Knowledge that Transforms

The article presents a reply to the comments of economist Richard Cothren on a paper related to efficient market theory written by the authors. According to the author Cothren's assertion that the authors incorrectly derived an informed trader's risky asset demand function is false. They permitted borrowing and short selling. For this reason there is no nonnegativity constraint on a trader's holdings of risky or risk-free assets. A trader's initial wealth is not the limit on the value of the risky assets that he can purchase. The trader can borrow, and in so doing finance a large purchase of risky assets. The goal of their paper was to show that when information is costly, a perfectly competitive equilibrium will not exist which completely transmits the informed traders' information to uninformed traders. It would have been trivial to prove that constraints on borrowing, or on short sales, prevent perfect arbitrage from occurring. They proved a more interesting result, which is that even in the absence of constraints on borrowing or short sales, markets cannot be fully arbitraged, when information about the arbitrage opportunity is costly.

This analysis suggests several distinctive policy recommendations about environmental problems. One is that some of the alarms about ecological catastrophes cannot simply be dismissed, even when some of those who sound the alarms seem almost fanatic. The information needed to be sure one way or another is simply lacking, and may not be attainable at reasonable cost for a long time. We are therefore left with inevitable risk. Ecological systems could also be incomparably more robust than the alarmists claim, so we might also be worrying needlessly. The implication for environmental and ecological research is that we should not exprect that it will produce conclusive information, but should fund a lot of it anyhow. If previous research has produced few compelling results, valid information about these problems is scarce and therefore more valuable. The harvest of research in the areas characterized by indivisibilities is then poor but precious knowledge. If it is important to be able to change behavior quickly, when and if we finally get the information that the ecosystem can't take any more, then it is important that we have the open-mindedness needed to change our views and policies the moment decisive information arrives. Those who shout wolfmore » too often, and those who are sure there are no wolves around, could be our undoing.« less

The recent White House Conference on Aging graphically demonstrated public concern over the welfare of the growing elderly segment of the U.S. population. How is this group faring economically? Have they suffered from the stagflation of the last decade, or have they been sheltered from economic harm by a combination of government programs and fortuitous asset holdings? How vulnerable were they as a group to the inflation of the 1970's? We answer some of these questions by focusing on the economic welfare of the elderly over the last decade. We assess the level and composition of real income and wealth of the elderly; we compare their incomes to those of the general population; and we compute a measure of their vulnerability to unexpected increases in the price level. We note, however, that there are many other important indicators of the welfare of the elderly, such as the increasing life expectancy, changing living arrangements and housing, trends towards earlier retirement, and decreasing intergenerational contact. We do not consider these issues, so our results do not give a complete assessment of the welfare of the elderly. We believe our results provide a good assessment of how their economic position changed over the decade.

This essay examines the role of economic research in affecting the recommendations of the National Commission of Unemployment Compensation, and the likely impacts of that Commission and economists' research findings on policy. Using a questionnaire addressed to Commission members, I find that most became quite aware of the results of research on the labor- market effects of unemployment insurance, with the degree of recognition proportional to the strength of the consensus among economists on a particular result; that the members had little awareness of the identity of particular economists who had done the research; and that, though the members claimed their recommendations were influenced importantly by research, that influence is difficult to detect in the Commission's Report. Because that Report goes against the tenor of current labor- market policy, its short-run impact will likely be small; and, because the focus of interest in policy will change over time, its long-term influence may not be great. Economic research, though, is shown to have had an immediate impact in three specific cases; and its long-run effect, by conditioning the policy discussion, has been and will likely be substantial.

The share of the federal budget devoted to the older population (defined in this paper as people who are 65 and above) has expanded substantially from approximately 2 percent in 1940 to 25 percent today. Over the next fifty years this older population is expected to more than double in size and increase from 11 percent of the population to between 20 and 26 percent. These increases will come in two distinct periods, the 1980's and the twenty years beginning in 2010. Even if no further responsibilities are assumed by the federal government, this population increase alone will put inexorable fiscal pressure on future federal budgets.

