Law and Economics

February 10, 2012
Christine Jolls of Yale Law School, Organizer

Zhiguo He, University of Chicago, and Gregor Matvos, University of Chicago and NBER

Debt and Creative Destruction: Why Could Subsidizing Corporate Debt Be Optimal?

The paper by He and Matvos illustrates the welfare benefit of tax subsidies to corporate debt financing. In their analysis, two firms engage in a socially wasteful competition for survival in a declining industry. The firms differ on two dimensions -- exogenous productivity and the endogenously chosen amount of debt financing -- which results in a two-dimensional war of attrition. Debt financing increases incentives to exit; while socially beneficial, this is costly for the firm. Therefore, the planner can increase welfare by subsidizing debt financing. The duration of industry distress determines the tradeoff between the welfare benefit illustrated in this model and the costs of subsidizing corporate debt taken from the existing literature. The theory here also sheds light on why the IRS considers "conflict of interest" to be one of the key determinants in identifying securities that are qualified for tax benefits.

Alberto F. Alesina, Harvard University and NBER; Yann Algan, Sciences Po; Pierre Cahuc, Ecole Polytechnique; and Paola Giuliano, University of California, Los Angeles and NBER

Family Values and the Regulation of Labor (NBER Working Paper No. 15747)

Flexible labor markets require geographically mobile workers to be efficient. Otherwise, firms can take advantage of the immobility of workers and extract monopsony rents. Yet in cultures with strong family ties, moving away from home is costly. Thus, individuals with strong family ties rationally choose regulated labor markets in order to avoid moving and to limit the monopsony power of firms, even though labor regulation generates lower employment and income. Alesina, Algan, Cahuc, and Guiliano find that individuals who inherit stronger family ties are less mobile, have lower wages, are less often employed, and support more stringent labor market regulations. The authors also find positive correlations between labor market rigidities at the beginning of the twenty-first century and family values that prevailed before World War II, and between family structures in the Middle Ages and the current desire for labor market regulation. Both of these results suggest that labor market regulations have deep cultural roots.

Ernst Fehr, University of Zurich; Oliver D. Hart, Harvard University and NBER; and Christian Zehnder, University of Lausanne

How Do Informal Agreements and Renegotiation Shape Contractual Reference Points? (NBER Working Paper No. 17545)

Previous experimental work provides encouraging support for some of the central assumptions underlying Hart and Moore's (2008) theory of contractual reference points. However, existing studies ignore realistic aspects of trading relationships, such as informal agreements and ex post renegotiation. Fehr, Hart, and Zehnder investigate the relevance of these features experimentally. Their evidence indicates that the central behavioral mechanism underlying the concept of contractual reference points is robust to the presence of informal agreements and ex post renegotiation. However, their data also reveal new behavioral features that suggest refinements of the theory. In particular, they find that the availability of informal agreements and ex post renegotiation changes how trading parties evaluate ex post outcomes. Interestingly, the availability of these additional options affects ex post evaluations even in situations in which the parties do not use them.

Steven Shavell, Harvard University and NBER

A Fundamental Enforcement Cost Advantage of the Negligence Rule over Regulation

Regulation and the negligence rule are both designed to obtain compliance with desired standards of behavior, but they differ in a primary respect: compliance with regulation is assessed independently of the occurrence of harm, whereas compliance with the negligence rule is evaluated only if harm occurs. Shavell shows that because the use of the negligence rule is triggered by harm, the rule enjoys an intrinsic enforcement cost advantage over regulation. Moreover, this advantage implies that the examination of behavior under the negligence rule should be more detailed than under regulation.

Special Session on Consumer Finance

Santosh Anagol, University of Pennsylvania, and Shawn Cole and Shayak Sarkar, Harvard University

Understanding the Incentives of Commissions Motivated Agents: Theory and Evidence from the Indian Life Insurance Market

Anagol, Cole,and Sarkar conduct a series of field experiments to evaluate two competing views of the role of financial service intermediaries in providing product recommendations to potentially uninformed consumers. One view argues that intermediaries provide valuable product education and guide consumers towards suitable products. Consumers understand how commissions affect agents' incentives and make optimal product choices. The second view argues that intermediaries recommend and sell products that maximize the agents' well-being, with little or no regard for the customer. Audit studies in the Indian life insurance market find evidence supporting the second view: in 60-80 percent of visits, agents recommend unsuitable (strictly dominated) products that provide high commissions to the agents. Customers who specifically express interest in a suitable product are more likely to receive an appropriate recommendation, although most still receive bad advice. Insurance agents cater to the beliefs of uninformed consumers, even when those beliefs are wrong. The authors then test how regulation and market structure affect advice. They find that a natural experiment requiring insurance agents to describe commissions for a specific product caused those agents to shift recommendations to an alternative product, which had even higher commissions but no disclosure requirement. The researchers find that when potential customers express inconsistent beliefs about the product suitable for them, and mention that they have received advice from another seller of insurance, they are more likely to receive suitable advice. In other words, agents provide better advice to more sophisticated consumers.

Will Dobbie, Harvard University, and Paige M. Skiba, Vanderbilt University

Information Asymmetries in Consumer Credit Markets: Evidence from Payday Lending

Information asymmetries are prominent in theory but difficult to estimate. Dobbie and Skiba present a new empirical test for moral hazard and adverse selection that exploits sharp discontinuities in borrowers' eligibility for payday loans. Surprisingly, they find no evidence of moral hazard. If anything, an exogenous increase in credit lowers the probability that a borrower defaults. On the other hand, there is evidence of significant adverse selection into larger payday loans. Borrowers who chose $50 larger loans are 7.8 to 9.0 percentage points more likely to default, an increase of 46 to 52 percent.

Dean Karlan, Yale University and NBER, and Jonathan Zinman, Dartmouth College and NBER

Borrow Less Tomorrow

Mounting evidence suggests that behavioral factors depress wealth accumulation. Although much research and policy focuses on asset accumulation, debt decumulation is more efficient for many households. However, the mass market for debt reduction services is thin. Karlan and Zinman develop and pilot-test Borrow Less Tomorrow (BoLT), a behavioral approach to debt reduction that combines a simple decision aid, social commitment, and reminders. The results from a sample of free tax-preparation clients with eligible debt in Tulsa (N=465) indicate strong demand for debt reduction: 41 percent of those offered BoLT used it to make a plan to accelerate debt repayment. Using random assignment to BoLT offers, the authors find weak evidence that the BoLT package offered here significantly reduces debt, and stronger evidence that it reduces credit scores compared to the no-BoLT counterfactual.

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