Paper # Author Title
A law prohibiting a particular behavior does not directly change the payoff to an individual should he engage in the prohibited behavior. Rather, any change in the individual’s payoff, should he engage in the prohibited behavior, is a consequence of changes in other peoples’ behavior. If laws do not directly change payoffs, they are “cheap talk,” and can only affect behavior because people have coordinated beliefs about the effects of the law. Beginning from this point of view, we provide definitions of authority in a variety of problems, and investigate how and when individuals can have, gain, and lose authority. Download Paper
We suggest that one way in which economic analysis is useful is by offering a critique of reasoning. According to this view, economic theory may be useful not only by providing predictions, but also by pointing out weaknesses of arguments. It is argued that, when a theory requires a non-trivial act of interpretation, its roles in producing predictions and offering critiques vary in a substantial way. We offer a formal model in which these different roles can be captured. Download Paper
People often consume non-durable goods in a way that seems inconsistent with preferences for smoothing consumption over time. We suggest that such patterns of consumption can be better explained if one takes into account the future utility flows generated by memorable consumption goods, such as a honeymoon or a vacation, whose utility flow outlives their physical consumption. We consider a model in which a consumer enjoys current consumption as well as utility generated by earlier memorable consumption. Lasting utility flows are generated only by some goods, and only when their consumption exceeds customary levels by a sufficient margin. We offer axiomatic foundations for the structure of the utility function and study optimal consumption in a dynamic model. We show that rational consumers, taking into account future utility flows, would make optimal choices that rationalize lumpy patterns of consumption . Download Paper
We analyze a model in which agents make investments and then match into pairs to create a surplus. The agents can make transfers to reallocate their pretransfer ownership claims on the surplus. Mailath, Postlewaite, and Samuelson (2013) showed that when investments are unobservable, equilibrium investments are generally inefficient. In this paper we work with a more structured model that is sufficiently tractable to analyze the nature of the investment inefficiencies. We provide conditions under which investment is inefficiently high or low and conditions under which changes in the pretransfer ownership claims on the surplus will be Pareto improving, as well as examine how the degree of heterogeneity on either side of the market a ffects investment efficiency. Download Paper
Much of the literature on mechanism design and implementation uses the revelation principle to restrict attention to direct mechanisms. This is without loss of generality in a well defined sense. It is, however, restrictive if one is concerned with the set of equilibria, if one is concerned about the size of messages that will be sent, or if one is concerned about privacy. We showed in McLean and Postlewaite (2014) that when agents are informationally small, there exist small modifications to VCG mechanisms in interdependent value problems that restore incentive compatibility. We show here how one can construct a two-stage mechanism that similarly restores incentive compatibility while improving upon the direct one stage mechanism in terms of privacy and the size of messages that must be sent. The first stage essentially elicits that part of the agents' private information that induces interdependence and reveals it to all agents, transforming the interdependent value problem into a private value problem. The second stage is a VCG mechanism for the now private value problem. Agents typically need to transmit substantially less information in the two stage mechanism than would be necessary for a single stage mechanism. Lastly, the first stage that elicits the part of the agents' private information that induces interdependence can be used to transform certain other interdependent value problems into private value problems. Download Paper
A literal interpretation of neo-classical consumer theory suggests that the consumer solves a very complex problem. In the presence of indivisible goods, the consumer problem is NP-Hard, and it appears unlikely that it can be optimally solved by humans. An alternative approach is suggested, according to which the household chooses how to allocate its budget among product categories without necessarily being compatible with utility maximization. Rather, the household has a set of constraints, and among these it chooses an allocation in a case-based manner, influenced by choices of other, similar households, or of itself in the past. We offer an axiomatization of this model. Download Paper
“Buy local” arrangements encourage members of a community or group to patronize one another rather than the external economy. They range from formal mechanisms such as local currencies to informal “I’ll buy from you if you buy from me” arrangements, and are often championed on social or environmental grounds. We show that in a monopolistically competitive economy, buy local arrangements can have salutary effects even for selfish agents immune to social or environmental considerations. Buy local arrangements effectively allow firms to exploit the equilibrium price-cost gap to profitably expand their sales at the going price. Download Paper
