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Annual Review of Economics - Volume 3, 2011
Volume 3, 2011
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Robustness and Macroeconomic Policy
Vol. 3 (2011), pp. 1–24More LessThis review considers the design of macroeconomic policies in the face of uncertainty. In recent years, several economists have advocated that, when policy makers are uncertain about the environment they face and find it difficult to assign precise probabilities to the alternative scenarios that may characterize this environment, they should design policies to be robust in the sense that they minimize the worst-case loss these policies could ever impose. I review and evaluate the objections cited by critics of this approach. I argue further that, contrary to what some have inferred, concern about worst-case scenarios does not always lead to policies that respond more aggressively to incoming news than the optimal policy would respond absent any uncertainty.
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Choosing Treatment Policies Under Ambiguity
Vol. 3 (2011), pp. 25–49More LessEconomists studying choice with partial knowledge typically assume that the decision maker places a subjective distribution on unknown quantities and maximizes expected utility. Someone lacking a subjective distribution faces a problem of choice under ambiguity. This article reviews recent research on policy choice under ambiguity, when the task is to choose treatments for a population. Ambiguity arises when a planner has partial knowledge of treatment response and does not feel able to place a subjective distribution on the unknowns. I first discuss dominance and alternative criteria for choice among undominated policies. I then illustrate with the choice of a vaccination policy by a planner who has partial knowledge of the effect of vaccination on illness. I next study a class of problems in which a planner may want to cope with ambiguity by diversification, assigning observationally identical persons to different treatments. Lastly, I consider a setting in which a planner should not diversify treatment.
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Empirical Models of Consumer Behavior
Vol. 3 (2011), pp. 51–75More LessModels of consumer behavior play a key role in modern empirical industrial organization. In this review, I survey some of the models used in this literature. In particular, I discuss two commonly used demand systems: multistage budgeting approaches and discrete choice models. I motivate their use and highlight some key modeling assumptions. I next briefly discuss key issues of estimation and conclude by summarizing some extensions.
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Theories of Heterogeneous Firms and Trade
Vol. 3 (2011), pp. 77–105More LessThis article reviews the recent theoretical literature on heterogeneous firms and trade, which emphasizes firm selection into international markets and reallocations of resources across firms. We discuss the empirical challenges that motivated this research and its relationship to traditional trade theories. We examine the implications of firm heterogeneity for comparative advantage, market size, aggregate trade, the welfare gains from trade, and the relationship between trade and income distribution. Although a number of studies examine the endogenous response of firm productivity to trade liberalization, modeling internal firm organization and the origins of firm heterogeneity remain interesting areas of ongoing research.
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Confronting Prior Convictions: On Issues of Prior Sensitivity and Likelihood Robustness in Bayesian Analysis
Vol. 3 (2011), pp. 107–131More LessIn this review we explore issues of the sensitivity of Bayes estimates to the prior and form of the likelihood. With respect to the prior, we argue that non-Bayesian analyses also incorporate prior information, illustrate that the Bayes posterior mean and the frequentist maximum likelihood estimator are often asymptotically equivalent, review a simple computational strategy for analyzing sensitivity to the prior in practice, and finally document the potentially important role of the prior in Bayesian model comparison. With respect to issues of likelihood robustness, we review a variety of computational strategies for significantly expanding the maintained sampling model, including the use of finite Gaussian mixture models and models based on Dirichlet process priors.
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The Gravity Model
Vol. 3 (2011), pp. 133–160More LessGravity has long been one of the most successful empirical models in economics. Incorporating deeper theoretical foundations of gravity into recent practice has led to a richer and more accurate estimation and interpretation of the spatial relations described by gravity. Wider acceptance has followed. Recent developments are reviewed here, and suggestions are made for promising future research.
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The Political Economy of Public Debt
Vol. 3 (2011), pp. 161–189More LessWe survey recent theories of public debt that incorporate political decision making in rich dynamic environments. These theories provide a new framework with which to interpret empirical evidence and to assess institutional reforms that may help control political inefficiencies. We discuss the inefficiencies that lead to overaccumulation of debt and their implications for the long-run distribution of debt.
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International Trade, Foreign Direct Investment, and Security
Vol. 3 (2011), pp. 191–213More LessThe main focus of this review is on international trade and foreign direct investment when the institutions that provide the security of property rights and enforcement of contracts are imperfect. Some issues of national security related to poor governance of international transactions are also considered. The discussion organizes a selective overview of the literature and offers some suggestions for future research.
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Can Informed Voters Enforce Better Governance? Experiments in Low-Income Democracies
Vol. 3 (2011), pp. 215–237More LessThis article evaluates a body of recent work that uses field and natural experiments to answer the question of whether informed voters can enforce better governance. A common finding in the literature is that voter behavior is malleable and that information about the political process and politician performance improves electoral accountability. Limited availability of information thus provides one explanation for the persistence of low-quality politicians and the existence of identity politics and electoral malpractices in low-income democracies. Understanding how voters can gain access to credible sources of information and understanding how politicians react to improved information about their performance are promising avenues for future research.
