Annual Review of Economics - Volume 6, 2014

Many decisions are made under uncertainty, and individuals are likely to form subjective expectations about the probabilities of events that are relevant to their decisions. I review here a recent and growing literature that uses probabilistic expectations elicited from survey respondents in developing countries. I first present an illustrative model of one particular decision under uncertainty—the choice of a college—to exemplify the importance of subjective expectations data for identification purposes. I then review existing evidence emphasizing that it is feasible to elicit probabilities from survey respondents in low-literacy settings and describe common patterns of answers. Finally, I describe existing applications, many of which seek to assess how expectations influence behavior, in various domains, including health, education, agricultural production, and migration.

A parameter of an econometric model is identified if there is a one-to-one or many-to-one mapping from the population distribution of the available data to the parameter. Often, this mapping is obtained by inverting a mapping from the parameter to the population distribution. If the inverse mapping is discontinuous, then estimation of the parameter usually presents an ill-posed inverse problem. Such problems arise in many settings in economics and other fields in which the parameter of interest is a function. This article explains how ill-posedness arises and why it causes problems for estimation. The need to modify or regularize the identifying mapping is explained, and methods for regularization and estimation are discussed. Methods for forming confidence intervals and testing hypotheses are summarized. It is shown that a hypothesis test can be more precise in a certain sense than an estimator. An empirical example illustrates estimation in an ill-posed setting in economics.

Baby boomers are now retiring in large numbers, and most do not have enough assets of their own to finance retirement. Social insurance programs help baby boomers afford retirement, but these programs are substantially underfunded. Reforming these institutions earlier will produce fewer distortions than continued delays. Several options also exist for helping households prepare for their own retirement: improving financial literacy, more opt-out defaults, better guidance about the value of delaying retirement, better guidance about delaying the claiming of social security benefits, improved estimation of out-of-pocket medical costs, and understanding the incentives facing their financial advisors. Some of these options are likely to be more effective than others.

This article reviews a number of recent contributions to estimation and inference for models defined by moment condition restrictions. The particular emphasis is on the generalized empirical likelihood class of estimators as an alternative to the generalized method of moments. Estimation methods for parameters defined through moment restrictions and their properties are described with tests of overidentifying moment restrictions and parametric hypotheses. Computational issues are discussed together with some proposals for their amelioration. Higher-order and other properties are also addressed in some detail. Models specified by conditional moment restriction models are considered, and the adaptation of these methods to weakly dependent data is discussed.

One constraint we face as economists is not being able to observe all the relevant variables required to test our theories or make policy prescriptions. Laboratory techniques allow us to convert many variables (such as beliefs) that are unobservable in the field into observables. This article presents a survey of the literature on belief elicitation in laboratory experimental economics. We discuss several techniques available to elicit beliefs in an incentive-compatible manner and the problems involved in their use. We then look at how successful these techniques have been when employed in laboratory studies. We find that despite some problems, beliefs elicited in the laboratory are meaningful (i.e., they are generally used as the basis for behavior), and the process of eliciting beliefs seems not to be too intrusive. One hope for the future is that by eliciting beliefs, we may be able to develop better theories of belief formation.

This article surveys the theoretical literature in which people are modeled as taking other people’s payoffs into account either because this affects their utility directly or because they wish to impress others with their social-mindedness. Key experimental results that bear on the relevance of these theories are discussed as well. Five types of models are considered. In the first, an individual’s utility function is increasing in the payoffs of other people. The more standard version of these preferences supposes that only consumption leads to payoffs and has trouble explaining prosocial actions such as voting and charitable contributions by poor individuals. If one lets other variables determine happiness as well, this model can explain a much wider set of observations. The second type of model surveyed involves people trying to demonstrate to others that they have prosocial (or altruistic) preferences. In these models, altruistic acts need not have a direct effect on utility. The third class of models includes those of reciprocity in which people’s altruism depends on whether others act kindly or unkindly toward them. In the fourth type of model, inequality has a profound effect on altruism, with individuals being spiteful toward people whose resources exceed their own. Finally, I discuss the fifth type of model, in which specifications of altruism might have to be modified to take into account how people behave when they are able to transfer lotteries to others.