We showed in McLean and Postlewaite (2014) that when agents are informationally small, there exist small modifications to VCG mechanisms in interdependent value problems that restore incentive compatibility. This paper presents a two-stage mechanism that similarly restores incentive compatibility. The first stage essentially elicits that part of the agents’ private information that induces interdependence and reveals it to all agents, transforming the interdependent value problem into a private value problem. The second stage is a VCG mechanism for the now private value problem. Agents typically need to transmit substantially less information in the two stage mechanism than would be necessary for a single stage mechanism. Lastly, the firrst stage that elicits the part of the agents’ private information that induces interdependence can be used to transform certain other interdependent value problems into private value problems. Download Paper
Maximizing subjective expected utility is the classic model of decision making under uncertainty. Savage (1954) provides axioms on preference over acts that are equivalent to the existence of a subjective expected utility representation, and further establishes that such a representation is essentially unique. We show that there is a continuum of other \expected utility" representations in which the probability distributions over states used to evaluate acts depend on the set of possible outcomes of the act and suggest that these alternate representations can capture pessimism or optimism. We then extend the DM's preferences to be defined over both subjective acts and objective lotteries, allowing for source-dependent preferences. Our result permits modeling ambiguity aversion in Ellsberg's two-urn experiment using a single utility function and pessimistic probability assessments over prizes for lotteries and acts, while maintaining the axioms of Savage and von Neumann-Morganstern on the appropriate domains. Download Paper
There is a large repeated games literature illustrating how future interactions provide incentives for cooperation. Much of the earlier literature assumes public monitoring. Departures from public monitoring to private monitoring that incorporate differences in players’ observations may dramatically complicate coordination and the provision of incentives, with the consequence that equilibria with private monitoring often seem unrealistically complex or fragile. We set out a model in which players accomplish cooperation in an intuitively plausible fashion. Players process information via a mental system — a set of psychological states and a transition function between states depending on observations. Players restrict attention to a relatively small set of simple strategies, and consequently, might learn which perform well. Download Paper
People often consume non-durable goods in a way that seems inconsistent with preferences for smoothing consumption over time. We suggest that such patterns of consumption can be better explained if one takes into account the memories that consumption generates. A memorable good, such as a honeymoon or a vacation, is a good whose mental consumption outlives its physical consumption. We consider a model in which a consumer enjoys physical consumption as well as memories. Memories are generated only by some goods, and only when their consumption exceeds customary levels by a sufficient margin. We offer axiomatic foundations for the structure of the utility function and study optimal consumption in a dynamic model. The model shows how rational consumers, taking into account their future memories, would make optimal choices that rationalize lumpy patterns of consumption. Download Paper
We propose a new category of consumption goods, memorable goods, that generate a flow of utility after consumption. We analyze an otherwise standard consumption model that distinguishes memorable goods from other nondurable goods. Consumers optimally choose lumpy consumption of memorable goods. We empirically document differences between levels and volatilities of memorable and other goods expenditures. Memorable goods expenditures are about twice durable goods expenditures and half the volatility. The welfare cost of consumption fluctuations driven by income shocks are overstated if memorable goods are not accounted for and estimates of excess sensitivity of consumption might be due to memorable goods. Download Paper
We propose a formal model of scientific modeling, geared to applications of decision theory and game theory. The model highlights the freedom that modelers have in conceptualizing social phenomena using general paradigms in these fields. It may shed some light on the distinctions between (i) refutation of a theory and a paradigm, (ii) notions of rationality, (iii) modes of application of decision models, and (iv) roles of economics as an academic discipline. Moreover, the model suggests that all four distinctions have some common features that are captured by the model. Download Paper
We propose a new category of consumption goods, memorable goods, that generate a flow of utility after consumption. We analyze an otherwise standard consumption model that distinguishes memorable goods from other nondurable goods. Consumers optimally choose lumpy consumption of memorable goods. We then empirically document significant differences between levels and volatilities of memorable and other nondurable good expenditures. In two applications we find that the welfare cost of consumption fluctuations driven by income shocks are significantly overstated if memorable goods are not accounted for and that estimates of excess sensitivity of consumption might be entirely due to memorable goods. Download Paper
Maximizing subjective expected utility is the classic model of decision-making under uncertainty. Savage (1954) provides axioms on preference over acts that are equivalent to the existence of a subjective expected utility representation, and further establishes that such a representation is essentially unique. We show that there is a continuum of other "expected utility" representations in which the probability distributions over states used to evaluate acts depend on the set of possible outcomes of the act and suggest that these alternate representations can capture pessimism or optimism. We then extend the DM's preferences to be defined over both subjective acts and objective lotteries, allowing for source-dependent preferences. Our result permits modeling ambiguity aversion in Ellsberg's two-urn experiment using a single utility function and pessimistic probability assessments over prizes for lotteries and acts, while maintaining the axioms of Savage and von Neumann-Morganstern on the appropriate domains Download Paper