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Social Norms and Social Assets
Vol. 3 (2011), pp. 239–259More LessSocial norms are often posited as an explanation of differences in the economic behavior and performance of societies that are difficult to explain by differences in endowments and technology. The successful integration of social norms into economic models requires an understanding of the basis of the differences in preferences that lead to different behaviors. I explore the difference between deep and reduced-form preferences and how both can differ across societies.
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Recent Perspectives on Trade and Inequality
Vol. 3 (2011), pp. 261–289More LessThe 1990s dealt a blow to traditional Heckscher-Ohlin analysis of the relationship between trade and income inequality, as it became clear that rising inequality in low-income countries and other features of the data were inconsistent with that model. As a result, economists moved away from trade as a plausible explanation for rising income inequality. In recent years, however, a number of new mechanisms have been explored through which trade can affect (and usually increase) income inequality. These include within-industry effects due to heterogeneous firms, the effects of offshoring of tasks, effects on incomplete contracting, and the effects of labor-market frictions. A number of these mechanisms have received substantial empirical support.
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Sparse High-Dimensional Models in Economics
Jianqing Fan, Jinchi Lv, and Lei QiVol. 3 (2011), pp. 291–317More LessThis article reviews the literature on sparse high-dimensional models and discusses some applications in economics and finance. Recent developments in theory, methods, and implementations in penalized least-squares and penalized likelihood methods are highlighted. These variable selection methods are effective in sparse high-dimensional modeling. The limits of dimensionality that regularization methods can handle, the role of penalty functions, and their statistical properties are detailed. Some recent advances in sparse ultra-high-dimensional modeling are also briefly discussed.
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Frictional Matching Models
Vol. 3 (2011), pp. 319–338More LessThis article reviews the developments in frictional matching models from 1990 to 2010, exploring how search frictions skew the matches that occur. This research succeeded by exploiting new tools from monotone methods under uncertainty. Seeing how this journey plays out is instructive in itself for economic theory. The article also describes in detail the different attacks on the existence of equilibrium required for these search and matching models.
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Imperfect Credit Markets, Household Wealth Distribution, and Development
Vol. 3 (2011), pp. 339–362More LessThis article discusses some key results in the theoretical literature on credit market imperfections, household wealth distribution, and development by conducting three types of analysis, which progressively build on one another. The first, a single dynasty model, explains how a household may be caught in a poverty trap because of credit market imperfections but says little about the effects of distribution on development. The second, a model of interacting dynasties with a fixed threshold, explains a collective poverty trap, with path dependence in the wealth distribution dynamics, but says little about the effects of inequality on development, owing to its absolute notion of the rich and the poor. The third, models of interacting dynasties with variable thresholds, offers a richer framework for understanding the dynamics of inequality and development under credit market imperfections, owing to its relative notion of the rich and poor.
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Practical Methods for Estimation of Dynamic Discrete Choice Models
Vol. 3 (2011), pp. 363–394More LessMany discrete decisions are made with an eye toward how they will affect future outcomes. Formulating and estimating the underlying models that generate these decisions is difficult. Conditional choice probability (CCP) estimators often provide simpler ways to estimate dynamic discrete choice problems. Recent work shows how to frame dynamic discrete choice problems in a way that is conducive to CCP estimation and demonstrates that CCP estimators can be adapted to handle rich patterns of unobserved state variables.
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Nonlinear Panel Data Analysis
Vol. 3 (2011), pp. 395–424More LessNonlinear panel data models arise naturally in economic applications, yet their analysis is challenging. Here we provide a progress report on some recent advances in the area. We start by reviewing the properties of random-effects likelihood approaches. We emphasize a link with Bayesian computation and Markov chain Monte Carlo, which provides a convenient approach to estimation and inference. The relaxation of parametric assumptions on the distribution of individual effects raises serious identification problems. In discrete choice models, common parameters and average marginal effects are generally set identified. The availability of continuous outcomes, however, provides opportunities for point identification. We end by reviewing recent progress on non-fixed-T approaches. In panel applications in which the time dimension is not negligible relative to the size of the cross section, it makes sense to view the estimation problem as a time-series finite-sample bias. Several perspectives to bias reduction are now available. We review their properties, with a special emphasis on random-effects methods.
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Health Behavior in Developing Countries
Vol. 3 (2011), pp. 425–449More LessThe disease burden in low-income countries is extremely high. Malaria, respiratory infections, diarrhea, AIDS, and other diseases are estimated to kill more than 15 million people each year, most of them children. Yet the great majority of these diseases can be prevented or treated. This article reviews microeconomic studies of health-seeking behavior in low-income countries. Factors examined include information, peers, liquidity constraints, and nonrational preferences, such as present bias. I then discuss the implications for policy, including the scope for mandates, subsidies, and incentives.
