Knowledge that Transforms

This paper describes a contract theory of public finance of college education that explains why everyone pays for the college education of a lucky minority. The contract provides gambles that families desire. Optimizing the contract determines the taxes paid by all members of society, fees paid by those whose children go to college, the fraction of children who are admitted to college, and the quality of college education. Changes in wealth lead to changes in taxes and admissions, but fees and quality are invariant. The practice of using a cutoff level of precollege achievement to determine admission to college is justified by the theory.

This paper develops the quantitative implications of optimal fiscal policy in a business cycle model. In a stationary equilibrium, the ex ante tax rate on capital income is approximately zero. The tax rate on labor income fluctuates very little and inherits the persistence properties of the exogenous shocks; thus there is no presumption that optimal labor tax rates follow a random walk. Most of the welfare gains realized by switching from a tax system like that of the United States to the Ramsey system come from an initial period of high taxation on capital income. Copyright 1994 by University of Chicago Press.

Using a game-theoretic approach, we examine possible equilibrium explanations of the often-observed phenomenon that two neighboring restaurants offering similar menus nevertheless experience vastly different demands. The essential aspect of this analysis is the presence of a consumption externality that makes the popularity itself a factor in the determination of the relative attractiveness of the restaurants.

Selection dynamics are often used to distinguish stable and unstable equilibria. This is particularly useful when multiple equilibria prevent a priori comparative static analysis. This paper reports an experiment designed to compare the accuracy of the myopic best-response dynamic and an inertial selection dynamic. The inertial selection dynamic makes more accurate predictions about the observed mutual best-response outcomes.

In this paper, a model of optimal employment contracting describes differences across countries in firing restrictions and short-time compensation systems for workers forced to work shorter hours to avoid layoff. The model predicts that the existence of a short-time compensation (STC) system will generate major fluctuations in working hours only if the STC system is more generous than the traditional unemployment insurance system. A test performed for 10 OECD countries shows that in countries with generous STC systems, the speed of adjustment of total hours worked is higher than in the United States, despite a much slower adjustment in the number of workers employed. On the other hand, in countries with less generous STC systems, hours adjustments are far from compensating the slower employment adjustments.

Consider a family of maximization models in which the optimum trades off beneficial and costly effects. Then comparative statics derived under many kinds of simplifying assumptions about the benefits technology are also true for general (convex and nonconvex) technologies. For example, any comparative statics conclusion about investment by a risk-averse decision maker under uncertainty that holds when expected returns are described by a general linear function also holds for an arbitrary nonlinear expected return function.

Focusing on the Southern Bell Telephone Company, we propose a modified version of the predation hypothesis to explain Bell's "natural" monopoly over local telephone service. Southern Bell effectively eliminated competition through a strategy of pricing below cost in response to entry, which deprived competitors of the cash flow required for expansion even if it failed to induce exit; investing in toll lines ahead of demand, isolating independent companies in smaller towns and rural areas, and forcing them to consolidate on favorable terms; and influencing local regulatory policy in large cities to weaken rivals and ultimately to institutionalize the Bell monopoly.

Trade is both uncertain and sequential. Money surprises are not neutral because prices at the beginning of the trading process cannot depend on its end. In contrast with fixed-price models, in this paper sellers can change prices during trade. In contrast with Lucas's article, here there is no asymmetry in the information about the money supply. The price quoted by individual sellers may adjust slowly to changes in the targeted money supply, but the distribution of quoted prices adjusts perfectly to these changes and the real price distribution is independent of the anticipated rate of change in the money supply.

Firm numbers first rise, then later fall, as an industry evolves. This nonmonotonicity is explained using a competitive model in which innovation opportunities fuel entry and relative failure to innovate prompts exit; equilibrium time paths for price and quantity also share features of the data. The model is estimated using data from the U.S. automobile tire industry, a particularly dramatic example of the nonmonotonicity in firm numbers. Copyright 1994 by University of Chicago Press.

Self-reporting --the reporting by parties of their own behavior to an enforcement authority --is a commonly observed aspect of law enforcement, as in the context of environmental and safety regulation. We add self-reporting to the model of the control of harmful externalities through probabilistic law enforcement. Optimal self-reporting schemes are characterized and are shown to offer two advantages over schemes without self-reporting: enforcement resources are saved because individuals who are led to report harmful acts need not be identified; risk is reduced because individuals bear certain sanctions when they report their behavior, rather than face uncertain sanctions.