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Economics Working Papers, 2010

Copies may be downloaded on pdf, or hard copies may be requested from Joshua Hall, Working Paper Coordinator.

10-01 Zuleta, Hernando and Young, Andrew T.

"Labor's Shares in a Model of Induced Innovation"

Abstract: The relative stability of aggregate labor's share constitutes one of the great macroeconomic ratios. However, relative stability at the aggregate level masks the unbalanced nature of sectoral labor's shares. We present a two-sector (manufacturing and services) model with induced innovation that can rationalize these phenomena as well as several other empirical regularities of actual economies. Specifically, along the transition path (i) manufacturing becomes increasingly capital-intensive over time while (ii) there is an increase in the relative price and production share of services and (iii) aggregate labor's share converges from above to a non-zero value. At the sectoral level (iv) labor's share in manufacturing trends towards zero. Notably, (v) the model may transition to either a neoclassical steady-state or long-run endogenous growth, so it has the potential to account for a wide range of growth experiences.

10-02 Young, Andrew T.

"Do US Federal Revenues and Expenditures Respond Asymmetrically to Budgetary Disequilibria?"

Abstract: The basic answer to the question posed by the title is: yes. We follow Ewing et al. (2006) and examine the US federal revenue-expenditure nexus in an error-correction model allowing for asymmetric adjustment. Symmetric adjustment is rejected by data from the 1959.3 to 2007.4 period. However, as do Ewing et al., I employ both threshold autoregression (TAR) and momentum threshold autoregression (M-TAR) models; depending on whether the TAR model or M-TAR model is employed, the estimated asymmetry is very different. The M-TAR model suggests that that revenues and expenditures respond to budgetary disequilibria only when the budget is worsening while the TAR model suggests responses only when the budget is improving. Ewing et al. take a strong stand in preferring the M-TAR-based results. I, however, argue that there is little justification for preferring one model over the other. More importantly, I also argue that the concepts of "worsening" or "improving" budgets are model-contingent in important ways. Taking this into account, the results across models need not be contradictory.

10-03 Young, Andrew T., Zuleta, Hernando, and Garcia-Suaza, Andres.

"Evidence of Induced Innovation in US Sectoral Capital's Shares"

Abstract: We use annual data on capital's share and relative factor prices from 35 US industries from 1960 to 2005 to test the induced innovation hypothesis. We derive, from a production function framework, testable implications for the effect of contemporaneous and lagged factor price ratios on capital's share of production. The predicted effect is positive or negative depending on the elasticity of substitution between labor and capital. From panel regressions, the estimated effect of the contemporaneous factor price ratio implies an elasticity of substitution that is less than unity, consistent with the consensus from the literature. Based on this, our negative estimated effects for lagged price ratios are both statistically significant and consistent with the induced innovation hypothesis.

10-04 Young, Andrew T., Wiseman, Travis, and Hogan, Thomas L.

"Changing Perceptions of Maturity Mismatch in the US Banking System: Evidence from Equity Markets"

Abstract: US banks are thought to have become increasingly fragile and exposed during the lead-up to the recent financial crisis. However, commercial bank leverage actually decreased during this period. To resolve this discrepancy, we explore another dimension of bank balance sheets: the effective maturity mismatch between assets and liabilities. Although banks assets are generally longer in term than their liabilities, we find evidence of a structural break in the mid-1990s when equity markets begin pricing banks as relatively longer-funded. Categories of bank assets such as real estate loans (i.e., mortgages and MBSs) and consumer loans were perceived as having become effectively shorter-term.

10-05 Klein, Rudolf F., and Chow, K. Victor.

"Orthogonalized Equity Risk Premia and Systematic Risk Decomposition"

Abstract: To solve the dependency problem between factors, in the context of linear multi-factor models, this study proposes an optimal procedure to find orthogonalized risk premia, which also facilitates the decomposition of the coefficient of determination. Importantly, the new risk premia may diverge significantly from the original ones. The decomposition of risk allows one to explicitly examine the impact of individual factors on the return variation of risky assets, which provides discriminative power for factor selection. The procedure is experimentally robust even for small samples. Empirically we find that even though on average, approximately eighty (sixtyfive) percent of style (industry) portfolios' volatility is explained by the market and size factors, other factors such as value, momentum and contrarian still play an important role for certain portfolios. The components of systematic risk, while dynamic over time, generally exhibit negative correlation between market, on one side, and size, value, momentum and contrarian, on the other side.

