Cer Fall 2013 Final

Columbia
Economics
Review
Vol. III, No. II
a free lunch on tips?

so sue me
taperpedic
unring the bell?
rounding it out
mixed messages
Fall 2013
25
000
,
The $
Steak
How Revolving Door Lobbyists

Gain From Political Connections
Fall 2013
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Columbia Economics Review
Fall 2013
TABLE OF CONTENTS
Labor Economics
4
A Free Lunch on Tips?

Analyzing the Choice of Compensation Structure in New York City Restaurants
Law and Political Economy

12
The $25,000 Steak

How Revolving Door Lobbyists Gain From Political Connections
16
So Sue Me
Market Reaction to Patent Litigation Verdicts and Patent Appeal Results
Monetary and Fiscal Policy

24
TaperPedic
An Analysis of the Federal Reserves Forecasted Asset Losses in the Face of Looming
Interest Rate Shocks
29
Unring the Bell?

The Threat to Deposit Insurance in Cyprus
Microeconomic Theory
32
Rounding It Out
The Effect of Round Number Bias in U.S. and Chinese Stock Markets
41
Mixed Messages
How Firms Should Utilize Private Information
Fall 2013
A Free Lunch on Tips?

Analyzing the Choice of Compensation Structure in New York City
Restaurants
Samuel Zakay
Columbia University
Introduction
Restaurant staffs in New York are generally compensated by hourly wages and
derive a majority of their salary from
tips. Restaurants in New York City have
two main methods of distributing tips.
Pooled houses are based on a share
system. At the end of the shift, each staff
member receives an amount equivalent
to the value per share multiplied by the
total shares allotted to them. In this system, servers receive the greatest percentage of shares. In non-pooled houses,
tips are collected by individual servers.
In this system, there could be large differences in the amount a server may be compensated on a given night and also large
differences between total compensation
amounts for different servers.
Barkan, Erev, Zinger and Tzach (2004)
argue that in a pooled system, servers are
given the incentive to provide good service and to work as a team. There is no
incentive to compete with servers at the
expense of other servers customers, as
each servers income is dependent on all
customers. However, a pooled system is
undermined by the problem of free riders. Since servers earnings do not solely
depend on their own efforts, they can
grow reliant on colleagues and become
unmotivated to work at a high level.
In an individual tip policy, servers are

given an incentive to provide the best service possible. Servers under this policy
may compete with one another and overuse limited common resources. In the
Pooled houses, are based on

a share system. At the end of
the shift, each staff member
receives an amount equivalent
to the value per share multiplied by the total shares allotted to them.
long term, servers do have an incentive to

make sure that the customers they are not
serving have a good experience as they
may serve the customer in the future.
B.E.Z.T (2004) argue that pooling yields
better service when there is a greater degree of visibility within the restaurant as
both management and restaurant staff
(mutual monitoring) can more easily
monitor the efforts of servers.
In addressing how staff compensaColumbia Economics Review
tion affects the quality of service in restaurants, I designed and implemented

a survey aimed at collecting restaurant
specific information. I surveyed restaurant managers and owners located on either the Upper West or Upper East Side
of Manhattan. All restaurants that participated had a ZAGAT review.
The survey had two major sections:
compensation structure information and
general restaurant characteristics information. In evaluating diners perception of a restaurant, I use secondary data
from ZAGAT and OpenTable. ZAGAT
measures a restaurant by 3 factors: Food,
Service, and Dcor. Each factor or score
is presented as a number between 0 and
30. OpenTable also rates restaurants by
Overall, Food, Ambiance and Service.
Reviewers are strictly people who made
a reservation through OpenTable.
The descriptive statistics in the survey are aimed at helping differentiate
between restaurants. While two restaurants may share a similar compensation
structure, other features of the restaurant
could be responsible for causing restaurants to produce better service in the eyes
of reviewers. Thus, many of the characteristics serve as controls in analyzing
the specific issue of moral hazard within
restaurant. Furthermore, I use the other
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diner observations such as cost range

from ZAGAT to examine relationships
between restaurants that could cater to
different types of customers (socio-economic class).
I first model restaurant managements
choice of compensation structure using
a two task, two servers principal-agent
problem framework. I then use the variable of a restaurants seating capacity
as a proxy for visibility (higher capacity
implies lower visibility). I find a negative statistically significant relationship
between the choice to pool and capacity.
I then examine managements choice
regarding the number of servers hired
per shift relative to the capacity of the
restaurant. I find a negative yet weak
non-statistically significant relationship
between servers per capita and pooling,
thus failing to support the idea of a team
incentive giving management more flexibility in the number of servers it hires.
I then investigate whether diners perceive differences in the quality of service
in pooled establishments. To investigate
the relationship over the full data set, I
use both ZAGAT and OpenTables measure of service quality. I find it difficult to
argue that pooling leads to higher quality service than non-pooling even when
controlling for other restaurant characteristics.
Next, I split the data into pooled restaurants and non-pooled restaurants,
and proceed to look at whether capacity
affects service quality within the sub-sets.
Although I do not find the relationship to
quite reach the level of statistical significance, within the pooled sub-set, as a res-
taurants capacity increases, and hence

visibility decreases, its service quality
5
falls. While the negative relationship is
not statistically significant, it remains
when controlling for other fixed effects
associated with a restaurants organizational and compensation structure.
I also examine the relationship between the quality of service and visibility amongst the non-pooled restaurants
to see whether non-pooled restaurants
yield higher quality service as visibility
decreases. I find it difficult to observe
any directional relationship with statistical significance that holds when controlling for other restaurant characteristics.
Part of the reason for the lack of results
could stem from the small sample of nonpooled restaurants.
Literature Review
Within a restaurant, managers and
owners wish to establish a culture
amongst the service staff to treat the
customer in the best way possible. If the
manager chooses to create a group-incentive structure, as with pooling, he or she
can run into the problem of moral hazard
amongst his team.
6
Alchian and Demsetz
(1972) argued that by
bringing in an individual
to monitor the actions of
workers, a firm can limit
the amount of free riding, and thus alleviate the
problem of moral hazard.
The monitor should be
able to renegotiate and
terminate contracts with
individual workers and
hold a residual claim on
the profitability of the
firm.
Rather than a observing each action, the central monitor needs only to
possess the ability to provide a productivity bonus
or terminate a contract of
an employee. Similarly
restaurant management is faced with the
issue of optimizing profits by establishing wages based on servers efforts. In the
case of the restaurant industry the owner
and general manager can often be considered a monitor of service staff actions.
The idea of mutual monitoring extends
the idea of the monitor as presented by
Alchian and Demsetz to a role that isnt
strictly centralized. Service staff may also
monitor the actions of their peers to ensure everyone is working within a pooled
system. This is consistent with Lazear
and Kandels (1992) argument that mutual monitoring is more effective when
profits are shared amongst a smaller
group. According to this logic a smaller
restaurant would be a stronger candidate
for mutual monitoring.
B.E.Z.T (2004) discuss the problem of
free riding within a pooled system. They
found that servers in both types of restaurants were bothered by the problem of
free riding. If a restaurant attracts fewer
customers, the negative effect of less income should reach both high effort and
low effort servers in the long run. With
regard to the problem of overuse of limited resources, they found that servers in
non-pooled restaurants were more bothered by co-workers relationships with
shift managers.
Bandiera, Barankay and Rasul (2008)
found that managers who were not given
a performance incentive tended to favor
workers who they were friendly with.
However, when a performance incentive
was issued that relationship tended to
disappear in favor of giving more tasks
and hence more opportunity to those
who were better. A residual claim for the
Fall 2013
monitor or manager is essentially a performance incentive for effective management, and should thus limit favoritism
within the restaurant.
After surveying cafe servers and noting
their concerns over free riding and competition, B.E.Z.T (2004) tested whether
the concerns manifested themselves in
the quality of service at the two types of
cafes. They recorded the level of visibility, service time and the number of service problems. As the number of service
spaces increases, visibility decreases. A
pooled system resulted in a higher quality of service in a higher visibility environment, while a non-pooled system resulted in a higher quality of service in a lower
visibility environment. Increased visibility within a pooled restaurant makes it
easier for workers to monitor the actions
of their peers and thus discourage free
riding, which is consistent with the general moral hazard literature. They also
argue that low visibility alleviates the
problem of overuse of limited resources
in non-pooled cafes, while the individual
tip system alleviates the problem of reduced-effort associated with free riding.
This study is similar to the research done
by B.E.Z.T (2004), however I use diners
actual ratings to measure service quality. In this survey, I also collect the general compensation structure for multiple
types of employees within the restaurant,
and general features about the restaurant
that were not collected by B.E.Z.T.
One dominant theory as to why customers tip is a fear of social disapproval.
Another dominant as to why customers
tip is in order to secure equitable relationships. A third theory for why customers
tip is in order to receive good service in
the future upon returning.
Lynn (2001) performs a meta-analysis

on fourteen studies, and determines that
although service evaluations are statistically significant when regressed against
tip sizes, the correlation between them
is 0.11. Lynn, Kwortnik Jr. and Sturman
(2011), Shamir (1983), and Harris (1995)
support that, even if service quality and
tipping are positively related, the cost
of expending energy on providing superior service may not be worth the extra
reward. This could complicate matters
regarding whether servers will even expend the extra effort to secure virtually
the same tip. Lynn and McCall (2000),
and Ostroff (1993) support the preceding notion by showing that servers may
be able identify how they are performing with respect to their peers and adjust
their effort accordingly.
Theoretical Model of Restaurant Managements Choice of Compensation
Structure Under Moral Hazard
Restaurant managements choice of
compensation structure can be construed
as an example of a moral hazard principal-agent problem. In the principal-agent
problem, output X can be defined as:
where y is a number transforms effort e
into output, and ~ N(0, 2). For simplicity, we assume that a worker has CARA
preferences and thus their utility can be
represented by their certainty equivalents. In general a workers wage can be
represented as:
where a is a fixed amount and b is a
piece rate. A worker is also faced with a
cost of effort c(e). Thus, an agents utility
function according to CARA preferences
can be written as:
Fall 2013
where rA is the coefficient of risk aversion of the agent. A principal pays the
wages of the worker and is thus faced
with a different utility function:
BP represents the piece-rate that a server collects from his primary table and BS
represents the piece-rate that a server
collects from his secondary table. Each
server is also faced with a quadratic cost
associated with effort represented by:
where rP is the coefficient of risk aversion of the principal. The linear quadratic
model also assumes cost to be quadratic
or
where is an agents ability. In the

moral hazard problem effort is not observable, and it is assumed that the agent
selects effort to maximize her payoff under the contract
In the principal-agent framework, both
the principal and agent have common
knowledge regarding the parameters of
the relationship and both agree upon the
relationship between effort and output.
The principal is in a position to anticipate
h o w
t h e
agent
w i l l
respond
to
the
compensation contract.
The agents are servers, which I will refer to as 1 and 2, and they are tasked with
serving two tables, which I will refer to
as A and B. The output of table A and B
respectively can be expressed as:
where E1A represents the effort of server

