Descriptive and Normative Theories

A great introductory book on decision theory written by a leading authority, professor Itzhak GIlboa, came out recently:

Professor Ehud Kalai at Northwestern University describes this book as follows:
"This book is extremely effective for anyone who wants to acquire quick, basic understanding of old and new concepts of decision theory, with a minimum level of technical details."
In the first chapter, the author indeed effectively explains two essential notions in economics, "descriptive" (sometime called "positive") and "normative" theories:
A descriptive theory is meant to describe reality. For instance, the claim that demand curves slope down attempts to tell us something about the world. Importantly, it does not make a value judgement and takes no stand on whether this feature of the world is good or bad.
A normative theory is a recommendation to decision makers, a suggestion regarding how they should make decisions. For instance, the claim that we should reduce income inequality is a normative claim. Note that the word "normative" does not mean here "the norm in a given society" as it does in other social sciences. The term only says something about the type of interaction between the theorist and the decision maker, namely, that this is an instance in which the former is trying to convince the latter to behave in a certain way.
The author continues to document the role of each theory, which is also very intuitive:
In decision theory it is often the case that a principle can be interpreted either descriptively or normatively. Consider the theory that each economic agent maximizes a utility function. I may propose it as descriptive, namely, arguing that this is a good description of real economic agents. And I may promote it as normative, in which case my claim will be that you would be wise to become such an agent. As a descriptive theory, the principle is tested for its correspondence to reality. The better it fits the data, the more successful it is. As a normative one, the principle should not fit reality. In fact, there is no point in giving decision makers recommendations that they anyway follow. Rather, the test is whether the decision makers would like to follow the principle.


Shapiro (1983)

Original article (link) posted: 29/09/2005

Shapiro (1983) "Premiums for High Quality Products as Returns to Reputations" QJE 98

Think about the market where producers can change product quality over time and consumers cannot observe quality prior to purchase. Then, what will happen? To answer this question, Shapiro (1983) develops a model that explores the implications of firm-specific reputations in a perfectly competitive environment. The one of the most interesting results is that in the equilibrium, firms produce higher quality products earn larger premiums. The premiums are needed for the following two reasons;
First, there is a cost to establish reputation and to offset the cost, positive return (=premium) is needed. Without a premium, no firm chooses high quality.
Second, in this market, sellers can always increase profits in the short-run by reducing the quality of their products (="fly-by-night strategy"). To prevent this deviation, positive return on the faithful path (which dominates the short-run return induced by fly-by-night strategy) is needed.
Although, the above point has already been recognized (Klein and Leffler (1981) explored this idea informally), this is the first paper which models reputation under competitive markets.

Tirole (1988) (2.6.2) provides a simplified version of the Shapiro model; one firm, and two types of qualities. He also points out two problems of Shapiro's model, which are the reliance of infinite-horizon time and bootstrap aspects of the equilibria. As is easily seen, only the lowest quality product is provided in each period with finite horizon model (by backward induction). Bootstrap aspects mean that reputation matters only because consumers believe it matters. Indeed, if, for example, consumers believe the firms produce the low quality no matter what the past history, then their expectation would again be fulfilled. In other words, the analysis suggests only that repetition may offer incentives to supply quality, not that it necessarily will.

Note) In the paper, this possibility is excluded since the author poses strong assumption about reputation formation; the expected quality of the firm's product at t is simply the product quality he chooses at t-1, i.e., R(t)=q(t-1). This simple adjustment expectation turns out to be a rational expectation. However, as Tirole mentions, there are other rational expectation equilibria and Shapiro (1983) does not mention them.

Finally, notice that Kreps and Wilson (1982) and Milgrom and Roberts (1982) showed that reputation effects can be obtained even with a finite horizon by introducing asymmetric information about firm's type. Their models also pin down the equilibrium strategy and high quality is necessarily observed.


