Kenneth J. Arrow - US grants

This project addresses two major gaps in general equilibrium theory: a full treatment of monopolistic competition and an explanation of the convergence of prices towards their equilibrium values. These are fundamental and as yet unresolved problems in economic theory. The insights from this project should improve the basic paradigm used by economic theorists to study market performance. Imperfect competition is modelled by taking firms to be "moderately small," although not so small the situation is essentially perfectly competitive. "Smallness" should be defined endogenously, by free entry in large markets, not by assuming that firms having rising average cost curves after a point. Prices are chosen by firms, but production requires time so that the competition is effectively Cournot-like. Stability theory has to be reconsidered as a learning process. Prices should be formed by firms making rational decisions. This is made possible by recognizing that out of equilibrium either sellers or buyers have market power. There is incomplete information. Each round yields a set of signals in the form of excess supplies or demands for individual firms. From this they can update their priors on the unknown parameters of the economy. In the next round, they choose production before the market opens and also choose new prices. Since the process is one of cumulative information (past signals still enter into present decisions), the failure of standard stability theory may not prevent better results in convergence.

This project provides theoretical and econometric methods for analyzing how advanced information technologies, and the structures of the organizations using them, affect the performance of modern, complex, industrial production facilities. The research focusses upon the productivity and reliability of established production facilities, and its ultimate aim is to assess the impacts of new technologies for process monitoring and control upon these two quantitative dimensions of performance. The research agenda has three elements. First, it aims to advance the analysis of production systems by examining the choices of techniques for process control and organizational design that would promote improvement sin reliability and productivity via more extensive uses of sophisticated information technology. Second, it proposes novel formulations of production theory that relate more directly to empirical observations of micro level production events. Third, the project undertakes to test the usefulness of its conceptual and methodological researches by applying these concretely, in a study of organizational and information-technology impacts on the performance of an economically important and exceptionally well-documented industry--commercial nuclear power plants operated by U.S. electric utility companies.

This project studies the microeconomic umderpinnings of the inflationary process. It is widely accepted among economic theorists that inflation, that is changes in the aggregate price level, is characterized by discrete jumps in individual prices. This work analyzes the theoretical feasibility of aggregating those discrete price changes into a smooth time path for an aggregate price level. Fundamental to such a study is the interaction of the firms in setting pricing policies. If firms follow identical real price cycles in setting prices, then consistent aggregation is feasible. However, there are important reasons why such uniformity in pricing policies among independent firms might not converge to an economic equilibrium. Specifically the project employs a duopoly model where demand depends on current real prices. Each firm faces a choice of a price path or price strategy which maximizes the present value of profits over a time horizon. The salient feature of the model is the discontinuous pattern of nominal price adjustments. The project characterizes those conditions under which the assumptions of a smoothly changing aggregate price level is consistent with economic equilibruim. %%% Among the most difficult and important areas of economic research is the characterization of price movements, production, and pricing strategies of firms in oligopolistic markets. Such markets by definition have only a few firms which account for all the industry's output, and are very prevalent in both the U.S. and international economy. Automobile manufacturing is an example of an oligopolistic market. In such markets prices are set based on the interaction among the firms, the relative size of each firm's market share, and the incentives faced by each firm to act independently of the others. This type of interaction results in the prices set by individual firms being changed in discrete intervals rather than moving smoothly through time. However, many studies of the aggregate economy, particularly those examining inflation, assume a continuous time path for prices. This project studies the conditions under which the assumption of a smooth time path for aggregate prices is consistent with the independent setting of prices by individual firms, and with economic equilibrium. In doing so, the work adds a fundamental theoretical basis to studies of both the aggregate economy and the behavior of individual firms.

This project studies the role of information in individual decision making and in the structure of markets by which resources are reallocated socially. The underlying theme is that recognizing that knowledge is neither free nor infinitely costly has many implications for the means by which individuals reallocate their resources, including their stock of information, and for transactions among individuals by which both goods and knowledge are transferred. The role of information in individual decisions is to be studied as a basis for the still more fundamental issue of providing a general model for economic activity. The market as understood in standard economic theory merely approximates economic processes, and is valid only in limiting cases where certain information costs vanish. The outcome of this research will be above all conceptual rather than technical, although numerous analytic questions must be raised in the process. Also, it provides better understanding of the foundations of the theory of economic institutions including firms, markets, and market equilibrium.

For the past two decades, Stanford has conducted a highly successful summer workshop that has served as a gathering place for extended research interactions among economic theorists. The intellectual and physical environment, extended program format, experienced staff, and support from the University and the Hoover Institution have combined to make the Stanford program uniquely successful over many years. The program has traditionally provided an important forum for younger economists to present and receive comments on their work. For the summer of 1993, a program with the following three themes is proposed: Environmental Economics, Financial Institutions and Imperfections, and Epistemic Foundations of Game Theory. Each topic will be centered on a workshop and will also include a series of presentations on the same theme. For the subsequent summers, topics to be concentrated on include: Implementation and Design of Economic Mechanisms, Applications of Game Theory to Oligopoly, and Discontinuous Changes Induced by Inflation.