Knowledge that Transforms

In this paper we examine the strategic value of flexibility in a world with incomplete contracting. The study of incomplete contracting is motivated by four factors: 1) In a world of complete contingent contracts, most (but not all) interesting strategic considerations disappear. 2) There is a significant literature that addresses the implications of bargaining under the assumption of incomplete contracting. 3) There are sound theoretical reasons why we would expect contracts to be incomplete. 4) Empirically, we observe that most contracts are indeed incomplete.

Overt terrorist acts and the specter of terrorism impose significant costs on the community of civilized nations. These costs can be reduced by taking retaliatory action against terrorist organizations and the countries that sponsor them. Assuming a positive range over which retaliatory cost is less at the marginal than the resulting benefit from reduced terrorism, there exists some positive level of retaliation which is efficient from the perspective of the victimized countries. An obstacle to achieving the efficient level of retaliation against terrorists results from the fact that much of the benefit from retaliation is general and cannot be captured entirely by the retaliating country. A fully efficient policy of retaliation will therefore require a cooperative response from all victimized countries. Achieving this cooperation, however, may confront the well-known free rider or prisoner's dilemma problem. While collectively the targets, and potential targets, of terrorism are better off retaliating, each will likely see its advantage best served by not retaliating. In this case it is quite possible that no one will retaliate when the best response is for everyone to retaliate. A closer look at the problem of terrorism, however, suggests that the standard prisoner's dilemma may not be a significant obstacle to retaliation. Under plausible conditions, it will pay one country to retaliate even if other countries choose to free ride. Indeed, given the two options in the standard prisoner's dilemma setting, (cooperating (retaliating) or noncooperating (nonretaliating), it is very likely that all victimized countries will retaliate; that no country will take a free ride. But this does not mean that the prospects for genuine cooperation in confronting terrorism are good. In the case of retaliation against terrorist, free riding is only one way a country can increase the net benefit it receives from the public good provided by another. It is possible for one country to, in effect, sell the public good of reduced terrorism that is generated by the retaliation of another country. This paidrider possibility has important, and obviously adverse, implications for the prospects that retaliation will result from a cooperative effort on the part of those countries victimized by terrorists. In Section I, the implication of free riding and paid riding for retaliation against terrorists will be investigated in a two-country setting. In Section II, the circumstances that either encourage or discourage a country from being a paid rider on the retaliation of another country will be considered and some real world examples of paid riding will be discussed.

Market making by merchants, who obtain stock from suppliers and resell it to con sumers, is modeled as a two-stage pricing game with winner-take-all c ompetition for the inputs (in contrast to fixed-capacity models). The re is a unique, subgame-perfect Nash equilibrium (SPNE) which is Walr asian for elastic demand and non-Walrasian for inelastic demand. Alte rnatively, when merchants first sell forward contracts to consumers a nd then compete for supplies, the unique SPNE is always Walrasian. Th us, the author has an equilibrium model in which Walrasian price aris es not from the benevolent actions of a fictitious auctioneer, but fr om optimal price-setting behavior of merchants.

This paper develops and implements a method for estimating price elasticities of demand using cross-sectional household survey data. Geographically clustered households report unit values, which when corrected for quality effects and for measurement error, indicate the underlying spatial variation in prices, and can be matched to variation in demand patterns. A simple model of quality choice is proposed, while the correction for measurement error exploits the clustered design of such surveys. Data from a 1979 household survey from the Ivory Coast are used to estimate price elasticities for beef, meat, fish, cereals, and starches.

National Price Levels and the Prices of Tradables and Nontradables This paper examines changes in national price levels and prices of tra— dables and nontradables and relates them to changes in variables found earlier to be associated with price level differences among countries. Across countries, national price levels increase systematically with the level of a country's per capita income, and the ratios of tradables to nontra— dables prices decrease. Over time, increases in per capita income are generally associated with increases in price levels in the industrial countries, although the opposite relationship tended to prevail among deve-loping countries. Increases in income are associated with declines in the ratio of tradables to nontradables price levels more consistently than with the increases in general price levels. Increases in the exchange value of a currency are also associated with declines in the price levels for tradables relative to nontradables. Countries with price levels that were high or low relative to those predicted by the structural equations tended to move toward those predicted levels.

Since 1980, the federal government has directly subsidized one-third of all nonfederal borrowing. This paper presents numerical estimates of the effects of federal lending. Existing credit subsidies appear to have important effects on the allocation of credit, but little effect on aggregate investment. Efficiency costs are shown to be large (approximately 1/3 percent of GNP). Government costs exceed fifty cents per dollar of incremental targeted lending. Interactions among programs can eliminate much or all of the original gain provided by a subsidy, especially if borrowers are rationed. The paper also examines the effects of several policy reforms.

One of the most puzzling paradoxes in decision theory is the preference reversal phenomenon. This phenomenon seems to contradict the transitivity axiom, for a long time, one of the cornerstones of utility theory. This paradox is established whenever a decision maker prefers lottery X to lottery Y, but is willing to put a lower selling price on X than on Y. Such experiments, first reported by Harold Lindman, 1971; and Sarah Lichtenstein and Paul Slovic, 1971, were repeated by David Grether and Charles Plott, 1979; Werner Pommerehne et al., 1982; and Robert Reilly, 1982. Although the later researchers improved the mechanism through which the selling price emerges, they all found systematic reversals. A new approach to this problem was developed by Charles Holt, 1986, and Edi Karni and Zvi Safra, 1987. From two different starting points, these authors showed that the preference reversal phenomenon does not necessarily prove a violation of the transitivity axiom, as it may contradict the independence axiom. This implies that people do not maximize expected utility, but in that case the preference reversal phenomenon becomes just another evidence against expected utility theory, but not against the transitivity axiom. These results have their own disadvantages. Although the independence axiom is not as fundamental as transitivity, it is nevertheless very appealing on normative grounds. Of course, the preference reversal phenomenon necessarily contradicts at least one of the assumptions of expected utility theory, but empirical evidence shows that despite its normative appeal, violations of the reduction of compound lotteries axiom may happen (see, for example, Joshua Ronen, 1971, and Doug Snowball and Clif Brown, 1979). In this paper I therefore suggest a decision mechanism for the preference reversals lotteries which is transitive and satisfies the independence axiom, but not the reduction axiom.