on the exclusion of assets from tests of the mean variance efficiency of the market portfolio this paper presents an analysis of the testability of the mean variance efficiency of a market index when the returns on some components of the index itself are not perfectly observable the results are basically not supportive of the notion that mean variance efficiency is testable on a subset of the assets bounding the market share of the missing asset and its expected return is not sufficient to produce a valid test when the variance of the missing asset is bounded and the amount of wealth that might be missing is small it is possible in principle to reject correctly the mean variance efficiency of a market index in his famous critique of the asset pricing theory tests roll 7 concludes that the only testable hypothesis associated with the generalized two parameter asset pricing model of black 1 is that the market portfolio is mean variance efficient it has been emphasized by ross 10 and roll 7 that the mean variance efficiency of the market portfolio is mathematically equivalent to a positive linear relation between expected returns and the betas calculated against such a portfolio roll 7 deduces that the theory capm is not testable unless the exact composition of the market portfolio is known and used in the tests this implies that the theory is not testable unless all individual assets are included in the sample errors of type one or two might occur when a market proxy is used instead of the true market portfolio even if the ex ante true expected returns and the covariance variance matrix of the returns on all the assets are used these errors are the result of the choice of the portfolio and as roll puts it even a small misspecification of the proxy s composition can lead to the wrong conclusion the market proxy might be mean variance efficient while the true market portfolio is not and vice versa in principle however there are cases in which the above two conditions are not both necessary to reject the theory one such exception presented by roll 7 is the case in which no totally positive portfolio is efficient if any totally positive market proxy is used a large sample would reject the null hypothesis unambiguously while the market portfolio identification problem constitutes a severe limitation to the testability of the theory the question of the mean variance efficiency of a particular market index with respect to a subset of assets is a typical problem of statistical inference the mean variance efficiency can be tested directly or by

efficient and durable decision rules with incomplete information we compare six concepts of efficiency for economies with incomplete information depending on the stage at which individuals welfare is evaluated and on whether incentive constraints are recognized an example is shown in which an incentive efficient decision rule may be unanimously rejected by the individuals in the economy we define durable decision rules which can resist such unanimous rejection and show that efficient durable decision rules exist

the cost of contract renegotiation evidence from the local public sector the renegotiation of regulatory contracts is known to prevent regulators from achieving the full commitment efficient outcome in dynamic contexts however assessing the cost of such renegotiation remains an open issue from an empirical viewpoint to address this question we fit a structural principal agent model with renegotiation on a set of urban transport service contracts the model captures two important features of the industry first only two types of contracts are used in practice fixed price and cost plus second subsidies increase over time we compare a scenario with renegotiation and a hypothetical situation with full commitment we conclude that the welfare gains from improving commitment would be significant but would accrue mostly to operators

investment horizon risk and compensation in the banking industry this paper examines the relation between the investment horizon of banks and their ceo compensation and its consequences for risk and performance we find that banks with short term investment intensity pay more cash bonus exhibit higher risk and perform more poorly than banks with longer term investment intensity this evidence is broadly consistent with the view that short term means of compensation encouraged a short term investment focus which in turn led to both higher risk and resulted in poorer performance culminating in the sub prime crisis the inverse risk performance relation suggests pay schemes were incongruent with shareholders interest moreover pay arrangements used in banks prior to the subprime crisis exposed banks to the ex post settling up problem the clawback problem

asymmetric benchmarking in compensation executives are rewarded for good luck but not penalized for bad abstract principal agent theory suggests that a manager should be paid relative to a benchmark that removes the effect of market or sector performance on the firm s own performance recently it has been argued that such indexation is not observed in the data because executives can set pay in their own interests that is they can enjoy pay for luck as well as pay for performance we first show that this argument is incomplete the positive expected return on stock markets reflects compensation for bearing systematic risk if executives pay is tied to market movements they can only expect to receive the market determined return for risk bearing this argument however assumes that executive pay is tied to bad luck as well as to good luck if executives can truly influence the setting of their pay they will seek to have their performance benchmarked only when it is in their interest namely when the benchmark has fallen using industry benchmarks we find significantly less pay for luck when luck is down in which case pay for luck would reduce compensation than when it is up these empirical results are robust to a variety of alternative hypotheses and robustness checks and they suggest that the average executive loses 25 45 less pay from bad luck than is gained from good luck

