Working Papers

Authors: Alan Morrison, Nir Vulkan

Feb 2003

It is received financial wisdom that when there is free entry by speculators, it is impossible to generate net profits on publicly available information. In this paper we study a version of the standard Kyle (85) model with endogenous information acquisition and we find that equilibria exist with free entry in which speculators make positive profits. Moreover, these equilibria are robust.

JEL Codes: D82, G14

Keywords: Market maker model, beliefs, information accquisition

Reference: 2003-FE-07

Authors: Dimitrios P Tsomocos, Eva Catarineu-Rabell, Patricia Jackson

Feb 2003

The Basel Committee on Banking Supervision is proposing to introduce, in 2006, new risk‑based requirements for internationally active (and other significant) banks. These will replace the relatively risk‑invariant requirements in the current Accord. This article examines the implications of this new risk‑based regime for procyclicality of minimum capital requirements – in particular whether the choice of particular loan rating system by the banks would significantly increase the likelihood of sharp increases in capital requirements in recessions, creating the potential for classic credit crunches. The paper finds that rating schemes that are designed to be more stable over the cycle, akin to those of the external rating agencies, would not increase procyclicality, but ratings that are conditioned on the current point in the cycle, akin in some respects to a Merton approach, could substantially increase procyclicality. This makes the question of which rating schemes banks will use very important. The paper uses a general equilibrium model of the financial system to explore whether banks would choose to use a countercyclical, procyclical or neutral rating scheme. The results indicate that banks would not choose a stable rating approach, which has important policy implications for the design of the Accord. It makes it important that banks are given incentives to adopt more stable rating schemes. This consideration has been reflected in the Committee’s latest proposals, in October 2002.

Reference: 2003-FE-06

In this paper we examine how the quantity of information generated about firm prospects can be improved by splitting a firm’s cash flow into a ‘safe’ claim (debt) and a ‘risky’ claim (equity). The former, being relatively insensitive to upside risk, provides a commitment to shut down the firm in the absence of good news. This commitment provides the latter a greater incentive to collect information than a monitor holding the aggregate claim would have. Thus debt and equity are shown to be complementary instruments in firm finance. We show that stock markets can play a useful role in transmitting information from equity to debt holders. This provides a novel argument as to why information contained in stock prices affects the real value of a corporation. It also allows us to make empirical predictions regarding the relation between shareholder dispersion, market liquidity and capital structure.

JEL Codes: D82, G3

Keywords: Debt, Equity, Soft Budget Constraint, Information Production

Reference: 2003-FE-09

Authors: Alan Beggs

Jan 2003

This paper shows how graphs can be used to calculate expected waiting times in models of equilibrium selection. It also shows how reducing the state space can simplify the calculations both of waiting times and selected equilibria. The results are applied to potential games and games with strategic complementarities.

JEL Codes: C72, C73

Keywords: waiting times, equilibruim selection, graphs

Reference: 142

Authors: Alexandre Debs

Jan 2003

In the last decade, with the publication of his Complete Works, there has been renewed interest in Walras’s methodology, mostly in the French economic literature. In particular, some scholars have argued that Walras characteristically confused positive and normative statements, a mistake all the more surprising given his impressive knowledge of philosophy (the so-called ‘Walras paradox’). This paper reviews these recent studies and, in particular, it contests the solution to the Walras paradox offered by R. Koppl. For Koppl, the paradox is explained by the fact that Walras was influenced by philosophers who did not distinguish between positive and normative statements. More precisely, the French philosopher E. Vacherot inspired him to an idealist theory of knowledge, where preconceived notions of justice could be defended as truths. This paper contests such a conclusion: Vacherot’s theory of science was not idealist and did not sanction a confusion of positive and normative statements. The Walras paradox could even be non-existent after all.

Reference: 049

Individual View

Authors: Dimitrios P Tsomocos, F.H. Capie, Geoffrey E. Wood

Jan 2003

New technology in computing has led some to suggest that the ability to settle transactions electronically will develop to such an extent that money disappears from use. Two versions of this belief exist. One maintains that there will be â€

JEL Codes: E42

Reference: 2003-FE-04

Authors: Neil Shephard, Ole Barndorff-Nielsen

Jan 2003

In this note we show that the feasible central limit theory for realised volatility and realised covariation recently developed by Barndorff-Nielsen and Shephard applies under arbitrary diffusion based leverage effects. Results from a simulation experiment suggest that the feasible version of the limit theory performs well in practice.

