Avinash Dixit

Hysteresis, Import Penetration, and Exchange Rate Pass-Through

A competitive industry has established home firms, and foreign firms with entry and exit costs. The real exchange rate follows a Brownian motion. Industry equilibrium is determined using methods of option pricing. Entry requires the operating profit to exceed the interest on the entry cost, and similarly for exit. The middle band of rates without entry or exit yields hysteresis; it is found to be very wide for plausible parameter values. The exchange rate pass-through to domestic prices is found to be close to one in the phases where foreign firms enter or exit, and near zero otherwise.

# Incentives and Organizations in the Public Sector: An Interpretative Review

The paper begins with a brief overview of the theory of incentives, with special attention to issues that are important in the public sector, in general and human capital in particular. It then reviews some case studies and empirical studies of incentives in the public sector, examining how these studies relate to the theory. Some implications for reform and design of organizations are drawn.

INTERNATIONAL TRADE POLICY FOR OLIGOPOLISTIC INDUSTRIES

Almost all of the received theory of international trade, positive and normative, is based on the model of atomistic competition. All individual consumers and producers are assumed to be price-takers. It is recognised that a country may have monopoly power in trade, but this is supposed to be exercised by its government through the use of tariffs. In reality, it is becoming increasingly evident that a significant proportion of international trade takes place in imperfectly competitive markets. Here the individual producers and sellers are aware of their monopoly power, and act to profit from it. The resulting market equilibrium, be it pure monopoly, oligopoly, or monopolistic competition, differs from the textbook Walrasian kind. The determinants and patterns of trade are different, and are differently affected by commercial policy. A new framework of theoretical analysis is therefore required for a proper understanding of many current issues of tradf, and of trade policy. Such research is still in its infancy, but is growing rapidly. This lecture is intended to provide a consolidation, and some extension, of the work. I shall begin by describing the new issues that arise when trade is imperfectly competitive, and some new features of the analysis. Then I shall give a brief and somewhat selective review of the literature. Finally, I shall construct a model that synthesises and extends some of the work on trade policy in the context of oligopoly.

Options, the Value of Capital, and Investment

Capital investment decisions must recognize the limitations on the firms ability to later sell or expand capacity. This paper shows how opportunities for future expansion or contraction can be valued as options, how their valuation relates to the q theory of investment, and their effect on the incentive to invest. Generally, the option to expand reduces the incentive to invest, while the option to disinvest raises it. We show how these options determine the effect of uncertainty on investment, how they are changed by shifts of the distribution of future profitability, and how the q-theory and option pricing approaches are related.

Advertising and Welfare

This paper applies conventional welfare-theoretic methods to study advertising which changes consumer tastes. In a wide range of empirically plausible circumstances, private profitability is seen to be necessary but not sufficient for the social desirability of a small amount of advertising. The market equilibrium level of such advertising is shown to be socially excessive, even when postadvertising tastes are used as the standard for welfare judgments and the monopoly profits resulting from the advertising are included in welfare. Settings of monopoly, oligopoly, and monopolistic competition are examined, and the contention that advertising is excessive is found to be strengthened at each stage.

Interactions of Commitment and Discretion in Monetary and Fiscal Policies

We consider monetary-scal interactions when the monetary authority is more conservative than the scal. With both policies discretionary, (1) Nash equilibrium yields lower output and higher price than the ideal points of both authorities, (2) of the two leadership possibilities, scal leadership is generally better. With scal discretion, monetary commitment yields the same outcome as discretionary monetary leadership for all realizations of shocks. But scal commitment is not similarly negated by monetary discretion. Second-best outcomes require either joint commitment, or identical targets for both authorities { output socially optimal and price level appropriately conservative { or complete separation of tasks. (JEL E61, E63)

Monetary-fiscal policy interactions and commitment versus discretion in a monetary union

We consider monetary fiscal policy interactions in a monetary union. If monetary and fiscal authorities have different ideal output and inflation targets, the Nash equilibrium output or inflation or both are beyond the ideal points of all authorities. Leadership of either authority is better. Fiscal discretion entirely negates the advantage of monetary commitment: The optimal monetary rule is equivalent to discretionary leadership of monetary over fiscal policy. Agreement about ideal output and inflation creates a monetary-fiscal symbiosis, yielding the ideal point despite disagreement about the relative weights of the two objectives, for any order of moves, without fiscal co-ordination, and without monetary commitment.

REDISTRIBUTIVE POLITICS AND ECONOMIC EFFICIENCY

The political process often compensates the losers from technical change or international competition in an economically inefficient way, namely by subsidizing or protecting declining industries instead of encouraging the movement of resources to other more productive uses. We find that a dynamic inconsistency in the game of redistributive politics contributes to this outcome. To achieve economically efficient outcomes, it is necessary that those making economically inefficient choices not be given offsetting transfers. But the political process distributes income on the basis of political characteristics, which are in general different from the economic characteristics that are rewarded by the market. We identify circumstances in which the inefficient choosers have desirable political characteristics and are therefore immune from threats of having to face the economic consequences of their choices.

Tax policy in open economies

Publisher Summary This chapter discusses tax policy in open economies. The chapter discusses the theory of optimum taxation in an economy open to international trade. Most formal models of optimum taxation assume away international trade. Its presence does not alter any basic issues or methods. The economic objectives of the policy remain the same, and can be broadly classified as (i) correcting externalities and distortions, (ii) raising revenue for government expenditure, and (iii) redistributing income. There may also be other “non-economic” objectives or constraints. The policy instruments to pursue these aims are taxes or subsidies on the activities and transactions in the economy, within limitations imposed by observability of the actions and enforceability of the policies. International trade introduces a new set of possible externalities and distortions, and a new set of transactions to tax or subsidize.

On Modes of Economic Governance

I consider transactions involving asymmetric prisoners’ dilemmas between pairs of players selected chosen from two large populations. Games are played repeatedly, but information about cheating is not adequate to sustain cooperation, and there is no official legal system of contract enforcement. I examine how profit-maximizing private intermediation can supply the information and enforcement. I obtain conditions under which private governance can improve upon no governance, and examine why it fails to achieve social optimality.