We analyze a model in which agents make investments and then match into pairs to create a surplus. The agents can make transfers to reallocate their pretransfer ownership claims on the surplus. Mailath, Postlewaite, and Samuelson (2013) showed that when investments are unobservable, equilibrium investments are generally inefficient. In this paper we work with a more structured model that is sufficiently tractable to analyze the nature of the investment inefficiencies. We provide conditions under which investment is inefficiently high or low and conditions under which changes in the pretransfer ownership claims on the surplus will be Pareto improving, as well as examine how the degree of heterogeneity on either side of the market affects investment efficiency. Download Paper
We propose a new classification of consumption goods into nondurable goods, durable goods and a new class which we call “memorable" goods. A good is memorable if a consumer can draw current utility from its past consumption experience through memory. We propose a novel consumption-savings model in which a consumer has a well-defined preference ordering over both nondurable goods and memorable goods. Memorable goods consumption differs from nondurable goods consumption in that current memorable goods consumption may also impact future utility through the accumulation process of the stock of memory. In our model, households optimally choose a lumpy profile of memorable goods consumption even in a frictionless world. Using Consumer Expenditure Survey data, we then document levels and volatilities of different groups of consumption goods expenditures, as well as their expenditure patterns, and show that the expenditure patterns on memorable goods indeed differ significantly from those on nondurable and durable goods. Finally, we empirically evaluate our model's predictions with respect to the welfare cost of consumption fluctuations and conduct an excess-sensitivity test of the consumption response to predictable income changes. We find that (i) the welfare cost of household-level consumption fluctuations may be overstated by 1:7 percentage points (11:9% points as opposed to 13:6% points of permanent consumption) if memorable goods are not appropriately accounted for; (ii) the finding of excess sensitivity of consumption documented in important papers of the literature might be entirely due to the presence of memorable goods. Download Paper
The art of rhetoric may be defined as changing other people’s minds (opinions, beliefs) without providing them new information. One technique heavily used by rhetoric employs analogies. Using analogies, one may draw the listener’s attention to similarities between cases and to re-organize existing information in a way that highlights certain regularities. In this paper we offer two models of analogies, discuss their theoretical equivalence, and show that finding good analogies is a computationally hard problem. Download Paper
We formulate a notion of stable outcomes in matching problems with one-sided asymmetric information. The key conceptual problem is to formulate a notion of a blocking pair that takes account of the inferences that the uninformed agent might make. We show that the set of stable outcomes is nonempty in incomplete-information environments, and is a superset of the set of complete-information stable outcomes. We then provide sufficient conditions for incomplete-information stable matchings to be efficient. Lastly, we define a notion of price-sustainable allocations and show that the set of incomplete-information stable matchings is a subset of the set of such allocations. Download Paper
Much of the repeated game literature is concerned with proving Folk Theorems. The logic of the exercise is to specify a particular game, and to explore for that game specification whether any given feasible (and individually rational) value vector can be an equilibrium outcome for some strategies when agents are sufficiently patient. A game specification includes a description of what agents observe at each stage. This is done by defining a monitoring structure, that is, a collection of probability distributions over the signals players receive (one distribution for each action profile players may play). Although this is simply meant to capture the fact that players don’t directly observe the actions chosen by others, constructed equilibria often depend on players precisely knowing these distributions, somewhat unrealistic in most problems of interest. We revisit the classic Folk Theorem for games with imperfect public monitoring, asking that incentive conditions hold not only for a precisely defined monitoring structure, but also for a ball of monitoring structures containing it. We show that efficiency and incentives are no longer compatible. Download Paper
The repeated game literature studies long run/repeated interactions, aiming to understand how repetition may foster cooperation. Conditioning future behavior on past play is crucial in this endeavor. For most situations of interest a given player does not directly observe the actions chosen by other players and must rely on noisy signals he receives about those actions. This is typically incorporated into models by defining a monitoring structure, that is, a collection of probability distributions over the signals each player receives (one distribution for each action profile players may play). Although this is simply meant to capture the fact that players don.t directly observe the actions chosen by others, constructed equilibria often depend on players precisely knowing the distributions, somewhat unrealistic in most problems of interest. This paper aims to show the fragility of belief free equilibrium constructions when one adds shocks to the monitoring structure in repeated games. Download Paper
