W. Bentley MacLeod

Caring About Sunk Costs: A Behavioral Solution to Holdup Problems with Small Stakes

Economics students need to be taught that opportunity costs are important for optimal decision making but that sunk costs are not. Why should this be? Presumably these students have been making optimal decisions all their lives, and the concepts should be easy for them. We show that caring about sunk costs can help agents achieve efficient investments in a simple team production environment. Furthermore, the solution we propose is uniquely efficient if the environment is sufficiently complex. Hence, in addition to explaining contract form and ownership (Williamson, 1975; Hart, 1995), studies of the holdup problem may also provide insights into observed behavior in day-today bilateral bargaining problems. Copyright 2003, Oxford University Press.

The Ratchet Effect and the Market for Secondhand Workers

Workers in a long-term relationship often have an incentive to hide their ability early in the relationship to avoid having the firm increase the level of output expected from them in the future. We show that competition for older workers will permit the implementation of efficient piece-rate contracts. When the difficulty of the job is unobserved by the firm, Gibbons (1987) has shown that all piece-rate contracts will be inefficient. Together, these results may explain why piece rates are common in some jobs, such as agricultural work and sales, and not as popular for many manufacturing jobs.

Construction Contracts (or: "How to Get the Right Building at the Right Price?")

Most contracts that individuals enter into are not written from scratch; rather, they depend upon forms and terms that have been successful in the past. In this paper, we study the structure of form construction contracts published by the American Institute of Architects (AIA). We show that these contracts are an efficient solution to the problem of procuring large, complex projects when unforeseen contingencies are inevitable. This is achieved by carefully structuring the ex post bargaining game between the Principal and the Agent. The optimal mechanism corresponding to the AIA construction form is consistent with decisions of the courts in several prominent but controversial cases, and hence it provides an economic foundation for a number of the common-law excuses from performance. Finally, the case of form contracts for construction is an example of how markets, as opposed to private negotiations, can be used to determine efficient contract terms.

Supply side hysteresis: the case of the Canadian unemployment insurance system

This paper presents results from a 1971 natural experiment carried out by the Canadian government on the unemployment insurance system. At that time, they dramatically increased the generosity of the system. We find that the propensity to collect UI increases with a first time exposure to the system. Hence as more individuals experience unemployment their lifetime use of the system increases. This supply side hysterisis effect may explain why unemployment has steadily increased over the 1972 - 1992 period, even though the generosity of unemployment insurance did not.

Contract Bargaining with Symmetric Information

This paper reviews a recent literature that extends the Rubinstein/Stahl bargaining model to the case of contract bargaining. Theoretical issues, such as the appropriate game form, existence, and uniqueness of equilibria, are discussed. The paper finishes with a brief overview of some applications of the framework.

Malpractice Liability for Physicians and Managed Care Organizations

This Article provides an economic analysis of optimal negligence liability for physicians and Managed Care Organizations explicitly modeling the role of physician expertise and MCO authority. We find that even when patients anticipate the risks imposed on them, physicians and MCOs do not take optimal care absent sanctions. Markets and contracts do not provide optimal incentives because market prices are determined at the moment of contracting, but physician expertise and MCO authority depend on non-contractable actions taken post-contract. Negligence liability can induce optimal care if damage rules are optimal. Optimality requires that MCOs be held liable for both their own negligent treatment coverage decisions and for negligence by affiliated physicians. Moreover, we find that MCOs should be liable even when they do not exert direct control over physicians. Finally, we show that it may be optimal to preclude physicians or MCOs from obtaining liability waivers from patients, even when patients are fully-informed and waive only when it is in their interests to do so at that moment.

Labor Turnover and the Natural Rate of Unemployment: Efficiency Wage vs Frictional Unemployment.

Wage and unemployment responses to changes in economic environment are compared for efficiency wage and frictional models. Changes in aggregate demand, persistence of job-specific shocks, cost of living, and unemployment benefits are considered. Wages and unemployment move in the same direction in the two models, except that an upward shift in aggregate labor demand can reduce the real wage in the efficiency wage, but not the frictional, model. In a numerical simulation calibrated to U.S. data, real productivity shocks in the efficiency wage model yield a ratio of unemployment to wage variability close to that of the United States.

Entry, Sunk Costs, and Market Structure

Typically, models that study the role of sunk costs suppose that incumbent firms face entry by a single firm each period. In this paper, the set of equilibrium market structures that result when all firms are free to enter or exit and set prices each period are characterized. The effect of sunk costs on the market structure is examined and it is shown that sunk costs can take on various forms, each having a different effect on the set of equilibrium market structures. Costs that are sunk due to the existence of product- specific capital do not in general deter entry. Rather, entry deterrence is a necessary outcome only when costs are sunk due to the time it would take to leave the market.

On the Efficiency of Standard Contracts the Case of Construction

Most contracts that individuals enter into are not written from scratch but depend upon forms and terms that have been successful in the past. In this paper we study the structure of the form construction contracts published by the American Institute of Architects (AIA). We show that these contracts are an efficient solution to the problem of procuring large, complex projects when unforeseen contingencies are inevitable. This is achieved by carefully structuring the ex post bargaining game between the Principal and the Agent. The optimal mechanism corresponding to the AIA construction form is consistent with decisions of the courts in several prominent, but controversial, cases, and hence provides an economic foundation for a number of the common-law excuses from performance. Finally, the case of form contracts for construction is an example of how markets, as opposed to private negotiation, can be used to determine efficient contract terms.

Diagnosis and Unnecessary Procedure Use: Evidence from C-Section

This paper provides a model of in which doctors have two dimensions of skill: diagnostic skill and skill in performing procedures. Unlike higher procedural skill, which leads to higher use of surgical procedures across the board, better diagnostic skill results in fewer procedures for the low risk, but more procedures for the high risk. That is, better diagnostic skill improves the matching between patients and procedures leading to better health outcomes. Using data on a million births we derive empirical analogues to our theoretical measures of doctor skill, and use these measures to show that improving diagnostic skills from the 25th to the 75th percentile of the observed distribution would reduce C-section rates by 15.8% among the lowest risk, and increase them by 4.7% among the high risk. Since there are many more low risk than high risk women, improving diagnosis would reduce overall C-section rates while improving health outcomes for both high risk and low risk women. We conclude that distinguishing between at least two dimensions of doctor skill is feasible and might help to improve the quality of medical care. ∗We thank Samantha Heep and Dawn Koffman for excellent research assistance, and Amitabh Chandra, Jonathan Gruber, Amy Finkelstein, Kate Ho, Jonathan Skinner and seminar participants at Princeton, Kyoto University, the National Institute of Population and Social Security Research, Warwick Univeresity, University College London, the London School of Economics, the Paris School of Economics, the NBER Summer Institute, and the University of Michigan for helpful comments. This research was supported by a grant from the Program on U.S. Health Policy of the Center for Health and Wellbeing.