Keywords: Euler approximation, Functional central limit theory, Quadratic variation, Realised volatility, Stochastic volatility

Reference: 2004-FE-03

Authors: Godfrey Keller, Martin Cripps, Olin School of Business, Washington University,Sven Rady, Department of Economics, University of Munich

Jan 2003

This paper studies a game of strategic experimentation with two-armed bandits whose risky arm might yield a payoff only after some exponentially distributed random time. Because of free-riding, there is an inefficiently low level of experimentation in any equilibrium where the players use stationary Markovian strategies with posterior beliefs as the state variable. After characterizing the unique symmetric Markovian equilibrium of the game, which is in mixed strategies, we construct a variety of pure-strategy equilibria. There is no equilibrium where all players use simple cut-off strategies. Equilibria where players switch finitely often between the roles of experimenter and free-rider all lead to the same pattern of information acquisition; the efficiency of these equilibria depends on the way players share the burden of experimentation among them. In equilibria where players switch roles infinitely often, they can acquire an approximately efficient amount of information, but the rate at which it is acquired still remains inefficient; moreoever, the expected payoff of an experimenter exhibits the novel feature that it rises as players become more pessimistic. Finally, over the range of beliefs where players use both arms a positive fraction of the time, the symmetric equilibrium is dominated by any asymmetric one in terms of aggregate payoffs.

JEL Codes: C73, D83, H41, O32

Keywords: strategic experimentation, two-armed bandit, exponential distribution, Bayesian learning, Markov perfect equilibrium, public goods

Reference: 143

This paper contains a General Equilibrium model of an economy with Incomplete Markets (GEI) with money and default. The model is a simplified version of the real world consisting of a non-bank private sector, banks, a Central Bank, a government and a regulator. The model is used to analyse actions by policy makers and to identify policy relevant empirical work. Key analytical results are: A financially fragile system need not collapse; efficiency can be improved with policy intervention; and that a system with heterogeneous banks is more stable than one with homogeneous ones. Existence of monetary equilibria allows for positive default levels in equilibrium. It also characterises contagion and financial fragility as an equilibrium phenomenon. A definition of financial fragility is proposed. Financial fragility occurs when aggregate profitability of the banking sector declines and defaults in the non-bank private and the banking sectors increase. Thus, equilibria with financial fragility require financial vulnerability in the banking sector and liquidity shortages in the non-bank private sector. The model will be used as a basis to carry out empirical work on the costs of financial instability, to quantify the effectiveness of particular regulatory tools such as capital requirements, and to identify tradeoffs between increasing stability through action by authorities and the efficiency of the financial system. Keywords: Financial fragility, contagion, competitive banking, capital requirements, incomplete markets, default.

JEL Codes: D52, E4, E5, G1, G2

Reference: 2003-FE-03

Authors: Alan Morrison, William Wilhelm

Jan 2003

In human capital intensive industries where it is difficult to contract upon the training effort of skilled agents a socially suboptimal level of training may occur. We show how partnership organisations can overcome this problem by tying human and financial capital. Partnerships are opaque so that the willingness of clients to pay depends upon reputation. Partnerships are illiquid and partners must stay with the firm until clients discover their type and update the firm`s reputation. This renders unskilled agents, who will aversely affect reputation, unwilling to accept partnerships. Skilled agents therefore train the next generation so as to ensure that there is an adequate market for their own shares. We comment upon the salient differences between partnerships and joint stock firms.

JEL Codes: J24, J41, L14, L22

Keywords: Partnership, on-the-job training, human capital, collective reputation.

