Working Papers

Keywords: Central Limit Theorem, Quadratic Variation, Bipower Variation

Reference: 2004-FE-21

Authors: Neil Shephard, Ole E. Barndorff-Nielsen, Department of Mathematical Sciences, University of Aarhus

Nov 2004

In this brief note we review some of our recent results on the use of high frequency financial data to estimate objects like integrated variance in stochastic volatility models. Interesting issues include multipower variation, jumps and market microstructure effects.

Reference: 2004-FE-22

Authors: David P. Myatt, Justin P. Johnson, Johnson Graduate School of Management, Cornell University

Nov 2004

We propose a framework for analyzing transformations of demand. Such transformations frequently stem from changes in the dispersion of consumers` valuations, which lead to rotations of the demand curve. In a wide variety of settings, profits are a U-shaped function of dispersion. A high level of dispersion is complemented by a niche posture, and low dispersion is complemented by a mass-market posture. We investigate numerous applications of our framework, including product design; advertising, marketing and sales advice; and the construction of quality-differentiated product lines. We also suggest a new taxonomy of advertising, distinguishing between hype, which shifts demand, and real information, which rotates demand.

JEL Codes: D21, D42, D83, L15, M31, M37

Keywords: Monopoly, Uncertainty, Dispersion, Advertising, Marketing, Product Design, Product Lines, Price Discrimination

Reference: 185

Individual View

Authors: Nicholas Dimsdale, N.H. Horsewood, A. van Riel

Nov 2004

This paper contributes to the debate on the causes of unemployment in interwar Germany. It applies the Layard-Nickell model of the labour market to interwar Germany, using a new quarterly data set. The basic model is extended to capture the effects of the tariff wage under the Weimar Republic and the Nazis. The estimated equations suggest that demand shocks, combined with nominal inertia in the labour market, were important in explaining unemployment. In addition real wage pressures due to the political processes of wage determination were a major influence on unemployment. Negative demand shocks appear to have been initially domestic and to have started before the impact of the World Depression. Both negative developments on the demand side of the economy and pressures coming from the supply side raised unemployment in the slump. In the recovery the wage policies of the Nazis and the revival of demand both contributed to the fall in unemployment. The mutual reinforcement of these factors may help to explain the severity of the interwar cycle in Germany. It also serves to emphasize the close connection between political and economic processes in this important episode in macroeconomic history.

JEL Codes: N14, E24, E32

Keywords: Great Depression, Germany, Real Wages, Unemployment

Reference: 056

Individual View

Authors: Thomas Norman

Oct 2004

This paper models the indirect evolution of the preferences of a population of fully rational agents repeatedly matched to play a symmetric 2 x 2 game in biological fitnesses. Each agent is biased in favor of one of the strategies, and receives a noisy signal of his and his opponent`s bias. With sufficiently accurate signals, the resulting global game selects a unique outcome, allowing preference biases to be shaped by the replicator dynamics. Stability analysis in this setting requires the extension of recent techniques for evolution on infinite strategy spaces, introducing new setwise stability concepts. In coordination games, the interval of preference biases supporting the Pareto-dominant equilibrium is Lyapunov stable and weakly attracting, by virtue of constituting a strongly uninvadable set. In Prisoners` Dilemmas that satisfy Kandori and Rob`s (Games and Economic Behavior 22, 1998, 30-60) marginal bandwagon property, meanwhile, an interval of biases supporting efficient cooperation is a neutrally uninvadable set, and thus Lyapunov stable.

JEL Codes: C70, C72

Keywords: Evolution, Preferences, Global Games, Replicator Dynamics, Continuous Strategy Space, Evolutionary Stability

Reference: 207

Individual View

Authors: John Thanassoulis

Oct 2004

This paper analyses how competition over rebates for customer loyalty across product lines affects firms` pricing and consumers generally. If buyers incur firm specific costs or have shop specific tastes then competitive loyalty discounts lower consumer surplus overall and raise profits - the same is true of competitive volume discounts. Competition without these discounts causes all prices to be kept low as larger customers are targetted; with discounts the prices for heavy users drop, but more is extracted from small users. The consumer surplus result is reversed if the differentiation between components as opposed to firms is key. Price discrimination is shown not to be the driving force behind the equilibrium prices - sellers price to steal customers from their rivals. The implications for diverse industries from professional services to cars and supermarkets are explored.