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Bargaining with Optimism
Vol. 3 (2011), pp. 451–478More LessExcessive optimism is a prominent explanation for bargaining delays. Recent results demonstrate that optimism plays a subtle role in bargaining, and its careful analysis may shed valuable insights into negotiation behavior. This article reviews some of these results, focusing on the following findings. First, when there is a nearby deadline, optimistic players delay the agreement to the last period before the deadline, replicating a broad empirical regularity known as the deadline effect. Second, there cannot be a substantial delay under persistent optimism; i.e., excessive optimism alone cannot explain delays. Third, when optimistic players are expected to learn during the negotiation, they delay the agreement in order to persuade their opponents. The delays in these results can be quite costly, Pareto inefficient, and common knowledge at the beginning of the game.
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Studying Discrimination: Fundamental Challenges and Recent Progress
Vol. 3 (2011), pp. 479–511More LessWe discuss research on discrimination against blacks and other racial minorities in labor market outcomes, highlighting fundamental challenges faced by empirical work in this area. Specifically, for work devoted to measuring whether and how much discrimination exists, we discuss how the absence of relevant data, the potential noncomparability of blacks and whites, and various conceptual concerns peculiar to race may frustrate or render impossible the application of empirical methods used in other areas of study. For work seeking to arbitrate empirically between the two main alternative theoretical explanations for such discrimination as it exists, we distinguish between indirect analyses, which do not directly study the variation in prejudice or the variation in information, the mechanisms at the heart of the two types of models we review, and direct analyses, which are more recent and much less common. We highlight problems with both approaches. Throughout, we discuss recent work, which, the various challenges notwithstanding, permits tentative conclusions about discrimination. We conclude by pointing to areas that might be fruitful avenues for future investigation.
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The Mechanism Design Approach to Student Assignment
Vol. 3 (2011), pp. 513–536More LessThe mechanism design approach to student assignment involves the theoretical, empirical, and experimental study of systems used to allocate students into schools around the world. Recent practical experience designing systems for student assignment has raised new theoretical questions for the theory of matching and assignment. This article reviews some of this recent literature, highlighting how issues from the field motivated theoretical developments and emphasizing how the dialogue may be a road map for other areas of applied mechanism design. Finally, it concludes with some open questions.
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News and Aggregate Demand Shocks
Vol. 3 (2011), pp. 537–557More LessIn this review, I look at the recent literature on news as a source of economic fluctuations. The main question in this literature is: how does the aggregate economy respond to a shock that raises consumers' and firms' expectations about future productivity growth? I discuss how different papers have addressed this question, emphasizing the mechanisms at work under different specifications of preferences and technology, under different assumptions about nominal and real rigidities, and under different assumptions about the agents' information structure. I also briefly discuss some challenges faced by the empirical literature on the topic.
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Housing Bubbles: A Survey
Vol. 3 (2011), pp. 559–577More LessThe past 25 years have represented two periods of extreme movements in U.S. and global house prices that appear to be much larger than can be easily explained by changes in fundamentals. These episodes spurred research on housing bubbles that focused attention on the role of outsized expectations in excessive house price appreciation. By contrast, some economists pointed to alternative explanations for excess volatility, including liquidity constraints, lending cycles, search externalities, and zoning delays. Empirical work supports the role of these factors in explaining at least some of the cyclical variation of house prices and inventories of homes for sale. Existing research does not yet provide a crisp definition of a housing bubble nor does it allow researchers to predict where or when bubbles can occur.
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Rent Seeking and Corruption in Financial Markets
Vol. 3 (2011), pp. 579–600More LessWe describe recent advances in the study of rent seeking and corruption in financial markets. We outline three areas of inquiry: (a) conceptualizing rent seeking, (b) identifying rent-provision channels and their general equilibrium impact, and (c) designing feasible remedial mechanisms. We provide suggestions for making further progress in these areas and review a variety of approaches taken in the recent literature.
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Gender and Competition
Vol. 3 (2011), pp. 601–630More LessLaboratory studies have documented that women often respond less favorably to competition than men. Conditional on performance, men are often more eager to compete, and the performance of men tends to respond more positively to an increase in competition. This means that few women enter and win competitions. We review studies that examine the robustness of these differences as well the factors that may give rise to them. Both laboratory and field studies largely confirm these initial findings, showing that gender differences in competitiveness tend to result from differences in overconfidence and in attitudes toward competition. Gender differences in risk aversion, however, seem to play a smaller and less robust role. We conclude by asking what could and should be done to encourage qualified males and females to compete.
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New Developments in Aggregation Economics
Vol. 3 (2011), pp. 631–668More LessThe goal of this article is to provide a general characterization of the aggregate behavior of a group in a market environment. We allow for public and private consumption, intragroup production, and consumption externalities within a group; we only assume that the group always reaches Pareto-efficient decisions. We show that aggregation problems involve a simple mathematical structure: The aggregate demand of the group, considered as a vector field, can be decomposed into a sum of gradients. We briefly introduce exterior differential calculus as a tool to study this structure. We analyze two main issues. One is testability: What restrictions (if any) on the aggregate demand function characterize the efficient behavior of the group? The second issue relates to identifiability; we investigate the conditions under which it is possible to recover the underlying structure—namely, individual preferences, the decision process, and the resulting intragroup transfers—from the group's aggregate behavior.
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