1 on table A and where E2A represents the
effort of server 2 on table A (the same is
true for Table B). As in real life restaurant,
I assume each server is assigned a primary table to serve (server 1 is assigned to A
and server 2 is assigned to table B). Each
server has a wage, which can be represented as:
where (theta)i represents the ability

of server i (cost decreases as ability increases) and generally c1B > c1A and c2A
> c2B, the cost of effort of serving your
secondary, non-assigned table, is greater
than the cost of serving your own table.
I use the following cost matrix because
each server aims at helping his secondary table if the ability of the other server
is different than his own. Servers seek to
supplement the other server only if the
other server needs it. Thus if the abilities
of the servers differ greatly (1 >>2), then
server 1 can really help out server 2 by
putting effort into his secondary table. I
also square the difference, as the cost of
effort should always be positive. For simplicity I assume no minimum effort (however efforts cannot be negative), and also
no effort in switching tables. Furthermore
in the principal-agent problem each server has a cost associated with risk that can
be represented as:
where ri is the coefficient of risk aversion for server i and i is the variance
associated with table i. For simplicity, I
assume that the covariance between table
A and B is zero. The principal, restaurant
manager or owner, has a profit column
vector, P = [PA PB], that transforms
output into profit. The principal agent
problem in the context of the two servers
and two tables can be stated as follows:
subject to:
where Wi0 is the servers next best alternative wage. For simplicity, I assume that
each agent choose his effort level independently of the other. In order to solve
the problem, I first solve for the optimal
effort of agent 1:
These solutions make sense as the cost

of effort associated with each table rises,
the effort decreases, and as the wage
from a table i increases, effort on table i
increases. Likewise I perform the same
process for server 2 and conclude:
As MacLeod (Forthcoming) writes the

fixed payment ai is adjusted to ensure
each IRi is binding, from which the payoff
to the principal is:
The optimal [Bp Bs] can be computed by

plugging in E*1A, E*1B, E*2A, E*2B and maximizing up (B):
The optimal contract is defined by [Bp

Bs]. In the real world, restaurants select between two options: pooling and
non-pooling. In a non-pooled house BS
8
= 0, a server does not derive any piece
rate wage from his secondary table. In a
pooled house BP = BS, as each server earns
the same fraction of his total wage from
each table.
Proposition 1: As the ability of both
servers rise, both servers work harder
and earn higher wages.
The coefficient on ability in the numerator is greater than the coefficient on ability in the denominator in the equation for
BP. More skilled workers should be paid a
higher wage by the restaurant as they are
producing more for the restaurant.
Proposition 2: If the ability of server 2
equals the ability of server 1, each server
puts no effort into his secondary table
and earns no wage from his secondary
table. In this case pooling is not efficient.
If 2=1, then E1B = E2A = 0, hence BS = 0.
If each server has equal abilities, then it
would be detrimental for each server to
devote any effort on a table where they
would not actually be helping the other
server and expending a greater cost, as
the cost of serving a secondary table is
larger than the cost of serving a primary
table. If this happens, management will
choose a non-pooled system as servers
will not be putting in any effort to their
secondary tables, and thus management
will not be deriving any benefit from issuing a team incentive of pooling.
Proposition 3: If the ability of server 2
differs from the ability of server 1, each
server will put some effort into his secondary table. Thus, the optimal contract
features a degree of pooling wages across
tables.
This result can be seen by observing
that E1B, E2A, BS 0 if 21. In the case of
unequal abilities, management wishes to
offer a form of pooled wages so the higher ability server is incentivized to work
on both tables. Since management offers
the same wage to both servers, both the
higher ability server and lower ability
server receive a wage from their secondary table. Thus, both servers have an incentive to expend effort on serving both
tables and the secondary server will seek
to supplement the efforts of the primary
server. While the optimal contract is a degree of pooling, in the real world, restaurant management will only choose pooling if the optimal contract more closely
resembles the pooled contract, BP = BS,
than the non-pooled contract, BS = 0.
Proposition 4: As the servers become
more risk averse, their wages fall and
hence effort falls.
This is consistent with economic theory
and the idea that risk poses a real cost for
the agents. If servers become more risk
Fall 2013
averse, r1, r2 >> 1, then the denominators

of the optimal contracts grow larger and
thus the optimal wages grow smaller.
Management can offer lower wages; a
servers total wage becomes closer to
the fixed wage, as management is bearing the risk. As the wages of the servers
grow smaller, servers expend less effort
on serving both their primary and secondary tables.
Proposition 5: If the abilities of the servers are not equal, as the capacity within
the restaurant grows, restaurant management will be more inclined to choose
non-pooling.
Earlier, I assumed that c1B > c1A, which
is sensible as it should be more costly for
a server to work on a table to which he
is not assigned. Assume that the abilities of each server are not equal (if so,
see Proposition 2). If it is more costly for
a server 1 to expend effort serving each
person at table B, then as the number of
people at table B increases, c1B should increase as well. Furthermore, c1B should
increase faster than c2B because the cost of
serving a secondary table is greater than
the cost of serving a primary table. If the
number of people at table B increases, or
c1B, c2B tends to infinity, then BS will reach
0 faster than BP, that is
. Furthermore if the number of people
at both tables increases, BS will fall even
faster than BP as c2A will also increase faster than c1A. Thus, as the number of people
that are eating in the restaurant increases
the cost of serving a secondary table and
thus non-pooling becomes more attractive. While the optimal contract is a mix
of non-pooling and pooling, restaurant
management can only pick one system
and thus chooses the system that the opColumbia Economics Review
timal contract most closely resembles.

Data
In selecting a sample, I chose to focus
on the Upper West Side and East Side of
Manhattan to minimize locational variance stemming from population composition that could affect the restaurants
composition and perception. I assembled
a list of rated restaurants by screening
the 371 restaurants listed on the ZAGAT
website, of which 71 agreed to participate
in the study.
Of the 71 restaurants that participated
in the survey, 44 were located on the Upper West Side, while 27 were located on
the Upper East Side. Several restaurants
chose not to answer certain questions
such as service staffs gross pay per shift.
No restaurants participating in the survey were given monetary compensation.
The full table of summary statistics are
available in Appendix Table 8.1. Within
the context of the service staff of the restaurant, bartenders seem to earn the highest gross pay per shift. A reason provided
by many managers as to why bartenders
are compensated more is their job affects
the operating margin of the restaurant.
Bartenders can more easily give a drink
on the house to secure a higher tip than a
server can give food on the house.
Servers earn a higher income then other
members of the service staff that do not
affect operating margins. The only difference between pooled houses and nonpooled houses exists on the server level.
After the bartender and server, a runner
earns the most in the context of the service staff. In many restaurants, managers
said that they viewed the role of the runner as equal to the role of the server and
thus established compensation systems
where runners and servers earned the
Fall 2013
same. A busser out-earns only the host.
While many managers often cited that
bussers were an important part of the service experience, a busser never earned as
much as a server. Finally, the host often
earns the least in a restaurant.
Restaurants tend to hire more servers
than other members of the service staff.
Furthermore there is a higher standard deviation for the number of servers
than number of other members of the
service staff, which reflects the greater
perceived role that servers play in customer service. Bussers and runners seem
to the longest tenured employees within
a restaurant. An extremely high percentage of them are full-time (nearly 90%).
Bartenders spend a similar amount of
time relative to servers employed within
a restaurant, yet there is a higher probability that a restaurant will have fulltime bartenders than full-time servers.
Management values honesty amongst the
bartenders, and if it finds bartenders that
it can trust, it may prefer employing fewer trustworthy bartenders on a full-time
basis to seeking outsiders for part-time
positions. Within the context of a restaurants, the host position is by far the most
transient.
Of the 71 restaurants that chose to participate in the survey, 54 can be categorized
as pooled houses, while 17 can be categorized as non-pooled houses. This percentage is consistent with managers who
guessed that 80% of New York City restaurants practiced pooling. This proportion is also consistent with the 42 restaurants that were also rated by OpenTable,
where 33 of them practiced pooling. The
pooled system appears to be the default
compensation structure both within the