JEL Codes: L11, L21, L41, C65, C72

Keywords: Bundling, Loyalty Rebates, Volume Discounts, Competitive Price Discrimination, Collusion

Reference: 208

Authors: Victoria Prowse

Oct 2004

A multivariate extension of the standard labour suppy model is presented. In the multivariate time allocation model leisure is disaggregated into a number of non market activities including sports, volunteer work and home production. Using data from the 2000 UK Time Use Survey, a linear expenditure system is estimated, allowing corner solutions in the time allocated to market work and non market activities. The effects of children, age, gender and education are largely as expected. The unusually high wage elasticities are attributed to a combination of the functional form of the linear expenditure and the treatment of the zero observations.

JEL Codes: C15, C34, J22

Keywords: Time Use, Labour Supply, Corner Solutions, Simulation Inference

Reference: 209

Individual View

Authors: Emilia Del Bono

Sep 2004

This paper investigates the effect of earnings and employment opportunities on pre-marital fertility. Using data from a sample of British women born in 1970, we estimate an independent competing risk harzard model of fertility and cohabitation decisions. Our results show that individual earnings opportunities are negatively related to pre-marital fertility but do not affect union formation. Local male unemployment, on the contrary, is a positive determinant of single motherhood and a negative factor in cohabitation decisions. The latter result is consistent with the Wilson hypothesis as it shows the existence of a direct effect of male joblessness on co-residential relationships.

JEL Codes: J13, J12, C41

Keywords: Fertility, Marriage, Competing Risks Harzard Models

Reference: 202

Individual View

Functional Signal plus Noise (FSN) time series models are introduced for the econometric analysis of the dynamics of a large cross-section of prices in which contemporaneous observations are functionally related. A semiparametric FSN model is developed in which a smooth, cubic spline signal function is used to approximate the price curve data. Estimation may then be performed using quasi-maximum likelihood methods based on the Kalman filter. The model is used to provide one of the first studies of the dynamics of the bid and ask curves of an electronic limit order book and enables the comprehensive measurement of the dynamic determinants of traders` execution costs. It is found that the differences between the bid and ask curves and their intercepts (i.e. the immediate price impacts of market orders) are well described by covariance stationary processes. The in-sample, 1-step ahead point predictions for these curves perform well and motivate the development of parametric FSN models that take into account the monotonicity of the price curves and can be used to form predictive distributions.

JEL Codes: C14, C32, C33, C51, G12

Keywords: Functional Time Series, Bid and Ask Curves, Liquidity, Electronic Limit Order Book, Cubic Spline, State Space Form, Kalman Filter, Quasi-Maximum Likelihood

Reference: 2004-FE-19

Authors: Kathryn Graddy, Orley Ashenfelter, Princeton University

Sep 2004

The Sotheby`s/Christie`s price-fixing scandal that ended in the public trial of Alfred Taubman provides a unique window on a number of key economic and antitrust policy issues related to the use of the auction system. The trial provided detailed evidence as to how the price fixing worked, and the economic conditions under which it was started and began to fall apart. The outcome of the case also provides evidence on the novel auction process used to choose the lead counsel for the civil settlement. Finally, though buyers received the bulk of the damages, a straightforward application of the economic theory of auctions shows that it is unlikely that successful buyers as a group were injured.

JEL Codes: D44, K21, L41

Keywords: Auctions, Price-Fixing, Cartels, Antitrust, Commissions

Reference: 203

Individual View

Authors: Pablo Casas-Arce, Santhi Hejeebu, Cornell College

Sep 2004

We reconsider the job design theory of Holmstrom and Milgrom (1991), to include career concerns considerations. When reputations are considered, discretion may play a more integral part of the incentive scheme. It can be a useful instrument to enhance incentives and prevent the adverse selection of low ability agents. We then show that these synergies are useful in explaining the employment of U.S. faculty members and the employment of agents in the English East India Company, an historically important firm.