This article considers recent literature on optimal monetary policy in simple open-economy models. The presence of pricing to market, incomplete financial markets, and differences in preferences among households (in different countries) introduces some fundamental differences between closed- and open-economy New Keynesian models. In addition to the goals of stabilizing inflation and the output gap, policy makers may target currency misalignments and global imbalances. Optimal policies may involve targeting the exchange rate both directly, because of currency misalignments, and indirectly, because of the effects of exchange rates on imbalances, inflation, and output gaps.

Copulas are functions that describe the dependence between two or more random variables. This article provides a brief review of copula theory and two areas of economics in which copulas have played important roles: multivariate modeling and partial identification of parameters that depend on the joint distribution of two random variables with fixed or known marginal distributions. We focus on bivariate copulas but provide references on recent advances in constructing higher-dimensional copulas.

In this article, we introduce an empirical framework to analyze how firm performance is affected by increased globalization. Using this framework, we discuss recent work on measuring the impact of various shocks firms face in the global marketplace, such as reductions in trade costs (through lowering tariffs and abolishing quotas). Our analytical framework nests most empirical approaches to estimating the impact of trade and industrial policies on firms active in international markets. We identify outstanding issues surrounding the identification of the underlying mechanisms and conclude with suggestions for future research.

In recent years, the econometrics literature has shown a growing interest in the study of partially identified models, in which the object of economic and statistical interest is a set rather than a point. The characterization of this set and the development of consistent estimators and inference procedures for it with desirable properties are the main goals of partial identification analysis. This review introduces the fundamental tools of the theory of random sets, which brings together elements of topology, convex geometry, and probability theory to develop a coherent mathematical framework to analyze random elements whose realizations are sets. It then elucidates how these tools have been fruitfully applied in econometrics to reach the goals of partial identification analysis.

In the past 10 years, there has been an explosion of well-identified studies that measure peer effects across many settings and for many outcomes. The emphasis on natural experiments and randomization is a highly useful one; in more standard observational studies, the self-selection of people into peer groups can make the measurement of peer effects extremely difficult. In the absence of exogenous variation, knowing that people have similar outcomes as their friends, classmates, and coworkers may tell us little about peer effects. I examine the successes, failures, and findings of experimental analyses of peer effects. I draw three broad conclusions. First, even more than in other areas of social science, the size and nature of peer effects estimated are highly context specific; peer effects in student test scores and grades are prominent in some cases and absent in others. That said, there is a pattern across studies suggesting that social outcomes (e.g., crime, drinking behavior) and career choices show larger peer influences than do test scores. Second, researchers have shown that the linear-in-means model of peer effects is often not a good description of the world, although we do not yet have an agreed-upon model to replace it. Third, despite potential temptation, we have not reached the point at which we can reliably use knowledge of peer effects to implement policies that improve outcomes for students and other human subjects.

The eductive approach consists of finding solutions consistent with common knowledge of individual rationality and the model. An equilibrium is stable whenever it is the unique outcome consistent with these assumptions. This is a strong stability criterion as it relies on no assumption of prior knowledge of others’ expectations. This review presents various (in)stability results. It focuses on the following method: Rewrite the model as a temporary equilibrium map in which the current economic outcome is determined by expectations and characterize stability by contracting properties of this map. The main insight suggested by these results is due to Guesnerie (2002): Stability is obtained when the actual outcome is not very sensitive to expectations. Additional insights include that agents’ heterogeneity is a source of instability; the ability of prices to transmit information is limited by the quality of private information; and coordination when agents are infinitely lived is difficult because of the large effect of long-run expectations.

