Review Article of Drèze's essays on economic decisions under uncertainty

Jacques Drèze has participated significantly in many fields of economic analysis. The book we have reviewed is limited to his main contributions to the economics of uncertainty and information. It is rich in ideas, models, and results for graduate students and researchers who are interested in this now basic dimension of economic analysis. We hope that its publication will permit the public at large to better appreciate the importance of its author's contributions.Economics Department and CRT Université de Montréal C.P. 6128. Succursale A Montréal (Québec) Canada H3C 3J7. Kenneth Arrow, Danielle Blanchard, Camille Bronsard, Leonard Dudley, Robert Gagné, Edi Karni and Françoise Shoumaker provided very useful comments on a first version of this review. Thanks are also due to Carole Laflamme for editorial assistance.     

稳字当头,把握结构性机会——商业银行如何应对疫情背景下的全球经济不确定性

当前,国内疫情得到有效控制,国外疫情正在爬坡过坎,全球金融市场震荡,经济发展面临着重大不确定性。疫情叠加全球经济放缓,对商业银行的影响主要表现为:线下业务拓展和服务受阻、信贷需求减弱、存款短期存在阶段性机会但稳存增存压力预计会逐步增加、息差收窄压力加大,中间业务收入明显下降,风险暴露逐步加快。同时也要看到,受疫情影响,财政货币政策更加积极,“新基建”四起,部分涉疫行业短期受益,疫情加快了企业运营和客户行为线上化迁徙步伐,为银行赢得再差异化竞争创造了时机。     

Strategy under uncertainty

At the heart of the traditional approach to strategy lies the assumption that by applying a set of powerful analytic tools, executives can predict the future of any business accurately enough to allow them to choose a clear strategic direction. But what happens when the environment is so uncertain that no amount of analysis will allow us to predict the future? What makes for a good strategy in highly uncertain business environments? The authors, consultants at McKinsey & Company, argue that uncertainty requires a new way of thinking about strategy. All too often, they say, executives take a binary view: either they underestimate uncertainty to come up with the forecasts required by their companies' planning or capital-budging processes, or they overestimate it, abandon all analysis, and go with their gut instinct. The authors outline a new approach that begins by making a crucial distinction among four discrete levels of uncertainty that any company might face. They then explain how a set of generic strategies--shaping the market, adapting to it, or reserving the right to play at a later time--can be used in each of the four levels. And they illustrate how these strategies can be implemented through a combination of three basic types of actions: big bets, options, and no-regrets moves. The framework can help managers determine which analytic tools can inform decision making under uncertainty--and which cannot. At a broader level, it offers executives a discipline for thinking rigorously and systematically about uncertainty and its implications for strategy.     

全球经济运行的不确定性正在增加

对中国而言,当前经济增长保持高速,在前期从紧的调控政策下,市场普遍预期4季度通胀将有所回落,但其对投资和消费的不利影响正逐步显现,同时人民币的持续升值也会拖累出口的增长并驱动热钱流入。以上错综复杂的内外环境增加了全球经济运行的不确定性,同时也将考验中国政府对整体形势的判断和政策的运用     

Carbon pricing under uncertainty

International Tax and Public Finance - Economists have adopted the Pigouvian approach to climate policy, which sets the carbon price to the social cost of carbon. We adjust this carbon price for...     

Investment under uncertainty and time-inconsistent preferences

While standard real options models assume that agents possess a constant rate of time preference, there is substantial evidence that agents are impatient about choices in the short term but are patient when choosing between long-term alternatives. We extend the real options framework to model the investment-timing decisions of entrepreneurs with time-inconsistent preferences. The impact on investment-timing depends on such factors as whether entrepreneurs are sophisticated or naive in their expectations regarding their future time-inconsistent behavior, and whether the payoff from investment occurs all at once or over time. The model is extended to the case of a competitive equilibrium.     

Stock market uncertainty and economic fundamentals: an entropy-based approach

This study investigates the effects of stock market uncertainty on economic fundamentals, represented by economic activities and systemic risk, in China. To capture the uncertainty in the Chinese stock market precisely, we use the entropy measure through symbolic time-series analysis. The empirical findings reveal strong spillover effects from stock market uncertainty to economic fundamentals. Specifically, an uncertainty shock generates (i) a short-term decline in industrial production, (ii) a rapid drop and rebound in the composite leading indicator, and (iii) an increase in systemic risk. To understand these findings, we suggest and validate the transmission channel through changes in consumption and investment.     

