The EconomicDynamics Newsletter

                Volume 1, Issue 2, April 2000

A free electronic supplement to the Review of Economic Dynamics
distributed through the EconomicDynamics mailing list and also available
on the web at http://www.EconomicDynamics.org/

In this issue:

- The Research Agenda: Search Theory beyond the Matching Function, by
  Shouyong Shi 
- EconomicDynamics Interviews Lee Ohanian on the Great Depression 
- Review of Economic Dynamics: A progress report 
- Society for Economic Dynamics: 2000 Meetings in Costa Rica, an
  update 
- Software: NEOS: Network-Enabled Optimization System 
- EconomicDynamics Links: QM&RBC: Quantitative Macroeconomics & Real
  Business Cycles 
- Impressum 
- Subscribing/Unsubscribing/Address change 

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The Research Agenda: Search Theory beyond the Matching Function, by
Shouyong Shi

Shouyong Shi is Associate Professor at the Department of Economics at
Queen's University (Kingston, Canada). He has published extensively on
search models, especially applied to monetary economics. His interests
also include capital accumulation, specialization, and financial 
intermediation. His home page is accessible at
http://qed.econ.queensu.ca/pub/faculty/shi/. 

The predominant theory for analyzing a frictional market is the search
theory developed by Diamond (1982), Mortensen (1982) and Pissarides
(1990). This theory has two distinctive elements. One is an exogenous
matching function that captures a time-consuming matching process and
generates unemployment in equilibrium. The other is an ex post
(after-match) wage determination scheme, often the Nash bargaining
formula, which splits the match surplus between the two sides of the
match. This theory has been used to organize a wide range of facts related
to unemployment, both over the business cycles and along the growth trend,
and to make policy recommendations. In contrast to other unemployment
models (e.g., efficiency-wage models), the search theory can be easily
integrated into an intertemporal framework. 

Yet, the exogenous matching function and the exogenous surplus-sharing
rule remain unsatisfactory. First, these exogenous features critically
affect the model's predictions on efficiency (see Hosios (1990)) and on
the effects of labor market policies (Shi and Wen (1999)). Second, and
more fundamentally, they eliminate any role for wages to direct matches ex
ante (before matches occur) and deprive agents of the ability to actively
influence their matches. In my current research I develop search models
that do not rely on these exogenous elements and apply them to analyze
wage inequality.  

A simple way to allow agents to actively organize their matches is to
replace the matching function by a two-stage, wage-posting game, where
firms simultaneously post wages first and then workers apply to jobs after
observing the wages. Such a price/wage-posting model, developed by Peters
(1991) and Montgomery (1991), preserves the time-consuming feature of the
search theory by assuming that a worker can only apply to a small fraction
of the job openings in each period. In contrast to the standard search
model, wages are determined before, not after, matches occur and so wages
"direct" workers' search. The matching process and the surplus division
are both endogenous outcomes of agents' actions. Each firm can
deliberately change the posted wage to affect the number of applicants it
receives. Firms and workers maximize the expected gains from a match,
making a trade-off between the matching probability and the ex post gains
from a match.  

I further develop this model and use it to examine the following issues. 

1. "Pricing with Frictions". In this paper with Kenneth Burdett and
Randall Wright, we first show that the price-posting equilibrium in a
market with finite numbers of sellers and buyers converges to the
equilibrium with infinitely many buyers and sellers. Since the latter is
considerably easier to characterize, this result greatly simplifies the
price/wage-posting game in large markets. 

Then we allow firms to differ in capacity. The main finding is that the
equilibrium price and the endogenous matching function both depend on not
only the number of buyers and the number of goods for sale in the market,
but also on how those goods are distributed across sellers. This result
suggests that the standard matching function adopted in the literature is
mis-specified. That is, the number of new matches should depend on whether
there are many firms, each with a few vacancies, or a few firms, each with
many vacancies.  

2. "Product Market and the Size-Wage Differential". In this paper I
examine whether the wage-posting model can be useful for explaining the
size-wage differential, i.e., the fact that employers with more workers
pay higher wages than smaller employers do to workers with the same
observable skills. This size-wage differential is a significant fraction
of the overall wage inequality but has not been well explained by
traditional theories.  

