Fiscal Rules and Discretion Under Persistent Shocks

This paper studies the optimal level of discretion in policymaking. We consider a fiscal policy model where the government has time‐inconsistent preferences with a present bias toward public spending. The government chooses a fiscal rule to trade off its desire to commit to not overspend against its desire to have flexibility to react to privately observed shocks to the value of spending. We analyze the optimal fiscal rule when the shocks are persistent. Unlike under independent and identically distributed shocks, we show that the ex ante optimal rule is not sequentially optimal, as it provides dynamic incentives. The ex ante optimal rule exhibits history dependence, with high shocks leading to an erosion of future fiscal discipline compared to low shocks, which lead to the reinstatement of discipline. The implied policy distortions oscillate over time given a sequence of high shocks, and can force the government to accumulate maximal debt and become immiserated in the long run.     

Robustness and Separation in Multidimensional Screening

A principal wishes to screen an agent along several dimensions of private information simultaneously. The agent has quasilinear preferences that are additively separable across the various components. We consider a robust version of the principal's problem, in which she knows the marginal distribution of each component of the agent's type, but does not know the joint distribution. Any mechanism is evaluated by its worst‐case expected profit, over all joint distributions consistent with the known marginals. We show that the optimum for the principal is simply to screen along each component separately. This result does not require any assumptions (such as single crossing) on the structure of preferences within each component. The proof technique involves a generalization of the concept of virtual values to arbitrary screening problems. Sample applications include monopoly pricing and a stylized dynamic taxation model.     

Consumption Dynamics During Recessions

Are there times when durable spending is less responsive to economic stimulus? We argue that aggregate durable expenditures respond more sluggishly to economic shocks during recessions because microeconomic frictions lead to declines in the frequency of households' durable adjustment. We show this by first using indirect inference to estimate a heterogeneous agent incomplete markets model with fixed costs of durable adjustment to match consumption dynamics in PSID microdata. We then show that aggregating this model delivers an extremely procyclical Impulse Response Function (IRF) of durable spending to aggregate shocks. For example, the response of durable spending to an income shock in 1999 is estimated to be almost twice as large as if it occurred in 2009. This procyclical IRF holds in response to standard business cycle shocks as well as in response to various policy shocks, and it is robust to general equilibrium. After estimating this robust theoretical implication of micro frictions, we provide additional direct empirical evidence for its importance using both cross‐sectional and time‐series data.     

Existence of Optimal Mechanisms in Principal‐Agent Problems

We provide general conditions under which principal‐agent problems with either one or multiple agents admit mechanisms that are optimal for the principal. Our results cover as special cases pure moral hazard and pure adverse selection. We allow multidimensional types, actions, and signals, as well as both financial and non‐financial rewards. Our results extend to situations in which there are ex ante or interim restrictions on the mechanism, and allow the principal to have decisions in addition to choosing the agent's contract. Beyond measurability, we require no a priori restrictions on the space of mechanisms. It is not unusual for randomization to be necessary for optimality and so it (should be and) is permitted. Randomization also plays an essential role in our proof. We also provide conditions under which some forms of randomization are unnecessary.     

Impatience versus Incentives

This paper studies the dynamics of long‐term contracts in repeated principal–agent relationships with an impatient agent. Despite the absence of exogenous uncertainty, Pareto‐optimal dynamic contracts generically oscillate between favoring the principal and favoring the agent.     

A Polynomial Optimization Approach to Principal–Agent Problems

This paper presents a new method for the analysis of moral hazard principal–agent problems. The new approach avoids the stringent assumptions on the distribution of outcomes made by the classical first‐order approach and instead only requires the agent's expected utility to be a rational function of the action. This assumption allows for a reformulation of the agent's utility maximization problem as an equivalent system of equations and inequalities. This reformulation in turn transforms the principal's utility maximization problem into a nonlinear program. Under the additional assumptions that the principal's expected utility is a polynomial and the agent's expected utility is rational in the wage, the final nonlinear program can be solved to global optimality. The paper also shows how to first approximate expected utility functions that are not rational by polynomials, so that the polynomial optimization approach can be applied to compute an approximate solution to nonpolynomial problems. Finally, the paper demonstrates that the polynomial optimization approach extends to principal–agent models with multidimensional action sets.     

The Non‐Democratic Roots of Elite Capture: Evidence From Soeharto Mayors in Indonesia

Democracies widely differ in the extent to which powerful elites and interest groups retain influence over politics. While a large literature argues that elite capture is rooted in a country's history, our understanding of the determinants of elite persistence is limited. In this paper, we show that allowing old‐regime agents to remain in office during democratic transitions is a key determinant of the extent of elite capture. We exploit quasi‐random from Indonesia: Soeharto‐regime mayors were allowed to finish their terms before being replaced by new leaders. Since mayors' political cycles were not synchronized, this event generated exogenous variation in how long old‐regime mayors remained in their position during the democratic transition. Districts with longer exposure to old‐regime mayors experience worse governance outcomes, higher elite persistence, and lower political competition in the medium run. The results suggest that slower transitions towards democracy allow the old‐regime elites to capture democracy.     