sample and across New York City.
The general manager is the primary individual responsible for monitoring the free
riding problem within the pooled system.
The vast majority of restaurant owners
are involved in the day-to-day operations
of the restaurant (over 80%). An active
owner can also provide another layer of
monitoring.
Within the sample, the mean capacity
of restaurants hovers around 100 people, with much variation. Capacity will
be a key variable in examining the free
rider problem and the difficulties associated with monitoring. Furthermore, the
number of people relative to a server,
when the restaurant is completely full,
is roughly 27 (the inverse of servers per
capita). There is also a large amount of
variation associated with servers per
capita.
Many of the restaurants surveyed are
full service restaurants (41%), meaning
that they contain all five types of service
staff. The two most expendable positions
within the sample are runner (37%) and
host (32%). All 71 surveyed restaurants
participated in ZAGAT (part of the search
criterion), while only 42 participated in
OpenTable. The ZAGAT ratings were all
lower on average than the OpenTable ratings. Furthermore, ZAGATs ratings had
a higher standard deviation than OpenTables. In trying to test hypotheses discussed by past literature along with new
hypotheses, I use both measures of service quality.
In order to assess whether there is a difference between the two measures of service quality, I created a correlation ma-
9
trix between all of the diner perception
variables. ZAGAT Service was positively
related to all of the ZAGAT measures of
restaurant quality. A similar phenomenon exists when considering OpenTable Services relationship with the other
OpenTable variables.
The preceding relationships support
the conclusion that restaurants with better food, higher cost, better decor and better ambiance tend to provide better service. When considering whether the two
measures of diner perceptions are correlated, the results are mixed. ZAGAT Service is positively correlated to OpenTable
Service. Furthermore, ZAGAT Food is
positively correlated to OpenTable Food.
None of the other cross variables between
ZAGAT and OpenTable is directly measuring the exact same thing, but all of the
variables are positively correlated.
Although ZAGAT has 29 more restaurant observations than OpenTable, I decided to examine both in my analyses.
The two measures of service and food are
positively correlated, however the correlation is far from 1. In several analyses,
especially concerning non-pooled restaurants, OpenTable is less reliable given the
relatively small data set.
As part of the survey, managers and
owners were asked the amount servers
could expect to earn in a shift and the percentage of a servers salary derived from
tips. A percentage of a servers income
derived from tips can serve as a good
measure for how dependent a server is
on customer approval. Several managers
declined to answer the question.
Common sense suggests that servers
who produce better service choose to
10
work at restaurants where they could
earn more. Likewise, servers who produce better service would choose to be at
a restaurant where a greater percentage
of their income would be derived from
tips. Both measures describe whether
there is a positive relationship between a
servers earnings and the quality of service provided. I regressed ZAGAT Service on a servers gross pay per shift and
found a positive and statistically significant relationship (t(68) = 2.764). I found
a similar positive relationship, although
it was not quite statistically significant,
when regressing OpenTable Service on a
servers gross pay per shift (t(39) = 1.563).
I suspect that if I had surveyed more restaurants that were rated by OpenTable,
the positive relationship would further
approach a level of statistical significance.
The positive relationship and hence
statistical significance between the quality of service and a servers gross pay
per shift diminished when controlling
for cost using ZAGAT Cost in both measures of service quality (ZAGAT (t(68) =
1.112) and OpenTable (t(39) = 0.538)). The
positive relationship and relative level of
non-statistical significance remains when
controlling for other fixed effects that
measure organizational and compensation structure.
I regressed ZAGAT service on the percentage of a servers income derived from
tips and found a positive and statistically
significant relationship between them
(t(70) = 3.079) as shown in Appendix Table 8.7. Furthermore, the positive and statistically significant relationship remains
even when controlling for cost and the
same fixed effects that measure organizational and compensation structure as
the regressions on servers gross pay per
shift. Curiously enough, the positive relationship does not exist when considering OpenTables measure of service quality (t(41)= -0.602). The preceding results
support common sense that servers who
produce better service will tend to work
at restaurants that will afford them better pay.
Results and Analysis
Endogenous Analysis of the Pooling Choice
Given the greater difficulty in monitoring free riding in a lower visibility environment, it is interesting to examine
whether owners and general managers
behave as the theory and literature predict by shying away from establishing a
pooled system as the size of the restaurant increases and visibility decreases.
I analyzed the question by performing a series of linear probability regressions of the dummy variable of whether
Fall 2013
a restaurant was pooled on the variable
of the seating capacity of the restaurant.
The variable of seating capacity is used
as a variable for assessing the visibility
within a restaurant. As the seating capacity within a restaurant increases, its size
increases and its visibility decreases.
Consistent with the theory and literature, capacity is negatively related to
whether a restaurant decides to institute
a pooled system, and the negative relationship is statistically significant (t(71)
= -1.900). The negative relationship persists and becomes even more statistically
significant when I control for the relative
price point of a restaurant by using ZAGAT Cost (t(71) = -2.600). Although diners of the restaurant assess cost, it should
be considered an endogenous variable as
the management of the restaurant sets
the prices. ZAGAT Cost is different from
other ZAGAT measures because it is observed by customers rather than rated by
customers, as is the case with ZAGAT Service, Food and Decor. Thus across both
cheaper and more expensive restaurants,
managements choice to pool is negatively related to the size of the restaurant.
The negative, statistically significant relationship persists when controlling for
other fixed endogenous effects of the organizational and compensation structure
(as well as cost) of the restaurant such as:
whether a restaurant is over three years
old, whether ownership is involved on a
day to day basis (a dummy variable that
suggests a higher degree of monitoring),
whether most of the servers are full-time,
whether some servers are paid a higher
hourly wage than others, whether a restaurant is a full-service restaurant with
all five types of service staff (a dummy
variable) and whether the restaurant is
located on the Upper West Side.
The negative statistically significant
persistent relationship suggests management is aware that servers are presented
with a greater incentive to free ride as
the size of the restaurant grows and their
income is less and less dependent on the
effort they expend at their own table.
Furthermore it suggests that restaurant
management is aware of the greater challenges of monitoring free riding (in the
context of management monitoring and
mutual service staff monitoring) within
a pooled restaurant consistent with the
theory of B.E.Z.T (2004). Aside from capacity, ZAGAT Cost also is related to
whether management decides to institute a pooled system. When controlling
for capacity, the relationship between
pooling and ZAGAT Cost is statistically
significant (t(71) = 2.513). The free ridColumbia Economics Review
ing problem could be less of an issue in

restaurants that charge higher prices,
where workers earn a higher tip. Servers
in more expensive restaurants have less
of an incentive to free ride because if they
do and are fired, they may have to settle
for employment at a less expensive restaurant with a lower gross pay per shift.
Endogenous Analysis of Hiring Choice and
Pooling
In assembling a service staff, if management would like each server to focus
on perfecting a smaller responsibility of
serving a smaller amount of customers
really well, it could hire a higher proportion of servers per capita. On the other
hand, some talented servers may choose
to seek employment elsewhere as they
will likely earn less income with fewer
tables (in the non-pooled case) or a lesser
share in the pool.
An additional layer of complexity is
added if a manager institutes a pooled
system, which incentivizes teamwork
amongst the staff as each staff member
benefits from the effort of the group. This
allows a manager to hire fewer servers
per capita, as other servers have an incentive to help each other out.
I analyzed the management-hiring dilemma in a multivariate regression of
servers per capita on the dummy variable
of whether a restaurant decides to pool
and the pricing of a restaurant measured
by ZAGAT Cost, servers per capita was:
negatively related to pooling (t(71) =
-0.002) at a non-statically significant level
and positively related to ZAGAT Cost at
a non-statistically significant level (t(71) =
0.962). The relationship between servers
per capita and pooling does not support
the hypothesis that management feels
that the team incentive provided by using a pooled system empowers them to
hire fewer servers per capita.
However, the positive non-statistically
significant relationship between servers
per capita and ZAGAT Cost suggests that
management of more expensive restaurants may tend to hire more servers per
capita than management of less expensive restaurants. Management of a more
expensive may charge higher prices because it believes the restaurant provides a
superior dining experience. The increase
in prices should attract talented servers to
a restaurant as many customers tip based
on a percentage of the overall cost of the
meal (Lynn and Grassman 1990). The
size of the positive non-statistically significant relationship between servers per
capita and cost remains when controlling for other fixed endogenous effects
of the organizational and compensation
Fall 2013
structure (as well as pooling) of the restaurant. Given the relatively small data
set, there is merit in further researching
the positive relationship between servers
per capita and cost to see whether the relationship further approaches statistical
significance.
Poolings Effect on Service Quality
Pooled restaurants offer a real incentive
Increased visibility within a

pooled restaurant makes it
easier for workers to monitor
the actions of their peers and
thus discourage free riding,
which is consistent with the
general moral hazard literature.
on a nightly basis for servers to serve all
customers of the restaurant, even ones
not at their own table. Prior to analyzing
the question, I acknowledge that there
is a partial flaw in the methodology of
performing a regression of a restaurants
service quality of (an exogenous variable)
and whether the restaurant is pooled (an
endogenous variable). In such a regression, I am examining whether pooled restaurants in general yield a higher service
quality.
Although it is difficult to extrapolate
causality from such a regression, the regression and subsequent analysis can be
used to describe whether higher service
quality is generally located within pooled
restaurants. I regressed ZAGAT Service
on a dummy variable for whether the
restaurant was pooled and found a positive, yet not statistically significant relationship (t(71) = 1.449). I found a similar
positive, yet non-statistically significant
result when performing such a regression
using OpenTable Service as the dependent variable (t(42) = 1.212). The strength
of such a relationship decreases when
considering restaurants of a similar price
point controlling for ZAGAT Cost in both
of the analyses, (t(71) = 0.387) for ZAGAT
Service and (t(42) = 0.435). This continues
when controlling for other endogenous
variables that differentiate a restaurants
organizational and compensation structure. Considering the small t values of the
coefficients on pooling, it is difficult to argue that pooled restaurants have higher
service quality.
Service Quality and Visibility within
Pooled and Non-Pooled Restaurants

I now examine whether diners perceive
a difference in service quality within
pooled and non-pooled restaurants as
visibility decreases. I split the data set
into pooled restaurants and non-pooled
restaurants.
I analyzed this question on the pooled
sub-set using both ZAGAT and OpenTables measure of service quality, regressing the two measures of service on
the variable capacity, controlling for the
pricing of restaurants by using ZAGAT
Cost. The regressions on ZAGATs and
OpenTables measure of service yield, respectively, two negative non- statistically
significant relationship for capacity (t(54)
= -0.983) and (t(33) = -1.405).
The direction of these relationships
hold when controlling for other fixed effects for organizational and compensation structure of a restaurant. The negative relationship seems to remain across
restaurants catering to different types of
customers (socio-economic classes). The
results support B.E.Z.Ts (2004) contention that an increase in visibility within
pooled restaurants should yield an increase in service quality as monitoring
free riding becomes easier. However, the
negative relationship between service
quality and capacity is not statistically
significant.
I also analyzed B.E.Z.Ts (2004) contention that service quality decreases in nonpooled restaurants as visibility increases.
I again used both ZAGAT and OpenTables measure of service quality. Analysis of the non-pooled data subset suffers
from the limited number of observations
(only 17 ZAGAT reviewed restaurants
and 9 OpenTable reviewed restaurants).
I regressed the two measures of service
quality on capacity while controlling for
the relative pricing of different restaurants using ZAGAT Cost. The regressions
on ZAGATs and OpenTables measure
of service yield, respectively, two negative non-statistically significant relationship for capacity (t(17) = -0.722 and t(9)
= -0.669). Both relationships seem to remain negative across the two measures of
service quality when controlling for the
same fixed effects for organizational and
compensation structure as the pooled
sub-set regressions. The results do not
support B.E.Z.Ts (2004), though it is difficult to refute B.E.Z.T (2004) completely
given the weak relationship and the relatively small size of the data subset of nonpooled restaurants.
Conclusion
The relatively higher frequency of
pooled restaurants within the sample
11
as well as conversations with restaurant
owners and general managers suggest
that pooling is the dominant form of
structuring compensation within New
York City restaurants. Poolings relative
dominance supports the idea that restaurant management wishes to foster a spirit
of teamwork amongst the service staff
and discourage competition that could
lead to unwanted behavior. However,
the empirical results suggest that restaurant management is less likely to choose
pooling as the seating capacity or size
of the restaurant increases and visibility
decreases. Although non-pooling suffers
from the problem of competition, restaurant management will more likely select it as visibility decreases because the
free riding costs associated with pooling
dominate as monitoring workers (both
management and mutual) becomes more
difficult. Furthermore, managements reluctance to institute a pooled system in a
higher capacity environment is apparent
even when one considers restaurants that
target different types of customers across
the socio-economic spectrum.
In general, diners dont appear to rate
pooled restaurants as providing superior
service to non-pooled restaurants. However, when considering only restaurants
that choose to institute a pooled compensation structure, the results suggest that
restaurants with a higher seating capacity and hence lower visibility are rated
as having inferior service by customers
consistent with B.E.Z.T (2004). While the
relationship is not statistically significant across the two measures of service,
it remains when controlling for different
categories of restaurants such as price,
whether the restaurant is over three years
old and whether ownership is involved
on a day to day basis. The result of inferior service within pooled restaurants
as capacity increases is further supported
by managements reluctance to institute a
pooled system in a higher capacity environment. Given the relatively small data
set, there is merit in further researching
the negative relationship of service quality and capacity in pooled restaurants by
collecting more data points in order to
see whether the relationship further approaches statistical significance. n
Fall 2013
12
The $25,000 Steak
How Revolving Door Lobbyists Gain From Political Connections
Gerard R. Fischetti
Bentley University and University of California, Berkeley
Introduction
Lobbyists act on behalf of corporations
and unions to persuade Congress to vote
in a particular way.1 In doing so, lobbyists build relationships with Congresspersons which have resulted in a revolving
door between K Street and Capitol Hill,
in which staffers become lobbyists, lobbyists become staffers, and Congresspersons become lobbyists. By examining the
revolving door phenomenon, I am able
The authors find that a lost