For this task, I integrate the product market and the labor market into a
price/wage-posting framework. In the product market the price-posting game
generates the outcome that buyers pay a higher price to a larger seller
than to a smaller seller for the higher service probability the larger
seller provides. Thus, a large firm obtains a higher expected revenue per
worker than a small firm. To capture this revenue differential, a large
firm posts a higher wage to fill the vacancy than a small firm does. High
and low wages generate the same expected wage to a searching worker
because a high wage attracts more applicants and hence is more difficult
to obtain. Thus, large firms not only pay a higher wage than small firms
but also have higher expected profit, although the workers are identical
and the firms are identical (except for size). 

An increase in the product demand changes the distribution of employment
across firms with different sizes and has ambiguous effects on the
size-wage differential. In particular, trade liberalization increases wage
inequality when the product demand is initially low but decreases wage
inequality when the product demand is already high. 

3. "Unskilled Workers in an Economy with Skill-Biased Technology". In this
paper I extend the wage-posting model to incorporate skill differences and
skill-biased technology. The purpose is to check whether search frictions
are important for explaining the following facts in the US data: In the
1970s, the skill premium fell but the within-group wage differential rose;
in 1980s, the skill premium and the within-group wage differential both
rose.  

In this model workers are either skilled or unskilled, while firms use
either a high technology or a low technology. The high technology is
biased toward skilled workers. High-tech firms prefer skilled workers to
unskilled workers and pay a skill premium, but they also post wages for
unskilled workers in case they do not receive any skilled applicants.
There is a wage differential among unskilled workers, i.e., unskilled
workers in high-tech firms are paid more than those in low-tech firms.
This within-group wage differential arises not from match-specific
productivity or the complementarity between skilled and unskilled workers,
but rather from the trade-off between a wage and the matching probability.
A high-tech firm's high wage comes with a low matching probability for an
unskilled worker while a low-tech firm's low wage comes with a high
matching probability.  

In this framework an increase in the skill-biased productivity increases
the skill premium and the wage differential among unskilled workers
simultaneously. In contrast, an increase in the general productivity of
all workers increases the skill premium but reduces the wage differential
among unskilled workers. These results indicate that search frictions can
be important for accounting for both the skill premium and the
within-group wage differential.   

4. "Frictional Assignment". In this paper I examine the assignment problem
in a frictional market, i.e., the two-sided matching problem in a market
where agents on each side are heterogeneous. In a frictionless market,
Becker (1973) has shown that the market assignment is efficient and
positively assortative (i.e., it matches high attributes on one side with
high attributes on the other side of the market). Neither feature holds in
a frictional matching market modeled in the standard search theory. I
re-examine these issues with a wage-posting framework and focus on the
assignment between skills and machines.  

Two results emerge. First, the efficient assignment in this frictional
world may not be positively assortative even when skills and machine
qualities are complementary with each other in production. This is because
skills and machines are not fully utilized and so, by matching high skills
with low-quality machines and high-quality machines with low skills,
efficiency may be improved if such a matching scheme increases the
utilization of both high skills and high-quality machines. Second, the
efficient assignment can be decentralized as follows. Each firm chooses
three things before matches occur: a machine quality, a desired skill to
be matched with, and a wage for the skill. After observing these choices,
workers apply to the firms. The ex ante competition between firms and the
endogenous division of the match surplus encourage the right number of
firms to enter the market to target each skill and induce them to select
the efficient machine quality for each skill.  

The price/wage-posting framework is tractable and useful for modeling
large, frictional labor markets. It allows search theory to go beyond
exogenous matching functions and exogenous surplus-splitting rules, to
make predictions and policy recommendations that are not vulnerable to
these exogenous elements, and to explain some well-known facts about
inequality. More fundamentally, the framework reinstates prices the ex
ante role of allocating resources.  

References to the papers mentioned are available in the web version of
this newsletter at http://www.EconomicDynamics.org/newsletter/. 

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EconomicDynamics Interviews Lee Ohanian on the Great Depression 

Lee Ohanian is Associate Professor at the Department of Economics,
University of California, Los Angeles. He specializes in macroeconomic
theory, the study of business cycles and growth. He has published in the
best journals on monetary policy, war finance, VARs, and other topics. His
home page is available at:
http://www.econ.ucla.edu/people/faculty/Ohanian.html.  

