American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Inventories and the Business Cycle: An Equilibrium Analysis of (S, s) Policies AubhikKhan Julia K.Thomas 1165 1188 We develop an equilibrium business cycle model where nonconvex delivery costs lead firms to follow (S, s) inventory policies. Calibrated to postwar US data, the model reproduces two-thirds of the cyclical variability of inventory investment. Moreover, it delivers strongly procyclical inventory investment, greater volatility in production than sales, and a countercyclical inventory-to-sales ratio. Our model challenges several prominent claims involving inventories, including the widely held belief that they amplify aggregate fluctuations. Despite the comovement between inventory investment and final sales, GDP volatility is essentially unaltered by inventory accumulation, because procyclical inventory investment diverts resources from final production, thereby dampening fluctuations in sales. (JEL E22, E32). http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=5&issue_date=September 2007 10.1257/aer.97.4.1165 http://www.e-aer.org/data/sept07/20031097_data.zip American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles On the Cyclicality of Research and Development GadiBarlevy 1131 1164 Economists have recently argued recessions play a useful role in fostering growth. Yet a major source of growth, R&D, is procyclical. This paper argues one reason for procyclical R&D is a dynamic externality inherent in R&D that makes entrepreneurs short-sighted and concentrate their innovation in booms, even when it is optimal to concentrate it in recessions. Additional forces may imply that procyclical R&D is desirable, but equilibrium R&D is likely to be too procyclical, and macroeconomic shocks are likely to have overly persistent effects on output and make growth more costly than in the absence of such shocks. http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=4&issue_date=September 2007 10.1257/aer.97.4.1131 http://www.e-aer.org/data/sept07/20050805_data.zip American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Subjective Expectations and Asset-Return Puzzles Martin L.Weitzman 1102 1130 In textbook expositions of the equity-premium, riskfree-rate and equity-volatility puzzles, agents are sure of the economy's structure while growth rates are normally distributed. But because of parameter uncertainty the thin-tailed normal distribution conditioned on realized data becomes a thick-tailed Student-t distribution, which changes the entire nature of what is considered "puzzling" by reversing every inequality discrepancy needing to be explained. This paper shows that Bayesian updating of unknown structural parameters inevitably adds a permanent tail-thickening effect to posterior expectations. The expected-utility ramifications of this for asset pricing are strong, work against the puzzles, and are very sensitive to subjective prior beliefs—even with asymptotically infinite data. (JEL D84, G12) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=3&issue_date=September 2007 10.1257/aer.97.4.1102 American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Mismatch RobertShimer 1074 1101 This paper develops a dynamic model of mismatch. Workers and jobs are randomly allocated to labor markets. Each market clears, but some have excess (unemployed) workers and some have excess (vacant) jobs. As workers and jobs switch markets, unemployed workers find vacancies and employed workers become unemployed. The model is quantitatively consistent with the business cycle frequency comovement of unemployment, vacancies, and the job finding rate and explains much of these variables' volatility. It can also address cyclicality in the separation rate into unemployment and duration dependence in the job finding rate. The results are robust to some nonrandom mobility. (JEL E24, J41, J63, J64) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=2&issue_date=September 2007 10.1257/aer.97.4.1074 http://www.e-aer.org/data/sept07/20051275_data.zip American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Reference-Dependent Risk Attitudes BotondKőszegi MatthewRabin 1047 1073 We use Koszegi and Rabin's (2006) model of reference-dependent utility, and an extension of it that applies to decisions with delayed consequences, to study preferences over monetary risk. Because our theory equates the reference point with recent probabilistic beliefs about outcomes, it predicts specific ways in which the environment influences attitudes toward modest-scale risk. It replicates "classical" prospect theory—including the prediction of distaste for insuring losses—when exposure to risk is a surprise, but implies first-order risk aversion when a risk, and the possibility of insuring it, are anticipated. A prior expectation to take on risk decreases aversion to both the anticipated and additional risk. For large-scale risk, the model allows for standard "consumption utility" to dominate reference-dependent "gain-loss utility," generating nearly identical risk aversion across situations. (JEL D81) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=1&issue_date=September 2007 10.1257/aer.97.4.1047 American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Markets in China and Europe on the Eve of the Industrial Revolution Carol H.Shiue WolfgangKeller 1189 1216 Why did Western Europe industrialize first? An influential view holds that its exceptionally well-functioning markets supported with a certain set of institutions provided the incentives to make