Standard Bayesian models assume agents know and fully exploit prior distributions over types. We are interested in modeling agents who lack detailed knowledge of prior distributions. In auctions, that agents know priors has two consequences: (i) signals about own valuation come with precise inference about signals received by others; (ii) noisier estimates translate into more weight put on priors. We revisit classic questions in auction theory, exploring environments in which no such complex inferences are precluded. This is done in a parsimonious model of auctions in which agents are restricted to using simple strategies. Download Paper
There is a large repeated games literature illustrating how future interactions provide incentives for cooperation. Much of the earlier literature assumes public monitoring: players always observe precisely the same thing. Departures from public monitoring to private monitoring that incorporate differences in players’ observations may dramatically complicate coordination and the provision of incentives, with the consequence that equilibria with private monitoring often seem unrealistically complex. We set out a model in which players accomplish cooperation in an intuitively plausible fashion. Players process information via a mental system — a set of psychological states and a transition function between states depending on observations. Players restrict attention to a relatively small set of simple strategies, and consequently, might learn which perform well. Download Paper
People often wonder why economists analyze models whose assumptions are known to be false, while economists feel that they learn a great deal from such exercises. We suggest that part of the knowledge generated by academic economists is case-based rather than rule-based. That is, instead of offering general rules or theories that should be contrasted with data, economists often analyze models that are "theoretical cases", which help understand economic problems by drawing analogies between the model and the problem. According to this view, economic models, empirical data, experimental results and other sources of knowledge are all on equal footing, that is, they all provide cases to which a given problem can be compared. We offer complexity arguments that explain why case-based reasoning may sometimes be the method of choice and why economists prefer simple cases. Download Paper
It is well-known that the ability of the Vickrey-Clarke-Groves (VCG) mechanism to implement efficient outcomes for private value choice problems does not extend to interdependent value problems. When an agent’s type affects other agents’ utilities, it may not be incentive compatible for him to truthfully reveal his type when faced with CGV payments. We show that when agents are informationally small, there exist small modifications to CGV that restore incentive compatibility. We further show that truthful revelation is an approximate ex post equilibrium. Lastly, we show that in replicated settings aggregate payments sufficient to induce truthful revelation go to zero. Download Paper
Savage (1954) provides axioms on preferences over acts that are equivalent to the existence of a subjective expected utility representation. We show that there is a continuum of other \expected utility" representations in which for any act, the probability distribution over states depends on the corresponding outcomes and is first-order stochastically dominated by (dominates) the Savage distribution. We suggest that pessimism (optimism) can be captured by the stake-dependent probabilities in these alternate representations. We then extend the DM's preferences to be defined over both subjective acts and objective lotteries. Our result permits modeling ambiguity aversion in Ellsberg's two-urn experiment using pessimistic probability assessments, the same utility over prizes for lotteries and acts, and without relaxing Savage's axioms. An implication of our results is that the large body of existing research based on expected utility can, with a simple reinterpretation, be understood as modeling the behavior of optimistic or pessimistic decision makers. Download Paper
We formulate a notion of stable outcomes in matching problems with one-sided asymmetric information. The key conceptual problem is to formulate a notion of a blocking pair that takes account of the inferences that the uninformed agent might make from the hypothesis that the current allocation is stable. We show that the set of stable outcomes is nonempty in incomplete information environments, and is a superset of the set of complete-information stable outcomes. We then provide sufficient conditions for incomplete-information stable matchings to be efficient. Lastly, we define a notion of price sustainable allocations and show that the set of incomplete- information stable matchings is a subset of the set of such allocations. Download Paper
A large literature uses matching models to analyze markets with two-sided heterogeneity, studying problems such as the matching of students to schools, residents to hospitals, husbands to wives, and workers to firms. The analysis typically assumes that the agents have complete information, and examines core outcomes. We formulate a notion of stable outcomes in matching problems with one-sided asymmetric information. The key conceptual problem is to formulate a notion of a blocking pair that takes account of the inferences that the uninformed agent might make from the hypothesis that the current allocation is stable. We show that the set of stable outcomes is nonempty in incomplete information environments, and is a superset of the set of complete-information stable outcomes. We provide sufficient conditions for incomplete-information stable matchings to be efficient. Download Paper