EconomicDynamics: With Hal Cole, you show in your Minneapolis Fed
Quarterly Review article that the major peculiarity of the Great
Depression was not so much the sharp decline in 1929-33 but rather the
extremely slow recovery until 1939. You argue that the key fact to explain
is stagnant hours. Why?  

Lee Ohanian: Productivity grew rapidly after 1933. Theory predicts that
the economy should have recovered to trend by 1936, with above-trend labor
input supporting higher consumption and investment. But hours worked
remained 20-25 % below trend until World War II. So why was labor input so
low given rapid productivity growth? It wasn't because other shocks were
negative - banking panics and deflation ended in 1933, and real interest
rates were low. Hours per adult should have been a lot higher after 1933. 

ED: In current work with Hal Cole, you argue that New Deal policies
encouraging cartelization linked to high wages are responsible for the
slow recovery. Why? How could the government be so wrong? 

LO: There must have been a major negative shock to offset the recovery of
economic fundamentals and keep the economy depressed. The government
adopted some extreme labor and industrial policies (the National
Industrial Recovery Act) in 1933 that really distorted markets. These
policies suspended the antitrust laws and permitted collusion, provided
that the rents were shared with labor. This was accomplished through
immediate wage increases and collective bargaining. 

Our new paper, "New Deal Policies and the Persistence of the Great
Depression", quantitatively analyzes these policies. We build a model of
the policies, and embed that model within a dynamic GE business cycle
model. In contrast to the fast recovery predicted by standard theory, our
model predicts economic activity remains far below trend after 1933. We
concluded that these policies were a key factor behind the persistence of
the Depression - they can account for about 60 % of the deviation between
the predicted trend levels and the actual data. 

Ironically, President Roosevelt thought that "excessive" competition was
responsible for the Depression, and that these policies would bring
recovery. He was wrong. My colleague Armen Alchian was a student at
Stanford at the time, and told me that his professors thought the policies 
were crazy - they couldn't understand how promoting monopoly could raise
employment. It is unfortunate that Roosevelt didn't listen to these
mainstream economists - if he had, the recovery would have been much
stronger. These policies were finally weakened during World War II - and
employment rose substantially. 

There also seemed to be a sentiment to redistribute income during the
1930s. But this policy was a really inefficient method of redistribution.
It created a lot of inequality by shutting down employment. 

ED: Why do you think it is necessary to use a dynamic general equilibrium
model to study the Great Depression? We have all been taught that the
economy was not in equilibrium during that period. 

LO: Theory has changed a lot since the Depression. I believe that
economists took the disequilibrium route because the general equilibrium
language of Arrow, Debreu, and McKenzie wasn't well known at the time. We
now know that disequilibrium models should be used very reluctantly,
because there are an infinite number of ways an economy can be out of
equilibrium. The model Hal and I developed for 1933-1939 is a dynamic
general equilibrium model - but with a cartel policy arrangement that
generates very low labor input, consumption, and investment. 

GE theory is important for understanding the Depression. There are a lot
of stories about the Depression, but without an explicit GE model you
don't know if the stories hold water. One of the benefits of GE theory is
that it forces you to look beyond the direct effects of shocks, and assess
the indirect effects. Hal and I are writing a paper for the NBER Macro
Annual that uses GE models to study the two most popular shocks for
1929-33: the money stock decline and bank failures. Using GE models, we
found that many of the indirect effects of these shocks offset the direct
effects, or were at variance with the data.  

For example, several economists think money shocks depressed the economy
through imperfectly flexible wages. Nominal wages were high in
manufacturing because President Hoover told the Fortune 500 C.E.O.'s not
to cut wages. But wages did fall in other sectors, so a multi-sector GE
model is needed to evaluate this story. We found that high manufacturing
wages reduced aggregate output only about 3 % between 1929-33. This is
because the direct effect of the wage shock is pretty small, and because
the indirect, general equilibrium effects offset some of the direct effect. 

The paper also develops a GE model with a banking sector. The model
predicts that bank failures should lead firms to substantially increase
retained earnings as a substitute for bank finance. However, firms cut
retained earnings like crazy during the Depression - In 1930, dividend
payments fell by 4% while profits fell by 63%. The model also predicts
that regions with more bank failures should have had deeper depressions.
But we found little correlation between state-level economic activity and
state-level bank failures.  