In June of 1978, the voters of California approved Proposition 13, restricting the rate of local property taxation to no more than 1 percent of 1975 market values. In November 1978, the voters of Michigan approved the Headlee Amendment, which limited state revenues from own sources to a fixed share of state personal income. In November of 1980, Massachusetts voters followed the lead of California and required all cities and towns to limit their taxation to a rate of 22 percent of full and fair cash value. Numerous hypotheses have been advanced and analyzed to explain the emergence of these new restrictions on fiscal choice. The results point to two explanations: voters feel governments are too big, providing more services than what they prefer, or governments spend too much on redistributive activities to help the poor and, through higher wages, to help public employees themselves.' The response to this perceived failure of government has been to propose-and in California, Michigan, and Massachusetts to approve-absolute limits to government expenditures. The question I wish to address here is whether a compelling economic argument can be advanced for such a policy response, politics and personalities aside. The answer, I think, is yes, but particular preconditions must apply. First, and perhaps most importantly, is the inability of citizens to directly control the provision of public services. Responsibility for providing public goods is delegated to agents of the voter, and these agents-be they bureaucrats or elected representatives-have their own objectives and an ability to act upon them to the possible disadvantage of the voters. Second, without direct control over public outputs, voters must use indirect controls through the manipulation of their appointed agents. These indirect controls take two general forms: price incentives or quantity restrictions. Third, the choice of either of these indirect controls must take place before the agent acts to provide public goods. Further, voters must often make their choice of a price or quantity control before the benefits or costs of the public service are known to them with certainty. Agents, however, can wait to observe true benefits and coststhat is why we use agents-and then provide a level of public services in response to costs, benefits, and the voters' chosen control. Voter uncertainty over benefits and costs can be interpreted as placing the voter within a constitutional perspective where a voter's precise position in society, that is, his or her benefits and costs, are unknown when choosing a control. Geoffrey Brennan and James Buchanan (ch. 1) were the first to really stress this important point. Fourth, if benefit and cost uncertainty is predominantly over the position (rather than slope) of the marginal benefit and marginal cost schedules and if the marginal benefit schedule is relatively steep (loosely, an inelastic demand curve) while the marginal cost schedule is relatively flat (an elastic supply curve), then quantity controls on agents' behavior through tax or spending limitations will be the preferred control. These four preconditions strike me as quite plausible. Rather than just an emotional reaction to a peculiar configuration of political and economic circumstances, Proposition 13, the Headlee Amendment, and Proposition 24 may be perfectly reasoned responses to a failure in the politi*Professor, University of Pennsylvania, and research associate, the National Bureau of Economic Research, Inc. 'An alternative hypothesis which has been tested and generally rejected attributes voter approval to a desire to alter the tax mix away from property taxation and towards other taxes. What approving voters really want, it seems, is increased government efficiency and less redistribution. See the recent studies by Jack Citrin; Paul Courant, Edward Gramlich, and Daniel Rubinfeld; and Helen Ladd and Julie Wilson.

A number of economists have studied the input behavior (Eugene Silberberg 1974a; Lowell Bassett and Thomas Borcherding 1 970a, b, c; C. E. Ferguson and Thomas Saving, and Paul Meyer, 1967) of a competitive industry in which entry or exit continues until industry output price moves to the minimum average cost of the marginal firm in the industry. However, this analysis requires very strong assumptions which severely restrict diversity between firms. Silberberg (1974a), for example, assumes all firms' production functions are identical except for a scale factor. Complementary to these long-run investigations, I will present a compact but thorough analysis of the short-run case in which technology and the number of firms are fixed, but industry output-price responds to aggregate supply changes of existing firms resulting from changes in factor prices. In contrast to the long-run analysis, no assumptions limiting interfirm diversity, nor any other restrictions (beyond definition of the usual neoclassical firm) are needed. Furthermore, results are obtained for industry factor demand which do not necessarily hold for individual firms when they respond to factor prices jointly with other firms in the industry. This contradicts the older methodology associated with Paul Samuelson (1947) in which factor-demand responses are derived for firms acting in isolation from each other, and their isolated responses are aggregated to obtain the industry factor response. For example, traditional theory shows input response obeys the law of demand for isolated firms. But this standard result no longer holds when a firm adjusts within a larger industry of firms whose collective output response can affect output price. Thus, the law of demand for industry factor behavior cannot be established by aggregation of isolated firm responses. However, its validity does nevertheless hold in the short run in which the number of firms in the industry is constant. Therefore, the purpose of this paper is to characterize the short-run industry level factor-demand implications, and to show how these implications relate to the traditional theory of isolated firm behavior. In addition, it is briefly shown how these short-run results also imply that the law of demand is likely to hold even in the long run, where entry and exit from the industry can occur (even for an industry of quite dissimilar firms). Given the well-established literature of the standard neoclassical firm, the main body of the paper will confine presentation to required definitions, and the statement plus interpretation of the main results. All proofs and derivations are reserved for the Appendix.