Marek Weretka

Competition in Financial Innovation

This paper examines the incentives to innovate securities provided by frictionless competitive markets (with short sales) to entrepreneurs. In economies with symmetric investor utilities, we provide the conditions under which a …rm’s market value is maximized by a complete …nancial structure –that is, when the mechanism that gives rise to market incompleteness is the one illustrated in the classical example of Allen and Gale (1991). The foundation for incompleteness in that case is derived from innovation costs and free riding among entrepreneurs. For the class of preferences where an incomplete …nancial structure maximizes the …rms’market values, markets are incomplete with a probability of one, even when innovation is cost free. In this sense, we provide an alternative to Allen and Gale’s foundation for market incompleteness.

Endogenous market power

In this paper we develop a framework to study markets with heterogeneous atomic traders. The competitive model is augmented as we provide traders with correct beliefs about their price impacts to define equilibrium with endogenously determined market power and show that such equilibrium exists in economies with smooth utility and cost functions and is generically determinate. Tradersʼ price impacts depend positively on the convexity of preferences or cost functions of the trading partners and are subject to mutual reinforcement. Compared to the competitive model, the volume of trade is reduced, and hence is Pareto inefficient. The price effects of non-competitive trading depend on the convexity of marginal utility or cost function.

Mutual Empathy in Games

We investigate the effects of players’ mutual empathy, or the interdependence of players’ payoffs, on their behavior and welfare. To this end, we augment the conventional game-theoretic framework by allowing players’ utilities to depend not only on the strategy profile being played, but also on the realized utilities of other players. We call the resulting framework an empathetic game. Generally, in these games players’ utilities are not reducible to preferences over strategies due to novel feedback effects; thus, standard solution concepts, such as the Nash equilibrium, cannot be applied. We extend the notion of a Nash equilibrium to these settings by endowing players with consistent beliefs regarding others’ payoffs. We show that under mild assumptions our solution concept is well defined. We then apply the framework to analyze how mutual empathy affects strategic interactions, and find that it qualitatively changes players’ incentives. First, empathetic games can generate excessive multiplicity of equilibria owing to many supporting beliefs. Second, we uncover a new source of inefficiency, called payoff inefficiency, as players may coordinate their beliefs on socially suboptimal solutions to the interdependent payoff system. Finally, we show that these two features are common in sympathetic (altruistic) games, in which the payoffs of all players depend positively on others’ payoffs; however, payoff inefficiency never occurs in two-player antipathetic games, in which payoffs are negatively related.

Empathy, Unemployment, and Wages

In this paper, we study the role and impact of workers’ empathy — or the interdependence of workers’ preferences — on the business cycle. We show how empathy affects managerial practices and how it impacts labor market outcomes such as wages and employment. To this end, we consider a labor market in which a firm’s manager chooses the set of workers to hire and how much to pay each worker. We explore how managers react to labor productivity shocks. In economic expansions, managers elect to raise wages and to hire more workers. However, in economic slowdowns, managers may find it optimal to freeze both wages and employment. Moreover, consistent with Bewley (1999), in times of severe economic downturns managers respond by reducing workforce, but not wages. The rationale of these asymmetric responses to productivity shocks is that a profit-maximizing firm is reluctant to cut wages, as that choice may trigger a low morale equilibrium, affecting its profits discontinuously.