Communication With Unknown Perspectives

Consider a group of individuals with unobservable perspectives (subjective prior beliefs) about a sequence of states. In each period, each individual receives private information about the current state and forms an opinion (a posterior belief). She also chooses a target individual and observes the target's opinion. This choice involves a trade‐off between well‐informed targets, whose signals are precise, and well‐understood targets, whose perspectives are well known. Opinions are informative about the target's perspective, so observed individuals become better understood over time. We identify a simple condition under which long‐run behavior is history independent. When this fails, each individual restricts attention to a small set of experts and observes the most informed among these. A broad range of observational patterns can arise with positive probability, including opinion leadership and information segregation. In an application to areas of expertise, we show how these mechanisms generate own field bias and large field dominance.     

Moral Hazard in High Office and the Dynamics of Aristocracy

Both aristocratic privileges and constitutional constraints in traditional monarchies can be derived from a ruler's incentive to minimize expected costs of moral‐hazard rents for high officials. We consider a dynamic moral‐hazard model of governors serving a sovereign prince, who must deter them from rebellion and hidden corruption which could cause costly crises. To minimize costs, a governor's rewards for good performance should be deferred up to the maximal credit that the prince can be trusted to pay. In the long run, we find that high officials can become an entrenched aristocracy with low turnover and large claims on the ruler. Dismissals for bad performance should be randomized to avoid inciting rebellions, but the prince can profit from reselling vacant offices, and so his decisions to dismiss high officials require institutionalized monitoring. A soft budget constraint that forgives losses for low‐credit governors can become efficient when costs of corruption are low.     

Stochastic Choice and Revealed Perturbed Utility

Perturbed utility functions—the sum of expected utility and a nonlinear perturbation function—provide a simple and tractable way to model various sorts of stochastic choice. We provide two easily understood conditions each of which characterizes this representation: One condition generalizes the acyclicity condition used in revealed preference theory, and the other generalizes Luce's IIA condition. We relate the discrimination or selectivity of choice rules to properties of their associated perturbations, both across different agents and across decision problems. We also show that these representations correspond to a form of ambiguity‐averse preferences for an agent who is uncertain about her true utility.     

Large Matching Markets as Two‐Sided Demand Systems

This paper studies two‐sided matching markets with non‐transferable utility when the number of market participants grows large. We consider a model in which each agent has a random preference ordering over individual potential matching partners, and agents' types are only partially observed by the econometrician. We show that in a large market, the inclusive value is a sufficient statistic for an agent's endogenous choice set with respect to the probability of being matched to a spouse of a given observable type. Furthermore, while the number of pairwise stable matchings for a typical realization of random utilities grows at a fast rate as the number of market participants increases, the inclusive values resulting from any stable matching converge to a unique deterministic limit. We can therefore characterize the limiting distribution of the matching market as the unique solution to a fixed‐point condition on the inclusive values. Finally we analyze identification and estimation of payoff parameters from the asymptotic distribution of observable characteristics at the level of pairs resulting from a stable matching.     

Inefficient Investment Waves

We show that firms' individually optimal liquidity management results in socially inefficient boom‐and‐bust patterns. Financially constrained firms decide on the level of their liquid resources facing cash‐flow shocks and time‐varying investment opportunities. Firms' liquidity management decisions generate simultaneous waves in aggregate cash holdings and investment, even if technology remains constant. These investment waves are not constrained efficient in general, because the social and private value of liquidity differs. The resulting pecuniary externality affects incentives differentially depending on the state of the economy, and often overinvestment occurs during booms and underinvestment occurs during recessions. In general, policies intended to mitigate underinvestment raise prices during recessions, making overinvestment during booms worse. However, a well‐designed price‐support policy will increase welfare in both booms and recessions.     

Insider Trading,Stochastic Liquidity,and Equilibrium Prices

We extend Kyle's (1985) model of insider trading to the case where noise trading volatility follows a general stochastic process. We determine conditions under which, in equilibrium, price impact and price volatility are both stochastic, driven by shocks to uninformed volume even though the fundamental value is constant. The volatility of price volatility appears ‘excessive’ because insiders choose to trade more aggressively (and thus more information is revealed) when uninformed volume is higher and price impact is lower. This generates a positive relation between price volatility and trading volume, giving rise to an endogenous subordinate stochastic process for prices.     

Robust Contracts in Continuous Time

We study a continuous‐time contracting problem under hidden action, where the principal has ambiguous beliefs about the project cash flows. The principal designs a robust contract that maximizes his utility under the worst‐case scenario subject to the agent's incentive and participation constraints. Robustness generates endogenous belief heterogeneity and induces a tradeoff between incentives and ambiguity sharing so that the incentive constraint does not always bind. We implement the optimal contract by cash reserves, debt, and equity. In addition to receiving ordinary dividends when cash reserves reach a threshold, outside equity holders also receive special dividends or inject cash in the cash reserves to hedge against model uncertainty and smooth dividends. The equity premium and the credit yield spread generated by ambiguity aversion are state dependent and high for distressed firms with low cash reserves.     