optimal taxation and strategic budget deficit under political regime switching i develop a dynamic political economy theory of optimal taxation and budget distortions in a model with partisan politics under asymmetric information politics affects the distribution of utilities in the economy political regime switching introduces fluctuations of this distribution these fluctuations justify strategic budget distortions by governments currently holding office and willing to favour their redistributive concerns against future majority under quite general assumptions on preferences these distortions take the form of budget deficits resp surpluses with leftist rightist governments endogenizing the probabilities of getting elected may reverse this result this paper presents a dynamic political economy theory of taxation policy showing how partisan governments create strategic budget distortions under quite general assumptions on preferences for redistribution these distortions take the form of budget surpluses resp deficits when rightist resp leftist governments hold office being uncertain on whether it will remain in office in the future the current government chooses a level of deficit which will favour its redistributive concerns against those of future majorities it does so by constraining the redistributive policy of its successor through the budget constraint that the latter inherits a leftist resp rightist government is more resp less enclined to redistribute income by running some deficit today the leftist government ensures that society gets poorer tomorrow a future rightist government will redistribute more as society gets poorer the implemented tax policy will thus be close to what a leftist government would have chosen itself on the contrary by running a surplus today a rightest government relaxes the burden of taxation imposed by tomorrow s leftist government on high income agents this leftist government will be less eager to redistribute and will adopt the rightist party s behaviour under political regime switching strategic distortions of the state budget constraint become important tools for current governments willing to favour their own redistributive concerns against those of future majorities as a result of this dynamic game between partisan governments playing at different points in time with the state budget constraint future policies blend together the preferences for redistribution of current and past governments the commitment value of budget deficits has already been stressed by persson and

further international evidence on asset pricing the case of the spanish capital market abstract a multivariate framework is used in order to study the price formation of risky assets in the spanish capital market issues regarding the efficiency of the spanish value weighted stock market index the validity of equilibrium considerations the size effect and the nature of the return generating process during january are analyzed

optimal domestic regulation under asymmetric information and international trade a simple general equilibrium approach we investigate the design of domestic incentive regulations in a small economy opened to trade and its implications for international specialization and for trade openness to remain welfare improving more specifically we append to an otherwise standard 2 2 heckscher ohlin model of a small open economy a continuum of intermediate sectors producing nontradable goods used in tradable sectors those goods are produced by privately informed regulated firms asymmetric information induces distortions with general equilibrium impacts the small economy becomes relatively richer in the informationally sensitive factor so that asymmetric information might reverse trade patterns free trade is pareto dominated by autarky when it exacerbates agency distortions

exact arbitrage pricing and the minimum variance frontier the author examines the relationship between the arbitrage pricing theory of ross and mean variance analysis in particular conditions are derived on the vector of the factor risk premia that are equivalent to the existence of a strictly positively weighted portfolio on the minimum variance frontier also a sufficient condition is given under which the existence of a positive minimum variance portfolio of all the assets in the economy will imply the existence of a positive minimum variance portfolio on a subset this means that rejection of the hypothesis of the existence of a positive minimum variance portfolio on a subset satisfying this condition implies rejection for the whole set a growing body of literature explores the relationship between the arbitrage pricing theory apt of ross 13 14 and the mean variance model among the early work in this direction were the papers of chamberlain and rothschild 2 and chamberlain 1 these papers examine a sequence of economies and characterize the relationship in the limit between the mean and portfolio cost functionals and the minimum variance frontier chamberlain 1 also gives a condition under which exact arbitrage pricing will hold dybvig 4 and grinblatt and titman 7 examine equilibrium models in an apt context for a finite economy they derive sharp bounds on the deviation from exact arbitrage pricing recent papers by huberman kandel and stambaugh 9 and grinblatt and titman 8 explore the relationship between the apt and the mean variance model by studying portfolios that can be used as proxies for the factors and examining the relationship these portfolios bear to the minimum variance frontier these two papers also deal with equilibrium models in spite of the number and variety of equilibrium apt models the question of the pricing of factor risk in equilibrium remains largely unexplored this paper makes some progress in addressing that issue by looking at a given equilibrium restriction and studying the constraints it imposes on the vector of factor premia itself the most familiar equilibrium restriction we might study is the central implication of the capital asset pricing model capm that the market portfolio is efficient in particular no portfolio with the same expected return as the market portfolio has a smaller variance the restriction we actually study is weaker than

