Contracts as reference points: evidence

In a previous post, I mentioned Oliver Hart and John Moore's recent paper, "Contracts As Reference Points", in which the authors found a new building block for incomplete contracts by incorporating behavioral elements, such as reference points, shade and retaliation. Although their earlier and more influential work - Grossman and Hart (1986), Hart and Moore (1990) and Hart (1995) - has laid down the foundation of incomplete contract theory, some critical assumptions of their model were challenged, like events that are observable but not verifiable and ex post efficiency. Hart finds that "the early debate a bit sterile". In this new paper, they bring back ex post inefficiency, which is caused by behavioral problems. Relational specific investment, a crucial element that leads to ex post renegotiation in their earlier model is assumed away. The theory becomes somewhat more "rigorous and testable".

In the latest NBER working paper series, Ernst Fehr, Oliver Hart and Christian Zehnder provide their first empirical test of the new incomplete contract theory (see here or here). Here is the abstract:

In a recent paper, Hart and Moore (2008) introduce new behavioral assumptions that can explain long-term contracts and important aspects of the employment relation. However, so far there exists no direct evidence that supports these assumptions and, in particular, Hart and Moore's notion that contracts provide reference points. In this paper, we examine experimentally the behavioral forces stipulated in their theory. The evidence confirms the model's prediction that there is a tradeoff between rigidity and flexibility in a trading environment with incomplete contracts and ex ante uncertainty about the state of nature. Flexible contracts - which would dominate rigid contracts under standard assumptions - cause a significant amount of shading on ex post performance, while under rigid contracts, much less shading occurs. Thus, although rigid contracts rule out trading in some states of the world, parties frequently implement them. While our results are broadly consistent with established behavioral concepts, they cannot easily be explained by existing theories. The experiment appears to reveal a new behavioral force: ex ante competition legitimizes the terms of a contract, and aggrievement and shading occur mainly about outcomes within the contract.

Cupid's Arrow...

In voting theory, one of the most important results is the so called "Arrow's Impossibility Theorem". For the uninitiated, here is the trick to memorize what the theorem is all about.

The theorem states that if a voting system satisfies:
Complete and transitive social preferences;
Universal domain, i.e., any individual preference ordering is allowed;
Pareto efficiency (or unanimity); and
Independence of irrelevant alternatives (IIA);

then there must exist a

Dictator. Well, don't forget that the theorem gots its own name, that is, ARROW's impossibility theorem.

So, just remember: Cupid's Arrow!!

HT to Uncle Marcus.

Who Am I? Arrogant? Impatient? Insensitive?

This is a site that analyzes blogs and also tells you what the bloggers' psychological profiles may look like.

Here is what it says about me:

INTP - The Thinkers

The logical and analytical type. They are especialy attuned to difficult creative and intellectual challenges and always look for something more complex to dig into. They are great at finding subtle connections between things and imagine far-reaching implications. They enjoy working with complex things using a lot of concepts and imaginative models of reality. Since they are not very good at seeing and understanding the needs of other people, they might come across as arrogant, impatient and insensitive to people that need some time to understand what they are talking about.

And this shows what parts of the brain that were dominant during writing:

HT to Mankiw.

US Auto Industry

GM, Ford and Chrysler, the Big Three US Automobile companies have lost tens of billions of dollars during the past few years, and they will shortly run out of cash. Recently, they asked the government for a bailout. Many Congressmen want to grant them at least $25 billion from the $700 billion Troubled Asset Relief Program on top of $25 billion in low-interest loans approved earlier this year. But the question is, should the government give them such a "free lunch"?

Here is the debate between two well known economists -- Jeffrey Sachs argues that a rescue of the Auto industry is essential, but Gary Becker, says this is not a good idea at all.

HT to Mankiw.

£arry $ummers's New Job

Not president of any Ivy-league university, not Treasury secretary, but the head of National Economic Council to the next President.

Here is a post in which Mankiw points out that in the future, NEC is likely to become a substitute rather than complement to the Council of Economic Advisors.

Dangerous Words: "Fair" and "Fairness"

...from Carpe Diem.

Richard Epstein on Happiness, Inequality and Envy

In last week's Econtalk, Richard Epstein of the University of Chicago talked about the relationship between happiness and wealth, inequality and happiness, and the economics of envy and altruism. He also applied the theory of evolution to explain some of the findings of the happiness literature.

Secrets of Success

In his new book, Outliers, Malcolm Gladwell tells us that in order to be successful, not only talent matters, but also timing, opportunity and not surprisingly, good old-fashioned hard work and discipline. However, what do surprise him most are the ordinary methods successful people use to achieve all they achieve.

In his words, "success is not a function of individual talent. It's the steady accumulation of advantages." Here are his five steps toward success:

1. Find meaning and inspiration in your work.
2. Work hard.
3. Discover the relationship between effort and reward.
4. Seek out complex work to avoid boredom and repetition.
5. Be autonomous and control your own destiny as much as possible.

Matrix Cookbook

If you are driven crazy again and again by those horrible matrix calculations in your econometrics class or in many other circumstances, here is (maybe) the best reference I can ever find. It just covers about every matrix and vector equality you will ever need.

Mankiw's advice

...to President-elect Obama, see here.

Job Market

Hat tip to Carpe Diem.

Cost and Benefit...

Gordon Tullock, cofounder of public-choice economics explains in this short PBS video why he does not vote.

Hat tip to Cafe Hayek.

The Lady Tasting Tea

Yesterday, a friend of mine recommended a book to me, The Lady Tasting Tea by David Salsburg, which is a book about the history of modern statistics and the role it played in the development of science and industry.

Here are some quotes from the publisher:

"At a summer tea party in Cambridge, England, a lady states that tea poured into milk tastes differently than that of milk poured into tea. Her notion is shouted down by the scientific minds of the group. But one guest, by the name Ronald Aylmer Fisher, proposes to scientifically test the lady's hypothesis. There was no better person to conduct such a test, for Fisher had brought to the field of statistics an emphasis on controlling the methods for obtaining data and the importance of interpretation. He knew that how the data was gathered and applied was as important as the data themselves. "

"In The Lady Tasting Tea, readers will encounter not only R.A. Fisher's theories (and their repercussions), but the ideas of dozens of men and women whose revolutionary work affects our everyday lives. Salsburg traces the rise and fall of Karl Pearson's theories, explores W. Edwards Deming's statistical methods of quality control (which rebuilt postwar Japan's economy), and relates the story of Stella Cunliffe's early work on the capacity of small beer casks at the Guinness brewing factory. The Lady Tasting Tea is not a book of dry facts and figures, but the history of great individuals who dared to look at the world in a new way. "

Must be interesting.