Utilitarian Preferences With Multiple Priors

This paper proposes a method for aggregating individual preferences in the context of uncertainty. Individuals are assumed to abide by Savage's model of Subjective Expected Utility, in which everyone has his/her own utility and subjective probability. Disagreement on probabilities among individuals gives rise to uncertainty at the societal level, and thus society may entertain a set of probabilities rather than only one. We assume that social preference admits a Maxmin Expected Utility representation. In this context, two Pareto‐type conditions are shown to be equivalent to social utility being a weighted average of individual utilities and the social set of priors containing only weighted averages of individual priors. Thus, society respects consensus among individuals' beliefs and does not add ambiguity beyond disagreement on beliefs. We also deal with the case in which society does not rule out any individual belief.     

Market‐Triggered Changes in Capital Structure: Equilibrium Price Dynamics

We analyze the internal consistency of using the market price of a firm's equity to trigger a contractual change in the firm's capital structure, given that the value of the equity itself depends on the firm's capital structure. Of particular interest is the case of contingent capital for banks, in the form of debt that converts to equity, when conversion is triggered by a decline in the bank's stock price. We analyze the problem of existence and uniqueness of equilibrium values for a firm's liabilities in this context, meaning values consistent with a market‐price trigger. Discrete‐time dynamics allow multiple equilibria. In contrast, we show that the possibility of multiple equilibria can largely be ruled out in continuous time, where the price of the triggering security adjusts in anticipation of breaching the trigger. Our main condition for existence of an equilibrium requires that the consequences of triggering a conversion be consistent with the direction in which the trigger is crossed. For the design of contingent capital with a stock price trigger, this condition may be interpreted to mean that conversion should be disadvantageous to shareholders, and it is satisfied by setting the trigger sufficiently high. Uniqueness follows provided the trigger is sufficiently accessible by all candidate equilibria. We illustrate precise formulations of these conditions with a variety of applications.     

Earnings and Consumption Dynamics: A Nonlinear Panel Data Framework

We develop a new quantile‐based panel data framework to study the nature of income persistence and the transmission of income shocks to consumption. Log‐earnings are the sum of a general Markovian persistent component and a transitory innovation. The persistence of past shocks to earnings is allowed to vary according to the size and sign of the current shock. Consumption is modeled as an age‐dependent nonlinear function of assets, unobservable tastes, and the two earnings components. We establish the nonparametric identification of the nonlinear earnings process and of the consumption policy rule. Exploiting the enhanced consumption and asset data in recent waves of the Panel Study of Income Dynamics, we find that the earnings process features nonlinear persistence and conditional skewness. We confirm these results using population register data from Norway. We then show that the impact of earnings shocks varies substantially across earnings histories, and that this nonlinearity drives heterogeneous consumption responses. The framework provides new empirical measures of partial insurance in which the transmission of income shocks to consumption varies systematically with assets, the level of the shock, and the history of past shocks.     

Efficient Competition Through Cheap Talk: The Case of Competing Auctions

We consider a large market where auctioneers with private reservation values compete for bidders by announcing cheap‐talk messages. If auctioneers run efficient first‐price auctions, then there always exists an equilibrium in which each auctioneer truthfully reveals her type. The equilibrium is constrained efficient, assigning more bidders to auctioneers with larger gains from trade. The choice of the trading mechanism is crucial for the result. Most notably, the use of second‐price auctions (equivalently, ex post bidding) leads to the nonexistence of any informative equilibrium. We examine the robustness of our finding in various dimensions, including finite markets and equilibrium selection.     

Random Choice and Private Information

We consider an agent who chooses an option after receiving some private information. This information, however, is unobserved by an analyst, so from the latter's perspective, choice is probabilistic or random. We provide a theory in which information can be fully identified from random choice. In addition, the analyst can perform the following inferences even when information is unobservable: (1) directly compute ex ante valuations of menus from random choice and vice versa, (2) assess which agent has better information by using choice dispersion as a measure of informativeness, (3) determine if the agent's beliefs about information are dynamically consistent, and (4) test to see if these beliefs are well‐calibrated or rational.     

Supply Chain Conflict Due to Store Brands: The Value of Wholesale Price Commitment in a Retail Supply Chain*

Store brands are of increasing importance in retail supply chains, often causing channel conflict, as the retailer's product directly competes with the manufacturer's national brand. Extant research on the resulting channel interactions either assumes the national brand manufacturer can credibly commit to maintaining a wholesale price or that he lacks such ability. However, these two scenarios imply very different supply chain interactions, as only a national brand manufacturer with commitment ability can strategically adjust a national brand wholesale price to prevent a store brand introduction by the retailer. We specifically analyze the impact of this assumption on the manufacturer, the retailer, and the customers. We determine when long‐term contracts that provide the manufacturer with such commitment ability can improve supply chain profitability.