derivatives regulation implications for central banks abstract we review aspects of derivatives markets that affect central bank operations we focus on how derivatives affect monetary policy and bank supervision and argue that derivatives have no material adverse impact on the conduct of monetary policy our analysis suggests that both derivatives users and dealers face relatively small default risks from derivatives systemic risk the risk of widespread default has been largely exaggerated policy debates have neglected incentives of employees the nature of this agency risk suggests that internal controls are more likely to reduce these problems than derivatives regulation

on multivariate tests of the capm abstract this paper evaluates the power of multivariate tests of the capital asset pricing model the results indicate that when employing an unspecified alternative hypothesis the ability of the tests to distinguish between the capm and other pricing models is poor an upper bound is derived for the distance the alternative distribution of the test statistic can be from the null distribution when the deviations from the capm are due to missing factors this upper bound explains the low power of the tests

accountability and incentives of appointed and elected public officials political agency models suggest that elected public officials choose different policies than appointed officials do this paper is the first a to apply a clean empirical design to study whether t

government intervention in production and incentives theory a review of recent contributions national science foundation the commissariat general du plan and the center for energy policy research at m i t

the volatility and price sensitivities of managerial stock option portfolios and corporate hedging we use estimates of the black scholes sensitivity of managers stock option portfolios to stock return volatility and the sensitivity of managers stock and stock option portfolios to stock price to test the relationship between managers risk preferences and hedging activities we find that as the sensitivity of managers stock and stock option portfolios to stock price increases firms tend to hedge more however as the sensitivity of managers stock option portfolios to stock return volatility increases firms tend to hedge less one of the agency costs associated with the corporate form of ownership comes from the risk aversion of the firm s managers the typical corporate manager has a significant portion of his or her wealth invested in the corporation both through portfolio holdings and the value of firm specific human capital as a result managers have an incentive to reduce firm risk more than may be desirable from the perspective of an unaffiliated diversified shareholder one way to mitigate managerial risk aversion is to provide the manager with contracts that have a payoff structure that is a convex function of the firm s stock price smith and stulz 1985 guay 1999 finds that stock options are an important way in which convexity is added to managers portfolios however as recognized by carpenter 2000 and lambert larcker and verrecchia 1991 stock options create two opposing effects on managerial incentives the first effect is sensitivity to stock return volatility due to the convex payoff structure of options the value of a manager s stock option portfolio increases with the volatility of the firm s stock returns this sensitivity to stock return volatility should ceteris paribus give the manager an incentive to take more risk the second effect is sensitivity to stock price this effect comes from the direct link between the payoff of an option and

lobbies delegation and the under investment problem in regulation abstract a time inconsistency problem in regulation often results in under investment especially where there are high sunk costs in network industries such as electricity gas telecommunications and water this paper provides a new perspective on this hold up problem facing the price regulation of a firm with market power where full commitment to a price regime is not possible we compare a political equilibrium based on a voting model with lobbying with a delegation equilibrium where a government can delegate to a particular type of pro or anti industry regulator our analysis suggests two possible ways in which we may observe price regulation that encourages socially optimal investment in the absence of externally imposed regulatory commitment first there is less than total transparency in which voters receive an optimal amount of information and second the decisions on price are delegated to a sufficiently but not excessively pro industry regulator