Hal and I thought monetary shocks were the key factor for 1929-33 when we
wrote our Minneapolis Fed QR paper. Our view has changed - either we need
alternative theories to revive the money and banking hypothesis, or some
other shock was responsible for 1929-33. 

ED: Were Keynes, and Friedman and Schwartz all wrong? 

LO: Keynes didn't have the benefit of modern theory to help understand the
Depression. He was wrong about "animal spirits" driving down investment,
employment, and output. Ed Prescott argues in his review of our
Minneapolis Fed Quarterly Review paper that the investment decline of the 
1930s is not a mystery - it is exactly what theory predicts, given the
policy shock that kept labor input so low. 

Friedman and Schwartz suggest that government policies contributed to the
post-1933 depression, which is consistent with our view. But we suspect
their emphasis on monetary shocks as a cause for 1929-33 may be misplaced.
Believe it or not, productivity (TFP) fell about 15 % relative to trend
between 1929-33. This drop isn't technological regress, and it doesn't
seem to be input measurement error. Hoover intervened in the private
economy significantly during this period. Perhaps his interference went
beyond wage policies, and affected work practices and expectations about
future returns to investment. We don't know the source of this TFP drop,
or all the consequences of Hoover's actions, but these factors might be
important for 1929-33.  

ED: Would you make a parallel between the slow recovery of the Great
Depression and the "jobless recovery" in the early 1990s? 

LO: There are some key differences between these two recoveries.
Employment growth was stagnant in the 1930s because of government policies
that raised wages and reduced competition. These types of policies weren't
in place during the 1990s. My guess is that a mismatch between new
technologies and the existing stock of labor may have contributed to the
more recent "jobless recovery". It is interesting that employment growth
has been rapid the last few years as the pool of workers able to use these
technologies has increased.  

ED: Would you say, like Ed Prescott, that the conclusions of your work 
with Hal Cole could be applied to contemporaneous France, Spain, and
Japan? 

LO: Economies normally recover rapidly from downturns. It is pathological
for a country to enjoy normal productivity growth but remain depressed for
many years. Japan is one of these pathologies. Many economists think that
Japan's problems could be solved if their banks could make more loans and
if fiscal and monetary policies stimulated aggregate demand. Some
economists even argue that higher inflation expectations would bring
recovery.  

We believe that Japan has more fundamental problems than finding the right
mix of fiscal and monetary policy. Japan has tried all sorts of Keynesian
stimuli, and it hasn't worked. When an economy stagnates year after year,
you have to ask: "What is preventing people from working and producing
more?" Banking problems affected their economy, but we don't think it is
the whole story. 15 years ago, 80 % of Ireland's banks shut down for six 
months because of a strike. Their economy did not falter - people found
substitutes for closed banks.  

If banking is the key to Japan's Depression, why haven't the Japanese
found substitutes after all these years? The persistence of their
depression and the failure of Keynesian policies suggest some other shock
is responsible for Japan's stagnation. My work with Hal suggests we should
look for policies that keep employment low. Ed, Hal, and I are planning to 
start research along these lines soon. 

References to the papers mentioned are available in the web version of
this newsletter at http://www.EconomicDynamics.org/newsletter/. 

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The Review of Economic Dynamics: A Progress Report 

As the coordinating editor of the Review of Economics Dynamics, I want to
update you on recent developments at RED. First, in order to get even
faster turn around times for submitted papers, we are now prepared to
receive electronic submissions that will be handled fully through email.
We require, however, that authors send properly formatted PDF files. The
RED web site has all necessary details. Of course, the traditional postal
submission on paper is still accepted. 

We also have started to put technical appendices of published papers on
the web site. We encourage past and future authors to send us such
material that should be a useful complement to the space constrained
articles. While on the web site, you may also have a peek at the great 
articles that are forthcoming. Our Web site will soon have a new look. Be
sure to check it out.  

Finally, I wish to encourage your library to subscribe to RED. The Review
is very reasonably priced for institutions, and given the high quality of
the Review, no research library should be without it. So please check with
your library.  