investments needed to industrialize. This paper examines this hypothesis by comparing the actual performance of markets in terms of market integration in Western Europe and China, two regions that were relatively advanced in the preindustrial period, but would start to industrialize about 150 years apart. We find that the performance of markets in China and Western Europe overall was comparable in the late eighteenth century. Market performance in England was higher than in the Yangzi Delta, and markets in England also performed better than those in continental Western Europe. This suggests strong market performance may be necessary, but it is not sufficient for industrialization. Rather than being a key condition for subsequent growth, improvements in market performance and growth occurred simultaneously. (JEL N13, N15, O47) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=6&issue_date=September 2007 10.1257/aer.97.4.1189 http://www.e-aer.org/data/sept07/20040419_data.zip http://www.e-aer.org/data/sept07/20040419_app.pdf American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Projection Bias in Catalog Orders MichaelConlin TedO'Donoghue Timothy J.Vogelsang 1217 1249 Evidence suggests that people understand qualitatively how tastes change over time, but underestimate the magnitudes. This evidence is limited, however, to laboratory evidence or surveys of reported happiness. We test for such projection bias in field data. Using data on catalog orders of cold-weather items, we find evidence of projection bias over the weather—specifically, people's decisions are overinfluenced by the current weather. Our estimates suggest that if the order-date temperature declines by 30°F, the return probability increases by 3.95 percent. We also estimate a structural model to measure the magnitude of the bias. (JEL D12, L81) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=7&issue_date=September 2007 10.1257/aer.97.4.1217 http://www.e-aer.org/data/sept07/20050302_data.zip American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Do Markets Reduce Costs? Assessing the Impact of Regulatory Restructuring on US Electric Generation Efficiency Kira R.Fabrizio Nancy L.Rose Catherine D.Wolfram 1250 1277 While neoclassical models assume static cost-minimization by firms, agency models suggest that firms may not minimize costs in less-competitive or regulated environments. We test this using a transition from cost-of-service regulation to marketoriented environments for many US electric generating plants. Our estimates of input demand suggest that publicly owned plants, whose owners were largely insulated from these reforms, experienced the smallest efficiency gains, while investor-owned plants in states that restructured their wholesale electricity markets improved the most. The results suggest modest medium-term efficiency benefits from replacing regulated monopoly with a market-based industry structure. (JEL D24, L11 , L51, L94, L98) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=8&issue_date=September 2007 10.1257/aer.97.4.1250 http://www.e-aer.org/data/sept07/20041018_data.zip http://www.e-aer.org/data/sept07/20041018_app.pdf American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Selection Bias, Demographic Effects, and Ability Effects in Common Value Auction Experiments MarcoCasari John C.Ham John H.Kagel 1278 1304 Inexperienced women, along with economics and business majors, are much more susceptible to the winner's curse, as are subjects with lower SAT/ACT scores. There are strong selection effects in bid function estimates for inexperienced and experienced subjects due to bankruptcies and bidders who have lower earnings returning less frequently as experienced subjects. These selection effects are not identified using standard econometric techniques but are identified through experimental treatment effects. Ignoring these selection effects leads to misleading estimates of learning. (JEL D44, D83, J16) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=9&issue_date=September 2007 10.1257/aer.97.4.1278 http://www.e-aer.org/data/sept07/20051324_data.zip http://www.e-aer.org/data/sept07/20051324_app.zip American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Naked Exclusion, Efficient Breach, and Downstream Competition JohnSimpson Abraham L.Wickelgren 1305 1320 Previous papers by Eric B. Rasmusen, J. Mark Ramseyer, and John S. Wiley, Jr. (1991) and Ilya R. Segal and Michael D. Whinston (2000) argue that exclusive contracts can inefficiently deter entry in the presence of scale economies and multiple buyers. We first show that these results no longer hold when buyers are final consumers who can breach these contracts and pay expectation damages. We then show, however, that exclusive contracts can inefficiently deter entry if buyers are downstream competitors, even in the absence of scale economies and even if breach is possible. (JEL D86, K21, L11 , L13, L14, L40) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=10&issue_date=September 2007 10.1257/aer.97.4.1305 American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Do Vertical Mergers Facilitate Upstream Collusion? VolkerNocke LucyWhite 1321 1339 We investigate the impact of vertical mergers on upstream firms' ability to collude when selling to downstream firms in a repeated game. We show that vertical mergers give rise to an outlets effect: the deviation profits of cheating unintegrated firms are reduced as these firms can no longer profitably sell to the downstream affiliates of their integrated rivals. Vertical mergers