Reference: 2003-FE-02

Authors: Marcel Fafchamps

Jan 2003

Drawing insights from the literature on credit and labor markets and from the author`s own survey work on contractual practices among manufacturers and traders in Africa, this paper investigates the spontaneous emergence of markets in the presence of heterogeneous agents. Using a dynamic game setting, we derive precise conditions under which relational contracting spontaneously emerges and deters opportunistic breach of contract even in the absence of formal market institutions. Exclusion of cheaters from future trade is not required for exchange to begin. Markets at early stages of development are characterized by trade based on mutual trust and on the sharing of information among acquaintances. As markets develop, newcomers may be excluded from trade when screening costs are high and agents long lived. Reputational equilibria in which cheaters are permanently excluded from trade are not decentralizable unless markets are already developed and breach of contract is interpreted as a sign of impending bankruptcy. Market emergence is a path dependent process.

JEL Codes: O1, K0, P5

Keywords: market institutions, information sharing, networks, social capital, path dependence

Reference: 138

Individual View

Authors: Marcel Fafchamps, Forhad Shilpi,DECRG, The World Bank

Jan 2003

Theories of city formation typically revert around agglomeration externalities driven by returns to specialization. Using survey data from Nepal, we test these theories by examining the relationship between proximity to urban centers and the organization of labor. We show that wards located in and near cities have more diversified and more market oriented activities. This suggests returns to specialization harnessed through the market. Wage work, work away from home, and unemployment are more prevalent in and around cities. These effects are felt up to four hours of travel time from large cities. We also find evidence of a weak relationship between city size and firm size. Urban specialization, however, does not extend to household chores. Urbanization is associated with lower female labor market participation and with specialization of women in market-related activities or strictly home-based chores.

JEL Codes: R12, 018

Keywords: spatial specialization, urbanization, household chores

Reference: 139

Individual View

Authors: Marcel Fafchamps, Christine Moser, Cornell University.

Jan 2003

This paper investigates the relationship between criminal activity and geographical isolation. Using data from Madagascar, we show that, after we control for population composition and risk factors, crime increases with distance from urban centers and, with few exceptions, decreases with population density. In Madagascar, crime and insecurity are associated with isolation, not urbanization. This relationship is not driven by placement of law enforcement personnel which is shown to track crime but fails to reduce feelings of insecurity in the population. Other risk factors have effects similar to those discussed in the literature on developed countries. We find a positive association between crime and the presence of law enforcement personnel, probably due to reporting bias. Law enforcement personnel helps solve crime but appears unable to prevent it.

JEL Codes: K42, O18.

Keywords: criminal activity, distance from city, rule of law.

Reference: 140

Individual View

Authors: Marcel Fafchamps

Jan 2003

This paper examines how wealth accumulation and risk sharing affect the evolution of inequality over time. We first assume risk sharing away and examine how inequality evolves over time when agents accumulate an asset. If asset accumulation is unbounded and the asset yields a positive return, inequality converges to single value over time. If the asset yields a zero or negative return (e.g., grain storage), there is no persistent inequality but inequality is nevertheless correlated over time. If wealth yields a positive return but is in finite supply (e.g., land), persistent inequality arises if one agent is more thrifty than the other. Multiple equilibria may obtain. Societies might prevent polarization by closing down markets in such assets. We then introduce risk sharing. With perfect risk sharing, welfare inequality is constant across time. For continued participation to mutual insurance to be voluntary, asset inequality must remain `close` to welfare inequality. With imperfect commitment, the end result is a hybrid situation half-way between the risk sharing model and the pure accumulation model. If risk aversion is high for poor agents but low for rich ones, patronage arises whereby the rich on average take away from the poor.

JEL Codes: D31, O16

Keywords: dynamic inequality, poverty dynamics, risk sharing

Reference: 141

Individual View

Authors: Tim Jenkinson, Alan Morrison, William Wilhelm

Jan 2003

In contrast to practice in the U.S., European IPOs are very rarely priced outside the indicative price range, and frequently are priced at its upper bound. We develop a model that provides a rationale for this seemingly inefficient pricing behaviour. The model allows for the practice, observed in Europe but not in the U.S., whereby underwriters obtain information from investors prior to establishing the indicative price range. With this alternative staging of the information game, first studied by Benveniste and Spindt (1989), a commitment to not exceeding the upper bound is necessary to extract private information from investors. The model has important implications for empirical research based on European primary market data.

