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Annual Review of Economics - Volume 2, 2010
Volume 2, 2010
- Preface
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Questions in Decision Theory
Vol. 2 (2010), pp. 1–19More LessThis review surveys a few major questions in the field of decision theory. It is argued that a re-examination of some of the fundamental concepts in decision theory may have important implications to theoretical and even empirical research in economics and related fields.
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Structural Estimation and Policy Evaluation in Developing Countries
Vol. 2 (2010), pp. 21–50More LessThis review discusses the use of discrete choice dynamic programming (DCDP) methods for evaluating policies of particular relevance to developing countries, such as policies to reduce child labor and increase school attendance, improve school quality, affect immigration flows, expand old-age pension benefits, or foster small-business investment through microfinance. We describe the DCDP framework and how it relates to static models, illustrate its application with an example related to conditional cash transfer programs, consider numerous empirical applications from the literature of how the DCDP methodology has been used to address substantively important policy issues, and discuss methods for model validation.
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Currency Unions in Prospect and Retrospect
Vol. 2 (2010), pp. 51–74More LessWe critically review the recent literature on currency unions and discuss the methodological challenges posed by the empirical assessment of their costs and benefits. In the process, we provide evidence on the economic effects of the euro. In particular, and in contrast with estimates of the trade effect of other currency unions, we find that the euro's impact on trade has been close to zero. After reviewing the costs and benefits of joining a currency union, we conclude with some open questions on normative and positive aspects of the theory of currency unions, emphasizing the need for a unified welfare-based framework to weigh their costs and gains.
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Hypothesis Testing in Econometrics
Vol. 2 (2010), pp. 75–104More LessThis article reviews important concepts and methods that are useful for hypothesis testing. First, we discuss the Neyman-Pearson framework. Various approaches to optimality are presented, including finite-sample and large-sample optimality. Then, we summarize some of the most important methods, as well as resampling methodology, which is useful to set critical values. Finally, we consider the problem of multiple testing, which has witnessed a burgeoning literature in recent years. Along the way, we incorporate some examples that are current in the econometrics literature. While many problems with well-known successful solutions are included, we also address open problems that are not easily handled with current technology, stemming from such issues as lack of optimality or poor asymptotic approximations.
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Recent Advances in the Empirics of Organizational Economics
Vol. 2 (2010), pp. 105–137More LessWe present a survey of recent contributions in empirical organizational economics, focusing on management practices and decentralization. Productivity dispersion between firms and countries has motivated the improved measurement of firm organization across industries and countries. There appears to be substantial variation in management practices and decentralization not only between countries, but also especially within countries. Much of the poorer average management quality in countries like Brazil and India seems to result from a long tail of poorly managed firms, which barely exist in the United States. Some stylized facts include the following: (a) Competition seems to foster improved management and decentralization; (b) larger firms, skill-intensive plants, and foreign multinationals appear better managed and are more decentralized; (c) firms that are both family owned and managed appear to have worse management and are more centralized; and (d) firms facing an environment of lighter labor market regulations and more human capital specialize relatively more in people management. There is evidence for complementarities between information and communication technology, decentralization, and management, but the relationship is complex, and identification of the productivity effects of organizational practices remains a challenge for future research.
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Regional Trade Agreements
Vol. 2 (2010), pp. 139–166More LessThis article reviews the theoretical and the empirical literature on regionalism. The formation of regional trade agreements has been, by far, the most popular form of reciprocal trade liberalization in the past 15 years. The discriminatory character of these agreements has raised three main concerns: that trade diversion would be rampant, because special interest groups would induce governments to form the most distortionary agreements; that broader external trade liberalization would stall or reverse; and that multilateralism could be undermined. Theoretically, all these concerns are legitimate, although there are also several theoretical arguments that oppose them. Empirically, neither widespread trade diversion nor stalled external liberalization has materialized, whereas the undermining of multilateralism has not been properly tested. There are also several aspects of regionalism that have received too little attention from researchers, but which are central to understanding its causes and consequences.
