Knowledge that Transforms

importance of divergence of opinion the functioning of capital markets was recognized by early economic writers. In the prevailing models of capital markets, however, differences of opinion either do not exist or do not matter. Thus, although heterogeneity of opinion is allowed the models developed by Kenneth Arrow, Gerard Debreu, and Peter Diamond, nothing essential would change if all individuals were to hold identical, homogeneous-equivalent average expectations. In the capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner (1965), homogeneous expectations are assumed at the outset. When they considered the implications of heterogeneity of expectations the model, both Lintner (1969) and Sharpe (1970) reached similar conclusions; as stated by Sharpe, in somewhat superficial sense the equilibrium relationships derived for world of complete agreement can be said to apply to world which there is disagreement, if certain values are considered to be averages (p. 291). Sharpe's conclusion was that a model based on disagreement has little value positive role (p. 113). aim of this paper is to present simple model of exchange capital markets where divergence of opinion not only exists, but is essential. It is essential because of its association with endogenous limitations on the number of active market participants. It will be argued that the models cited above, the significance of divergence of opinion was dismissed because of the failure to recognize the implications of the obvious fact that investors choose not only the size of their holdings each asset, but also which assets to invest. Correspondingly, they failed to recognize that (imperfect) capital markets, equilibrium requires the simultaneous determination of asset prices and the identity of investors trading each asset. As both Lintner (1969) and Sharpe (1970) recognized, the case of divergent opinions may differ from the case which there is no such divergence, if only because it implies that investors may seek to sell short assets that they believe to be overrated. Lintner, who pursued the implications of the case which short sales are not allowed, argued that, when not all investors trade every asset, the price of an asset will reflect an average of the assessments of only those investors who actually hold the asset. Lintner, however, did not realize that, given that the set of active investors is endogenously determined, this is an incomplete characterization of how asset prices are determined. It leaves an integral question unanswered; namely, what distinguishes the active from the nonactive investor? Lintner was thus led to dismiss an alternative characterization of equilibrium asset prices-the marginal-investor theory-proposed by John Maynard Keynes and John Burr Williams thirty years earlier.' Keynes characterized the determination of asset prices manner that attests to the importance that he attached to divergence of opinion among investors: The prices of capital assets move until... they offer an

Myron Ross correctly points out in his comment that U.S. price inflation is better predicted by the American money supply (MlUS) than by the broader ten-country world money supply (MlW) over the whole statistical time-series from 1960 to 1980 provided in McKinnon's 1982 article. Specifically, he showed that American price inflation is more highly correlated with MlUS lagged one or two years than with MlW similarly lagged. However, McKinnon's present-tense assertion that general, in the world money supply is a better predictor of American price inflation than is American money growth applies only to the weak dollar standard of the 1970's and early 1980's-as his preceding discussion intended, but failed to indicate clearly. Only in this later period of volatile exchange rates and price-level instability in the United States do alternative hard currencies (such as the yen and deutsche mark) become competitive as international stores of value and units of account. Hence, international currency substitution-associated with the ebb and flow of speculation against or for the dollar-significantly destabilized the demand for MlUs in the 1970's and 1980's. And only in this later period might one expect the sum of these internationally substitutable monies, Ml, to predict world, and perhaps even American, price inflation better than does Mlus. In contrast, during the strong dollar standard of the 1950's and 1960's, the dollar was unchallenged as international money. Exchange rates were (by and large) convincingly fixed: speculation for or against the dollar was incapable of substantially altering U.S. interest rates or of directly affecting the demand for MlUS. Because cyclical international influences did not then destabilize the demand for dollars, MlUS was by itself a fairly efficient predictor of American prices. Thus Ross's statistical results for the period 1960 to 1980 show somewhat greater predictive strength in Mlus, compared to Ml', because the 1960's data outweigh the dissimilar data of the 1970's. Let us instead partition the sample of IMF data around the year 1970, whence began the transition from fixed to fluctuating exchange rates and the maturation of alternative monetary systems in Europe and Japan. After applying similar statistical correlation procedures to those used by Ross, we show a striking structural shift in the world's monetary system: the explanatory power of Mlw increases sharply as that of MlUS declines moderately (Tan, 1982). For the early period of 1960 to 1970, Table 1 shows simple correlation coefficients between annual percentage changes in money supplies and changes in American and world wholesale price indices. The MlUs provides a good explanation of U.S. prices and of world prices one to two years hence, whereas the broader definition of Mlw (in which MlUs enters with a 50 percent weight) does surprisingly poorly, being insignificantly correlated with American or world prices. Apparently, money in industrial countries other than the United States was not then an independent source of worldwide inflationary pressure during the strong dollar standard. Table 2 shows the same simple correlations between percentage changes in prices and money for the weak dollar standard of * Stanford University. Please note that a typographical error giving the last word in the original title as Market appeared on the cover of the June 1982 issue of this Review. The title was correct in the table of contents and on the article.

We demonstrate that the phenomenon of immiserizing transfers from abroad (and the analytically symmetric phenomenon of enriching transfer payments) in the presence of market stability can arise only if there is a distortion characterizing the economy in question.

Three separate effects of regulatory policies on enterprise decisions can be distinguished. First, increased regulatory penalties will diminish output and profits in static models or, equivalently, in multiperiod models in which investments are completely reversible, as is well known. Second, if investment commitments are irreversible, there will be an additional effect of a known schedule of changes in the regulatory policy, which will depress output even further. Finally, the addition of uncertainty with regard to regulatory policy produces a third effect resulting in expected opportunity losses for firms. Both output and quality investments will be depressed by regulatory policy lotteries. Regulations influence current enterprise decisions not only through their current level, but through their expected future level and the degree of uncertainty regarding these future regulatory policies. 9 references, 1 figure.