JEL Codes: J33, J41, L14, M52, M54

Keywords: Job Design, Multitasking, Career Concerns

Reference: 204

Individual View

Authors: Dimitrios P Tsomocos, Xavier Freixas, Universitat Pompeu Fabra and CEPR

Sep 2004

The aim of this paper is to examine the pros and cons of book and fair value accounting from the perspective of the theory of banking. We consider the implications of the two accounting methods in an overlapping generations environment. As observed by Allen and Gale (1997), in an overlapping generation model, banks have a role as intergenerational connectors as they allow for intertemporal smoothing. Our main result is that when dividends depend on profits, book value ex ante dominates fair value, as it provides better intertemporal smoothing. This is in contrast with the standard view that states that, fair value yields a better allocation as it reflects the real opportunity cost of assets. Banking regulation play an important role by providing the right incentives for banks to smooth intertemporal consumption whereas market discipline improves intratemporal efficiency.

Reference: 2004-FE-13

Authors: Simon GB Cowan, Simon Cowan

Sep 2004

The welfare effects of third-degree price discrimination are known to be negative when demand functions are linear, marginal cost is constant and all markets are served. This paper shows that discrimination lowers welfare for a more general class of demand functions. Demand varies across markets with additive and multiplicative shift factors. Total welfare (defined as consumer surplus plus profits) with discrimination is lower than with uniform pricing when the density function of consumer valuations satisfies a weak version of concavity that encompasses logconcavity. Most standard demand functions including linear, quadratic, probit, logit, exponential and iso-elastic ones, satisfy this assumption, which is also a weak sufficient condition for existence.

JEL Codes: D42, L12, L13

Keywords: Price Discrimination, Monopoly

Reference: 205

Authors: Alan Morrison, William J. Wilhelm, Jr., McIntire School of Commerce, University of Virginia

Sep 2004

Until 1970, the New York Stock Exchange prohibited public incorporation of member firms. After the rules were relaxed to allow joint stock firm membership, investment-banking concerns organized as partnerships or closely-held private corporations went public in waves, with Goldman Sachs (1999) the last of the bulge bracket banks to float. In this paper we ask why the Investment Banks chose to float after 1970, and why they did so in waves. Our explanation extends previous work which examined the role of partnerships in fostering the formation of human capital (Morrison and Wilhelm, 2003). We examine in this context the effect of technological innovations which serve to replace or to undermine the role of the human capitalist and hence we provide a technological theory of the partnership`s going-public decision. We support our theory with a new dataset of investment bank partnership statistics.

JEL Codes: G24, G32, J24, J41, L14, L22

Keywords: Partnership, Human Capital, Collective Reputation, Investment Bank, Going-Public Decision

Reference: 2004-FE-14

Authors: David Gill, Daniel Sgroi, Churchill College and Department of Applied Economics, University of Cambridge

Sep 2004

This paper considers the impact of reviewers on sales of products of quality unknown to consumers. Sales occur simultaneously after consideration by a reviewer with a known level of bias. Consumers observe the reviewer`s decision and a private signal. We find that: (a) with flexible prices and signals that are not too revealing the reviewer most biased against the product is best for profits; (b) with flexible prices and very revealing private signals the reviewer most biased in favour is optimal; (c) with fixed prices then a reviewer biased against, but close to unibased, is optimal.

