Michael T. Rauh

Heterogeneous beliefs, price dispersion, and welfare-improving price controls*

Summary. We consider a search market model where agents have heterogeneous beliefs about the distribution of prices. A suggestive example shows that Jevons Law of One Price and standard welfare results are not robust to small heterogeneous errors in beliefs. In particular we show that a price ceiling above marginal cost can reduce price dispersion and improve welfare (by lowering aggregate search costs) without decreasing quantity supplied. These results are broadly consistent with the empirical evidence.

Nonstandard foundations of equilibrium search models

We develop an equilibrium sequential search model which includes most of the literature as special cases. In particular, the model can accommodate heterogeneity in buyers’ search costs and demand functions and firms’ cost functions, with general demand and cost functions. We identify conditions which ensure existence of equilibrium in pure strategies, utilizing recent progress in the theory of large games by Khan and Sun. These conditions elucidate the essential structure of equilibrium search models. Although we focus on sequential search, our methodology can be used for other classes of equilibrium search models as well.

ANXIETY AND PERFORMANCE: AN ENDOGENOUS LEARNING-BY-DOING MODEL*

In this article, we show that a standard economic model, the endogenous learning-by-doing model, captures several major themes from the anxiety literature in psychology. In our model, anxiety is a fully endogenous construct that can be separated naturally into its cognitive and physiological components. As such, our results are directly comparable with hypotheses and evidence from psychology. We show that anxiety can serve a motivating function, which suggests potential applications in the principal-agent literature.

The Firm as a Socialization Device

Why do firms exist? What is their function? What do managers do? What is the role, if any, of social motivation in the market? In this paper, we address these questions with a new theory of the firm, which unites some major themes in management, principal-agent theory, and economic sociology. We show that although the market is a superior incentive mechanism, the firm has a comparative advantage with respect to social motivation. We then show that the market is efficient in environments that favor the provision of incentives, such as when subjective risk is low and performance is easy to measure. The firm is efficient in other environments where incentives are costly and/or ineffective. We compare our model and results with the views of Durkheim (Durkheim, E. 1984. The Division of Labor in Society. Free Press, New York) and Granovetter (Granovetter, M. 1985. Economic action and social structure: The problem of embeddedness. Amer. J. Sociol. 91(3) 481--510).

Strategic Complementarities and Search Market Equilibrium

In this paper, we apply supermodular game theory to the equilibrium search literature with sequential search. We identify necessary and sufficient conditions for strategic complementarities and prove existence of search market equilibrium. When firms are identical, the Diamond Paradox obtains and is robust within the class of search cost densities that are small near zero and support strategic complementarities. Price dispersion is therefore inherently incompatible with strategic complementarities. Finally, we show that a major criticism of the literature, that agents act as if they know the distribution of prices, can be justified in the sense of convergent best response dynamics.

Agency and Anxiety

In this paper, we introduce the psychological concept of anxiety into agency theory. An important benchmark in the anxiety literature is the inverted-U hypothesis, which states that an increase in anxiety improves performance when anxiety is low, but reduces it when anxiety is high. We show that the inverted-U hypothesis is consistent with evidence that high-powered incentives can reduce the agents optimal effort and expected performance. In equilibrium, however, a profit-maximizing principal never offers such counterproductive incentives. We also show that the inverted-U hypothesis can explain empirical anomalies related to monitoring, the informativeness principle, and the risk–reward tradeoff.

Incentives, Wages, Employment, and the Division of Labor in Teams

We develop a theory of incentives, wages, and employment in the context of team production. A central insight is that specialization and division of labor not only improve productivity but also increase e ort and the sensitivity of e ort to incentives under moral hazard. We show that incentives and employment are complements for the principal when the positive e ects of specialization and division of labor outweigh the negative e ects of increased idiosyncratic risk and are substitutes otherwise. We provide new characterizations of the partnership, the rm, and the role of the budget-breaker that are quite di erent from the classical literature.

Honesty and Adverse Selection

There is substantial evidence that generalized trust improves economic outcomes at both the individual and aggregate levels. Furthermore, certain institutions such as educational and religious institutions foster trust, trade, and economic growth. A specific mechanism through which trust might operate is honest communication. We consider the problem of a parent who can enroll her child in an institution which can make her child honest with probability less than one. We assume that whether the child is honest or not is the private information of the child but that institutional membership is observable so that institutions can serve as both imperfect socialization technologies and potentially informative signals of honesty. We consider the two main benchmark adverse selection models in the literature: the screening model and a game-theoretic version of the market for lemons. We provide conditions under which market institutions provide explicit monetary incentives for socialization. When socialization occurs in equilibrium it improves allocative efficiency in the screening model and reduces adverse selection in the market for lemons.There is substantial evidence that many parents value honesty in their children and that trust is an important determinant of trade. There is also evidence that certain institutions (i.e., religious institutions) foster trust, trade, and economic growth. In this paper we consider a parent who can enroll her child in an imperfect institution which can make her child honest with some probability less than one. We assume that institutional membership is observable so that institutions serve as both imperfect socialization technologies and potentially informative signals that such socialization has taken place. We provide necessary and sucient conditions for nonzero investments in honesty in the two main benchmark models of exchange under asymmetric information: the basic two-type screening model and a game-theoretic version of Akerlofs market for lemons. Consistent with the evidence, we show that when non-zero socialization occurs in equilibrium it improves economic performance by increasing allocative eciency in the screening model and reducing adverse selection in the market for lemons.

The O-ring theory of the firm

We develop an O†ring production function characterized by specialization and division of labor and where shirking or negative shocks can have major adverse consequences. We show that when the principal can monitor individual output, the firm tends be large (potentially larger than first best), with a high degree of specialization and division of labor, weak incentives, and low pay as in traditional nonunion manufacturing. Moral hazard can only limit the size of the firm relative to the first best when the principal can only monitor team output, in which case the firm has the opposite characteristics.

The Firm as an Intrinsic Motivation Device

In this paper, we develop a new theory of the firm where the market is primarily an incentive system whereas the firm is an intrinsic motivation device. The firm is more efficient than the market when asset specificity and subjective risk are sufficiently high because it provides balanced incentives, fosters intrinsic motivation, and economizes on risk. An efficient firm is unambiguously the more ethical institution in the sense that the component of production effort due to intrinsic motivation and the agents rents in exchange for commitment are higher. The exception is when the market approximates the first best.