connection to a senator
results in a 24% decrease in
revenue and a lost connection
to a representative results
to understand how these connections are
benefiting lobbyists.
This paper examines the robustness of
the main results in Jordi Blanes i Vidal,
Mirko Draca, and Christian Fons-Rosen
(2012). The authors find that a lost con1
American League of Lobbyists. Code of Ethics.
Last modified September 28, 2011. http://www.alldc.org/
ethicscode.cfm
nection to a senator results in a 24% decrease in revenue and a lost connection to

a representative results in a 10% decrease
in revenue. I use a fixed-effects estimator
to arrive at a slightly different conclusion.
Additionally, by looking at a politicians
rank in Congress, I provide further evidence that revolving door lobbyists are
benefitting from their connections when
a certain party is in power.
Data
My data consists of 10,418 lobbyistperiod observations from 1998-2008. A
period (or semester) is defined as six
months. There are 1,113 individual lobbyists in my sample. This dataset was
assembled by Blanes i Vidal et al. (2012)
and consists of the following variables:
The lobbyists name and unique
lobbyist ID
The semester(s) in which the
lobbyist worked (1-22)
Lobbyist revenue, reported as the
value of the lobbying contract
divided by the number of lobbyists
who were assigned to the contract
Dummy variables for the periods in
which a senator or representative
leaves Congress
The party of the politician
(Democrat or Republican)2
2
Independents are reported as members of the party
The chamber of Congress the

politician belongs to (House or
Senate)
Number of semesters of lobbying
experience
For my extension of the study, I addto
this database the following variables:
The name of the politician the
lobbyist is connected to3
The year the politician first entered
Congress
The number of years a politician has
been in Washington4
Table 1 lists the summary statistics for
U.S. revolving door lobbyists, including
statistics for revolving door lobbyists
who are present in the lobbying industry from 1998-2008 (Panel A) the types of
connections as a fraction (Panel B), and
descriptions of the politicians the lobbyists are connected to, broken down by
party and chamber (Panel C).
with which they voted most often.
3
Because revolving door lobbyists are, by definition,
staffers who have worked in Congress, I define the connection as their former boss. This allows me to identify
one connection per lobbyist.
4
Some politicians have gaps in their years of service.
I construct the variable to be the number of years since
first entering Congress regardless if their service is not
continuous. My rationale is that the connection between
lobbyist and politician is still relevant the more years they
know each other. In thinking about seniority, a politician
who leaves still has the level of influence, experience, and
other connections when s/he returns.
Fall 2013
Table 2 shows the seat changes in Congress from 2000-2008. I focus on the 109th
Congress of 2005-2006 and the 110th Congress of 2007-2008 to understand how
lobbyists gain from being connected to
a politician whose party is in power, as
well as how a politicians seniority affects
lobbyist revenue.
The 2004 reelection of George W. Bush
corresponds with the 109th Congress and
the midterm election of 2006 corresponds
to the 110th Congress. I focus on these
final four years of the Bush presidency
as the multiple seat changes provide a
useful case study. The Republicans lost
30 House seats in the 2006 election and
Democrats gained 31. The Democrats
also gained all six Senate seats that were
previously occupied by Republicans.
Ideally, Id like to also include the 2008
election in my analysis, but my dataset
does not currently have lobbyist information for 2009-2010.
Empirical Strategy
I outline a replication strategy and introduce my own model for addressing
seniority effects in Congress and consider
some theoretical limitations of my empirical strategy.
Model Replication
Following Blanes i Vidal et al. (2012), I
estimate:
(1) Rit=i+SPitS+HPitH+Xit+tpc+vit
where is the log of revenue; i is the individual lobbyist fixed effect; PitS denotes
a lobbyist who is connected to a senator;
PitH denotes a lobbyist who is related to
a representative; Xit is a vector of control variables such as experience; tpc are
time period, by party and chamber, fixed
effects; and vit is the idiosyncratic error
term. I also define a vector:
which is a vector
related to senator
tive. The parameters
and H. Under the
of the variables
and representaof interest are s
assumption that
the estimates of the parameters of interest will

be unbiased and can therefore be interpreted as the percent increase in revenue
due to being connected to a senator and
representative, respectively.
The motivation for including i in (1)
above is that there are unobservable attributes (such as natural ability or motivation) that are correlated with the connection to a Congressperson. Using a
fixed-effects estimator eliminates this bias
13
under the assumption that the unobservable attribute of interest is time-invariant.

I also de-mean (1) within lobbyists to
control for unobserved heterogeneity of
lobbyists.
Model Extension
I specifically look at the 109th and 110th
Congress, as there was a reversal in power from Republican control of both chambers in the 109th to Democratic control of
both chambers in the 110th. I consider the
following model:
(7)
Fall 2013
14
where Rit is the log of revenue; i is the

individual effects; Majority is a dummy
variable that equals one when the politician is a member of the majority party;
Majority x Rank is the interaction for majority party and rank percentile; Rank is
a percentile-adjusted rank of seniority
based on the Congresspersons years in
office; Expit is a control variable for lobbyist experience; tpc is a control, across
time, for party and chamber; and it is the

error term. I estimate this model to show
differences across parties, rank levels and
time.
This model shows the relative importance of connections in the lobbyists networks.
I can figure out how important a connection is to the lobbyist by looking at the
politicians seniority, measured by years
since his/her first election. I apply my
model to see how politicians of a majority party affect lobbyist revenue through
their rankings, a metric I construct.
Fixed-effects estimation is used for the
same reasons outlined in Section A.
I create an adjusted rank which
constructs percentiles from one to 100 to
normalize all ranks along the same relative scale. Adjusted rank is calculated
by sorting the dataset by semester, party,
chamber and experience. A lobbyist who
has the same rank by any of these dimensions is grouped together. Thus, for
every observation of the same rank, the
variable Rank makes this adjustment according to the following equation:

(8)
Limitations
Blanes i Vidal et al. (2012) compares
two groups of lobbyists: those who lost
a political connection and those who did
not. Their paper ignores the wider set of
connections a lobbyist may have in his/
her personal and professional networks,
an assumption I also make. A limitation of their study is underestimation of
the effect of connection, in general, on
revenue. Lobbyists who suffered higher
revenue losses after a connection was lost
were more likely to drop out of the lobbying industry and thus were not included
in the sample in later time periods. My
strategy only includes lobbyists present
in the lobbyist industry. This may lead to
minor overestimation of results, but since
I am only looking at a span of eight semesters from 2005-2008, this is not a great
issue.
Results
Table 3 displays the results of the regressions in which I replicate Blanes i Vidal et
al. (2012). All of the lobbyists in this sample are ex-staffers of Congresspersons. I
define a connection as the Congressperson who previously employed the staffer.
The result can be interpreted as the percent increase in revenue.
In column (1) I control for time but not
for individual fixed effects, i. Additional control variables are added in each column: model (2) adds a control for party
(Democrat, Republican), model (3) adds
a control for chamber (Senate, House),
model (4) adds a control for experience
(in semesters) and model (5) adds controls for individual fixed effects.
The connection to a senator is not statistically significant until models (4) and
(5), while the connection to a representative becomes insignificant in model (5).
The addition of controls in models (1) to
(5) has little change in the coefficient for
senators, which shows that differences
across lobbyists were not biasing the effect. However, for representatives, the
addition of controls causes the coefficient
to drop dramatically; the drop from (4) to
(5) is the most notable because the coefficient becomes insignificant. This shows
that unobserved heterogeneity among
lobbyists biases the effect of their connections to representatives. Ultimately, I
cannot conclude that there is any benefit
to being connected to a representative.
My findings are consistent with the intuition that being connected to a senator is
more valuable than being connected to a
representative.
For the extension, my dataset includes
all 454 Congresspersons who served in
the 109th and 110th Congresses.
Table 4 gives the results of the model
given by Equation (7) and shows the effects of majority status and rank on lobbyist revenue. The number of observations refers to the number of groups of
politicians who share the same ranking.
In the first column, model (6), I estimate
the effect of rank, majority and their interaction. Model (7) adds a control for
lobbyist experience. Models (8), (9), (10),
and (11) all control for lobbyist experience and control for chamber and party
in the following ways: (8) estimates the
effects for Republican representatives; (9)
for Democratic representatives; (10) for
Republican senators and (11) for Democratic senators.
Controlling for lobbyist experience in
model (7) shows that being connected to
a politician in the majority party leads to
21% higher revenue, significant at the 5%
level. The politicians rank in model (7)
is not significant. I consider this the most
important model in Table 4 because it establishes that connection to a more experienced politician isnt necessarily indicative of higher revenue.
Interestingly, being connected to a
politician in the majority party has significant effects for lobbyist revenue. Table
4 uses the 109th Congress, when Repub-
Fall 2013
15
status as a high-ranking Democrat or Republican.
Conclusion
My study finds that being connected
to a senator leads to 24% higher revenue,
while the value of a connection to a representative is more complicated. Being
connected to a representative is not important unless the representative belongs
to the majority party, in which case the
lobbyists revenue increases (33% in my
Being connected to a member

of the majority party results
in 21% higher revenue.
case study). More generally, I estimate
that being connected to a member of the
majority party results in 21% higher revenue.
This leads to the conclusion that being connected to a majority party is more
important than the politicians relative
rank. n
licans controlled the House and Senate,

as its majority party baseline. The effect
of being connected to a Republican Congressperson (estimated in models (8) and
(10)) is 34% in the 109th Congress, while
being connected to a Democrat in either