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Partial Identification in Econometrics
Vol. 2 (2010), pp. 167–195More LessIdentification in econometric models maps prior assumptions and the data to information about a parameter of interest. The partial identification approach to inference recognizes that this process should not result in a binary answer that consists of whether the parameter is point identified. Rather, given the data, the partial identification approach characterizes the informational content of various assumptions by providing a menu of estimates, each based on different sets of assumptions, some of which are plausible and some of which are not. Of course, more assumptions beget more information, so stronger conclusions can be made at the expense of more assumptions. The partial identification approach advocates a more fluid view of identification and hence provides the empirical researcher with methods to help study the spectrum of information that we can harness about a parameter of interest using a menu of assumptions. This approach links conclusions drawn from various empirical models to sets of assumptions made in a transparent way. It allows researchers to examine the informational content of their assumptions and their impacts on the inferences made. Naturally, with finite sample sizes, this approach leads to statistical complications, as one needs to deal with characterizing sampling uncertainty in models that do not point identify a parameter. Therefore, new methods for inference are developed. These methods construct confidence sets for partially identified parameters, and confidence regions for sets of parameters, or identifiable sets.
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Intergenerational Equity
Vol. 2 (2010), pp. 197–222More LessAxiomatic analysis of intergenerational social preferences over infinite streams of well-being faces the following dilemma. Equal treatment of generations combined with sensitivity for the interests of each generation rules out explicitly defined preferences that can rank any pair of infinite well-being streams. Hence, either intergenerational social preferences must be incomplete or equal treatment and sensitivity must be compromised. This critical review of axiomatic analyses of preferences over infinite streams evaluates different kinds of intergenerational social preferences by comparing their axiomatic basis as well as their performance in simple present-future conflicts. The scope for application is discussed, using real-world intergenerational conflicts (such as global warming) as a backdrop.
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The World Trade Organization: Theory and Practice
Vol. 2 (2010), pp. 223–256More LessWe consider the purpose and design of the World Trade Organization (WTO) and its predecessor, the General Agreement on Tariffs and Trade (GATT), and review recent developments in the relevant theoretical and empirical literature. We describe the GATT/WTO architecture and briefly trace its historical antecedents. We suggest that the existing literature provides a useful framework for understanding and interpreting central features of the design and practice of the GATT/WTO, and we identify key unresolved issues.
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How (Not) to Do Decision Theory
Vol. 2 (2010), pp. 257–282More LessWe discuss the goals and means of positive decision theory and the implications for how to do decision theory. We argue that the goal of positive economic theory generally is to provide predictions and understanding and that representation theorems and other results of decision theory should be seen as ways to achieve these goals. We also argue that the interpretation of a model is relevant to whether and how we use the model, that psychological considerations are not necessary for useful decision theory but can be helpful, and that nonchoice data, interpreted properly, can be valuable in predicting choice and therefore should not be ignored.
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Health, Human Capital, and Development
Vol. 2 (2010), pp. 283–310More LessHow much does disease depress development in human capital and income around the world? I discuss a range of micro evidence, which finds that health is both human capital itself and an input to producing other forms of human capital. I use a standard model to integrate these results and suggest a reinterpretation of much of the micro literature. I then discuss the aggregate implications of micro estimates but note the complications in extrapolating to general equilibrium, especially because of health's effect on population size. I also review the macro evidence on this topic, which consists of either cross-country comparisons or measuring responses to health shocks. Micro estimates are one to two orders of magnitude smaller than the cross-country relationship but nevertheless imply high benefit-to-cost ratios from improving certain forms of health.
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Beyond Testing: Empirical Models of Insurance Markets
Vol. 2 (2010), pp. 311–336More LessWe describe recent advances in the empirical analysis of insurance markets. This new research proposes ways to estimate individual demand for insurance and the relationship between prices and insurer costs in the presence of adverse and advantageous selection. We discuss how these models permit the measurement of welfare distortions arising from asymmetric information and the welfare consequences of potential government policy responses. We also discuss some challenges in modeling imperfect competition between insurers and outline a series of open research questions.
