Sharing a River

A group of agents located along a river have quasi-linear preferences over water and money. We ask how the water should be allocated and what money transfers should be performed. We are interested in efficiency, stability (in the sense of the core), and fairness (in a sense to be defined). We first show that the cooperative game associated with our problem is convex : its core is therefore large and easily described. Next, we propose the following fairness requirement : no group of agents should enjoy a welfare higher than what it could achieve in the absence of the remaining agents. We prove that only one welfare vector in the core satisfies this condition : it is the marginal contribution vector corresponding to the ordering of the agents along the river. We discuss how it could be decentralized or implemented.

Core Retionalizability in Two-Agent Exchange Economies.

We provide a characterization of selection correspondences in two-person exchange economies that can be core rationalized in the sense that there exists a preference profile with some standard properties that generates the observed choices as the set of core elements of the economy for any given initial endowment vector. The approach followed in this paper deviates from the standard rational choice model in that a rationalization in terms of a profile of individual orderings rather than in terms of a single individual or social preference relation is analyzed.

Non-Deteriorating Choice

We analyze an alternative to the standard rationalizability requirement for observed choices by considering non-deteriorating selections. A selection function is a generalization of a choice function where selected alternatives may depend on a reference (or status quo) alternative in addition to the set of feasible options. A selection function is non-deteriorating if there exists an ordering over the universal set of alternatives such that the selected alternatives are at least as good as the reference option. We characterize non-deteriorating selection functions in an abstract framework and in an economic environment.

Ranking Sets of Objects

We provide a survey of the literature on ranking sets of objects. The interpretations of those set rankings include those employed in the theory of choice under complete uncertainty, rankings of opportunity sets, set rankings that appear in matching theory, and the structure of assembly preferences. The survey is prepared for the Handbook of Utility Theory, vol. 2, edited by Salvador Barberà, Peter Hammond, and Christian Seidl, to be published by Kluwer Academic Publishers. The chapter number is provisional.

Asymmetric Smiles, Leverage Effects and Structural Parameters.

In this paper, we characterize the asymmetries of the smile through multiple leverage effects in a stochastic dynamic asset pricing framework. The dependence between price movements and future volatility is introduced through a set of latent state variables. These latent variables can capture not only the volatility risk and the interest rate risk which potentially affect option prices, but also any kind of correlation risk and jump risk. The standard financial leverage effect is produced by a cross-correlation effect between the state variables which enter into the stochastic volatility process of the stock price and the stock price process itself. However, we provide a more general framework where asymmetric implied volatility curves result from any source of instantaneous correlation between the state variables and either the return on the stock or the stochastic discount factor. In order to draw the shapes of the implied volatility curves generated by a model with latent variables, we specify an equilibrium-based stochastic discount factor with time non-separable preferences. When we calibrate this model to empirically reasonable values of the parameters, we are able to reproduce the various types of implied volatility curves inferred from option market data.

Empirical Assessment of an Intertemporal Option Pricing Model with Latent variables

This paper assesses the empirical performance of an intertemporal option pricing model with latent variables which generalizes the Hull-White stochastic volatility formula. Using this generalized formula in an ad-hoc fashion to extract two implicit parameters and forecast next day S&P 500 option prices, we obtain similar pricing errors than with implied volatility alone as in the Hull-White case. When we specialize this model to an equilibrium recursive utility model, we show through simulations that option prices are more informative than stock prices about the structural parameters of the model. We also show that a simple method of moments with a panel of option prices provides good estimates of the parameters of the model. This lays the ground for an empirical assessment of this equilibrium model with S&P 500 option prices in terms of pricing errors.

On the Political Economy of Sequential Reforms

This paper proposes an explanation for why efficient reforms are not carried out when losers have the power to block their implementation, even though compensating them is feasible. We construct a signaling model with two-sided incomplete information in which a government faces the task of sequentially implementing two reforms by bargaining with interest groups. The organization of interest groups is endogenous. Compensations are distortionary and government types differ in the concern about distortions. We show that, when compensations are allowed to be informative about the government’s type, there is a bias against the payment of compensations and the implementation of reforms. This is because paying high compensations today provides incentives for some interest groups to organize and oppose subsequent reforms with the only purpose of receiving a transfer. By paying lower compensations, governments attempt to prevent such interest groups from organizing. However, this comes at the cost of reforms being blocked by interest groups with relatively high losses.

Trade Liberalization and the Profitability of Domestic Mergers.

It is often thought that a tariff reduction, by opening up the domestic market to foreign firms, should lessen the need for a policy aimed at discouraging domestic mergers. This implicitly assumes that the tariff in question is sufficiently high to prevent foreign firms from selling in the domestic market. However, not all tariffs are prohibitive, so that foreign firms may be present in the domestic market before it is abolished. Furthermore, even if the tariff is prohibitive, a merger of domestic firms may render it nonprohibitive, thus inviting foreign firms to penetrate the domestic market. In this paper, we show, using a simple example, that in the latter two cases, abolishing the tariff may in fact make the domestic merger more profitable. Hence, trade liberalization will not necessarily reduce the profitability of domestic mergers.

Rank Regressions, Wage Distributions and the Gender Gap.

In this paper, we model the interactions between the distribution of male and female wages under the assumption that any change in the wage distribution of women must be offset by an opposite change in the wage distribution of men.