chamber is insignificant. The main conclusion to draw from Table 4 is that a
politicians standing in a majority party
is more important than the politicians
16
Fall 2013
So Sue Me
Market Reaction to Patent Litigation Verdicts and Patent Appeal Results
Lorna Zhang
Columbia University
Introduction
Patents are one of the most significant legal
instruments that protect intellectual property
(IP) rights. A patent gives the inventor the exclusive rights to their patented idea for a limited period of time, typically 20 years from
the date the patent was filed. A patentable
invention must be new, useful, and nonobvious to a person skilled in the field of application at the time. Though new ideas resulting
in useful products have an obvious economic
value, these ideas are often pure public goods,
rendering them unprofitable for the inventor.
Patents alleviate this problem by creating a
legal means of conferring excludability upon
otherwise non-excludable innovations.
Recently, we have seen a steady rise in patent litigation, with the number of patent litigations rising from 2,281 in 2000 to 5,484 in
2012, a 140%1 increase. These litigations are
costly affairs, causing an average decrease in
firm value of -2% upon the initial litigation
announcement for 26 biotechnology suits,
representing a median shareholder value loss
of $20 million. Additionally, numerous studies have shown that firms often choose not to
apply for a patent due to the expected cost and
likelihood of defending the patent in court.
Given its high cost, litigation can only serve
1
Statistic obtained from the Lex Machina intellectual property (IP) litigation database.
its purpose of protecting valuable innovation,

if court rulings are accurate. However, 116 of
the 560 cases that went to trial in my sample
set had verdicts that were later reversed or
vacated upon appeal, a rate of about 20.7%2.
In this paper, I examine whether markets,
through the aggregation of individual expectations, are capable of indicating which cases
are more likely to be overturned upon appeal.
Given the wealth of information embedded in
market responses to events, we would suspect
that market reaction to these trials might be
an indicator as to whether a verdict will be
overturned upon appeal if one of the companies involved is a publicly traded company.
There is ample evidence to suggest that
markets have already incorporated expectations about the outcome of the litigation
into stock prices well before a verdict is announced. The premise of an event study is
based on the assumption that financial markets are efficient at aggregating information,
and thus stock prices reflect investors private
expectations of the results of litigation before
a verdict is publicly announced. If new information is revealed at the commencement (or
termination) of litigation, we expect markets
2
Statistic calculated using data provided by the Lex Machina IP litigation database; this rate is likely to be even higher
as firms involved in cases where judgements were rendered in
late 2011 or 2012 have likely not yet had enough time to file an
appeal, or, if an appeal has been filed, the US Court of Appeals
has likely not had the time to deliver a final ruling.
to reevaluate their holdings to reflect new expectations about cash flow and risk, revaluing
the firm accordingly.
Any changes in the stock prices of the companies involved in the litigation after a verdict is publicized will consist of two components: an uncertainty removal component
and a surprise component. The uncertainty
removal portion arises from the fact that after the verdict is made public, the uncertainty
surrounding the outcome of the litigation is
removed, and stock prices will shift to reflect that. The surprise component of the
stock price change measures whether or not
the verdict was in line with investor expectations. Raghu et al finds that, at least for the
defendant, the market reaction at the time of
a settlement/termination of the IP litigation
largely reflects discrepancies between the expectations of the investors and the actual outcome. If we assume that markets are capable
of accurately assessing the optimal scope and
value of a patent, then any deviations from
market expectations would suggest a problematic ruling. The presence and magnitude
of a surprise component could indicate that
there is something troubling about the ruling
and that it might be more likely to be overturned in the appeals process.
Studying the predictive power of this market response will allow us to determine both
whether or not market reaction is a potential
Fall 2013
indicator of the success of a future appeal and

to what extent markets accurately assess the
optimal scope and value of a patent, if at all.
My results suggest that the impact of market reaction on the probability of reversal
differs significantly between claimant and defendant firms. Specifically, markets seem to
have some predictive power in determining
the likelihood that an initial verdict will be
overturned upon appeal when the event study
firm is the defendant. An OLS regression indicates that a 1 unit increase in the deviation
of actual market reaction from the expected
market value results in a 7.35% increase in
the probability that the verdict will be reversed upon appeal, with a p-value of roughly
11%. The positive coefficient suggests that
the larger the deviation of the actual stock return from the expected return, the more likely
it is that the verdict will later be reversed, reaffirming the theory.
It is also possible that this reaction is somewhat dampened because markets might be
anticipating an appeal, and have therefore already factored some of that anticipation into
the reaction. This is very plausible given the
fact that over 80% of the cases in my initial
sample were later appealed. However, this is
only the case when the event study is done on
defendant firms. When I split my sample into
claimant and defendant firms and run separate
regressions, the coefficient on the market reaction variable when the event study firm is
the claimant is insignificant, with a p-value of
around 70%. This indicates that only market
reaction for defendant firms relates to probability of reversal. This is likely because defendant firms have a much larger downside
than claimant firms. A defendant firm may
experience significant financial distress if
it is ruled to have infringed upon the claimants patents. A decrease in their wealth and
competitiveness is inevitable if the ruling is
not later overturned. On the other hand, if
the claimant loses, it does not have to cease
production of its product or pay royalties
17
to the defendant firm. Thus, the claimants

downside is essentially capped at the status
quo. It is therefore unsurprising that market
reactions are much larger for defendant firms.
Similarly, the effect of industry character-
Though new ideas resulting

in useful products have an
obvious economic value, these
ideas are often pure public
goods, rendering them unprofitable for the inventor.
istics on probability of reversal is very significant for defendant firms (p-value 1%),
while extremely insignificant for claimant
firms (p-value 94%). These results suggest
18
Fall 2013
that publicly traded claimant and defendant

firms have markedly different characteristics
and reaction magnitudes to unexpected initial verdicts. Additionally, I found that when
the claimant wins the trial, the verdict is significantly more likely to be overturned upon
appeal. This result is very strong (p-value
< 0.01 for most regressions) and consistent
across regressions with different specifications. Similarly, when both the claimant and
defendant are publicly traded, the probability
that the ruling will be reversed is significantly
higher.
Background
Patent litigations are complicated proceedings with a significant amount of
variation between cases. At any point in
the process, litigation can be terminated
if the parties reach a settlement agreement. Additionally, the judge can dismiss
the case in a summary judgment if it is
determined that either side does not have
enough evidence to argue the infringement case further, and both parties can
file a motion for a summary judgment
any time before the commencement of
the trial.
While summary judgment rulings can
also be appealed, I chose to only study
cases that actually went to trial, as these
are the cases that are most heavily contested. Additionally, if markets adjust
their expectations as new information
comes to light during the litigation, as
theory suggests, then we would expect
to see the market capitalizations of the
claimant and defendant firms moving opposite to each other as information that
strengthens the claimants case will necessarily weaken the defendants.
Figure 1 displays the movement in the
market capitalization of two firms involved in a patent litigation, with reference lines placed at key points in the liti-
We have seen a steady rise in

patent litigation, with the
number of patent litigations
rising from 2,281 in 2000 to 5,484 in
2012, a 140% increase
gation process. It is clear from this graph
that the movement in market capitalizations of the two firms mirrors one another in the period between the commencement of the litigation and the delivery of
the jury verdict. This suggests that markets are constantly adjusting their expec-
tations throughout the litigation process

and will have formed reasonable expectations of the outcome of the litigation
before the actual verdict is announced.
These market cap adjustments imply that
markets find patent litigations to be economically significant events, consistent
with past studies on patent litigation.
Figure 1: Movement in market capitalization of the claimant and defendant
firms during litigation. Graph created
using stock price and shares outstanding
data provided by the Center for Research

in Security Prices
Research Hypothesis
It is evident that intellectual property
rights disputes greatly affect the present
value of expected cash flows of the firms
involved, causing changes in the valuations of said firms, as in Figure 1. Moreover, given that markets continuously
adjust their expectations as new information is revealed throughout the course of
litigation implies that markets will have
Fall 2013
19
vided into two parts. The first part is an
event study. The second part is a regression utilizing the results from the event
study. There are four parts to every event
study: (1) Defining the event day(s); (2)
measuring the stocks return during the
event period; (3) estimating the expected
return of the stock during this period,
and (4) computing the abnormal return
(actual return minus expected return).
The event date was defined as the first
Any changes in the stock prices of the companies involved in

the litigation after a verdict
is publicized will consist of
two components: an uncertainty removal component
and a surprise component.
formed expectations about the result of

the litigation before a verdict is reached.
If the final verdict parallels market expectations, then we would expect to see
a relatively small deviation from the expected stock return for both firms. However, if the final verdict is not in line with
expectations, then the deviations should
be much larger.

Regardless of expectations, the
announcement of a verdict will reduce
the uncertainty surrounding the litigant
firms. This will have a positive effect on
all firms involved in the case because
when uncertainty decreases, the risk surrounding the projected future cash flows
of the firm also decreases. When the firm
that the market expects to win a case
does indeed win, there will certainly be
a positive effect on that firms stock return; however, the net effect on the other
firm is ambiguous. Though uncertainty

has been reduced, the firm has lost the
litigation suit. Moreover, investors expectations are not identical; those who
invest in the defendant firm may be more
optimistic about the defendants position
than those investing in the claimant, and
vice versa. Thus, for example, the shareholders of the losing firms are likely to
experience a negative shock even if the
result is in line with market expectations.
However, the magnitude of this surprise
component is likely to be much smaller
than if the entire market were surprised
by a ruling.
Event Study Methodology
The methodology for evaluating
whether market response to a verdict
announcement can be used to assess the
probability of an initial verdict being
overturned in the appeals process is diColumbia Economics Review
date where the result(s) of the litigation

