choice among such opportunity sets, where the individual has a desire for flexibility which is irrational if the individual knows what his subsequent preferences will be.

The paper investigates an econometric method for selecting macroeconomic policy rules when expectations are formed rationally. A simple econometric model of the U.S. is estimated subject to a set of rational expectations restrictions using a minimum distance estimation technique. The estimated model is then used to calculate optimal monetary policy rules to stabilize fluctuations in output and inflation, and to derive a long run tradeoff between price stability and output stability which incorporates the rationally formed expectations. The optimal tradeoff curve is compared with actual U.S. price and output stability and with the results of a monetary policy rule with a constant growth rate of the money supply. 1