Tests of Conditional Asset Pricing Models in the Brazilian Stock Market

In this paper, we test a version of the conditional CAPM with respect to a local market portfolio, proxied by the Brazilian stock index during the 1976-1992 period. We also test a conditional APT model by using the difference between the 30-day rate (Cdb) and the overnight rate as a second factor in addition to the market portfolio in order to capture the large inflation risk present during this period. The conditional CAPM and APT models are estimated by the Generalized Method of Moments (GMM) and tested on a set of size portfolios created from a total of 25 securities exchanged on the Brazilian markets. The inclusion of this second factor proves to be crucial for the appropriate pricing of the portfolios.

How do Young People Choose College Majors?

Previous studies on the determinants of the choice of college major have assumed a constant probability of success across majors or a constant earnings stream across majors. Our model disregards these two restrictive assumptions in computing an expected earnings variable to explain the probability that a student will choose a specific major among four choices of concentrations. The construction of an expected earnings variable requires information on the student s perceived probability of success, the predicted earnings of graduates in all majors and the student s expected earnings if he (she) fails to complete a college program. Using data from the National Longitudinal Survey of Youth, we evaluate the chances of success in all majors for all the individuals in the sample. Second, the individuals' predicted earnings of graduates in all majors are obtained using Rumberger and Thomas's (1993) regression estimates from a 1987 Survey of Recent College Graduates. Third, we obtain idiosyncratic estimates of earnings alternative of not attending college or by dropping out with a condition derived from our college major decision-making model applied to our sample of college students. Finally, with a mixed multinominal logit model, we explain the individuals' choice of a major. The results of the paper show that the expected earnings variable is essential in the choice of a college major. There are, however, significant differences in the impact of expected earnings by gender and race.

Risk Aversion, Intertemporal Substitution, and Option Pricing

This paper develops a general stochastic framework and an equilibrium asset pricing model that make clear how attitudes towards intertemporal substitution and risk matter for option pricing. In particular, we show under which statistical conditions option pricing formulas are not preference-free, in other words, when preferences are not hidden in the stock and bond prices as they are in the standard Black and Scholes (BS) or Hull and White (HW) pricing formulas. The dependence of option prices on preference parameters comes from several instantaneous causality effects such as the so-called leverage effect. We also emphasize that the most standard asset pricing models (CAPM for the stock and BS or HW preference-free option pricing) are valid under the same stochastic setting (typically the absence of leverage effect), regardless of preference parameter values. Even though we propose a general non-preference-free option pricing formula, we always keep in mind that the BS formula is dominant both as a theoretical reference model and as a tool for practitioners. Another contribution of the paper is to characterize why the BS formula is such a benchmark. We show that, as soon as we are ready to accept a basic property of option prices, namely their homogeneity of degree one with respect to the pair formed by the underlying stock price and the strike price, the necessary statistical hypotheses for homogeneity provide BS-shaped option prices in equilibrium. This BS-shaped option-pricing formula allows us to derive interesting characterizations of the volatility smile, that is, the pattern of BS implicit volatilities as a function of the option moneyness. First, the asymmetry of the smile is shown to be equivalent to a particular form of asymmetry of the equivalent martingale measure. Second, this asymmetry appears precisely when there is either a premium on an instantaneous interest rate risk or on a generalized leverage effect or both, in other words, whenever the option pricing formula is not preference-free. Therefore, the main conclusion of our analysis for practitioners should be that an asymmetric smile is indicative of the relevance of preference parameters to price options.

Political Influence, Economic Interests and Endogenous Tax Structure in a Computable Equilibrium Framework: with Applicatioon to the United States, 1973 and 1983

A full understanding of public affairs requires the ability to distinguish between the policies that voters would like the government to adopt, and the influence that different voters or group of voters actually exert in the democratic process. We consider the properties of a computable equilibrium model of a competitive political economy in which the economic interests of groups of voters and their effective influence on equilibrium policy outcomes can be explicitly distinguished and computed. The model incorporates an amended version of the GEMTAP tax model, and is calibrated to data for the United States for 1973 and 1983. Emphasis is placed on how the aggregation of GEMTAP households into groups within which economic and political behaviour is assumed homogeneous affects the numerical representation of interests and influence for representative members of each group. Experiments with the model suggest that the changes in both interests and influence are important parts of the story behind the evolution of U.S. tax policy in the decade after 1973.

Efficient Strategy-Proof Allocation Functions in Linear Production Economies

In a linear production model, we characterize the class of efficient and strategy-proof allocation functions, and the class of efficient and coalition strategy-proof allocation functions. In the former class, requiring equal treatment of equals allows us to identify a unique allocation function. This function is also the unique member of the latter class which satisfies uniform treatment of uniforms.

The Shape of the Risk Premium: Evidence from a Semiparametric Garch Model.

We examine the relationship between the risk premium on the S&P 500 index return and its conditional variance. We use the SMEGARCH - Semiparametric-Mean EGARCH - model in which the conditional variance process is EGARCH while the conditional mean is an arbitrary function of the conditional variance. For monthly S&P 500 excess returns, the relationship between the two moments that we uncover is nonlinear and nonmonotonic. Moreover, we find considerable persistence in the conditional variance as well as a leverage effect, as documented by others. Moreover, the shape of these relationships seems to be relatively stable over time.