Monetary policy under financial uncertainty

Monetary policy may play a substantial role in mitigating the effects of financial crises. In this paper, I suppose that the economy occasionally but infrequently experiences crises, where financial variables affect the broader economy. I analyze optimal monetary policy under such financial uncertainty, where policymakers recognize the possibility of crises. Optimal monetary policy is affected during the crisis and in normal times, as policymakers guard against the possibility of crises. In the estimated model this effect is quite small. Optimal policy does change substantially during a crisis, but uncertainty about crises has relatively little effect.     

Corporate liquidity and dividend policy under uncertainty

We examine optimal liquidity (retained earnings) and dividend choice incorporating debt financing with risk of default and bankruptcy costs as well as growth options under revenue uncertainty. We revisit the conditions for dividend policy irrelevancy and the broader role of retained earnings and dividends. Retained earnings have a net positive impact on firm value in the presence of growth options, high external financing costs and low default risk. High levels of retained earnings enhance debt capacity but have a negative effect on equity value due to the likelihood of losing accumulated cash balances in case of default, unless offset by high external financing costs. Opposite directional effects of retained earnings on equity and debt create a U-shaped relation with firm value. The framework is extended to analyze management-shareholder conflicts, demonstrating that managers accumulate higher than optimal cash.     

Monetary policy under model and data-parameter uncertainty

Empirical Taylor rules are much less aggressive than those derived from optimization-based models. This paper analyzes whether accounting for uncertainty across competing models and (or) real-time data considerations can explain this discrepancy. It considers a central bank that chooses a Taylor rule in a framework that allows for an aversion to the second-order risk associated with facing multiple models and measurement-error configurations. The paper finds that if the central bank cares strongly enough about stabilizing the output gap, this aversion leads to significant declines in the coefficients of the Taylor rule even if the central bank's loss function assigns little weight to reducing interest rate variability. Furthermore, a small degree of aversion can generate an optimal rule that matches the empirical Taylor rule.     

The cost of electricity under uncertainty

Electricity supply, and cost, is influenced by three major areas of uncertainty: the type and scale of generating technology, the magnitude and end use of demand, and the economic background. If nuclear electricity is to fulfil the role given it by ‘orthodox’ opinion—to capture much of the bulk heating market and become the prime marginal fuel by the year 2000—it must have a price advantage. Yet nuclear costs continue to rise rapidly. As demand growth slackens, energy planners, too often in the past exuberantly certain, should make a more flexible assessment of the true social costs and benefits of such options as renewable sources, smaller generating units, and combined heat and power.     

Investment with network externality under uncertainty

The purpose of this paper is to develop a real option model with a stochastic network size to simultaneously consider firm’s investment and household’s consumption behaviors in an equilibrium framework. First, the consumer’s waiting-to-buy effect is crucial in determining trigger network size of firm’s investment. Second, increasing network externality has an ambiguous effect on trigger network size of firm’s investment. Third, using NPV rule not only underestimates trigger network size but, also possibly results in the misleading relationship between network externality and trigger network size.     

Going multinational under exchange rate uncertainty

We analyze a model where an exporting firm competes a la Cournot in a foreign market. The firm faces exchange rate uncertainty and has the option to invest abroad. The paper contributes four results. First, real option pricing techniques are used to derive the optimal timing rule of the investment and the price of the firm and foreign competitors. Second, the sunk cost of entry into the foreign market introduces hysteresis in direct investment flows. We find that the degree of hysteresis grows with the number of firms in the industry. Third, we determine the conditions under which dumping may appear and the role of FDI in precluding this type of dumping. Fourth, tariffs have the well known FDI-inducing effect, more so in less competitive markets, and are more effective at deterring delocation. Furthermore, a tariff might have the effect of triggering dumping.     

Lay views on uncertainty in environmental health risk assessment

It has been argued that presenting uncertainty in environmental health risk estimates may increase citizens' risk knowledge and trust in the honesty and competence of the institutions providing such estimates; on the other hand, careless communication could have undesirable results. Reported here is a study of how American laypeople think about uncertainty in risk assessment, and its implications for risk management, extending earlier experimental research (Johnson and Slovic, 1995). A long closedended questionnaire (based in part on qualitative research) was given to 280 Eugene, Oregon, residents (largely college students). Uncertainty was presented in the form of a range of risk estimates, primarily in a hypothetical case of a chemical in drinking water. The findings suggest that it will be a challenge to present uncertainty in environmental health risk estimates to the public in ways that inform, rather than confuse or outrage, this important audience.     