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Inside Organizations: Pricing, Politics, and Path Dependence
Vol. 2 (2010), pp. 337–365More LessWhen economists have considered organizations, much attention has focused on the boundary of the firm, rather than its internal structures and processes. In contrast, this review sketches three approaches to the economic theory of internal organization—one substantially developed, another rapidly emerging, and a third on the horizon. The first approach (pricing) applies Pigou's prescription: If markets get prices wrong, then the economist's job is to fix the prices. The second approach (politics) considers environments where important actions inside organizations simply cannot be priced, so power and control become central. Finally, the third approach (path dependence) complements the first two by shifting attention from the between variance to the within. That is, rather than asking how organizations confronting different circumstances should choose different structures and processes, the focus here is on how path dependence can cause persistent performance differences among seemingly similar enterprises.
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Identification of Dynamic Discrete Choice Models
Vol. 2 (2010), pp. 367–394More LessEconometric models of dynamic discrete choice processes are applied to a wide variety of economic problems. Recent research on their empirical content has brought important new insights. It has clarified the conditions for their identification from choice and covariate panel data in the absence of dynamic selection on unobservables. It has provided important new identification results for discrete-time models with unobserved heterogeneity and unobserved states. Finally, it has enhanced the attractiveness of continuous-time models, by developing new insights on the identification of continuous-time optimal stopping models. Current developments in the literature promise to shed further light on the specification and identification of models with unobserved state variables, theory-based nonproportional hazard models, continuous-time optimal stopping models with time-varying covariates, and dynamic games in discrete and continuous time.
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Microeconomics of Technology Adoption
Vol. 2 (2010), pp. 395–424More LessDifferences in technology levels across countries account for a large component of the differences in wages and per-capita GDP across countries worldwide. This article reviews micro studies of the adoption of new technologies and the use of inputs complementary with new technologies to shed light on the barriers to technology diffusion in low-income countries. Among the factors examined affecting decisions pertaining to technology choice and input allocations are the financial and nonfinancial returns to adoption, one's own learning and social learning, technological externalities, scale economies, schooling, credit constraints, risk and incomplete insurance, and departures from behavioral rules implied by simple models of rationality.
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Heterogeneity, Selection, and Wealth Dynamics
Vol. 2 (2010), pp. 425–450More LessThe market selection hypothesis states that, among expected utility maximizers, competitive markets select for agents with correct beliefs. In some economies this hypothesis holds, whereas in others it fails. It holds in complete-markets economies with a common discount factor and bounded aggregate consumption. It can fail when markets are incomplete, when consumption grows too quickly, or when discount factors and beliefs are correlated. These insights have implications for the general equilibrium modeling of asset prices and macroeconomic phenomena.
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Social Interactions
Vol. 2 (2010), pp. 451–478More LessThe study of social interactions has enriched both the domain of inquiry of economists and the way economists conceptualize individual decision making. The review aims to introduce the classes of models that accommodate estimation of social interactions and to examine the key areas where significant advances have been made in the identification of social effects. It surveys linear and nonlinear models and their applications, including results regarding partial identification. The review also examines conceptual and methodological links with the spatial econometrics and the social networks literatures. It considers empirical applications in the context of our methodological overview.
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The Consumption Response to Income Changes
Vol. 2 (2010), pp. 479–506More LessWe review different empirical approaches that researchers have taken to estimate how consumption responds to income changes. We critically evaluate the empirical evidence on the sensitivity of consumption to predicted income changes, distinguishing between the traditional excess sensitivity tests and the effect of predicted income increases and income declines. We also review studies that attempt to estimate the marginal propensity to consume out of income shocks, distinguishing between three different approaches: identifying episodes in which income changes unexpectedly, relying on the covariance restrictions that the theory imposes on the joint behavior of consumption and income growth, and combining realizations and expectations of income or consumption in surveys in which data on subjective expectations are available.