In the 1990s, Sudden Stops in emerging markets were a harbinger of the 2008 global financial crisis. During these Sudden Stops, countries lost access to credit, which caused abrupt current account reversals, and suffered severe recessions. This article reviews a class of models that yield quantitative predictions consistent with these observations, based on an occasionally binding credit constraint that limits debt to a fraction of the market value of incomes or assets used as collateral. Sudden Stops are infrequent events nested within regular business cycles and occur in response to standard shocks after periods of expansion increase leverage ratios sufficiently. When this happens, the Fisherian debt-deflation mechanism is set in motion, as lower asset or goods prices tighten the constraint further, causing further deflation. This framework also embodies a pecuniary externality with important implications for macroprudential policy because agents do not internalize how current borrowing decisions affect collateral values during future financial crises.

A recent wave of economic research has studied the transformation of China from a poor country in the 1970s to a middle-income economy today. Based on this literature, we discuss the factors driving China’s development process. We provide a historical account of China’s rise, fall, and resurgence. We then discuss the stylized facts associated with China’s growth process and review a comprehensive theory of its economic transition. Finally, we discuss China’s future. In particular, we review some recent studies about technological and politico-economic factors that may foster or hinder its future economic performance.

Many explanations have been offered for the British Industrial Revolution. This article points to the importance of human capital (broadly defined) and the quality of the British labor force on the eve of the Industrial Revolution. It shows that in terms of both physical quality and mechanical skills, British workers around 1750 were at a much higher level than their continental counterparts. As a result, new inventions—no matter where they originated—were adopted earlier, faster, and on a larger scale in Britain than elsewhere. The gap in labor quality is consistent with the higher wages paid in eighteenth-century Britain. The causes for the higher labor quality are explored and found to be associated with a higher level of nutrition and better institutions, especially England’s Poor Law and the superior functioning of its apprenticeship system.

We review literature examining the effects of laws and regulations that require public disclosure of information. These requirements are most sensibly imposed in situations characterized by misaligned incentives and asymmetric information between, for example, a buyer and seller or an advisor and advisee. We review the economic literature relevant to such disclosure and then discuss how different psychological factors complicate, and in some cases radically change, the economic predictions. For example, limited attention, motivated attention, and biased assessments of probability on the part of information recipients can significantly diminish, or even reverse, the intended effects of disclosure requirements. In many cases, disclosure does not much affect the recipients of the information but does significantly affect the behavior of the providers, sometimes for the better and sometimes for the worse. We review research suggesting that simplified disclosure, standardized disclosure, vivid disclosure, and social comparison information can all be used to enhance the effectiveness of disclosure policies.

The rational expectations hypothesis is one of the cornerstones of current economic theorizing. This review discusses a number of experiments that focus on expectation formation by human subjects in a number of learning-to-forecast experiments and analyzes the implications for the rational expectations hypothesis. In these experiments, most agents are rational in an operational sense, and their expectations coordinate quickly, but not necessarily on the rational expectations value. In several situations, the homogeneous rational expectations hypothesis of Lucas and Prescott poorly describes the expectational dynamics and is outperformed by other hypotheses. But even in those situations in which the hypothesis gives a good description, it is more likely that coordination on rational values is brought about by the institutional structure of the market rather than the rationality of the agents.

This article reviews the literature on the optimal design and regulation of funded pension schemes. We first characterize optimal saving and investment over an individual’s life cycle. Within a stylized modeling framework, we explore optimal individual saving and investing behavior. Subsequently, various extensions of the model are considered, such as additional financial risk factors, stochastic human capital, and more elaborate individual preferences. We then turn to the literature on intergenerational risk sharing, which suggests that a long-lived entity such as a pension fund or the government can yield ex ante welfare gains by allowing nonoverlapping generations to trade risk. The scope for this type of intergenerational risk sharing, however, is limited by the ability to commit generations to the contract. These commitment problems raise concerns with respect to sustainability and intergenerational fairness. We explore the role of solvency regulations to address these concerns about intergenerational fairness and discontinuity risk.

Household-level data on consumer expenditures underpin a wide range of empirical research in modern economics, spanning micro- and macroeconomics. This research includes work on consumption and saving, on poverty and inequality, and on risk sharing and insurance. We review different ways in which such data can be collected or captured: traditional detailed budget surveys, less onerous survey procedures that might be included in more general surveys, and administrative or process data. We discuss the advantages and difficulties of each approach and suggest directions for future investigation.