were accessible to the public. This does
not necessarily coincide with the final
judgment date, where the results are
made official. In those cases, the date
of the jury verdict is used as the event
date as it is the first date that the markets will receive the news. Additionally,
in order to ensure that the abnormal return we calculate embodies the market
reaction to the verdict, we use a two-day
event window. This window accounts
for the day before and after the verdict
announcement, because we do not know
what time the ruling was released to the
public. If it was released after the markets had closed, the reaction would not
be seen until the next day.
The expected return, measured in step
3, is the return that would have accrued
to shareholders in the absence of the
event. There are several models to measure expected return. The most widely
used model, and the one used in this
study, is the market model which states
that, Rit=i+i*Rmt+eit
Rit The expected return on the stock of
firm i at time t.
i, i Firm specific parameters measuring how the security varied with the market portfolio
Rmt The market return for period t.
The firm-specific parameters, i and i;
were calculated using 200 daily returns
in the period leading up the announcement. This period of 200 returns must
20
be free of firm-specific shocks that might
cause its returns to deviate from its baseline level as these will resulted in biased
estimated parameters3. However, it is not
necessary that the market as a whole be
free of shocks. So long as the shock is not
specific to the firm that the event study is
being conducted on, then we can expect
that the market returns will also reflect
the effect of these events.
I used the estimated i and i along
with the return on the market portfolio
to calculate an expected return on the
event study firms stock. The abnormal
return was calculated by subtracting the
actual return from the expected return.
As I used a two-day event window, for
each event study, the abnormal returns
for day 0 and day 1 were summed to give
a cumulative abnormal return (CAR).
The standardized CARs were calculated
using the formula CARit/sit, where sit is
the standard deviation of the regression
residuals.
Data
This study examines both the claimants (the firm(s) seeking damages for infringement) and the defendants (firm(s)
that have allegedly infringed) of patent
infringement litigation. In court documents, the first firm to file a lawsuit is
labeled the claimant regardless of who
owns the patent. For consistency, I define
the person or firm that owns the patent in
question as the claimant and the person or firm that has allegedly infringed
on the patent the defendant, regardless of who filed first. As we are interested in observing the market reactions
to the announcement of a verdict, at least
one firm involved in the litigation must
be a publicly traded company. I have
excluded subsidiaries of publicly traded
companies from this study as there is no
data readily available that points to the
importance of the subsidiary to the parent firm.
The data collection process was twofold: first, litigation data was obtained
and the characteristics of the case ascertained. Once a useable sample was assembled by paring down the dataset to
cases where an appeal was filed with at
least one publicly traded firm, an event
study analysis was done for each publicly traded company, for a total of 142
event studies. As there was no consolidated list of appealed cases, I created my
own dataset using litigation data from
the Lex Machina database. I looked at
562 cases from 2000-2012, determining
Fall 2013
whether each case had been appealed
and the outcome of the appeal.
A large majority (81%) of cases that
went to trial were appealed; this is unsurprising given that only cases where
both firms felt strongly about their positions would go to trial. The true value is
actually probably even higher, as firms
involved in cases resolved in 2012 likely
have not had the time file an appeal.
Of the 142 event studies, 64 were reversed upon appeal. Oftentimes, an appeal will not result in a simple decision
to affirm or reverse, rather an appeal
will be reversed-in-part, affirmed-inpart, and/or remanded. In these cases,
I have chosen to denote any case where
any portion was reversed or vacated
upon appeal as reversed, because a reversal of any part of the original verdict
indicates that there was something problematic about the initial ruling that I expect the market to have captured.
Analysis
Table 1 displays three different results
of my regression estimations using a
probit regression. Table 2 displays the results of an ordinary least squares (OLS)
regression, to interpret the results of Table 1 only at a specific point.
The OLS regression estimates that there

is about a 26% increase in the probability of reversal when both companies are
publicly traded compared to when only
one of them is4. Further, all three regression models indicate that this correlation
is significant at the p<0.01 level. This result corroborates previous studies which
have shown that the impact of patent
litigation depends on who the opposing
firm is. It is unsurprising that, when both
firms are publicly traded, the probability
of the verdict being overturned is higher,
because it is more likely that both firms
will have the resources to fully pursue
the expensive appeals process. The event
study firms market capitalization is also
used as a control variable as to whether
a case had to be terminated due to financial difficulties.
I further find that when the patent
holder wins the trial, there is a much
higher probability that the verdict will be
overturned upon appeal. In Table 2, I find
that there is roughly a 36% higher probability that the case will be overturned
on appeal when the patent holder, the
claimant, wins the initial trial than when
the non-patent holding firm, or defendant, wins.
4
I do not have any results for when
neither company is publicly traded as in order to run my regression and calculate an abnormal return, at least one company had to be
publicly traded
3
This can be anything from the
commencement of a litigation to a change in
upper level management of the firm
Fall 2013
This might be expected when we consider that, for two reasons, the burden
of proof is much higher for defendants
than for plaintiffs. Firstly, over the past
few decades, there has been a trend in
policy to strengthen patent protection;
as a result, patent rates, claimant success rates in infringement suits, and the
number of infringement suits filed have
all increased. If a firm knows that there
is a high probability that the court will
rule either invalidity or non-infringement
when it tries to defend its patent in court,
then there would be no incentive for the
firm to patent their innovation. Thus, necessarily, the patent litigation system is be
set up so that the probability that an invalid or non-infringed patent will be declared valid and infringed upon is higher
than the reverse situation.
Secondly, when a firm is sued for infringement, it will often argue that the
patent in question is invalid or unenforceable. However, any patent that has
been issued has already been screened
by the US Patent Office and as a result of
this, proving invalidity is difficult. These
two facts mean that when the non-patent
holding firm does win, due to the high
burden of proof required to achieve such
an outcome, the verdict is less likely to be
overturned upon appeal.
It is interesting that the magnitude of
the defendant firms abnormal market returns is much more effective in predicting the probability that a verdict will be
reversed than the claimants; however,
this is not completely unexpected. As
mentioned earlier, studies have shown
that the defendant has much more at
stake in a patent infringement case than
the claimant because there is a much larger downside for the defendant. The worst
case scenario for the claimant is that their
patent is declared invalid and they lose
royalties, but they would not have to stop
producing their product. Additionally,
it is also unclear whether the claimant
will be able to take full advantage of the
reduced competition should they win.
Since there are usually more than two
firms competing in single market, it is
highly likely that other firms might come
in and take advantage of the reduced
competition as well.
On the other hand, if the defendant loses, the firm could experience significant
financial distress due to the damages and
royalties they would be ordered to pay to
the claimant firms. Even if the defendant
could afford these costs, they will likely
have to cease producing and marketing
the offending product. This fact could
significantly damage their long-term
profit prospects and cause them to lose

market share, in the event that they are
not able to reach a licensing agreement
with the plaintiff. Given that the defendants in these cases have much more at
stake than the claimants, the stocks of
defendant firms are likely to react more
strongly, both positively and negatively,
to a verdict the market did not predict,
and would therefore be a better indicator
than the reaction of the claimant firms.
To explore this possibility, I split my
sample based on whether the event study
firm was the claimant or defendant, and
ran both probit and OLS regressions on
each sample set. The results of this regression are displayed in Table 3. The
p-value on the coefficient of |STDCAR|
for the claimant sample is 66.6% for the
probit regression and 70% for the OLS
regression, indicating that the magnitude
21
of the standardized CARs is completely

insignificant in predicting the probability
that the initial verdict will be overturned
upon appeal when the event study firm
is the claimant. However, for the defendant, the p-values are 10.2% and 11%, respectively. As mentioned above, it is possible that this result is dampened by the
markets anticipation that an appeal will
be filed and that the true market movement is in reality much larger. These results suggest that it is only in the case of
defendant firm event studies that market
reaction is capable of providing us with a
useable prediction of the probability that
the initial ruling will be overturned upon
appeal.
Additionally, it also appears that the
effect of whether or not the firms industry is a complex technology industry on
the probability of reversal differs greatly
22
Fall 2013
between claimant and defendant firms.

The OLS regression indicates that when
a firm is part of an industry with complex
technology, there is a 29.3% increase in
the probability of reversal when the firm
is the defendant. However, when the firm
is a claimant, the coefficient on this variable is completely insignificant (p-value
around 94%). One possible explanation
for this discrepancy could be due to the
The importance of market

reaction and industry type
on the probability of reversal
differs significantly between
publicly traded claimant and
defendant firms
type of companies or individuals likely
to sue large, publicly traded firms. Aside
from the 22 out of 83 firms where both
the claimant and defendant were publicly traded, it is possible that that claimant
is a much smaller firm that is looking to
capitalize on a larger firm infringing on
one of their patents or a non-practicing
entity (NPE). NPEs are patent owners
who use their patents solely for the purpose of suing infringers. It is much easier
for these plaintiffs to make a case when
the defendant firm is in a complex technology industry where the boundaries
of a patented invention are less clearly
defined and where a single product can
consist of hundreds, if not thousands, of
different patented parts and processes. At
the same time, due to such complexities,
it is also less difficult to make a compelling case for non-infringement. These
cases are thus much less clear cut. All
these factors combined make it much
more likely that the initial verdict will be
reversed upon appeal.
Conclusion
Using a market-based approach, I have
studied the relationship between the
characteristics of a patent litigation case
and probability of reversal upon appeal.
Previous works that have used the same
approach have only focused on cases
where a settlement is reached, and these
studies have shown that markets view
patent litigations as economically significant events. Based on these results, I have
chosen to look at a previously unexamined set of cases to determine whether
market reaction, along with other attrib-
utes of the case, are capable of predicting

the probability of reversal upon appeal.
My results suggest that the impact of
certain case characteristics is not homogeneous across all publicly traded firms. In
particular, the importance of market reaction and industry type on the probability
of reversal differs significantly between
publicly traded claimant and defendant
firms. The results show that market reaction is related to the probability that the
verdict will be overturned upon appeal
when the event study firm is the defendant, but is insignificant when the event
study firm is the claimant. This difference
confirms results from past studies that
have shown there to be asymmetric effects of litigation depending on whether
a firm is a plaintiff or a defendant.
Additionally, the effect of whether the
event study firm is in a complex technology industry also differs significantly
between claimant and defendant firms.
This difference suggests that there might
be a divergence in the way large, publicly