JEL Codes: D82, D83, L15

Keywords: Private Information, Reviewers, Bias, Simultaneous Sales, Marketing

Reference: 206

Individual View

Authors: Dimitrios P Tsomocos, Gael Giraud, CNRS, Universite Paris-1

Sep 2004

We define a non-tatonnement dynamics in continuous-time for pure-exchange economies with outside and inside fiat money. Traders are myopic, face a cash-in-advance constraint, and play dominant strategies in a short-run monetary strategic market game involving the limit-price mechanism. The profits of the Bank are redistributed to its private share-holders, but they can use them to pay their own debts only in the next period. Provided there is enough inside money, monetary trade curves converge towards Pareto optimal allocations; money has a positive value along each trade curve, except on the optimal rest-point where it becomes a veil while trades vanish. Moreoever, generically, given initial conditions, there is a piecewise globally unique trade-and-price curve not only in real, but also in nominal variables. Finally, money is locally neutral in the short-run and non-neutral in the long-run.

Reference: 2004-FE-15

Authors: Neil Shephard, Yashurio Omori, Faculty of Economics,University of Tokyo,Siddhartha Chib, Olin School of Business, Washington University,Jouchi Nakajima, Faculty of Economics, University of Tokyo

Sep 2004

Kim, Shephard, and Chib (1998) provided a Bayesian analysis of stochastic volatility models based on a fast and reliable Markov chain Monte Carlo (MCMC) algorithm. Their method rules out the leverage effect, which is known to be important in applications. Despite this, their basic method has been extensively used in the financial economics literature and more recently in macroeconometrics. In this paper we show how the basic approach can be extended in a novel way to stochastic volatility models with leverage without altering the essence of the original approach. Several illustrative examples are provided.

Keywords: Leverage Effect, Markov Chain Monte Carlo, Mixture Sampler, Stochastic Volatility, Stock Returns

Reference: 2004-FE-16

Authors: Neil Shephard, Siddhartha Chib, Olin School of Business, Washington University,Michael K. Pitt, Department of Economics, University of Warwick

Sep 2004

This paper provides methods for carrying out likelihood based inference for diffusion driven models, for example discretely observed multivariate diffusions, continuous time stochastic volatility models and counting process models. The diffusions can potentially be non-stationary. Although our methods are sampling based, making use of Markov chain Monte Carlo methods to sample the posterior distribution of the relevant unknowns, our general strategies and details are different from previous work along these lines. The methods we develop are simple to implement and simulation efficient. Importantly, unlike previous methods, the performance of our technique is not worsened, in fact it improves, as the degree of latent augmentation is increased to reduce the bias of the Euler approximation. In addition, our method is not subject to a degeneracy that afflicts previous techniques when the degree of latent augmentation is increased. We also discuss issues of model choice, model checking and filtering. The techniques and ideas are applied to both simulated and real data.

Keywords: Bayes Estimation, Brownian Bridge, Non-linear Diffusion, Euler Approximation, Markov Chain Monte Carlo, Metropolis-Hastings Algorithm, Missing Data, Simulation, Stochastic Differential Equation

Reference: 2004-FE-17

Authors: Dimitrios P Tsomocos, Charles A.E. Goodhart, Bank of England, London School of Economics, and Financial Markets Group,Pojanart Sunirand, Bank of England

Sep 2004

This paper extends the model proposed by Goodhart, Sunirand, and Tsomocos (2003, 2004a,b) to an infinite horizon setting. Thus, we are able to assess how the model conforms with the time series data of the U.K. banking system. We conclude that, since the model performs satisfactorily, it can be readily used to assess financial fragility given its flexibility, computability, and the presence of multiple contagion channels and heterogeneous banks and investors.

JEL Codes: C68, E4, E5, G11, G21

Keywords: Financial Fragility, Systemic Risk, U.K. Banking Systems, Default

Reference: 2004-FE-18

Authors: Colin Jennings, Alan Hamlin, School of Social Sciences, University of Manchester

Aug 2004

We model the choice of leaders of groups within society, where leaders influence both the mode of interaction between groups (either peaceful compromise or costly conflict) and the outcome of these interactions. Group members may choose leaders strategically/instrumentally or they may choose leaders expressively. We characterize the equilibria of the instrumental choice model and also argue that leadership elections may overemphasise the role of expressive considerations in the choice of leader, and that this may result in increased conflict between groups.

