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Economics Working Papers, 1995


"Mean Reversion and Optimal Intertemporal Portfolio Choice."

Abstract: It has been well documented, empirically and theoretically, that stock returns may be predictable in the context of efficient markets. Over longer horizons stock prices are mean revertive causing returns to be negatively autocorrelated. In this context of serially correlated returns the present paper is the first to derive an explicit analytical solution to the dynamic portfolio problem of an individual household saving for retirement. Using a normal ARMA (1,1) process, dynamic programming techniques combined with the use of Stein's Lemma are employed to obtain a qualified confirmation of the age effect for CARA preferences and for a version with CRRA preferences.


"Estimation of Relative Standards of Living Among the United States Using Cross-Migration Data."

Abstract: This paper presents a random utility "voting with your feet" model of the link between relative standard of living and the decision to migrate, and develops a new estimator to link this model to the available census data. It compares this estimator to previous ones found in the literature, and presents an algorithm for converting the observed pairwise choices between U.S. states into overall rankings for 1970 and 1980. The rankings show a persistently high standard of living in the Northwest (especially Washington state), with the Northeast and upper Midwest persistently trailing the rest of the county. Cross-migration data using the new estimator provides different rankings, with a former theoretical basis and more efficient use of migration information, than did the estimators used in previous work.

95-03 DOUGLAS, STRATFORD and David K. Guilkey.

"Bootstrap Standard Error Estimates in a Switching Regression Model with Unknown Switch Point."

Abstract: We identify and analyze a problem in switching regressions estimation, and evaluate the bootstrap as a solution. Regression parameters and standard errors are estimated conditional on the switch point estimate and hence are biased downward relative to unconditional standard errors. We estimate a response surface to evaluate the accuracy and responsiveness of the bootstrap standard errors. Our results indicate that the bootstrap estimates standard errors of both the switch point estimator and regression coefficient estimators with reasonable accuracy


"Commitment in Dynamic Voluntary Provision of Public Goods."

Abstract: Fershtman and Nitzan (1991) employed a differential game framework to study a dynamic public goods problem in which individuals' contributions are accumulated over time. They claim that the free riding problem is more severe when players use feedback strategies than when players use open-loop strategies. We reexamine Fershtman and Nitzan's model and obtain the opposite result. Since an open-loop strategy consists of an entire course of action precommited at the beginning of the game, the free riding problem can be aggravated by such commitments in their model.


"Toward a Better Understanding of Differential Games."

Abstract: A common conclusion in several recent studies of differential game models is that players are better off in an open-loop equilibrium than in a feedback equilibrium. In this paper, we show that this common conclusion is misleading. We find that this common erroneous claim is due to the improper treatment of interaction terms in their derivation of the feedback equilibrium. We propose a computationally efficient method that allows us to fully characterize both feedback and open-loop equilibria. We also provide a "formula" to calculate the stable equilibrium state when one has a system of coupled differential equations that is obtained using the traditional value-function approach.


"Growth, Welfare, and Optimal Trade Taxes - A Fallacy of Composition," published in Journal of Development Economics.

Abstract: Optimal export taxation rules out the possibility of immiserizing growth in a two county world. Thus, productivity increases in the exporting sector must be welfare improving. This paper shows that in a multicounty world such reasoning commits a fallacy of composition. Simultaneous growth of exporting nations can lead to welfare losses in the presence of unilaterally optimal export taxes. Also, optimal export taxes can decline in response to such growth. This result further strengthens the possibility of perverse welfare movements. Thus, standard policy recommendations of increasing productivity in the exporting sector may lead to unintended and self defeating outcomes.


"Foreign Investment in the Exporting Sector - Welfare Enhancing or Welfare Reducing?" published in Southern Economic Journal, October 1995.

Abstract: This paper analyzes the welfare effect of simultaneous foreign investments in the exporting sector of primary-product-producing nations in three different contexts. Two polar results are obtained. Under free trade welfare unambiguously falls while under optimal cooperative intervention welfare unambiguously rises. On the other hand, if the exporting nations impose unilaterally optimal export taxes, the direction of the welfare effect is critically dependent on the income elasticity of demand. Each exporting nation imposes a terms of trade externality on the other exporting nation that is not internalized by the imposition of the unilaterally optimal trade taxes.


"Wage and Employment Negotiations between a Union and a Firm in a Dynamic Context," published in Southern Economic Journal, October 1995.

Abstract: This paper studies the implications of deviation (from cooperation) by both the union and the firm on the equilibrium paths of wage and employment, in the context of a simultaneous move repeated game model. We get the surprising result that when both firms and unions have the power to deviate, some cooperation is not guaranteed and the non-cooperative monopoly union equilibrium obtains over large ranges of the discount factor. Therefore cooperation is much harder to sustain the in the case where only the firm can deviate. The union may also enjoy a higher wage for a given level of employment as compared to the case where the firm alone can deviate.


"Using Migration Data to Estimate Relative Amenities in Canadian Provinces."