also result in an opposing punishment effect: integrated firms typically make more profit in the punishment phase than unintegrated upstream firms. The net result of these effects in an unintegrated industry is to facilitate upstream collusion. We provide conditions under which further vertical integration also facilitates collusion. (JEL D43, G34, L12, L13) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=11&issue_date=September 2007 10.1257/aer.97.4.1321 http://www.e-aer.org/data/sept07/20031190_app.pdf American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Individual Behavior and Group Membership GaryCharness LucaRigotti AldoRustichini 1340 1352 People who are members of a group and identify with it behave differently from people who perceive themselves as isolated individuals. This paper shows that group membership affects preferences over outcomes, and saliency of the group affects the perception of the environment. We manipulate the saliency of group membership by letting a player's own group watch as a passive audience as decisions are made, and/or by making part of the payoff common for members of the group. In contrast to the minimal-group paradigm, minimal groups alone do not affect behavior in our strategic environments. However, salient group membership significantly increases the aggressive stance of the hosts (people who have their group members in the audience), and tends to reduce that of the guests. (JEL D71, Z13) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=12&issue_date=September 2007 10.1257/aer.97.4.1340 http://www.e-aer.org/data/sept07/20060519_data.zip http://www.e-aer.org/data/sept07/20060519_app.pdf American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles Political Bias and War Matthew O.Jackson MassimoMorelli 1353 1373 We examine how countries' incentives to go to war depend on the "political bias" of their pivotal decision makers. This bias is measured by a decision maker’s risk/ reward ratio from a war compared to that of the country at large. If there is no political bias, then there are mutually acceptable transfers from one country to the other that will avoid a war in the presence of commitment or enforceability of peace treaties. There are cases with a strong enough bias on the part of one or both countries where war cannot be prevented by any transfer payments. Our results shed some new light on the uneven contender paradox and the interpretation of the "democratic peace." We examine countries' choices of the bias of their leaders and show that when transfers are possible, at least one country will choose a biased leader, as that leads to a strong bargaining position and extraction of transfers. (JEL D72, D74) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=13&issue_date=September 2007 10.1257/aer.97.4.1353 American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Articles A Political-Economy Theory of Trade Agreements GiovanniMaggi AndrésRodríguez-Clare 1374 1406 We present a model where trade agreements are motivated by the desire of governments to commit vis-à-vis domestic lobbies, in addition to standard terms-of-trade externalities. The model predicts that trade liberalization is deeper when capital is more mobile across sectors, and when governments are more politically motivated (provided domestic-commitment motives are strong enough). The model also provides a new rationale for the use of tariff ceilings. In a fully dynamic specification of the model, tariffs are reduced in two stages: an immediate cut and a subsequent gradual reduction, with the speed of liberalization increasing in the degree of capital mobility. (JEL D72, F13) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=14&issue_date=September 2007 10.1257/aer.97.4.1374 American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Shorter Papers Auctions with Anticipated Regret: Theory and Experiment EmelFiliz-Ozbay Erkut Y.Ozbay 1407 1418 This paper demonstrates theoretically and experimentally that in first-price auctions overbidding with respect to the risk neutral Nash equilibrium might be driven from anticipated loser regret (felt when bidders lose at an affordable price). Different information structures are created to elicit regret: bidders know they will learn the winning bid if they lose (loser regret condition); or the second-highest bid if they win (winner regret condition); or they will receive no feedback regarding the other bids. Bidders in loser regret condition anticipated regret and significantly overbid. However, bidders in the winner regret condition did not anticipate regret. (JEL D44) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=15&issue_date=September 2007 10.1257/aer.97.4.1407 http://www.e-aer.org/data/sept07/20050951_data.zip http://www.e-aer.org/data/sept07/20050951_app.zip American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Shorter Papers Labor and the Market Value of the Firm MonikaMerz EranYashiv 1419 1431 What role does labor play in firms' market value? We use a production-based asset pricing model with factor adjustment costs and forward-looking agents to explore this question. We posit that the hiring of labor is akin to investment in capital and that the two interact, with the interaction being a crucial determinant of the dynamic behavior of market value. Using aggregate US corporate sector data, we estimate firms' optimal hiring and investment decisions and the consequences for firms' value. (JEL E22, E24, G31, G32, M51) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=16&issue_date=September 2007 