CVP under uncertainty and the manager's utility function

Cost-volume-profit analysis has focused on the firm's short-run output decision assuming that the manager maximizes the firm's objective function rather than his or her own. This study argues that the decision problem facing the manager is to determine not only the level of output, but also the level of investment in risky assets in such a way that the expected utility of the manager's own end-of-period wealth can be maximized when the manager's wealth function is dependent on vested interests both within and outside of the firm, possibly in competition with the firm. Through analytical work, it is demonstrated that a change in fixed costs of the firm affects not only the production decision of a manager, but also his orher decision to invest in risky assets. The direction of this fixed cost effect depends on the particular type of risk aversion displayed by the manager. From the analytical work, five propositions are developed for empirical investigation in the future.The most helpful comments of Professor Cheng-few Lee are greatly acknowledged. We wish to thank anonymous referees who's comments have improved the paper. Furthermore, participants at the seminar at the University of Massachusetts Lowell also provided helpful comments.     

Optimal dealer pricing under transactions and return uncertainty

The paper examines the optimal behavior of a single dealer who is faced with a stochastic demand to trade (modeled by a continuous time Poisson jump process) and facing return risk on his stock and on the rest of his portfolio (modeled by diffusion processes). Using stochastic dynamic programming, we derive the optimal bid and ask prices that maximize the dealer's expected utility of terminal wealth as a function of the state in which he finds himself. The relationship of the bid and ask prices to inventory of the dealer, instantaneous variance of return, stochastic arrival of transactions and other variables is examined.     

International conditional asset allocation under specification uncertainty

This paper examines the impact of specification uncertainty on the performance of international mean–variance conditional asset allocation. Specification uncertainty is defined as the uncertainty faced by the investor regarding the specification choices necessary to implement a conditional strategy. To assess the impact of this phenomenon, we measure the performance of a group of strategies that the investor could reasonably consider. The strong performance variability across the strategies indicates that the gains previously documented are overstated. Our findings provide an explanation to the apparent paradox between the economic and statistical significance of predictability, and are consistent with the semi-strong form of market efficiency.     

Heuristic learning in intraday trading under uncertainty

Until recently economists focused on structural models that were constrained by a lack of high-frequency data and theoretical deficiencies. Little academic research has been invested in actually trying to build successful real-time trading models for the high-frequency foreign exchange market, which is characterized by inherent complexity and heterogeneity. The present work opens new directions for inference on market efficiency in an attempt to account for the use of technical analysis by practitioners over many years now. This paper presents a heuristic model that efficiently emulates the dynamic learning of intraday traders. The proposed setup incorporates agent beliefs, preferences and expectations while it integrates the calibration of technical rules by means of adaptive training. The study focuses on EUR/USD which is the most liquid and widely traded currency pair. The data consist of a very large tick-by-tick sample of bid and ask prices covering many trading periods to enhance robustness in the results. The efficiency of a technical trading strategy based on the proposed model is investigated in terms of directional predictability. The heuristic learning system is compared against many non-linear models, a random walk and a buy & hold strategy. Based on statistical testing it is shown that, with the inclusion of transaction costs, the profitability of the new model is consistently superior. These findings provide evidence of technical predictability under incomplete information and can be justified by invoking the existence of heterogeneity caused by many factors affecting market microstructure. Overall, the results suggest that the proposed model can be used to improve upon traditional technical analysis approaches.     

Investment decisions: The trade-off between economic and environmental objectives

While there are broader socio-political, psychological, and structural factors that influence investment decisions (see Harris et al., 2016), in line with the critical approach, this study provides an empirical insight into the notion that financialization, specifically the tendency to prioritise economic over environmental objectives, has a strong bearing on how managers view investment trade-off decisions in relation to sustainability issues. The study empirically investigates this notion by examining the investment trade–off preferences of Australian managers in relation to three decision attributes – economic outcomes (i.e. financial returns), environmental impact (i.e. carbon emissions) and stakeholder pressure to consider environmental issues. We use the discrete choice experimental method to quantify the trade-offs between the above mentioned three attributes. In addition, we also investigate the potential effect of three contingency factors on individual's preferences. Specifically, at the organisational level, we explore the effects of financial and environmental rewards and at the individual level, we explore the effect of environmental consciousness. In line with the financialization hypotheses our results indicate that managers prioritise financial returns over carbon emissions and stakeholder pressures with the preference for financial returns found to be positively associated with rewards for financial performance. However, in line with the pragmatic approach and despite the overall dominance of financial returns, there is evidence that manager's focus on financial returns can be influenced, with the preference for financial returns negatively associated with rewards for environmental performance and environmental consciousness. In addition, while stakeholder pressure was not found to be associated with any of the three contingency factors and, manager's emphasis on carbon emissions was not associated with financial rewards, manager's emphasis on carbon emissions was found to be positively associated with both rewards for environmental performance and environmental consciousness. Therefore, our findings suggest that corporate management have an important role to play, both in respect to the design of performance rewards systems and the recruitment of environmentally conscious managers, in order to promote the sustainability agenda.