Forward-Looking Decision Making

Forward-Looking Decision Making

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The Gorman Lectures in Economics

Series Editor, Richard Blundell Lawlessness and Economics: Alternative Modes of Governance, Avinash K. Dixit Rational Decisions, Ken Binmore Forward-Looking Decision Making: Dynamic-Programming Models Applied to Health, Risk, Employment, and Financial Stability, Robert E. Hall A series statement appears at the back of the book

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Forward-Looking Decision Making

Dynamic-Programming Models Applied to Health, Risk, Employment, and Financial Stability

Robert E. Hall

Princeton University Press Princeton and Oxford

Copyright ? Princeton University Press. Posting or other electronic distribution is not permitted.

Copyright ? 2010 by Princeton University Press

Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540

In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW

All Rights Reserved

Library of Congress Cataloging-in-Publication Data

Hall, Robert Ernest, 1943? Forward-looking decision making : dynamic programming models applied to health, risk, employment, and financial stability / Robert E. Hall. p. cm. ? (The Gorman lectures in economics) Includes bibliographical references and index. ISBN 978-0-691-14242-5 (alk. paper) 1. Households?Decision making?Econometric models. 2. Families?Decision making?Econometric models. 3. Decision making?Econometric models. I. Title.

HB820.H35 2010 330.01 5195?dc22

2009042465

British Library Cataloging-in-Publication Data is available

This book has been composed in LucidaBright using TEX Typeset and copyedited by T&T Productions Ltd, London Printed on acid-free paper. press.princeton.edu

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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Contents

Foreword

vii

Preface

ix

1 Basic Analysis of Forward-Looking

Decision Making

1

1.1 The Dynamic Program

1

1.2 Approximation

5

1.3 Stationary Case

6

1.4 Markov Representation

7

1.5 Distribution of the Stochastic Driving

Force

9

2 Research on Properties of Preferences

10

2.1 Research Based on Marshallian and

Hicksian Labor Supply Functions

13

2.2 Risk Aversion

15

2.3 Intertemporal Substitution

17

2.4 Frisch Elasticity of Labor Supply

19

2.5 Consumption?Hours Complementarity

20

3 Health

23

3.1 The Issues

23

3.2 Basic Facts

25

3.3 Basic Model

26

3.4 The Full Dynamic-Programming Model

31

3.5 The Health Production Function

35

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vi

Contents

3.6 Preference Parameters

36

3.7 Solving the Model

37

3.8 Concluding Remarks

38

4 Insurance

42

4.1 The Model

43

4.2 Calibration

45

4.3 Results

46

5 Employment

50

5.1 Insurance

52

5.2 Dynamic Labor-Market Equilibrium

53

5.3 The Employment Function

58

5.4 Econometric Model

59

5.5 Properties of the Data

64

5.6 Results

65

5.7 Concluding Remarks

69

6 Idiosyncratic Risk

70

6.1 The Joint Distribution of Lifetime and

Exit Value

73

6.2 Economic Payoffs to Entrepreneurs

74

6.3 Entrepreneurs in Aging Companies

82

6.4 Concluding Remarks

85

7 Financial Stability with

Government-Guaranteed Debt

87

7.1 Introduction

87

7.2 Options

92

7.3 Model

94

7.4 Calibration

100

7.5 Equilibrium

101

7.6 Roles of Key Parameters

113

7.7 Concluding Remarks

115

7.8 Appendix: Value Functions

116

References

119

Index

123

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Foreword

Forward-looking behavior is at the heart of economics. Choices over savings, occupations, earnings, investments, etc., all require forward planning under uncertainty. Just how individuals and firms go about doing this and how, as economists, we should best model what they do are key to our understanding of economic behavior and are the core concern of this book. Few people have had such an impact on the development of these aspects of economics as has Robert Hall.

This volume makes a compelling case for the use of the dynamic-programming approach to modeling choices across a wide range of economic decision making. Not just forward-looking consumption and labor market decisions, but also health-care choices, where the payoff is measured in terms of future quality of life. Entrepreneurial startup decision making under uncertainty is carefully examined too and a coherent framework for examining moral hazard issues in the provision of insurance to the risks faced on uncertain investments is provided, using this to show the value of venture investors.

The reader is introduced to the dynamic-programming approach to modeling forward-looking behavior in an accessible but rigorous way, emphasizing the relationship to the choices being made by the decision maker and the key issues the researcher will face in practical implementation. The key preference

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viii

Foreword

parameters required for modeling choices are described as well as how to recover them from empirical analysis in a fashion that is consistent with the forward decision making framework.

We were extremely fortunate to have Robert Hall present these ideas in the Gorman Lecture series and it is wonderful to have them now brought together in one volume.

Richard Blundell University College London Institute for Fiscal Studies

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