traded defendant firms deal with claimant firms of differing sizes, especially
within industries with complex technologies. Given that a single product in a complex industry is likely to use hundreds or
even thousands of different patents, when
both firms are large and publicly traded,
it is probable that they both produce
products that mutually infringe upon
the others patents. Rather than going to
trial, it is more efficient and beneficial for
both firms to enter into a cross-licensing
agreement with each other. In fact, surveys have shown that firms in complex
industries often patent their innovations
for the sole purpose of strengthening
their negotiating power when forming
these agreements. However, when there
is a significant discrepancy in the size and
importance of the two firms, it is unlikely
that the larger firm will have sufficient
incentive to enter into a cross-licensing
agreement with the smaller one. Thus,
Fall 2013
when the smaller firm is the patent holder, it has no recourse but litigation5. The
significant difference in the coefficient
on whether or not a firm is in a complex
technology industry between the claimant and defendant firm samples, may in
fact be capturing the divergence between
how a large, publicly traded firm deals
with other firms of varying sizes. Further work might look into the magnitude
and significance of these differences and
whether smaller firms choose to litigate
because they have no other option or because they want to take advantage of the
potential royalties that would result from
winning a patent litigation suit against a
large, well-endowed firm.
These results further elucidate the relationship between patent litigation and
financial markets. I have shown that
markets exhibit some capabilities in predicting whether an initial verdict will be
overturned upon appeal. This suggests
that in some cases market forces may
be more capable of rendering unbiased
rulings than district courts. This is corroborated by the fact that my results also
show that courts are consistently handing
down too many initial rulings in favor of
the patent holder. While this is partly due
to the way that the court system has been
designed, it is in reality counter-productive. If potential patent holders know that
there is a significantly higher probability
that a ruling in their favor will be overturned upon appeal than a ruling against
them, there will still be incentives against
patenting. I would argue that slightly
stricter requirements should be placed on
claimant firms to prove that the patents
in question have been infringed upon so
that more accurate rulings will be made
more often, thus reducing costs for all
parties involved and increasing overall
welfare. n
5
When the larger firm is the patent holder, there is a higher
possibility that it may determine that the costs of litigation outweigh the benefits and thus decide not to litigate the infringed
patent.
23
24
Fall 2013
TaperPedic
An Analysis of the Federal Reserves Forecasted Asset Losses in the Face
of Looming Interest Rate Shocks
Jenna Rodrigues
Princeton University
Introduction
The size of the Federal Reserves balance sheet has increased significantly
throughout the recent economic recession. In this study, I use data for average coupon returns on mortgage-backed
securities, short-term Treasury Bills, and
long-term Treasury Bills in order to create a forecasting model to assess how
much the value of the Feds core assets
will decline when they raise interests
rates. Looking at the predicted change in
the value of the core assets on the Feds
balance sheet that will come with an interest rate hike will serve as a means of
assessing the risk they took on during the
crisis when they expanded their holdings
of each of these three assets. My empirical results suggest that when the Fed decides to raise interest rates in an effort to
initiate an exit strategy from the recent
balance sheet expansion, the value of
their core assets overall will drop significantly in value, with the majority of loss
coming from their holdings of long-term
Treasury Bills. If the Fed is still holding a
large quantity of these assets when they
begin to tighten monetary policy, they
will experience a significant decrease in
their net income. A drop in net income
could have serious negative implications
on the economy and the scope of mon-
etary policy.
The unconventional policy decisions
that the Federal Reserve made during the
recent economic recession have been under the microscope for the past few years.
While such an active attempt to ease
Looking at the predicted

change in the value of the
core assets on the Feds balance sheet that will come
with an interest rate hike will
serve as a means of assessing
the risk they took on during
the crisis when they expanded
their holdings of each of
these three assets.
monetary policy was arguably essential during the peak of the recession, the
Federal Reserve had to utilize extremely
risky measures that will be matched with
a complex exit strategy in the coming
years. In its attempt to implement extensive easing policies when interest rates
were settled at the zero bound, the Fed

significantly expanded the overall size of
its balance sheet and altered the composition of its asset portfolio. At first glance,
it appears that the Fed made a significant
amount of money through their increased
holdings of these riskier assets through
its balance sheet expansion and portfolio
shift, but inflation becomes a concern, the
Fed is likely to have to switch its trajectory and begin tightening monetary policy.
In initiating its exit strategy, how will the
Feds raising of interest rate affect the value of its asset portfolio? In examining the
potential loss in capital the Fed is likely
to undergo as they implement their exit
strategy, it is also essential to consider the
implications that it will have on the future of monetary policy decisions.
I plan to perform an econometric assessment in attempt to quantify how the
value of the three core assets on the Feds
balance sheet will change when the Fed
raises interest rates. Through my forecasting model, I will generate a series of
expected asset returns based on a historical period of monetary tightening. I use
the mean values of these forecasted asset
returns in each of the three cases to assess
the difference between the baseline accumulated asset returns and the generated
accumulated returns given a case of mon-
Fall 2013
25
ASSET VALUE
OVER TIME
$
$
ASSET VA
LUE
RAT
EST
ER
INT
etary policy tightening. Through analyzing the difference between the two series
of accumulated returns for each asset, I
will analyze the forecasted valuation loss
that will occur with the Feds decision to
initiate contractionary monetary policy
as it begins to implement their exit strategy. After running all three assets through
this forecasting model, I will combine the
three projections to simulate an overall
level of net income loss that the Fed will
undergo when it tightens monetary policy. In the case that the model predicts that
the Fed will in fact undergo a significant
loss, I will proceed to analyze potential
macro-level ramifications of the resulting
capital loss that can be attributed to the
increased risk-taking on behalf of the Fed
during the crisis.
Literature Review
Balance Sheet Expansion
Some top fed officials point to the fact
that the risk is under control and does not
pose a huge threat to Federal Reserve. For
quite some time, Bernanke attempted to
minimize the idea of imposing risk to the
public in stating that the Federal Reserve
loans that are collateralized by riskier securities are quite small compared with
our holdings of assets with little or no
credit risk (Bernanke: The Federal Reserves Balance Sheet 1). However, In
a noteworthy research article, Fed analyst Asani Sarkar sets the stage for the
ways in which the Fed portfolio changed
throughout different stages of the crisis;
beginning with providing short-term liquidity to sound financial institutions,
proceeding to provide liquidity directly
to borrowers and investors in key credit
markets, and finally expanding to the
purchase of longer-term securities for
the Feds portfolio (Sarkar 3). The author proceeds to briefly discuss the risk
associated with some of these programs
as they are incorporated in the Federal
Reserves balance sheet and the differences in the level of credit risk in the different stages of portfolio expansion and
diversification. In his analysis on changes
in the Feds balance sheet over time, Kenneth Kuttner discusses in great depth the
massive shift out of Treasuries and into
private sector assets, which means the
Fed now has assumed some amount of

default risk, although exactly how much
is hard to know (Kuttner 3). Rudebusch
writes an effective paper that delves into
this concern of interest rate risk, which I
will be addressing further in my analysis
of the implications of the Feds changed
balance sheet. He specifically states that
the Feds purchase of longer-term securities have been controversial, in part because of the associated interest rate risk,
including the possibility that increases in
interest rates will cause the market value
of the Feds portfolio to fall (Rudebusch
1).

Implications for an Exit Strategy
Janet Yellen is much more direct in her
rhetoric as per her speech on March 4th,
when she discusses the potential losses
the Fed may experience when interest
rates increase. Yellen expresses her concerns for the agency when she states that
the Federal Reserve has, to be sure, increased its exposure to interest rate risk
by lengthening the average maturity of its
securities holdings. As the economic re-
26
covery strengthens and monetary policy
normalizes, the Federal Reserves net interest income will likely decline (Yellen
1). Losses may particularly occur in the
case that the Federal Reserves interest
The Federal Reserve had to

utilize extremely risky measures that will be matched with
a complex exit strategy in the
coming years.
expenses will increase as short-term interest rates rise, while reserve balances
initially remain sizable. In addition, policy normalization may well involve significant sales of the Federal Reserves agency securities holdings, and losses could
be incurred in these sales (Yellen 1).
Yellen suggests that projections resulting from this exercise imply that Federal
Reserve remittances to the Treasury will
likely decline for a time. In some scenarios, they decline to zero (Yellien 1). While
she concludes that the Federal Reserves
purchase programs will very likely prove
to have been a net plus for cumulative
income and remittances to the Treasury
over the period from 2008 through 2025,
how the Fed is going to cope with the net
income losses that it will undergo in the
early stages of its exit strategy remains a
question. (Yellin 1)
Mishkin, Greenlaw, Hamilton, and
Hooper further performed a quantitative
study to analyze potential losses that the
Fed may endure based upon different
versions of an exit strategy and the fiscal
situation at hand. In examining a potential exit strategy, the economists come to
the following conclusion:
Should it sell assets to shrink its balance sheet as it has indicated is likely,
the Fed will realize a capital loss on longterm securities that it bought when interest rates were lower. In our baseline
assumptions, these forces would result
in losses equal to a significant portion
of Fed capital by 2018, after which these
losses could gradually be worked off.
But departures from the baseline, such
as large-scale purchases continuing past
2013, or a more rapid rise of interest rates
would saddle the Fed with losses beginning as early as 2016, and losses that in
some cases could substantially exceed
the Feds capital. Such a scenario would
at very least present public relations chal-
Fall 2013
lenges for the Fed and could very well
impact the conduct of monetary policy.
(Greenlaw, David, et al 4).
The economists demonstrate that one
major area of potential loss is the duration (average term to maturity) of the
Feds portfolio (which) peaks at nearly 11
years in 2013 with the end of new quantitative easing.... The duration is important because as it rises, it increases the
potential losses on the Feds portfolio as
the Fed strives to return its portfolio to a
more normal level upon exit in a rising
rate environment (Greenlaw, David, et
al 65). The authors also focus a significant amount of energy on this overlap
between monetary and fiscal policy, and
come to the conclusion that [a] fiscal risk
shock occurring within the next five years
would complicate matters greatly for a
Fed that will be in the process of exiting
from its massive balance sheet expansion (Greenlaw, David, et al 81).
While the economists took a large scale
approach to obtain overall loss forecasts
given a set of conditions, my model will
serve as a means of examining how an
interest rate hike could shift the forecasted expected returns of certain assets
in the Feds asset portfolio, thus contributing to these levels of losses that many
economists have recently been alluding
to. Since it is not clear where fiscal policy
will be at the time of a rate hike or the
stage at which the Fed will precisely begin to sell assets and drain reserves, the
results of my study will serve as a more
narrow lens of examination that can be
utilized to provide a starting point for examining potential losses given any set of
conditional variables.
Methodology/Data

In order to quantify the level of
interest rate risk the Fed took on through
its changing asset portfolio over time in
a roundabout manner, I constructed an
econometric forecasting model to assess
how a rise in interest rates could shift the
value of the three core assets on the Feds
balance sheet. Since the Fed is holding
a substantial amount of these assets, a
decrease in the value of these core assets
would contribute to significant losses in
the Feds net income given that they are
still holding a large amount of these assets in their portfolio at the time that they
raise interest rates. In order to reach my
final stage of analysis, I performed a vector autoregression of the core set of assets
on the Feds balance sheet during the relevant time span. I will break up the model that I used into multiple stages in order
to clarify my econometric approach:

econometric approach
Selecting the period of data
In order to simulate a rate environment
that could mirror one that we might see
when the Fed begins to raise interest rates
in the near term, I will construct a forecasting model where I will obtain shock
values from time series regressions using
average coupon return data from the historical period of interest rate hikes from
04-06. To simplify potential complications in the forecasting model, I will assume that when the FOMC begins to announce an increase in interest rates in the
near term, the trend will be generally upward sloping for two years at the least (as
was the case from 2004-2006). This will allow me to capture a forecasting segment
that is likely to be similarly aligned with
the trend in the fed funds rate target from
the historical period. While it is unlikely
that the looming rate hikes will exactly
mirror the historical rate hikes of 2004 to
2006, the model will maintain more consistency than not when looking at a period of time where contractionary policy
was implemented in the case that there
was not abundant financial turmoil.
Vector Autoregression to Obtain
Matrix
Utilizing data on the average coupon returns for the three core assets from 20002013 on a monthly basis, I performed a
vector autoregression in order to estimate the expected coefficient matrix ().
I considered the following types of assets in my regression, which made up a
significant portion of the composition of
the risky assets on the Feds balance sheet
throughout the span of the crisis:
Short-term Treasury Bills (3-Month Returns)
Mortgage-Backed Securities (Barclays
US MBS Index)
Long-term Treasury Bills (10-Year Returns)
I will assign the following variables to
represent the individual asset returns: rs
will represent average coupon returns on
short-term Treasury Bills; rm will represent average coupon returns on MBS; rl
will represent average coupon returns on
long-term Treasury Bills. Vector R will
represent the vector of returns, taking
into account the individual returns of the
three assets under examination, where:
Vector R =
rs
rm
rl
In the case of three time series variables, the