Klein and Leffler (1981) "The Role of Market Forces in Assuring Contractual Performance" JPE, 81
Kreps and Wilson (1982) "Reputation and Imperfect Information" JET, 27
Milgrom and Roberts (1982) "Predation, Reputation, and Entry Deterrence" JET, 27
Tirole (1988) "The Theory of Industrial Organization" MIT Press


Game Theory in Finance

What is going on in the up-front academic research in finance? I found a concise description of the field of finance from the great survey article:
"Finance Applications of Game Theory"by Franklin Allen and Stephen Morris (1998, link)

In Introduction, they say the following:

1. Introduction
Finance is concerned with how the savings of investors are allocated through financial markets and intermediaries to firms, which use them to fund their activities. Finance can be broadly divided into two fields. The first is asset pricing, which is concerned with the decisions of investors. The second is corporate finance, which is concerned with the decisions of firms. Traditional neoclassical economics did not attach much importance to either kind of finance. It was more concerned with the production, pricing and allocation of inputs and outputs and the operation of the markets for these. Models assumed certainty and in this context financial decisions are relatively straightforward. However, even with this simple methodology important concepts such as the time value of money and discounting were developed.
Finance developed as a field in its own right with the introduction of uncertainty into asset pricing and the recognition that classical analysis failed to explain many aspects of corporate finance.

Although the paper was written more than 10 years ago, game theoretical perspectives in finance has still not been widespread. If you are interested in these materials, you should definitely check this. Here is the abstract of the paper:
Traditional finance theory based on the assumptions of symmetric information and perfect and competitive markets has provided many important insights. These include the Modigliani and Miller Theorems, the CAPM, the Efficient Markets Hypothesis and continuous time finance.
However, many empirical phenomena are difficult to reconcile with this traditional framework. Game theoretic techniques have allowed insights into a number of these. Many puzzles remain. This paper argues that recent advances in game theory concerned with higher order beliefs, informational cascades and heterogeneous prior beliefs have the potential to provide insights into some of these remaining puzzles.


IO Seminar (Kadyrzhanova)

Original article (link) posted: 28/09/2005

Kadyrzhanova "The Leader-Bias Hypothesis: Monopolization and Industry Structure under Imperfect Corporate Control" Job Market Paper

The paper examines the effect of the imperfect corporate control in a dynamic oligopoly market with cost reducing R&D investments. The managers are assumed to have an over-producing incentive ("empire-building" hypothesis), and hence, they do not maximize firms' short-run profit without intervention of the shareholders. Corporate control serves to shift managers' preference from "empire-building" to "profit maximization".
The key observation is that shareholders may want to choose imperfect control because of the commitment benefit of the over-producing derived by "empire-building" preference of the manager. Indeed, she shows that even if there is no cost of corporate control, shareholders do not choose full control. Moreover, it is shown that shareholders are more willing to leave discretionary authority to managers when ahead of rivals, which results in lower turnover, higher concentration, persistently monopolized markets, and significantly lower consumer surplus.

I found the paper quite interesting. However, there were so many things she put in her presentation and the relationship among those are not clear enough for me. I am afraid that audiences also got little because her focus of the talk is vague. I think her presentation could have become much better if she had tried the followings:
1) Stress and make clear the contribution to the literature
2) Put more intuitive explanation of the main results
3) Be more confident on mathematical parts
4) Mention some actual story in markets or empirical facts as a motivation
5) Explain which element of the model is a key to derive the corresponding result

Interesting Papers in Reference

Athey and Schmutzler (2001) "Investment and Market Dominance" RAND 32 (1): 1-26
Bagwell, Ramey and Spulber (1997) "Dynamic Retail Price and Investment
Competition" Rand, 28(2), 207-227
Bolton, Brodley, and Riordan (2000) "Predatory Pricing: Strategic Theory and Legal Policy" Georgetown Law Journal, 88, pp. 2239-2330
Bolton and Scharfstein (1990) "A Theory of Predation Based on Agency Problems in Financial Contracting" American Economic Review 80(1): 93-106
Cabral and Riordan (1994) "The Learning Curve, Market Dominance and Predatory Pricing" Econometrica, 62, pp. 1115-1140
Fershtman and Judd (1987) "Equilibrium Incentives in Oligopoly" American Economic Review, 77(5), 927-940


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