regulation and legislative choice regulation has economic and political dimensions both of which i endogenize in this hierarchical model in which a legislature chooses by majority rule the mandate of an agency that faithfully regulates a firm with private information about its costs sufficient conditions are given for an equilibrium to exist if there is a strong electoral connection between the benefits delivered to constituents and their electoral support the legislature will choose a regulatory mandate that favors consumer over producer interests and results in regulation that does not maximize expected total surplus political interest in delivering benefits to constituents through factor employment results in a regulatory mandate that yields greater expected total surplus

the likelihood ratio test statistic of mean variance efficiency without a riskless asset abstract the question whether a given porfolio is mean variance efficient is a basic problem of investment analysis mean variance efficiency is also the basis of the capital asset pricing model this paper presents the explicit form of the likelihood ratio test of the hypothesis that a given portfolio or a particular market index is ex ante mean variance efficient in the case where there is no riskless asset geometric relations are illustrated to provide intuition about the constrained maximum likelihood estimators and the test statistic and two simple economic interpretations of the test are given

on the exclusion of assets from tests of the mean variance efficiency of the market portfolio an extension this paper extends kandel s 3 analysis of the testability of the mean variance efficiency of a market index when the return on some component of the index is not perfectly observable in addition to information about the mean and variance of the missing asset considered by kandel we explore the usefulness of information about the beta of the missing asset on the observed sub portfolio in an economy with a riskless asset the results are somewhat more supportive of the notion that mean variance efficiency is testable on a subset of the assets in his important critique of tests of the capital asset pricing model roll 4 emphasizes that empirical results obtained with market proxies need not be indicative of the results that would be obtained in testing the efficiency of the true market portfolio were it observable more recently kandel 3 has analyzed the testability of the mean variance efficiency of a market portfolio when the return on some component of the portfolio is not perfectly observable but partial information about its characteristics is available he finds that knowledge of the market share and expected return of the missing asset is not sufficient to permit a test however bounding the variance of return on the missing asset does make it possible in principle to correctly reject the efficiency of the portfolio provided that the market share of the missing asset is not too large building on the analytical framework established by kandel we explore the value of information about the riskless rate of return and the covariance betwen the return on the missing asset and the observed sub portfolio given a riskless asset the question we address is whether the unobservable market portfolio of risky assets is equal to the tangency portfolio of the efficient frontier we find that knowledge of the market share and expected return of the missing asset is still not sufficient to permit a test of this more restrictive efficiency condition as in the no riskless asset case given a bound on the variance of the missing asset it is sometimes possible to correctly infer that the unobserved portfolio is inefficient this occurs when the market share of the missing asset or the variance of its return is small and the sub portfolio is sufficiently far from the linear

how much discretion for risk regulators we analyze the regulation of firms that undertake socially risky activities but can reduce the probability of an accident inflicted on third parties by carrying out non verifiable effort congress delegates regulation to an agency although these two bodies may have different preferences toward the industry the optimal level of discretion left to the agency results from the following trade off the agency can tailor discretionary policies to its expert knowledge about potential harm but it implements policies that are too pro industry the agency should be given full discretion when the firm is solvent partial discretion is preferred otherwise we then investigate how this trade off changes as the political and economic landscapes are modified

the tenuous trade off between risk and incentives empirical work testing for a negative trade off between risk and incentives has not had much success the data suggest a positive relationship between measures of uncertainty and incentives rather than the posited negative trade off i argue that the existing literature fails to account for an important effect of uncertainty on incentives through the allocation of responsibility to employees when workers operate in certain settings firms are content to assign tasks to workers and monitor their inputs by contrast when the situation is more uncertain they delegate responsibility to workers but to constrain their discretion base compensation on observed output

multivariate proxies and asset pricing relations abstract a framework is developed in which inferences can be made about the validity of an equilibrium asset pricing relation even though the central aggregate in this relation is unobservable a multivariate proxy for the true market portfolio consisting of an equal weighted stock index and a long term government bond index is employed in an investigation of the sharpe lintner capm the empirical evidence suggests that we can reject the joint hypothesis that a capm is valid and b multiple correlation between the true market portfolio and proxy assets exceeds 0 7 connections to the equilibrium factor pricing literature are also explored