The dictionary defines paradigm as a model or pattern. In grammar, an example of conjugation or declension, showing word in all its inflectional forms. A paradigm is thus practical example which perfectly illustrates an abstract principle. Its hallmark, in this dictionary definition, is the complete correspondence between the abstract and the applied, between theory and praxis. The term was adapted to the discussion of theory by Thomas Kuhn, and its current vogue in economics is attributable directly to his book. As Kuhn used the term, paradigm retains its double meaning of theory and of praxis, but the relationship between the two becomes ambiguous. Scientists believe, Kuhn seems to argue, that their inquiry is based upon theory of how the world operates and how the investigation of its operation ought to proceed. But science is in fact largely set of practices in which members of given community customarily engage. Students seeking to follow their professors in careers in which the latter will judge them and ultimately determine their fate are not encouraged to andertake projects which depart radically From those which their professors conceive For them. When suggestions for such projects trise, either from students or competing nembers of the community, they are as often reated by sarcasm and ridicule as the subect of seasoned discourse and debate. In this )rocess, what students acquire is less an abtract understanding of what they are doing han set of habits, or instincts, about what constitutes legitimate mode of inquiry or plausible explanation. The disjuncture between theory and practice which arises in this way creates the potential for scientific revolution. To ask in this context about the paradigm to which notions of labor market segmentation belong is thus to ask question about the relationship between that mode of research and the theory and practice of economics. I never considered myself revolutionary; indeed quite the contrary. But as an exponent of labor market segmentation in the community of normal economics, I can assure you that labor market segmentation does not fit the paradigm. The sentiments and reactions which Kuhn tells us greet the abnormal and aparadigmatic in discipline, that is, fury, disdain, resentment, sarcasm, and condescension have definitely greeted labor market segmentation. This is matter of fact; an observation about praxis. The question is then what aspect of the conceptual structure of the discipline accounts for this practical result. In most discussions, labor market segmentation is contrasted with human capital theory, but this does not account for the hostile reception it has received. It fails, first, because the treatment accorded market segmentation by the profession is not that different from the treatment accorded human capital when it first appeared. Gary Becker describes his personal experience on this score in the introduction to his book of essays, The Economic Approach to Human Behavior, and the disdain and antagonism which he attributes to his colleagues are at least as great as anything experienced by the proponents of segmentation. But, perhaps more fundamentally, the two views are not, as we shall see shortly, necessarily in conflict. *Professor of economics, Mitsui Professor for Probems of Contemporary Technology, Massachusetts Intitute of Technology.

In their 1981 article, Joseph Stiglitz and Andrew Weiss analyze adverse selection and incentive effects in the loan market. The models considered are based on two crucial assumptions: borrowers are subject to limited liability; and lenders cannot distinguish borrowers (projects) of different risk. Stiglitz and Weiss show that a bank that raises its interest rate may suffer adverse selection because only risky borrowers will be willing to borrow at the higher rate. Thus lenders may choose not to raise the interest rate to eliminate excess demand, resulting in the possibility of a rationing equilibrium. Stiglitz and Weiss also consider briefly the role of collateral in such credit rationing models. They conclude that lenders may choose not to use collateral requirements as a rationing device. An increase in collateral requirements, like an increase in the interest rate, potentially leads to a decrease in the lender's expected return on loans because of resulting adverse incentive and selection effects. The purpose of this note is to further investigate the role of collateral in these models. Stiglitz and Weiss' discussion in Section III establishes that adverse selection effects can result from increases in collateral when borrowers are risk averse. I will show by returning to a model they discussed earlier in Section I, that the adverse selection effects can also occur when borrowers are risk neutral. Stiglitz and Weiss outline a model to consider the use of collateral as a rationing device (Section III). In that model, all potential borrowers face the same array of risky projects; each potential borrower chooses (at most) one of those projects to undertake. The individuals are, by assumption, risk averse with decreasing absolute risk aversion, and possess different amounts of initial wealth. Thus, choice of project (if any) to undertake and the method of finance-selffinance from initial wealth or loan finance-will differ from one individual to the next. Stiglitz and Weiss show that, among those who undertake risky projects and who choose borrowing as the method of finance, wealthier individuals undertake riskier projects. An increase in collateral has two effects on the market for loans: those individuals who remain in the market will choose to undertake less-risky projects; and those individuals who drop out of the market are less-wealthy, low-risk borrowers. If the second effect is sufficiently strong, then increased collateral requirements will mean decreased expected returns for the lender. Thus, a credit rationing equilibrium may occur, since lenders may not choose to use collateral requirements (or the interest rate) to eliminate excess demand. The adverse selection effect just described does not occur in this model if the individuals are risk neutral. Consequently, the potential for a credit rationing equilibrium is limited to cases where borrowers are risk averse. To see that increases in collateral requirements can also result in adverse selection if borrowers are risk neutral, consider the model Stiglitz and Weiss used to analyze the adverse selection effects of increases in the interest rate (Section I, pp. 395-99). It differs from the Section III model discussed above in three ways. First, borrowers are risk neutral; second, all projects ar loan financed. The analogy to the Section III model is that no individuals have sufficient wealth to self-finance projects.' Third, in the Section

Not only can competition provide a basis of comparison, which enables the design of reward structures that can simultaneously provide a high level of incentives with relatively low level risk; but compensation schemes based on relative performance have the further advantage of automatically adjusting incentives to changes in the economic environment.