Abstract: This paper uses migration data to calculate differences in amenities across regions. When there are moving costs, amenity differentials may not be completely compensated for by differences in market-generated variables at each point in time, meaning that the standard of living may not be uniform across regions. Thus, market-generated variables, such as income and rent, may not accurately reflect compensating differentials. Because of this, we use cross-migration rates to estimate the relationship between migration and income, and to calculate the income for which standard-of-living equivalence would occur.


"The Revealed Cost of Unemployment."

Abstract: We propose estimating the costs of cyclical unemployment by the amount that people would be willing to pay to avoid it. Because unemployment rates are a measure of labour market risk, regional income differentials should tend to compensate for regional differences in unemployment. Because this compensation is not complete in the short run, we use cross-migration rates to reveal people's preferences towards the income-unemployment tradeoff. We estimate that the total cost of cyclical unemployment in Canada from 1971-1986 was between 3.3 and 7.4% of national income. This amount of additional income is comparable to additional growth of 0.4 to 0.8% every year.


"The Duration of the Smoking Habit."

Abstract: I investigate the determinants of the decisions to start and quit smoking in a rational addiction framework using an ordered probit split sample duration model with time-varying covariates and lagged duration dependence. While controlling for the probability that a nonsmoker will never start and that smoker will never quit, this technique allows for interaction between that durations of the nonsmoking and smoking periods, and allows changing cigarettes prices to affect each individual's hazard rates. Results support the proposition that cigarettes are addictive, and indicate that cigarette price changes have a statistically significant effect on both the hazard rate of starting smoking a, and the hazard of quitting smoking. However, as a practical matter the effect of cigarette prices on starting hazard is quite small. The Surgeon General's report in 1964 is estimated to have little or no effect on the starting hazard, but a relatively large effect on quitting hazard.


"The Political Cost of Tax Increases and Expenditure Reductions: Evidence from State Legislative Turnover."

Abstract: This paper estimates the political costs of increasing taxes and cutting expenditures for members of a legislature. For the average state legislature it is found that both costs are individually significant, but that they are not different from each other. This is consistent with the first order condition from models where legislators attempt to maximize their probability of reelection. It is also found that Republican controlled legislatures have a higher political cost for increasing taxes. This suggests that the Republican party's relative bias toward smaller government is founded in stronger constituent preferences against taxes, not constituent preferences for lower spending.


"Endogenous Effort in a Dyanmic Model of Union-Firm Interaction."

Abstract: This paper studies the implications of union deviation by reducing effort in the context of a repeated game model. We argue that it is important to model effort as an endogenous variable and also to consider the repeated nature of the bargaining process. We find that when unions deviate by slowing down cooperation becomes impossible to sustain for low values of the discount factor. Introduction of endogenous effort generates relative wage stability across parameter values since that variability is distributed between wage, effort and employment. This paper also finds that wage concessions are quite consistent with an end game situation.

95-14 Gelles, Gregory and DOUGLAS MITCHELL.

"Comparative Portfolio Behavior with Multiple Risky Assets."

Abstract: We consider the partial offering of utility functions to predict comparative portfolio features with two or more risky assets. First, we show that no utility ordering can predict comparative holdings of the riskier asset for any reasonable definition of the latter. Second, we reinterpret results of Arrow-Pratt and Ross as predicting comparative mean-seeking behavior. Third, we present a stronger utility ordering which predicts comparative portfolio means for tow risky assets with no joint distribution restrictions. Finally we show that the latter utility ordering also predicts comparative portfolio means with n risky assets.


"Portfolio Response to a Shift in a Return Distribution: The Case of n Dependent Assets."

Abstract: Recent papers have shown utility function conditions which are necessary and sufficient, in a two-asset context with or without stochastic dependence, for a conditional first-order stochastically dominating shift (or a conditional mean-preserving contraction ) of one asset's return distribution never to result in a decline in holdings of the asset. These condition are also known to be necessary when there are an arbitrary number of assets. The present paper shows that these conditions are sufficient when there are an arbitrary number of assets.


"Wage Endogeneity and Unionized Oligopoly: A Paradox."

Abstract: This paper finds that unionization is welfare augmenting in the context of strategic export policy. Two nations are considered who are symmetric in all respects other than that one has a unionized labor market and the other a competitive labor market. The nation with the unionized labor market has the higher welfare level in the policy equilibrium.


"Illegal Immigration: A Supply Side Analysis."

Abstract: This paper analyzes the source country (supply side) determinants of illegal immigration in the context of a three-sector general equilibrium model. Liberalization of the agricultural sector increases illegal immigration which liberalization of the high tech sector reduces it. Under capital mobility, illegal immigration is independent of trade liberalization. Paradoxically, increased enforcement may raise unskilled wages in the source country, even though illegal immigration will necessarily fall.


"Unionized Bertrand Duopoly and Strategic Export Policy."