the analytics of performance measurement using a security market line security market line sml analysis while an important tool has never been fully justified from a theoretical standpoint assuming symmetric information and an inefficient index we show that sml analysis can be grossly misleading since in general efficient and inefficient portfolios can plot above and below the sml on a more positive note if sml analysis uses the return on a marketed riskless asset for the zero beta rate efficient portfolios must plot above the sml nonetheless arbitrarily inefficient portfolios also plot above the sml mean variance theory is still the premier theory in finance it continues to survive theoretical criticism and empirical rejection2 and it does so in no small part because of the popularity of using deviations from the security market line sml in performance measurement of portfolio managers and in event studies of the price impact of information the sml is the relationship between risk and return predicted by the mean variance model namely that risk as measured by beta and expected return are linearly related sml analysis interprets deviations in expected return from the sml as abnormal returns above or below what is appropriate or warranted for the amount of risk taken on however in the mean variance model all assets and portfolios lie on the sml ex ante and any ex post deviations from the sml are attributable solely to statistical measurement errors it is for this reason that roll 22 25 has argued that justification for sml analysis must lie outside the original mean variance model the purpose of this paper and its companion paper dybvig and ross 8 is to study whether sml analysis is valid in several plausible theoretical frameworks i e whether theory justifies intuition specifically in this article we examine the validity of using sml analysis when the index portfolio is inefficient in the companion paper we look at performance yale school of management the authors appreciate especially helpful comments from michael brennan gregory conner mike gibbons mark grinblatt jon ingersoll paul pfeiderer and richard roll the first author is grateful for support under the batterymarch fellowship program and the second author is grateful for support from the national science foundation this paper and its campanion paper dybvig and ross 8 evolved from dybvig and ross 7

the political economy of benefits and costs a neoclassical approach to distributive politics this essay offers a rational political explanation for the notorious inefficiency of pork barrel projects with an optimization model of legislative behavior and legislative institutions the model emphasizes the economically arbitrary from a welfare point of view importance of the geographic incidence of benefits and costs owing to the geographic basis for political representation we explore the implications of a legislator s objective function and derive conditions under which a representative legislature will select an omnibus of projects each of which exceeds the efficient scale

regulation asymmetric information and auditing this article analyzes a model of a regulated firm that is better informed about its cost function than is the regulator by auditing at a cost however the regulator is assumed to be able to observe the realized cost of the firm if the regulator finds that the firm had misrepresented its costs at the time at which prices were set he can order a refund to consumers in the optimal policy the regulator audits when the firm reports for pricing purposes that its costs will be high and orders a refund when the auditfinds that realized costs are lower than anticipated given the original report a separation result that obtains for an important case indicates that the initial pricing decision is independent of the auditing decision the auditing decision however depends on the price that was initially set the optimal auditing strategy is characterized and the nature of the welfare gains are identified the methodology used in the analysis involves the characterization of an equilibrium of a revelation game with an ex post observable

using cost observation to regulate firms the paper emphasizes the use of accounting data in regulatory or procurement contracts when the supplier 1 has superior information about the cost of the project and 2 invests in cost reduction the main result states that under risk neutrality the supplier announces an expected cost and is given an incentive contract linear in cost overruns this optimal contract moves toward a fixed price contract as the announced cost decreases an investment choice is then introduced and the use of a rate of return regulation is studied

