Overreaction to Fearsome Risks

When risks threaten, cognitive mechanisms bias people toward action or inaction. Fearsome risks are highly available. The availability bias tells us that this leads people to overestimate their frequency. Therefore, they also overreact to curtail the likelihood or consequences of such risks. More generally, fear can paralyze efforts to think clearly about risks. We draw on a range of environmental risks to show the following: (1) Fear leads us to neglect probability of occurrence; (2) As fearsome environmental risks are usually imposed by others (as externalities), indignation stirs excess reaction; (3) We often misperceive or miscalculate such risks. Two experiments demonstrate probability neglect when fearsome risks arise: (a) willingness-to-pay to eliminate the cancer risk from arsenic in water (described in vivid terms) did not vary despite a 10-fold variation in risk; (b) the willingness-to-accept price for a painful but non dangerous electric shock did not vary between a 1 and 100% chance. Possible explanations relate to the role of the amygdala in impairing cognitive brain function. Government and the law, both made by mortals and both responding to public pressures, similarly neglect probabilities for fearsome risks. Examples relating to shark attacks, Love Canal, alar and terrorism are discussed.     

Profit-Enhancing Parallel Imports

We investigate competition between a domestic intellectual property right holder and a foreign imitator and consider how parallel imports affect their profits. We consider a two-country model. Country A is a developed country where intellectual property rights are highly protected, and country B is a developing country where protection is weak. The intellectual property right holder can sell the products for both markets while the imitator cannot export the products to country A. We find that permitting parallel imports can be beneficial for both players because it serves as a commitment device to soften price competition.     

Government Purchases and the Real Exchange Rate

Recent empirical research documents that an exogenous rise in government purchases in a given country triggers a persistent depreciation of its real exchange rate—which raises an important puzzle, as standard macro models predict an appreciation of the real exchange rate. This paper presents a simple model with limited international risk sharing that can account for the empirical real exchange rate response. When faced with a country-specific rise in government purchases, local households experience a negative wealth effect; they thus work harder, and domestic output increases. Under balanced trade (financial autarky) this supply-side effect is so strong that the terms of trade worsen, and the real exchange rate depreciates. In a bonds-only economy, an increase in government purchases triggers a real exchange rate depreciation, if the rise in government purchases is sufficiently persistent and/or labor supply is highly elastic.     

Do Institutions Matter for Foreign Direct Investment?

Using a panel of 69 countries during 1981 and 2005, we investigate the role of institutions in determining foreign direct investment (FDI). We find that institutions are a robust predictor of FDI and that the most significant institutional aspects are linked to propriety rights. Using a novel data set, we also study the impact of institutions on FDI at the sectoral level. We find that institutions do not have a significant impact on FDI in the primary sector but that institutional quality matters for FDI in manufacturing, and particularly in services.     

Attitudes Towards Foreign Products and Welfare with Capital Mobility

We develop a model of trade with imperfect competition to study the welfare implications in developing and developed countries of the asymmetry in attitudes towards foreign products. In the developed country, consumers benefit from a better perception of foreign products while the rental rate of capital declines as long as the location of capital remains unchanged. However, when capital is mobile, the developing country hosts more and more capital at the expense of the developed country as perception of varieties produced in the developed country improves and the surplus of consumers in the developed country can decrease.     

Do Sovereign Defaults Hurt Exporters?

This paper uses a difference-in-difference methodology similar to the one originally proposed by Rajan and Zingales to test whether sovereign defaults hurt the more export-oriented industries disproportionately, and it finds strong support for this hypothesis. However, contrary to the findings of previous studies, our estimates suggest that the effect of defaults is short-lived.