Annual Review of Economics - Volume 7, 2015

Incorporating the decision of how to organize the acquisition, use, and communication of knowledge into economic models is essential to understand a wide variety of economic phenomena. We survey the literature that has used knowledge-based hierarchies to study issues such as the evolution of wage inequality, the growth and productivity of firms, economic development, and the gains from international trade, as well as offshoring and the formation of international production teams. We also review the nascent empirical literature that has, so far, confirmed the importance of organizational decisions and many of their more salient implications.

International trade has experienced a Ricardian revival. In this article, we offer a user guide to assignment models, which we refer to as Ricardo-Roy (R-R) models, that have contributed to this revival.

Is the high degree of gender inequality in developing countries—in education, personal autonomy, and more—explained by underdevelopment itself? Or do the societies that are poor today hold certain cultural views that lead to gender inequality? This article discusses several mechanisms through which gender gaps narrow as countries grow. I argue that although much of the GDP/gender-inequality relationship can be explained by the process of development, society-specific factors are also at play: Many countries that are poor today have cultural norms that exacerbate favoritism toward males. Norms such as patrilocality and concern for women’s “purity” help explain the male-skewed sex ratio in India and China and low female employment in India, the Middle East, and North Africa, for example. I also discuss why the sex ratio has become more male-skewed with development. Finally, I lay out some policy approaches to address gender inequality.

The response of aggregate labor supply to various changes in the economic environment is central to many economic issues, including the optimal design of tax policies. Whereas the earlier literature often concluded that aggregate labor supply elasticities were small, we argue that recent work using structural models and micro data credibly supports large aggregate elasticities. We focus on three issues. First, earlier analyses abstracted from several key features, including human capital accumulation, that severely negatively biased estimates of a key preference parameter. Second, failure to understand that aggregate labor supply adjustments can occur along both the hours per worker and employment margins has led economists to misinterpret the implications of preference parameters for aggregate labor supply. Third, structural estimation of models that feature choice along the extensive margin using micro data typically finds large responses.

An emerging new literature brings unique ideas from corporate finance to the study of international trade and investment. Insights about differences in the development of financial institutions across countries, the role of financial constraints, and the use of internal capital markets are proving central in understanding international economics. The ability to access financial capital to pay fixed and variable costs affects choices firms make regarding export entry and operations and, as a consequence, influences aggregate trade patterns. Financial frictions and the use of internal capital markets shape decisions that multinationals make regarding production locations, integration, and corporate governance. This article surveys this recent research with the goal of highlighting the main themes it explores, the key results it establishes, and the leading open questions it raises.

The dynamic public finance literature underwent significant changes over the past decade. This research agenda has now reached a stage at which it is able to analyze the design of social insurance programs and optimal taxation in rich environments that can be closely matched to microeconomic data. We provide an overview of the recent advances in this literature, discuss the key trade-offs, and explain how the prescriptions for the optimal policy depend on the specific parameters that can be estimated in the data. We also describe the relationship between the dynamic mechanism design approach to optimal taxation and the approach that considers sophisticated tax functions chosen within parametrically restricted classes.

This article provides a review of recent literature in economics on the effect of mass media on politics. The focus is on the welfare effects of mass media. I also discuss the likely implications of existing behavioral theories of media effects, developed outside of economics.

This review provides an overview of forecasting methods that can help researchers forecast in the presence of nonstationarities caused by instabilities. The emphasis of the review is both theoretical and applied, and we provide several examples of interest to economists. We show that modeling instabilities can help, but it depends on how they are modeled. We also demonstrate how to robustify a model against instabilities.

I provide a critical overview of the literature on political decentralization. After reviewing first- and second-generation theories of federalism, I describe recent empirical studies focusing mainly on determinants of capture and local government accountability emphasized by second-generation theories. The article concludes by describing emerging new issues that deserve more attention in future research: a wider range of political distortions beyond capture and corruption; effects of decentralization on intercommunity allocations, learning, and experimentation, and on democracy itself; a comparison of decentralization with other organizational alternatives; and issues pertaining to design and implementation raised by first-generation federalism theories, such as interjurisdictional spillovers, vertical fiscal relations, the range of devolution, and the political economy of implementation.

Borrowing decisions affect most households, with large stakes and implications for research subfields as varied as macroeconomics and industrial organization. I review theoretical and empirical work on household debt: its prevalence, level, growth, and composition, as well as various measures of consumer choice and market (in)efficiency, elasticities, and prices, including new evidence on how borrowing heterogeneity affects the distribution of the opportunity cost of consumption. I also discuss opportunities and challenges in policy evaluation. A key takeaway is that puzzles abound, and I highlight numerous avenues for further research.

Foreign aid is one of the most important policy tools that rich countries use to help poor countries improve population well-being and facilitate economic and institutional development. The empirical evidence on its benefits is mixed and has generated much controversy. This article presents descriptive statistics that show that foreign aid to very poor countries accounts for very little of total global aid; reviews the evidence that foreign aid is often determined by the objectives of donor countries rather than the needs of recipient countries; argues that the evidence on the impact of aggregate foreign aid is hindered by problems of measurement and identification, which partly result from the heterogeneous nature of aid; and discusses recent studies using natural and randomized experiments to examine narrowed definitions of aid on more disaggregated outcomes.