positively weighted portfolios on the minimum variance frontier duality theory is employed to provide necessary and sufficient conditions for portfolios on the minimum variance frontier to have positive investment proportions in all assets these conditions involve the feasibility of portfolios that have non negative correlation with all assets and positive correlation with at least one using these results several qualitative results concerning the signs of investment proportions in efficient portfolios are proved it is argued that the conditions that ensure all positive weights in efficient portfolios are intuitively compelling and are not unique to the capm with large numbers of assets however the signs of weights in minimum variance portfolios can be very sensitive to slight departures from these conditions due to for example sampling error the behavior of the minimum variance frontier is of general concern to portfolio theory and plays a central role in the study of asset pricing an unresolved question in the theory of the minimum variance frontier involves when it will contain portfolios with positive weights on all assets this paper addresses that question we show that the conditions that ensure positive investment proportions in efficient portfolios have by farkas lemma a simple dual this dual or alternative system of inequalities puts conditions directly on the variances covariances and means of the returns and these conditions can be interpreted intuitively this contrasts with simply considering the first order conditions for variance minimization since these involve the inverted covariance matrix with a large number of assets it can be difficult to translate one s intuitive sense about how assets covary into statements about the inverse of the covariance matrix the duality conditions we derive involve the existence of portfolios that are positively or negatively correlated with all assets indeed we show that a necessary and sufficient condition for no portfolio on the frontier to have all positive weights is the feasibility of an arbitrage or hedge portfolio with weights that sum to zero that has an expected payoff of zero and has non negative correlation with all assets the duality conditions also make it easy to construct examples of the types of covariability that permit or preclude positive investment proportions on all assets in frontier portfolios there are at least three apparent reasons for interest in the signs of weights

an international capm for bonds and equities abstract previous empirical studies of international capm models have not found much supporting evidence in this paper we suggest reasons why this might have happened and perform new tests using improved models and data a range of monthly capm models are estimated for 1973 1987 for aggretate equities and bonds in germany japan the us and uk the models are an improvement on earlier work in that we integrate equity markets into the analysis instead of focusing exclusively on government bond stocks and we carefully measure the rates of return for both bonds and equities in particular bond returns reflect changes in the price of bonds as well as coupons despite this wider portfolio and the introduction of arch effects in the conditional covariance matrix of errors our model still yields unlikely estimates of the coefficient of relative risk aversion and provides very little explanatory power for expected relative rates of return correcting the icapm for these major deficiencies does not reverse earlier conclusions in the literature a close examination of the residuals of the estimated equations suggest that garch models are not required for our new data set jel fh

incentive contracting and value relevance of earnings and cash flows accounting performance measures such as earnings and cash flows are useful for both valuation and performance evaluation purposes however little evidence exists on whether there is any association between these two roles in this study we provide large sample empirical evidence that the value relevance of earnings explains a significant amount of the cross sectional variation in the pay sensitivity of earnings and the incremental value relevance of cash flows explains variation in the marginal pay sensitivity of cash flows we document that while both value relevance and compensation weight on earnings decline from the subperiod of 1993 to 1997 to the subperiod of 1998 to 2003 both value relevance and compensation weight on cash flows increase from the earlier subperiod to the later subperiod overall our results provide additional evidence that value relevance of a performance measure plays a significant role in its use for performance evaluation

on correlations and inferences about mean variance efficiency a framework is presented for investigating the mean variance efficiency of an unobservable portfolio based on its correlation with a proxy portfolio a sensitivity analysis derives the highest correlation between the proxy and a portfolio that reverses the inference of a test of sharpe lintner tangency for example the maximum correlation between the value weighted nyse amex portfolio and a portfolio inferred tangent ranges from 0 76 to 0 48 we also test whether the correlation between the proxy and the tangent portfolio exceeds a given level this hypothesis is often rejected for the nyse amex proxy at a correlation of 0 7

yes the apt is testable the arbitrage pricing theory apt has been proposed as an alternative to the meanvariance capital asset pricing model capm this paper considers the testability of the apt and points out the irrelevance for testing of the approximation error we refute shanken s objections including his assertion that roll s critique of the capm is applicable to the apt we also explain the testability of the apt on subsets and we explore the relationship between the apt and the capm the arbitrage pricing theory apt has been the subject of extensive research efforts since it was introduced by ross 36 37 the research has included theoretical papers and a growing empirical literature 2 nonetheless there seems to be some confusion in the literature about the relation between the theoretical underpinnings of the apt and its empirical tests this paper is an attempt to alleviate the confusion to illustrate the issues and to provide a focus section i of this paper is devoted to examining and refuting some points raised in shanken 40 which considers the testability of the apt the underlying premise of the apt is that asset returns ri are generated by a factor model of the form