Savage (1954) provided axioms on preferences over acts that were equivalent to the existence of an expected utility representation. We show that there is a continuum of other expected utility" representations in which for any act, the probability distribution over states depends on the corresponding outcomes. We suggest that optimism and pessimism can be captured by the stake-dependent probabilities in these alternative representations. Extending the DM's preferences to be defined on both subjective acts and objective lotteries, we suggest how one may distinguish optimists from pessimists and separate attitude towards uncertainty from curvature of the utility function over monetary prizes. Download Paper
People often wonder why economists analyze models whose assumptions are known to be false, while economists feel that they learn a great deal from such exercises. We suggest that part of the knowledge generated by academic economists is case-based rather than rule-based. That is, instead of offering general rules or theories that should be contrasted with data, economists often analyze models that are “theoretical cases”, which help understand economic problems by drawing analogies between the model and the problem. According to this view, economic models, empirical data, experimental results and other sources of knowledge are all on equal footing, that is, they all provide cases to which a given problem can be compared. We offer complexity arguments that explain why case-based reasoning may sometimes be the method of choice; why economists prefer simple examples; and why a paradigm may be useful even if it does not produce theories. Download Paper
Consider an agent who is unsure of the state of the world and faces computational bounds on mental processing. The agent receives a sequence of signals imperfectly correlated with the true state that he will use to take a single decision. The agent is assumed to have a finite number of "states of mind" that quantify his beliefs about the relative likelihood of the states, and uses the signals he receives to move from one state to another. At a random stopping time, the agent will be called upon to make a decision based solely on his mental state at that time. We show that under quite general conditions it is optimal that the agent ignore signals that are not very informative, that is, signals for which the likelihood of the states is nearly equal. This model provides a possible explanation of systematic inference mistakes people may make. Download Paper
We examine markets in which agents make investments and then match into pairs, creating surpluses that depend on their investments and that can be split between the matched agents. In general, each of the matched agents would ”own" part of the surplus in the absence of interagent transfers. Most of the work in the large bargaining-and matching literature ignores this initial ownership of the surplus. We show that when investments are not observable to potential partners, initial ownership affects the efficiency of equilibrium investments and affects the agents' payoffs. In particular, it is possible that reallocating initial ownership could increase welfare on both sides of the match. Download Paper
People often wonder why economists analyze models whose assumptions are known to be false, while economists feel that they learn a great deal from such exercises. We suggest that part of the knowledge generated by academic economists is case-based rather than rule-based. That is, instead of offering general rules or theories that should be contrasted with data, economists often analyze models that are “theoretical cases”, which help understand economic problems by drawing analogies between the model and the problem. According to this view, economic models, empirical data, experimental results and other sources of knowledge are all on equal footing, that is, they all provide cases to which a given problem can be compared. We offer some complexity arguments that explain why case-based reasoning may sometimes be the method of choice; why economists prefer simple examples; and why a paradigm may be useful even if it does not produce theories. Download Paper
Savage (1954) provided a set of axioms on preferences over acts that were equivalent to the existence of an expected utility representation. We show that in addition to this representation, there is a continuum of other “expected utility”representations in which for any act, the probability distribution over states depends on the corresponding outcomes. We suggest that optimism and pessimism can be captured by the stake-dependent probabilities in these alternative representations; e.g., for a pessimist, the probability of every outcome except the worst is distorted down from the Savage probability. Extending the DM’s preferences to be de…ned on both subjective acts and objective lotteries, we show how one may distinguish optimists from pessimists and separate attitude towards uncertainty from curvature of the utility function over monetary prizes. Download Paper
We consider repeated games with private monitoring that are "close" to repeated games with public/perfect monitoring. A private monitoring information structure is close to a public monitoring information structure when private signals can generate approximately the same distribution of the public signal once they are aggregated into a public signal by some public coordination device. A player's informational size associated with the public coordination device is the key to inducing truth-telling in nearby private monitoring games when communication is possible. A player is informationally small given a public coordination device if she believes that her signal is likely to have a small impact on the public signal generated by the public coordinating device. We show that a uniformly strict equilibrium with public monitoring is robust in a certain sense: it remains an equilibrium in nearby private monitoring repeated games when the associated public coordination device, which makes private monitoring close to public monitoring, keeps every player informationally small at the same time. We also prove a new folk theorem for repeated games with private monitoring and communication by exploiting the connection between public monitoring games and private monitoring games via public coordination devices. Download Paper