10.1257/aer.97.4.1419 http://www.e-aer.org/data/sept07/20031233_data.zip American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Shorter Papers Contracting with Repeated Moral Hazard and Private Evaluations WilliamFuchs 1432 1448 A repeated moral hazard setting in which the Principal privately observes the Agent's output is studied. The optimal contract for a finite horizon is characterized, and shown to require burning of resources. These are only burnt after the worst possible realization sequence and the amount is independent of both the length of the horizon and the discount factor. For the infinite horizon. it is shown that there is no loss from restricting the analysis to contracts in which the Agent receives a constant efficiency wage and no feedback until he is fired. Furthermore, optimal contracts cannot be replicated by short-term contracts. A family of fixed interval review contracts is characterized. Longer review intervals are preferable but harder to implement. Comparative statics on the review length are carried out. Finally, these contracts are shown approximate first best if players are very patient. (JEL D82, D86) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=17&issue_date=September 2007 10.1257/aer.97.4.1432 http://www.e-aer.org/data/sept07/20050880_app.pdf American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Shorter Papers Exchange Asymmetries Incorrectly Interpreted as Evidence of Endowment Effect Theory and Prospect Theory? Charles R.Plott KathrynZeiler 1449 1466 Systematic asymmetries in exchange behavior have been widely interpreted as support for "endowment effect theory," an application of prospect theory positing that loss aversion and utility function kinks set by entitlements explain observed asymmetries. We experimentally test an alternative explanation, namely, that asymmetries are explained by classical preference theories finding influence through the experimental procedures typically used. Contrary to the predictions of endowment effect theory, we observe no asymmetries when we modify procedures to remove the influence of classical preference theories. When we return to traditional-type procedures, however, the asymmetries reappear. The results support explanations based in classical preference theories and reject endowment effect theory. (JEL D01) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=18&issue_date=September 2007 10.1257/aer.97.4.1449 http://www.e-aer.org/data/sept07/20051143_data.zip American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Shorter Papers Surviving Andersonville: The Benefits of Social Networks in POW Camps Dora L.Costa Matthew E.Kahn 1467 1487 Twenty-seven percent of the Union Army prisoners captured July 1863 or later died in captivity. At Andersonville, the death rate may have been as high as 40 percent. How did men survive such horrific conditions? Using two independent datasets, we find that friends had a statistically significant positive effect on survival probabilities and that the closer the ties between friends as measured by such identifiers as ethnicity, kinship, and the same hometown, the bigger was the impact of friends on survival probabilities. (JEL N41, Z13) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=19&issue_date=September 2007 10.1257/aer.97.4.1467 http://www.e-aer.org/data/sept07/20050916_data.zip American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Shorter Papers Individual Consumption Risk and the Welfare Cost of Business Cycles MassimilianoDe Santis 1488 1506 We measure the welfare gain from removing aggregate consumption fluctuations in a model where each individual faces incomplete consumption insurance. We show that, because this welfare gain is a convex function of the overall consumption risk—aggregate plus idiosyncratic—each individual faces, to gauge the magnitude of the gain, it is important to match individuals' overall risk prior to any policy. In an economy calibrated to match individuals' overall risk, even removing 10 percent of aggregate fluctuations can result in a large welfare gain. Further, large gains do not necessarily depend on the countercyclical nature of idiosyncratic risk. (JEL E21, E32) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=20&issue_date=September 2007 10.1257/aer.97.4.1488 American Economic Association Nashville, TN 0002-8282 American Economic Review http://www.aeaweb.org/aer/ 97 4 September 2007 http://www.aeaweb.org/articles/issue_detail.php?journal=AER&volume=97&issue=4&issue_date=September 2007 Shorter Papers Goodbye Lenin (or Not?): The Effect of Communism on People AlbertoAlesina NicolaFuchs-Schündeln 1507 1528 Preferences for redistribution, as well as the generosity of welfare states, differ significantly across countries. This paper tests whether there exists a feedback process of the economic regime on individual preferences. We exploit the experiment of German separation and reunification to establish exogeneity of the economic system. We find that, after German reunification, East Germans are more in favor of state intervention than West Germans. This effect is especially strong for older cohorts. We further find that East Germans' preferences converge toward those of West Germans. It will take one to two generations for preferences to converge completely. (JEL D12, D72, H11, H23, P26) http://www.aeaweb.org/articles/article_detail.php?journal=AER&volume=97&issue=4&article=21&issue_date=September 2007 10.1257/aer.97.4.1507 http://www.e-aer.org/data/sept07/20051016_data.zip http://www.e-aer.org/data/sept07/20051016_app.zip