political solutions to market problems for some market failures serve as a rationale for public intervention however the fact that self interested market behavior does not always produce felicitous social consequences is not sufficient reason to draw this conclusion it is necessary to assess public performance under comparable conditions and hence to analyze self interested political behavior in the institutional structures of the public sector our approach emphasizes this institutional structure warts and all and thereby provides specific cautionary warnings about optimistic reliance on political institutions to improve upon market performance

ceo compensation and bank risk is compensation in banking structured to promote risk taking abstract this paper examines whether executive compensation in banking is structured to promote risk taking we find that on average bank ceos receive less cash compensation are less likely to participate in a stock option plan hold fewer stock options and receive a smaller percentage of their total compensation in the form of options and stock than do ceos in other industries cross sectional differences in the structure of compensation contracts within banking are also examined we find a positive and significant relation between the importance of equity based incentives and the value of the bank s charter this result is inconsistent with the hypothesis that compensation policies promote risk taking in banking

block holding and keiretsu in japan the effects of capital markets liberalization measures on the stock market abstract long term block holding among large industrial corporations and financial institutions is prevalent in japan little is known about the implications of such business practice on portfolio returns we document the portfolio relationships of parent firms sub firms and specific industry portfolios and we hypothesize that these relationships have changed substantially in japan using certain measures for evaluating portfolios and mean variance spanning we test the hypothesis our empirical results suggest that market efficiency and integration of the japanese stock market may have been greatly enhanced by the japanese government s capital markets liberalization measures implemented in the 1970s and early 1980s

regulating a monopolist with unknown costs we consider the problem of how to regulate a monopolistic firm whose costs are unknown to the regulator the regulator s objective is to maximize a linear social welfare function of the consumers surplus and the firm s profit in the optimal regulatory policy prices and subsidies are designed as functions of the firm s cost report so that expected social welfare is maximized subject to the constraints that the firm has nonnegative profit and has no incentive to misrepresent its costs we explicitly derive the optimal policy and analyze its properties in their classic papers dupuit 2 and hotelling 5 considered pricing policies for a bridge that had a fixed cost of construction and zero marginal cost they demonstrated that the pricing policy that maximizes consumer well being is to set price equal to marginal cost and to provide a subsidy to the supplier equal to the fixed cost so that a firm would be willing to provide the bridge this first best solution is based on a number of informational assumptions first the demand function is assumed to be known to both the regulator and to the firm while the assumption of complete information may be too strong the assumption that information about demand is as available to the regulator as it is to the firm does not seem unnatural a second informational assumption is that the regulator has complete information about the cost of the firm or at least has the same information about cost as does the firm this assumption is unlikely to be met in reality since the firm would be expected to have better information about costs than would the regulator as weitzman has stated an essential feature of the regulatory environment i am trying to describe is uncertainty about the exact specification of each firm s cost function in most cases even the managers and engineers most closely associated with production will be unable to precisely specify beforehand the cheapest way to generate various hypothetical output levels because they are yet removed from the production process the regulators are likely to be vaguer still about a firm s cost function 12 p 684 as this observation suggests it is natural to expect that a firm would have better information regarding its costs than would a regulator the purpose of this paper is to develop an optimal regulatory policy for the case in which the regulator does not know the costs of the firm one strategy that a regulator could use in the absence of full information about costs is to give the firm the title to the total social surplus and to delegate the pricing decision to the firm in pursuing its own interests which would then be to maximize the total social surplus the firm would adopt the same marginal cost pricing strategy that the regulator would have imposed if the regulator had

politicians bureaucrats and targeted redistribution abstract the paper argues that for political reasons elected politicians are more likely to be engaged in targeted redistribution than appointed bureaucrats it uses the example of patronage jobs in the u s local governments to provide empirical support for this claim it shows that the number of public employees is higher for elected chief executives this difference is stronger in public services with bigger private public wage differential and it increases during election years it also finds that the number of public employees increases with the age of bureaucrats while there is no such relationship in the case of politicians which is consistent with younger bureaucrats having stronger career concerns