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Financial Structure and Economic Welfare: Applied General Equilibrium Development Economics
Vol. 2 (2010), pp. 507–546More LessThis review provides a common framework for researchers thinking about the next generation of micro-founded macro models of growth, inequality, and financial deepening, as well as direction for policy makers targeting microfinance programs to alleviate poverty. Topics include treatment of financial structure general equilibrium models: testing for as-if-complete markets or other financial underpinnings; examining dual-sector models with both a perfectly intermediated sector and a sector in financial autarky, as well as a second generation of these models that embeds information problems and other obstacles to trade; designing surveys to capture measures of income, investment/savings, and flow of funds; and aggregating individuals and households to the level of network, village, or national economy. The review concludes with new directions that overcome conceptual and computational limitations.
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Models of Growth and Firm Heterogeneity
Vol. 2 (2010), pp. 547–576More LessAlthough employment at individual firms tends to be highly nonstationary, the employment size distribution of all firms in the United States appears to be stationary. It closely resembles a Pareto distribution. There is a lot of entry and exit, mostly of small firms. This review surveys general equilibrium models that can be used to interpret these facts and explores the role of innovation by new and incumbent firms in determining aggregate growth. The existence of a balanced growth path with a stationary employment size distribution depends crucially on assumptions made about the cost of entry. Some type of labor must be an essential input in setting up new firms.
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Labor Market Models of Worker and Firm Heterogeneity
Vol. 2 (2010), pp. 577–602More LessMicroeconomic data on individual firms and employer-employee matches reveal substantial and persistent dispersion in firm size, productivity, and average wage paid and a positive correlation between each pair. To the extent that intrinsic differences in firm productivity explain these facts, there are several important consequences. First, the reallocation of employment from less to more productive firms will yield efficiency gains. Second, workers will find it in their interest to seek out higher-paying employers. Recent research has provided support for both hypotheses. Third, the existence of worker and employer heterogeneity offers possible gains from sorting. However, because the problem of identifying the presence of sorting is model dependent, it is too early for conclusions about its significance.
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The Changing Nature of Financial Intermediation and the Financial Crisis of 2007–2009
Vol. 2 (2010), pp. 603–618More LessThe current financial crisis has highlighted the changing role of financial institutions and the growing importance of the shadow banking system, which grew on the back of the securitization of assets and the integration of banking with capital market developments. This trend has been most pronounced in the United States but has had a profound influence on the global financial system as a whole. In a market-based financial system, banking and capital market developments are inseparable, and funding conditions are closely tied to the fluctuations in leverage of market-based financial intermediaries. Balance-sheet growth of market-based financial intermediaries provides a window on liquidity in the sense of the availability of credit, whereas financial crises tend to be associated with contractions of balance sheets. We describe the changing nature of financial intermediation in the market-based financial system, chart the course of the recent financial crisis, and outline the policy responses that have been implemented by the Federal Reserve and other central banks to counter it.
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Competition and Productivity: A Review of Evidence
Vol. 2 (2010), pp. 619–642More LessDoes competition spur productivity? And if so, how does it accomplish this? These have long been regarded as central questions in economics. This article reviews the literature that makes progress toward answering both questions.
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Persuasion: Empirical Evidence
Vol. 2 (2010), pp. 643–669More LessWe provide a selective survey of empirical evidence on the effects as well as the drivers of persuasive communication. We consider persuasion directed at consumers, voters, donors, and investors. We organize our review around four questions. First, to what extent does persuasion affect the behavior of each of these groups? Second, what models best capture the response to persuasive communication? Third, what are persuaders' incentives, and what limits their ability to distort communications? Finally, what evidence exists on the way persuasion affects equilibrium outcomes in economics and politics?
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Commitment Devices
Vol. 2 (2010), pp. 671–698More LessWe review the recent evidence on commitment devices and discuss how this evidence relates to theoretical questions about the demand for, and effectiveness of, commitment. Several important distinctions emerge. First, we distinguish between what we call hard and soft commitments and identify how soft commitments, in particular, can help with various dilemmas, both in explaining empirical behavior and in designing effective commitment devices. Second, we highlight the importance of certain modeling assumptions in predicting when commitment devices will be demanded and examine the laboratory and field evidence on the demand for commitment devices. Third, we present the evidence on both informal and formal commitment devices, and we conclude with a discussion of policy implications, including sin taxes, consumer protection, and commitment device design.
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