EVALUATING ALTERNATIVE REPRESENTATIONS OF THE CHOICE SETS IN MODELS OF LABOR SUPPLY

Abstract.  During the last two decades, the discrete choice modeling of labor supply decisions has become increasingly popular. Within the literature adopting this approach, however, there are two potentially important issues that so far have not been given the attention they might deserve. A first issue concerns the procedure by which the discrete alternatives are selected to enter the choice set. Most authors choose (not probabilistically) a set of fixed points identical for every individual. Some authors adopt instead a sampling procedure and also assume that the choice set may differ across households. A second issue concerns the availability of the alternatives. Most authors assume all the values of hours of work within some range are equally available. At the other extreme, some authors assume only two or three alternatives (for example, nonparticipation, part-time and full-time) are available for everyone. Some studies account instead for the fact that not all the hour opportunities are equally available to everyone specifying a probability density function of opportunities for each individual. In this paper we explore by simulation the implications of (i) the procedure used to build the choice set (fixed alternatives versus sampled alternatives); (ii) accounting or not accounting for a different availability of alternatives. The results of the evaluation performed in this paper show that the way the choice set is represented has little impact on the fitting of observed values, but a more significant and important impact on the out-of-sample prediction performance. Thus, the treatment of the choice sets might have a crucial effect on the result of policy evaluations.     

A THEORETICAL AND PRACTICAL PERSPECTIVE ON THE EQUITY RISK PREMIUM*

Abstract In historical perspective, equity returns have been higher than interest rates but have also varied a good deal more. However, the average excess return has been larger than what could be expected based on classical equilibrium theory: the equity risk premium (ERP) puzzle. This paper has two objectives. First, the paper presents a comprehensive overview of the vast literature developed aimed at adjusting theory and testing the robustness of the puzzle. Here we will show that the failure of theory to link asset prices to economics is mostly quantitative by nature and not qualitative (anymore). Second, beyond providing a survey of theory, we aim for a relevant practical angle as well. Our main contribution is that we spend time on why returns have been higher than investors reasonably could have expected. We present evidence that forecasts of equity returns can be enhanced by valuation models: low valuation levels (low price‐to‐earnings ratios) portend high subsequent returns. While conventional wisdom (several years ago) was to use historical returns to forecast future returns, a growing consensus now recognizes that the predictive power of valuation ratios is preferred. Finally we provide some practical implications based on this predictability. While the ERP is essentially a long‐term issue, the likelihood of a lower risk premium increases risk for many and means that short‐term volatility might not be neglected.