10-06 Young, Andrew T.

"US Elasticities of Substitution and Factor-Augmentation at the Industry Level"

Abstract: We provide industry-level estimates of the elasticity of substitution (σ) between capital and labor in the US economy. We also estimate rates of factor-augmentation. Aggregate estimates are produced using the same data. Our empirical model comes from the first-order conditions associated with a CES production function. Our data represents 35 industries at roughly the 2-digit SIC level from 1960 to 2005 and covers the entire US economy. We find that aggregate US σ is less than unity and perhaps less than 0.5.The same is likely true for the large majority of individual industries. We find no consistent and/or systematic evidence that aggregate σ is either greater or less than the value-added share-weighted average of industry σs. Also, there is still considerable variation across the industry-level σ point estimates. Technical change in the aggregate appears to be net labor-augmenting. However, at the industry-level there is little evidence that the type of technical change is uniform across industries. For many individual industries, technical change may be characterized by net capital-augmentation.

10-07 Young, Andrew T., Levy, Daniel

"Explicit Evidence on an Implicit Contract"

Abstract: We offer the first direct evidence of an implicit contract in a goods market. The evidence we offer comes from the market for Coca-Cola. We demonstrate that the Coca-Cola Company left a substantial amount of written evidence of its implicit contract with its consumers—a very explicit form of an implicit contract. The contract represented the promise of a five cent (nominal) price and adherence to the "Secret Formula". In general, the implicit nature of such contracts makes observation difficult. To overcome this difficulty, we adopt a narrative approach. Based on the analysis of a large number of historical documents obtained from the Coca-Cola Archives and other sources, we offer evidence of the Coca-Cola Company both acknowledging and acting on this implicit contract. We also make another unique contribution by exploring quality as a margin of adjustment available to Coca-Cola. The implicit contract included a promise not only of a constant nominal price but also a constant quality (i.e., 6.5 oz. of the Secret Formula). During a period of over 70 years, we find evidence of only a single case of true quality change. By studying the margin of adjustment the Coca-Cola Company chose in response to changes in market conditions, we demonstrate that the perceived costs of breaking the implicit contract were large. We argue that one piece of direct evidence on the magnitude of these costs is the aftermath "New Coke's" introduction in 1985.

10-08 Klein, Rudolf F., Chow, K. Victor

"Sentiment Effect and Market Portfolio Inefficiency"

Abstract: We apply Marginal Conditional Stochastic Dominance (MCSD) tests to returns on sentiment beta sorted portfolios and sentiment-arbitrage portfolios, constructed using the Baker and Wurgler (2007) index of sentiment levels. The theory of MCSD demonstrates that, if one (mutually exclusive) subset of a core portfolio dominates another, conditional on the return distribution of the core portfolio, then the core portfolio is inefficient for all utility-maximizing risk-averse investors. Based on returns on the U.S. equity market, we show that both positively and negatively sentiment sensitive stocks are conditionally and stochastically dominated by sentiment insensitive stocks. Moreover, we find dominance among sentiment-arbitrage portfolios, constructed with positively sensitive vs. insensitive, insensitive vs. negatively sensitive, and positively vs. negatively sensitive stocks. Therefore, we conclude that the market portfolio is stochastically inefficient.

10-09 Martins-Filho, Carlos, Yao, Feng

"Nonparametric stochastic frontier estimation via profile"

Abstract: We consider the estimation of a nonparametric stochastic frontier model with composite error density which is known up to a finite parameter vector. Our primary interest is on the estimation of the parameter vector, as it provides the basis for estimation of firm specific (in)efficiency. Our frontier model is similar to that of Fan et al. (1996), but here we extend their work in that: a) we establish the asymptotic properties of their estimation procedure, and b) propose and establish the asymptotic properties of an alternative estimator based on the maximization of a conditional profile likelihood function. The estimator proposed in Fan et al. (1996) is asymptotically normally distributed but has bias which does not vanish as the sample size n→∞. In contrast, our proposed estimator is asymptotically normally distributed and correctly centered at the true value of the parameter vector. In addition, our estimator is shown to be efficient in a broad class of semiparametric estimators. Our estimation procedure provides a fast converging alternative to the recently proposed estimator in Kumbhakar et al. (2007). A Monte Carlo study is performed to shed light on the finite sample properties of these competing estimators.