Reference: 2003-FE-05

Authors: Christine Greenhalgh, Mark Longland, Oxford Intellectual Property Research Centre

Dec 2002

We construct a unique panel dataset to examine how R&D and intellectual property (IP), via patents and trade marks, increase firm productivity. Knowledge has public good characteristics of non-depletability and non-excludability. Even with IP, imitation and inventing around other firm`s products is possible, so we examine the size and duration of benefits to IP protection. If non-depletion is correct, this implies that absolute R&D, or total IP assets are important. We examine this hypothesis against the alternative of depletability, where innovative intensity relative to the size of the firm matters. The results support rapid depletability and poor ability to exclude.

JEL Codes: L11, L60, O33, O34

Keywords: intellectual property, R&D, value added, manufacturing

Reference: 134

Individual View

Authors: Christine Greenhalgh, Padraig Dixon

Dec 2002

This paper reviews the literature on the economics of intellectual property rights (IPR), with a particular focus on the main industrial property rights of patents and trade marks. Intellectual property rights arise from the legal protection accorded to certain inventions or creations. We begin with a review of studies of innovation and IPR incidence, including their relationship with market structure. Our second topic is the valuation of IPR, which has been attempted via cost-based methods and econometric studies of productivity and market value. The cost incurred in the enforcement of IPR is a growing practical concern, but the literature here is less rich than for valuation. Our fourth topic is the relationship between public science and industry, which has been evolving rapidly in recent years. We then examine policy for the promotion of IPR both in the domestic policy arena and in the international context of the TRIPS agreement. We conclude with a list of suggested questions for future research.

JEL Codes: K0, L0, O3

Keywords: intellectual property, R&D, patents, trade marks, technology

Reference: 135

Individual View

Authors: Juan ToroNatalia Fabra, Universidad Carlos III de Madrid

Dec 2002

We analyze the time-series of prices in the Spanish electricity market by means of a time varying-transition-probabilities Markov Switching model. Accounting for demand and supply conditions, we show that the time-series of prices is characterized by two significantly different price levels. Based on a Green and Porter type of model that specifically introduces the rules of the bidding process, we construct several triggers for price wars. The triggers considered are statistically significant and report the predicted signs. In particular, price wars are triggered by unexpected changes in the major generators` market shares and revenues. We obtain more empirical support to Green and Porter`s model than previous studies.

JEL Codes: C22, L13, L94

Keywords: electricity markets, tacit collusion, Markov Switching

Reference: 136

Individual View

Authors: Oliver Board

Dec 2002

The standard model of an extensive form game rules out an important phenomenon in situations of strategic interaction: deception. Using examples from the world of ancient Greece and from modern-day Wall Street, we show how the model can be generalized to incorporate this phenomenon. Deception takes place when the action observed by a player is different from the action actually taken. The standard model does allow imperfect information (modeled by non-singleton information sets), but not deception: the actual action taken is never ruled out. Our extension of extensive form games relaxes the assumption that the information sets partition the set of nodes, so that the set of nodes considered possible after a certain action is taken might not include the actual node. We discuss the implications of this relaxation, and show that in certain games deception is inconsistent with common knowledge of rationality even along the backward induction path. `You are to hear now how the Greeks tricked us. From this one proof of their perfidy you may understand them all` (Aeneas).

JEL Codes: C72, D82

Keywords: deception, extensive form games, information

Reference: 137

Individual View

Authors: Colin Mayer, Julian Franks, Stefano Rossi

Dec 2002

In the first half of the twentieth century, the UK capital markets were marked by an absence of investor protection; by the end of the century, there was more extensive protection there than virtually anywhere else in the world. The UK therefore provides an exceptional laboratory for evaluating how regulation affects the development of securities markets and corporations. We investigate this question by tracing the ownership and board composition of firms incorporated around 1900 over the subsequent 100 years and comparing the pattern of ownership and control with a sample incorporated around 1960. We find that at the beginning of the century there were active securities markets, firms were able to raise substantial outside equity finance, and there was rapid dispersion of ownership even in the absence of investor protection. The introduction of investor protection in the second half of the century was not associated with greater dispersion of ownership but with more trading in share blocks. We offer an explanation as to how U.K. capital markets could flourish in the absence of investor protection.

