Knowledge that Transforms

Real output in most advanced capitalist economies fluctuates around a rising trend. One can argue about whether it is best to think about that trend as passing through successive cyclical averages, defined in one way or another, or best to think of it as passing through cyclical peaks, or some other measure of output. While the outcome of that argument has consequences for macroeconomic theory, I will bypass it for now. The important observation is that, on the whole, the observed fluctuations around trend are contained within a moderately narrow corridor. Unemployment rates tend to run between, say, 5 percent and 10 percent in the United States. (Other countries have different typical ranges, and in each of them, the range can shift from time to time. It is important, theoretically and practically, to understand why; but that remains an open question.) There are notable exceptions to this generalization, of course, the most famous being the depression of the 1930's; but they are exceptions. Again it is important to know why fluctuations are so contained. This could reflect some natural equilibrating process, or it could reflect the intervention of automatic or discretionary government policy, or it could be a mixture of both. That is another issue on which opinions differ. I think it is part of the usable common core of macroeconomics that the trend movement is predominantly driven by the supply side of the economy (the supply of factors of production and total factor productivity) and that the appropriate vehicle for analyzing the trend motion is some sort of growth model, preferably mine. Now, what about those fluctuations around the trend of potential output? A moment ago I put the normal range of unemployment rates at 5-10 percent. By Okun's law I am talking about fluctuations of real GDP with an amplitude of 8-10 percent or so from peak to trough-contained, but not trivial. In my picture of the usable common core of macroeconomics, those fluctuations are predominantly driven by aggregate demand impulses, and the appropriate vehicle for analyzing them is some model of the various sources of expenditure. I am not so obtuse as not to have observed that the whole point of theory is the assertion that these short-run motions of the economy are in fact supplydriven. But my view is that this explanation has been an empirical failure, or at best a nonsuccess. There are now two possibilities. As for the first, I entertain the hope that flexible, observant members of the real-business-cycle school, like Martin Eichenbaum and his coworkers, have come more or less to the same conclusion, and they have found ways to open up the fabric of their underlying model so that it will allow-or insist-that demand-side impulses play the dominant role in short-run macroeconomic fluctuations. Then this proposition is indeed part of the usable core of macroeconomics, and economists can go on to argue back and forth about the best way of modeling those demand-side forces. The other case is that the situation is as before, and the real-business-cycle school holds monolithically to the view that short-run fluctuations are just optimal supply-side adjustments to unforeseeable shocks to tastes and * Department of Economics, Massachusetts Institute of Technology, Cambridge, MA 02139.

Exchange economies were created in which individuals faced losses. If people are risk seeking in the losses, as predicted by prospect theory, then due to the nonconvexity, the competitive equilibria are all on the boundaries of the Edgeworth box. The experimental results are that risk-seeking behavior is observed in many people and appears in markets as predicted. In addition, market behavior is consistent with answers to hypothetical questionnaires. Contrary to prospect theory, risk seeking seems to diminish with experience: preferences in the market setting are not labile; and risk-seeking preferences are not simply a result of framing effects.

January 1997, Version 1.01 Prepared for the American Economic Review Papers and Proceedings , May 1997. See also "The Productivity of Nations"

We build a conceptual framework to analyze the virtues and limitations of alternative mechanisms that can be used to auction a highway. We argue that current mechanisms, which fix the term of the franchise, create unnecesary risk and facilitate post-contract opportunism by the regulator and the franchise-holder. We propose a new mechanism that allocates the franchise to the firm asking the least present value of toll revenue. We argue that this mechanisms is clearly superior to those currently in use.

During World War II, government expenditures were financed primarily by issuing debt. During the Korean War, expenditures were financed almost exclusively by higher taxes, reflecting President Truman's preference for balanced budgets. This paper evaluates quantitatively the economic effects of the different policies used to finance these two wars. Counterfactual experiments are used to explore the implications of financing World War II like the Korean War, and financing the Korean War like World War II. The author finds that using a Korean War policy during World War II would have resulted in much lower output and welfare relative to the actual policy.

This paper offers a new theory of destructive competition. The authors compare minimum resale price maintenance to retail market-clearing in a model with a monopolistic manufacturer selling to competitive retailers. In both the resale price maintenance and flexible-price games, retailers must order inventories before the realization of demand uncertainty. The authors find that manufacturer profits and equilibrium inventories are higher under resale price maintenance than under market-clearing. Surprisingly, consumer surplus can also be higher, in which case unfettered retail competition can legitimately be called 'destructive.'