Since the 2008 global financial crisis, and after decades of relative neglect, the importance of the financial system and its episodic crises as drivers of macroeconomic outcomes has attracted fresh scrutiny from academics, policy makers, and practitioners. Theoretical advances are following a lead set by a fast-growing empirical literature. Recent long-run historical work has uncovered a range of important stylized facts concerning financial instability and the role of credit in advanced economies, and this article provides an overview of the key findings.

Recent improvements in the data infrastructure at US statistical agencies have dramatically enhanced the ability to measure and study job creation and job destruction. The longitudinal data now permit the tracking of all firms and establishments in the US private sector in a comprehensive and integrated manner. This allows researchers to distinguish between the contribution of new firms and that of new establishments. In addition, firm entry, growth, and survival dynamics can be tracked in terms of organic changes instead of changes associated with mergers and acquisitions or other forms of business ownership changes. These new developments have led to a burgeoning literature on US firm dynamics. The recent literature has especially focused on the role of young businesses for job and productivity growth. The findings from that literature are the focus of the current article. The recent developments are discussed in light of the large literature on firm dynamics (in terms of both theory and empirics) that has developed over the past few decades.

Social norms are patterns of behavior that are self-enforcing within a group: Everyone conforms, everyone is expected to conform, and everyone wants to conform when they expect everyone else to conform. Social norms are often sustained by multiple mechanisms, including a desire to coordinate, fear of being sanctioned, signaling membership in a group, or simply following the lead of others. This article shows how stochastic evolutionary game theory can be used to study the resulting dynamics. I illustrate with a variety of examples drawn from economics, sociology, demography, and political science. These include bargaining norms, norms governing the terms of contracts, norms of retirement, dueling, foot binding, medical treatment, and the use of contraceptives. These cases highlight the challenges of applying the theory to empirical cases. They also show that the modern theory of norm dynamics yields insights and predictions that go beyond conventional equilibrium analysis.

In economic models of crime, changing economic incentives alter the participation of individuals in criminal activities. We critically appraise the work in this area. After a brief overview of the workhorse economics of crime model for organizing our discussion on crime and economic incentives, we first document the significant rise of the economics of crime as a research field and then go on to review the evidence on the relationship between crime and economic incentives. We divide this discussion into incentives operating through legal wages in the formal labor market and the economic returns to illegal activities. Evidence that economic incentives matter for crime emerges from both.

We review both the theoretical and empirical literature on entrepreneurship and financial frictions, with an emphasis on the heterogeneous and dynamic microlevel implications of financial frictions for macrodevelopment.

Electricity restructuring in the 1990s ended the era of vertically integrated monopolies in many states, allowing nonutility generators to sell electricity to utilities and, in fewer states, allowing retail service providers to buy electricity from generators and sell to end-use customers. We review the economic arguments for restructuring and the resulting effects in subsequent years. We argue that the greatest political motivation for restructuring was rent shifting, not efficiency improvements. Although electricity restructuring has brought efficiency improvements, it has generally been viewed as a disappointment because the price-reduction promises made by some advocates were based on politically unsustainable rent transfers. In reality, electricity rate changes since restructuring have been driven more by exogenous factors, such as generation technology advances and natural gas price fluctuations, than by restructuring. We argue that a similar dynamic underpins the current political momentum behind distributed generation, primarily rooftop solar photovoltaic systems, which remains costly from a societal viewpoint, but privately economic owing to the rent transfers it enables.

Social and economic networks are ubiquitous, serving as contexts for job search, technology diffusion, the accumulation of human capital, and even the formulation of norms and values. The systematic empirical study of network formation—the process by which agents form, maintain, and dissolve links—within economics is recent, is associated with extraordinarily challenging modeling and identification issues, and is an area of exciting new developments, with many open questions. This article reviews prominent research on the empirical analysis of network formation, with an emphasis on contributions made by economists.

The use of race in college admissions is one of the most contentious issues in US higher education. We survey the literature on the impact of racial preferences in college admissions on both minority and majority students. With regard to minority students, particular attention is paid to the scope of preferences as well as how preferences affect graduation, choice of major, and labor market earnings. We also examine how schools respond to bans on racial preferences and the effects these responses have on racial diversity at elite schools. With regard to majority students, we examine the evidence on the returns to attending a more racially diverse school, as well as how racial preferences affect friendship formation. Finally, we supplement studies of affirmative action in the United States with evidence from India, which provides a much more straightforward environment in which to study affirmative action owing to the use of quotas and admissions rules based solely on exam scores.

This article surveys the existing evidence on the return to a college education and offers new calculations based on recent data. We focus on an individual’s decision and outline the standard conceptual framework used by economists to analyze investments in education. We then compare alternative estimates of the value of a college education in the literature and reconcile them with our own preferred estimates. We also conduct a selective review of the literature seeking to estimate the causal effects of college on pecuniary and nonpecuniary outcomes. Finally, we provide additional calculations showing the heterogeneity in returns to college across certain institutional and demographic characteristics, review the related academic literature, and discuss the risk associated with a college investment. We conclude that college is certainly a worthwhile investment on average and likely worthwhile for many subgroups, although not necessarily for everyone.