JEL Codes: D72, D74

Keywords: Leadership, Conflict, Political Process

Reference: 200

Individual View

Authors: Christopher Adam,David Bevan

Aug 2004

Contemporary policy debates on the macroeconomics of aid often concentrate on short run Dutch disease effects, ignoring the possible supply side impact of aid financed public expenditure. We present a simple model of aid and public expenditure in which public infrastructure generates an inter-temporal productivity spillover which may exhibit a sector-specific bias. The model also provides for a learning-by-doing externality, through which total factor productivity in the tradable sector is an increasing function of past export volumes. We then use an extended version of this model, calibrated to contemporary conditions in Uganda, to simulate the effect of a step increase in net aid flows. Our simulations show that beyond the short-run, where conventional demand-side Dutch disease effects are present, the relationship between enhanced aid flows, real exchange rates, output growth and welfare is less straightforward than simple models of aid suggest. We show that public infrastructure investment which generates a productivity bias in favour of non-tradable production delivers the largest aggregate return to aid, but it does so at the cost of a deterioration in the income distribution. Income gains accrue predominantly to urban skilled and unskilled households, leaving the rural poor relatively worse off. Under plausible parameterizations of the model the rural poor may also be worse off in absolute terms.

JEL Codes: O41

Keywords: Aid, Dutch Disease, Public Expenditure, Africa

Reference: 201

Authors: David Hendry, Guillaume Chevillon

Jul 2004

We evaluate the asymptotic and finite-sample properties of direct multi-step estimation (DMS) for forecasting at several horizons. For forecast accuracy gains from DMS in finite samples, mis-specification and non-stationarity of the DGP are necessary, but when a model is well-specified, iterating the one-step ahead froecasts may not be asymptotically preferable. If a model is mis-specified for a non-stationary DGP, in particular omitting either negative residual serial correlation or regime shifts, DMS can forecast more accurately. Monte Carlo simulations clarify the non-linear dependence of the estimation and forecast biases on the parameters of the DGP, and explain existing results.

JEL Codes: C32, C51, C53

Keywords: Adaptive Estimation, Multi-Step Estimation, Dynamic Forecasts, Model Mis-Specification

Reference: 196

Authors: Daniel John Zizzo

Jul 2004

Game harmony is a generic game property that describes how harmonious (non-conflictual) or disharmonious (conflictual) the interests of players are, as embodied in the payoffs. It can be used to predict cooperation in two-player games. We show how, for large enough positive harmony transformations of the game, a utilitarian solution is always a Nash equilibrium, coincides with the Nash bargaining solution and acquires further desirable properties of payoff and risk dominance. Case-based reasoning and team reasoning are alternative mechanisms by which game harmony measures can successfully predict cooperative behavior.

JEL Codes: C72, C79

Keywords: Cooperation, Game Harmony, Payoff Dominance, Risk Dominance

Reference: 197

Individual View

Authors: Pablo Casas-Arce

Jul 2004

The existing literature on training is concerned with understanding the reasons why firms pay for the general skills of their workers, but without explaining which firms train which workers. This paper develops a theory that both explains the willingness of firms to pay for general training, and accounts for the pattern of training provision empirically observed. It is assumed that labor markets are perfectly competitive, but there is imperfect contractibility of human capital. Under these assumptions, when training and specific human capital are complements, the firm would pay for the former in order to induce the acquisition of complementary specific skills by the worker.

JEL Codes: J24, J31, J41

Keywords: Training, Human Capital, Incomplete Contracts

Reference: 198

Individual View

Authors: Pablo Casas-Arce

Jul 2004

This paper studies games in which the players are not locked into their relationship for a fixed number of periods. We consider two-player games where player 1 can decide to let the opponent continue in the game or replace it with a new player. We also allow the possibility of player 2 quitting the game. When only layoffs can occur, cooperation takes place in finite horizons due to the threat that termination of the relationship imposes on player 2. However, quits limit that cooperation to those cases where the outside option for player 2 is small (lower than some Nash equilibrium of the stage game).

JEL Codes: C70, C72

Keywords: Repeated Games, Folk Theorem, Layoffs, Quit

Reference: 199

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