Thomas F. Cooley
Coordinating Editor
Review of Economic Dynamics 
http://www.EconomicDynamics.org/review/

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Society for Economic Dynamics: 2000 Meetings in Costa Rica 

The 2000 Meetings of the Society for Economic Dynamics will be held June
29-July 2 (Thursday-Sunday), 2000 in San José, Costa Rica. The conference
is hosted by INCAE with the co-sponsorship of the Central Bank of Costa
Rica. Registration and welcome reception will be held on Wednesday, June 28,
2000. The conference director is Alberto Trejos and the program organizer
is Per Krusell. As in previous editions, the program will consist of
several rounds of simultaneous sessions (both with submitted and invited
papers) throughout the day for each day, followed by a plenary session at
the end of each day. We are pleased to inform that Thomas Sargent,
Guillermo Calvo and Patrick Kehoe have accepted to be our plenary speakers
for the year 2000 edition of the conference. 

For those wishing to attend the conference, online registration forms are
available both for the hotel and the meetings at the web site. We will
also soon post information about vacation packages for those wishing to
extend their stay in Costa Rica. The web site already gives much details
about attractions and other visitor information. 

SED: http://www.EconomicDynamics.org/society/
Conference: http://www.incae.ac.cr/ES/noticias/eventos/sed/

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Software: NEOS: Network-Enabled Optimization System 

Economics is mostly about constrained optimization. With the increasing
complexity or size of models, computers have been gradually taking over
the task of finding optima. For such numerical analyses, techniques
developed in operations research have helped a lot to solve problems that
grew faster in complexity than the power of the computers. But one has to
be aware that not all models can be solved efficiently with the same
algorithm. Many solution methods have been developed, each geared to a
particular set of problems. In fact, there are now so many methods that it
becomes a complex task in itself to select the appropriate algorithm. 

This richness in algorithms has also the drawback that one has to learn
new tools for each model. To help reduce this type of cost to the
researcher, the Optimization Technology Center of the Argonne National
Laboratory has put together a web site introducing the many techniques,
the Network-Enabled Optimization System (NEOS) at
http://www-fp.mcs.anl.gov/otc/. This very complete site guides the reader
through the various types of problems, showing for each several solution
algorithms that are explained and that can even be tried online. In fact,
it is possible to have very large and complex problems solved on the NEOS
server, a great opportunity for those who do not have the necessary
resources available to them directly.  

Most of the algorithms on NEOS deal with rather simple objective functions
with numerous but simple constraints. In economic dynamics, problems have
usually more complex functions and fewer constraints. Yet, the latter can
be converted to the former, as shown for example by Trick and Zin (1997)
who demonstrate that a standard dynamic problem is equivalent to a linear
programming problem with one constraint for each state. Such problems can
be solved easily now, even if they have millions of constraints. 

References to the papers mentioned are available in the web
version of this newsletter at http://www.EconomicDynamics.org/newsletter/.

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EconomicDynamics Links: QM&RBC: Quantitative Macroeconomics and Real
Business Cycles 

Economic Dynamics covers many fields, but Real Business Cycle theory is
certainly one of the more prominent ones. Yet, his theory has difficulties
getting mainstream economics because of its technical difficulty. For
example, very few undergraduates study it, and for a long time only PhDs
coming from some schools could master its techniques. This is changing
now, and this is partly due to the Quantitative Macroeconomics & Real
Business Cycle home page. The web has democratized the access to
information, and this includes getting access to latest research, data and
solution techniques.  

Indeed, since early 1995, QM&RBC has provided sample codes for solving
some of the standard problems in the field. Also, it features links to
selected home pages of researchers who provide their latest results
online. QM&RBC has provided complementary reading material for many
classes, in fact it has even lead many to discover the RBC models they
would not have covered in the regular training.   

QM&RBC is still being maintained to continue to serve the research
community and the aspiring researchers. But the field has evolved and RBC
is now synonymous with much more that "real" shocks or "business cycles".
This is why a poll is currently being conducted to choose for a new
acronym for RBC that would more appropriately describe it. We encourage
you to provide your input. 

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Impressum 

The EconomicDynamics Newsletter is a free supplement to the Review of 
Economic Dynamics (RED). It is distributed through the EconomicDynamics
mailing list and archived at http://www.EconomicDynamics.org/newsletter/.
The responsible editors are Christian Zimmermann (RED associate editor),
[log in to unmask] and Thomas Cooley (RED coordinating editor),
[log in to unmask]   

The EconomicDynamics Newsletter is published twice a year in April and 
November. 

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