Reference: 2003-FE-01

Authors: David P. Myatt, Stephen D. Fisher

Dec 2002

Simple plurality election systems (commonly known as `First-Past-The-Post`) are often associated with the dominance of two political parties. Such systems tend to reward leading parties with too many seats (known as the `mechanical` effect) and provoke tactical voting, where voters switch away from trailing parties (known as the `psychological` effect). We view tactical voting as a coordination problem. A group of voters wish to prevent a win by a disliked party (such as the Conservatives in recent UK elections) and must partially coordinate behind a single challenger (such as Labour or the Liberal Democrats) in order to do this. Crucially, voters have limited information on the situation within their constituency and hence there is no common knowledge of the game being played - tactical voting is a global game. We show that in this setting, voters will only partially coordinate. Furthermore, tactical voting exhibits negative feedback - tactical voting by others reduces the incentive for an individual to vote tactically, since they become concerned that they may switch in the wrong direction. We calibrate our model, and apply it to the UK General Election of 1997. Throughout England, we find that the `mechanical` and `psychological` effects tend to offset each other: Tactical voting serves to reverse the Conservative bias that results from the geographic distribution of votes.

JEL Codes: D72

Keywords: strategic voting, tactical voting, Duverger`s Law, plurality rule, elections

Reference: 133

Individual View

Authors: Mary Silles, Peter Dolton, Department of Economics, University of Newcastle

Nov 2002

The massive transition to higher education and the large number of university graduates taking school-leavers` jobs has led many to question the widely held view that a university education is a good investment and a guarantee of economic success. This paper using data from one large civic university in the UK to consider the determinants and consequences of over-education. Approximately one in five graduates genuinely have more education than their jobs require. This study tests and rejects the hypothesis of non-random selection into over-education among graduates who have been in the labour market for some time. In addition, the evidence strongly suggests that ordinary least squares systematically underestimate the magnitude of the negative effects of over-education of earnings.

JEL Codes: I21, J31

Keywords: educational economics, wage differentials

Reference: 126

Individual View

Authors: Mary Silles, Peter Dolton, Department of Economics, University of Newcastle

Nov 2002

Several studies for the UK and other countries have shown that a significant number of university graduates are in jobs that do not require a university degree i.e., over-educated. This paper using data from one large civic university in the UK investigates the true incidence and determinants of over-education. The results indicate that previous studies have largely over-stated the extent of over-education in the graduate labour market. Various labour market constraints as well as the vocational orientation of educational qualification were shown to be among most important factors that influence graduate placement.

JEL Codes: I21, J31

Keywords: educational economics, wage differentials

Reference: 127

Individual View

Authors: Katsushi Imai, Raghav Gaiha, University of Delhi

Nov 2002

This paper focuses on vulnerability of rural households to poverty when a negative crop shock occurs. Of particular concern is the possibilty of some sections experiencing long spells of poverty as a consequence of such shocks. The analysis is based on the ICRISAT panel survey of households in a semi-arid region in south India during 1975-84. Using alternative specifications that take into account direct effects of crop shocks as well as their indirect effects through asset adjustment, an assessment of vulnerability of different groups of households (e.g. classified on the basis of caste affiliation) is carried out. Whether transfers of land and non-land assets would reduce significantly their vulnerability is also examined. A reorientation of anti-poverty strategy is necessary to avoid welfare losses from negative crop shocks that are frequent and occasionally large.

JEL Codes: H53, I32, Q15

Keywords: shocks, dynamics, vulnerability, transfers, poverty

Reference: 128

Individual View

Authors: Alan Beggs

Nov 2002

This paper uses the theory of large deviations to analyse equilibrium selection in one-dimensional games with large populations where the system evolves according to a jump Markov process. The equilibria selected maximise a quasi-potential function which can be determined by solving a polynomial equation. Estimates of waiting times are also given. It shows that equilibria about which there is more noise are less likely to be selected and clarifies the role of the limiting deterministic dynamic in selection.

JEL Codes: C72, C73

Keywords: equilibrum selection, large deviations, large populations, games

Reference: 129


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