Abstract: We find that the degree of product differentiation is crucially linked to the optimality of a strategic export subsidy/tax in a unionized Bertrand duoploy. An export subsidy is generally optimal except for a very narrow range of extreme substitutability between the two products. We also find that for sufficiently differentiated products the union wage rises with a fall in the alternative wage. This result is shown to hold under homogeneous good Cournot competition as well.


"Borrower Risk and the Choice of Mortgage Type: A Theoretical and Empirical Analysis."

Abstract: This article provides a theory-based empirical study of the main determinants of the borrower's mortgage instrument preference in the presence of both nominal and real shocks. The empirical findings reinforce that particular, heretofore not examined, individual characteristics and risk components can be important determinants of the mortgage type selection. Specifically the initial down payment, the value of the house, and nominal and real risks are significant, while on the other hand income is insignificant. The analysis of the payment-to-income and there for liquidity constrained borrowers reveals that liquidity and income also influence the mortgage instrument selection.


"Racial Differences in the Migration Response to Social Welfare Benefits: Revisited."

Abstract: A large body of empirical research conducted during the past 30 years found that, at least during the 1950s and 1960s, the effect of welfare benefits on migration differed significantly by racial group. Blacks searched for higher welfare benefits while whites were repulsed by areas that provided high welfare benefits. This study revisits the issue of racial differences in attractiveness to interregional differences in welfare benefits. Using a comprehensive model of state-to-start migration that accounts for a variety of economic, amenity, and spatial factors, there is no statistically significant evidence that either origin or destination AFDC benefits affected migration decisions of blacks during the 1960s and 1970s. In the case of whites, origin AFDC benefits had no effect while higher destination benefit levels had a very mild repulsive effect.


"Income and Poverty in Appalachia: A Report to the Appalachian Regional Commission."

Abstract: This paper presents a general analysis of income and poverty in Appalachia. It addresses four main questions: (1) What is the current status of living standards in Appalachia? (2) What are the sources of income for the Appalachian population? (3) What is the current start of poverty in Appalachia? (4) What are the characteristics of the Appalachian poor? The first question focuses on average income and wealth (housing), the second on the importance of earnings, capital income, and transfers in the Appalachia income stream, the third on the degree and location of poverty in Appalachia, and the fourth on the key demographic characteristics generally associated with higher rates of poverty. Appalachia is compared with the rest of the United States on several geographic levels. In addition to considering the nonmetropolitan and metropolitan portions of Appalachia's three subregions, and urban/rural continuum is employed in the analysis. Finally, to take some account of regional cost-of-living differentials, Appalachian counties are compared to counties in their own Bureau of Economic Analysis economic region.


"Estimating Relative Standard of Living Among the United States Using Cross-Migration Data."

Abstract: This research presents a random utility "voting with your feet" model of the standard of living and develops a new estimator to link this model to migration data. It compares this estimator to previous ones found in the literature, and presents an algorithm for converting the observed pairwise choices between U.S. states into overall rankings for 1970 and 1980. This rankings shoe a persistently high standard of living in the Northwest (especially Washington state), with the Northeast and upper Midwest persistently trailing the rest of the country. The new estimator provides different rankings, with a firmer theoretical basis and more efficient use of migration information, than did the estimators used in previous work. It also implements a nonparametric test that provides evidence that the system was near equilibrium in 1970, but not in 1980.


"Optimal Export Tax When Demand is Uncertain."

Abstract: A standard result in export subsidy/tax game models is that if governments can credibly precommit themselves to a particular trade policy, an export subsidy (tax) is optimal when firms engage in quantity (price, respectively) competition (Brander and Spencer, 1985; Eaton and Grossman, 1986). In this paper, we consider a model of dynamic duopoly when demand in importing country is uncertain. We show that in a symmetric equilibrium a subsidy is optimal for both quantity and price competition, In both cases, bilateral government interventions via taxes move equilibrium toward the joint-profit maximizing outcome away from the competitive outcome.

95-24 Robert A. Lawson and RUSSELL SOBEL.

"Will Term Limits Limit Government Spending?"

Abstract: This paper empirically examines the likely efficacy of term limits as a means of limiting the size and growth of government. Our data form the 103rd Congress include the dollar amounts of spending associated with every bill which the legislators sponsored or cosponsored, and favorably voted. Control variables based on the personal characteristics of the legislator, including the number of terms in office, and the district from which they were elected are included in the regression analyses. The results indicate that term limits may reduce government spending but that the effect is probably quite small.


"Optimal Taxation in a Federal System of Governments."

Abstract: This paper examines several alternative structures of taxation in a federal system of governments. It is shown that a system where only states have the power of taxation, and the federal government gets its revenues as contributions from the states, is preferable to a system where both levels have the power of taxation. In essence, this paper argues that the system present under the Articles of Confederation, and partially in the Confederate States, is preferable to the current U.S. system. The conclusions of this paper also favor the current U. N. system, where nations make contributions, over the U.N. having the power of taxation.