10-10 Martins-Filho, Carlos, Yao, Feng

"A note on some properties of a skew-normal density"

Abstract: The sum of two independent random variables with normal and half normal densities has a skew-normal density (Azzalini, 1985). In this note we show that this skew-normal density satisfies all assumptions required in establishing the asymptotic properties of the estimators discussed in Martins-Filho and Yao (2010).

10-11 Yao, Feng, Zhang, Junsen

"Efficient semiparametric instrumental variable estimation"

Abstract: We consider the estimation of a semiparametric regression model where data is independently and identically distributed. Our primary interest is on the estimation of the parameter vector, where the associated regressors are correlated with the errors and contain both continuous and discrete variables. We propose three estimators by adapting Robinson's (1988) and Li and Stengos' (1996) framework and establish their asymptotic properties. They are asymptotically normally distributed and correctly centered at the true value of the parameter vector. Among a class of semiparametric IV estimators with conditional moment restriction, the first two are efficient under conditional homoskedasticity and the last one is efficient under heteroskedasticity. They allow the reduced form to be nonparametric, are asymptotically equivalent to semiparametric IV estimators that optimally select the instrument and reach the semiparametric efficiency bounds in Chamberlain (1992). A Monte Carlo study is performed to shed light on the finite sample properties of these competing estimators. Its applicability is illustrated with an empirical data set.

10-12 Sobel, Russell S., Nabamita Dutta, and Sanjukta Roy

"Does Cultural Diversity Increase The Rate Of Entrepreneurship?"

Abstract: In the economic development literature, cultural diversity (for example, ethnolinguistic fractionalization) has been shown to have a negative impact on economic outcomes in many underdeveloped countries. We hypothesize that the impact of diversity on economic performance depends on the quality of a country's institutions. Under bad institutions diversity leads to conflict and expropriation, while under good institutions diversity leads to economic progress. A culturally diverse society or interaction among different cultures encourages exchange of, and competition between ideas and different world views. Under good institutions, this amalgamation of ideas and views leads to greater entrepreneurial initiatives. We show that higher levels of cultural diversity increase the rate of entrepreneurship in the presence of good institutions using evidence from the United States.

10-13 Crowley, George R. and Russell S. Sobel

"Adam Smith: Managerial Insights from the Father of Economics."

Abstract: This paper applies the ideas found in the work of Adam Smith, the preeminent 18th century economist, to the field of management. Adam Smith was the first person to identify specialization and the division of labor as the main drivers of productivity. He also conceptualized the 'invisible hand principle' which explains how, under the proper set of incentives, self-interested individuals are directed to pursue activities that benefit the whole of society. Both ideas are of utmost importance in the field of management. Specifically, successful managers are those who are able to create good 'rules of the game' which align the incentives of labor with the goals of the firm. Smith's contributions provide a foundation for the division of labor and demonstrate the importance of establishing the right 'institutions' within a firm.

10-14 Sobel, Russell S. and Christopher J. Coyne

"Cointegrating Institutions: The Time-Series Properties of Country Institutional Measures."

Abstract: A country's political and economic institutions are critical for economic prosperity. The literature abounds with institutional measures, precisely because institutions are multi dimensional. We use panel-unit-root and cointegration tests to examine the time-series properties of several institutional measures to answer two questions. First, do institutional changes tend to be permanent? Second, which subsets of institutions tend to converge or move together? These answers have important implications for whether permanent institutional reform is possible, and whether reforms can be undertaken one institutional area at a time, or instead must simultaneously encompass multiple institutional areas.

10-15 Hall, Joshua C., Russell S. Sobel, and George R. Crowley

"Institutions, Capital, and Growth."

Abstract: The international development community has encouraged investment in physical and human capital as a precursor to economic progress. Recent evidence shows, however, that increases in capital do not always lead to increases in output. We develop a growth model where the allocation and productivity of capital depends on a country's institutions. We find that increases in physical and human capital lead to output growth only in countries with good institutions. In countries with bad institutions, increases in capital lead to negative growth rates because additions to the capital stock tend to be employed in rent-seeking and other socially unproductive activities.

10-16 Crowley, George R. and Russell S. Sobel

"Does Fiscal Decentralization Constrain Leviathan? Evidence from Local Property Tax Competition."

Abstract: This paper reexamines whether fiscal decentralization constrains Leviathan government. Using panel data for Pennsylvania, we compare actual property tax rates to the Leviathan revenue-maximizing rates for municipalities, school districts, and counties. Using spatial econometric methods we also estimate the degree of spatial dependence at the three levels of local government. We find that fiscal decentralization results in stronger intergovernmental competition and lower tax rates. We also find evidence of collusion among school districts that exhibit high interdependence but also high tax rates. This calls into question the current literature's blind use of spatial dependence as a measure of intergovernmental competition.

10-17 Sobel, Russell S., Young, Andrew

"Recovery and Reinvestment Act Spending at the State Level: Keynesian Stimulus or Distributive Politics?"

Abstract: We examine the US state-level pattern of American Recovery and Reinvestment Act (ARRA) spending. We relate spending to (1) Keynesian determinants of countercyclical policy, (2) congressional power and dominance, and (3) presidential electoral vote importance. We find that the ARRA is, in practice, poorly-designed countercyclical stimulus. After controlling for political variables, coefficients on Keynesian variables are often statistically insignificant. When they are statistically significant they are often the "incorrect" sign. On the other hand, statistically significant effects associated with political variables are almost always of the sign predicted by public choice theory. One striking result is that the elasticity of ARRA spending with respect to the pre-ARRA levels of federal grants and payments to state and local governments is between 0.254 and 0.361. States previously capturing large amounts of federal funds continue to do so under the ARRA stimulus.

10-18 Carton, Joel, Guse, Eran

"Replicator Dynamic Learning in Muth's Model of Price Movements"

Abstract: We investigate the stability properties of Muth's model of price movements when agents choose a production level using replicator dynamic learning. It turns out that when there is a discrete set of possible production levels, possible stable states and stability conditions differ between adaptive learning and replicator dynamic learning. Furthermore, we show that the stability disparities between the two types of learning are due to the way asymptotic stability is defined under the replicator dynamics.

10-19 Douglas, Stratford, Nishioka, Shuichiro

"International Differences in Emissions Intensity and Emissions Content of Global Trade" Note: This is a major update of working paper 09-02.

Abstract: Understanding international differences in the emissions intensity of trade and production is essential to understanding the effects of greenhouse gas limitation policies. We develop data on emissions from 41 industrial sectors in 39 countries and estimate the CO2 emissions intensity of production and trade. We find no evidence that developing countries specialize in emissions-intensive sectors; instead, emissions intensities differ systematically across countries because of differences in production techniques. Thus, the technology of developing countries drives the greater emissions intensity of their exports. Our results suggest that international differences in emissions intensity, while substantial, do not play a significant factor in determining patterns of trade.

10-20 Young, Andrew T, Dove, John A.

"Policing the Chain Gang: Panel Cointegration Analysis of the Stability of the Sufforl System, 1825-1858"(Revised)

Abstract: Conventional monetary theory suggests that a closed system banking regime may lead to a systematic and uniform over-expansion of circulation. However, Selgin (2001, 2010) argues that as the number of banks increases, they act much as a "chain gang" does, making coordination all the more difficult. As long as note redemption occurs rapidly, banks are forced to pay a penalty for holding negative balances with one another, and there is a positive rate of interest charged for loans between banks, then the only possible means for a uniform increase to occur is dependent upon a prior increase in specie. In order to test this conjecture, we employ a battery of cointegration techniques upon a unique dataset compiled from the Suffolk Banking System between 1825-1858. We find evidence to suggest that Selgin's (2001,2010) conjecture is indeed correct and is robust to a number of specifications, something never before empirically tested or observed within the literature.

10-21 Harris, David.

"A Necessary Limitation for Models of Capital and Capital Markets"

Abstract: The principal models in finance contain the implicit assumption that people invest money with the belief they will make a profit. This implicit assumption, when made explicit, gives rise to contradictions in the derivation of these models as they currently exist. As such, existing models fail to predict many observed behaviors and indeed many contradictions appear in the literature. Making the assumption of profitability explicit is necessary in modeling human behavior. The Capital Asset Pricing Mode, Arbitrage Pricing Theory and Itô Calculus based models for derivative pricing contain a mathematical contradiction corrected by this model and they are false by contradiction.