VAR consists of three equations:
rst = gssrst-1 + gsmrmt-1 + gslrlt-1 + est
Fall 2013
rmt = gmsrst-1 + gmmrmt-1 + gmlrlt-1 + emt
rlt = glsrst-1 + glmrmt-1 + gllrlt-1 + elt
where the gs are unknown coefficients
and the ext are error terms.
I proceeded to calculate the following
[3 x 3] matrix (1) based upon the g coefficients after running the vector autoregression:
ss =.9661373* sm = -.1582282*
sl = .1150768* ms= .0079022*
mm= .9879826* ml= .0022588
ls = .0224532
lm =
.0490017
ll = .9141076*
model, I will use February 2013 data to

predict March asset return values. The
first period (1-month) forecast was performed as follows:
1 =
In using the constants from the regression outputs for each of the three time
series regressions, I constructed the following matrix that will be held constant
through the remainder of the forecasting
model:
0 =
When constructing a one-year forecasting model for the (r) values of the
three assets in consideration, I will look
at a case where I will perform a baseline
analysis where no shocks are introduced.
This will allow me to see where the value
of assets would naturally trend without
the introduction of shocks to the VAR beyond monetary policy tightening.
One-year forecasting Model Without
Shocks:
{Assume et = 0}
I will begin my forecasting model using the (r) values from February of 2013
to construct the Rt-1 matrix in the equation
to follow. I will utilize the 0 and 1 matrices that were constructed above based
upon the output from the vector autoregression.
Rt = 0 + 1 * Rt-1
In the first stage of my forecasting
The * symbol following the coefficient

value is representative of the coefficient
being significant at the 5% level.
Using the coefficients obtained from
performing the three time series regressions above, I constructed the following
coefficient matrix 1 that will be used as
a constant through the remainder of the
one-year forecasting model, where:
Rt
The following resulting matrix will

then be used as the Rt -1 value when proceeding to the next stage of the model
where March predicted returns will be
used to predict asset return values for
April:
Rt =
I repeated this cycle period by period until I

obtained a set of predicted asset returns
for 120 periods. I will introduce the first
set of outputs for a year of forecasts in the
results section to follow.
Results
In order to assess the effectiveness of
the vector autoregression model overall, I
graphed the trajectories for the returns of
the three assets on a monthly basis using
the projected asset returns from the vector
autoregression without the implementation of the vector of shocks. This graph
demonstrates the forecasted monthly
asset returns for each of the three assets
under examination, given that there are
no additional shocks to the VAR model.
The fact that returns on the three assets
all converge over time demonstrates the
effectiveness of the VAR model in projecting forecasted asset returns. This graph
extends the timeline of the forecasted returns beyond the time frame in the table
above, accounting for projected returns
for 120 monthly periods. The graph of
monthly asset returns demonstrates that
even without the introduction of the vector of shocks, all three series of returns
on assets are increasing fairly rapidly
over time. For further analysis of how
asset valuation could fluctuate further,
the model could be run again with the
incorporation of the vector of shocks
based upon the contractionary period beginning in 2004. For the purpose of this
27
study, I will only run the case where the
vector of shocks is held at zero.
After the (r) values were obtained for
the 120 individual month periods to acquire a ten-year forecast for the model
without additional shocks introduced, I
proceeded to utilize these forecasted (r)
values of the individual assets to determine the anticipated projected losses in
the values of short-term Treasury Bills,
long-term Treasury Bills, and mortgagebacked securities. The implied mean asset returns for each of the three asset series can be represented as follows:
m = (II A1)-1 * A0
where the values of m, A1, and A0 are
predicted values.
Discussion
In examining the accumulated returns
on mortgage-backed securities, it seems
that the forecasted accumulated returns
are actually marginally lower when the
interest rate spike is taken into account,
which would make the valuation of MBS
slightly higher than under benchmark
conditions. Thus this particular asset
class would not be negatively affected by
monetary policy tightening by the Fed.
Yellen expresses her concerns

for the agency when she states
that the Federal Reserve has,
to be sure, increased its exposure to interest rate risk by
lengthening the average maturity of its securities holdings. As the economic recovery
strengthens and monetary
policy normalizes, the Federal
Reserves net interest income
will likely decline
Proceeding to short-term Treasury Bills,
it seems that at first glance, there is an
extremely large difference between the
accumulated returns of this asset in the
benchmark state verse the VAR forecasted state. While this large gap between the
VAR model forecast and the benchmark
seems quite significant over the 120 periods, only the first three periods of the
short-term Treasury Bills are relevant in
analyzing the effect an interest rate spike
would have on the valuation of this asset. In looking at the output again with
a focus on the first three months of ac-
28
cumulated asset returns for short-term
Treasury Bills, the gap is significantly
smaller between the benchmark and
VAR forecast. While the VAR forecast is
slightly larger than the benchmark over
the first three month period, signifying a
slight gain in accumulated returns of this
asset (and thus a decrease in valuation)
when interest rates are raised, the differential is not large enough to be of great
significance. In calculating the value loss
of short-term treasuries with more precision, the loss in the value of the threemonth security is .0058%, which is somewhat insignificant. This valuation can be
calculated as follows:
Benchmark: P0 = 1 / [1 + (.001/12) * 1 +
(.001/12) * 1 + .001/12)] = .99975
VAR Forecast: P0 = 1 / [1 + (.001/12) * 1
+ (.001293/12) * 1 + .001402/12)] = .99969
Valuation Loss of Asset: P0 - P0 = .99975
- .99969 = .000058 * 100% = .0058% loss
While it is not the case that an increase
in interest rates would have a significant effect on the accumulated returns
of mortgage-backed securities or shortterm Treasury Bills, this is not the case
for long-term Treasury Bills. In looking
at the accumulated asset returns graph
below, it becomes apparent that over
then ten-year maturity period of a longterm Treasury bill, there is a significant
divergence between the benchmark accumulated returns and the VAR forecast.
This divergence that occurs as the asset
approaches its time to maturity demonstrates that the Fed would undergo significant gains in the accumulated returns
of long-term Treasury Bills when they
raise interest rates. Such large increases
in accumulated returns of long-Term
Treasury Bills would contribute to a significantly lower valuation of this asset
class, and a significant capital loss when
the valuation decrease is brought to scale.
In examining the degree of divergence on
the graph, it seems that the Fed would experience approximately a ten percent loss
in the value of their holdings of long-term
Treasury Bills.

In examining the degree to
which the decrease in valuation will affect the Feds portfolio value on a larger
scale, it is essential to revert back to the
discussion of the how the asset distribution and size of the Feds balance sheet
has changed. Since the vector autoregression does not predict a significant increase
in accumulated reserves for short-term
Treasuries and actually predicts a slight
decrease for mortgage-backed securities
in the set of periods relevant to their re-
Fall 2013
spective valuations, the majority of losses
in reserves to the Feds asset portfolio
will be attributed to the increase in accumulated returns on long-term Treasury Bills. Assuming that approximately
fifty percent of the Feds asset portfolio is
made up of long-term Treasury Bills, and
there is a ten percent decrease in the valuation of this asset as forecasted through
the VAR model, the Fed can anticipate
an expected five percent decline in their
overall reserves. While a five percent loss
in overall reserves may not appear to be
significant at first glance, it is essential
to examine the overall size of the Feds
portfolio holdings to see the scale of a
five percent loss. Given the significant
expansion of the Feds overall asset holdings and balance sheet size over time, the
five percent loss due to their holdings of
long-term Treasury Bills alone could lead
to billions of dollars in losses.
This forecasted decline in overall reserves of the Fed is quite substantial
and could have significant effects on the
Feds decision-making process moving
forward. The fact that the Fed could and
most likely will lose a significant amount
of capital when they raise interest rates
is a clear indicator that they took on a
significant amount of risk through their
innovative use of monetary policy tools
throughout the crisis.
Conclusion
While it is highly likely that the Fed is
going to see valuation decreases in their
asset holdings when they raise interest
rates, it is essential to question whether
or not this is a relevant concern to the
Federal Reserve.
What implications
would a significant decrease in the value
of the Feds assets have on the Fed itself and the financial system as a whole?
Would this undermine the credibility of
the Fed in the publics eyes and shift the
lens of monetary policy going forward? A
group of economists argue that [many]
observers have expressed concern about
the magnitude of balance sheet expansion that the Fed and other central banks
have engaged in, noting the potential
costs in terms of market interference, disruption to the markets upon exit, potential losses effectively resulting in a drain
on the Treasury, and rising inflation expectations, eventually leading to rising
inflation (Greenlaw, David, et al 62). A
decrease in Federal Reserve net income
would leave room open for turmoil in
a variety of areas that could raise larger
economic concerns.
In Greenlaws analysis, the authors consider what would happen if remittances
from the Treasury became negative with
a decrease in the Feds net income into

the negative range (Greenlaw, David,
et al 74). They conclude that under the
Feds new accounting practices adopted
in January 2011, when net income available for remittance to Treasury falls below zero, this does not eat into the Feds
contributions to capital or threaten the
Feds operating expenses. Rather, the
Fed would create new reserves against
an item called the Feds deferred asset
account on the asset side of its balance
sheet (Greenlaw, David, et al 74). While
the Fed seems to be somewhat prepared
for a net income loss, there is still the potential for significant financial turmoil
that could easily result based upon different potential exit strategies that the Fed
may seek to impose.
The fact that the Fed is going to lose
a significant amount of capital when they
raise interest rates is likely to make them
think extremely carefully about what the
best time is to raise rates that would minimize the level of resulting loss. Beyond
a monetary policy shock, [a] fiscal risk
shock occurring within the next five years
would complicate matters greatly for a
Fed that will be in the process of exiting
from its massive balance sheet expansion (Greenlaw, David, et al 81). Thus
when strategizing an exit to the recent
period of monetary easing, the Fed not
only has to consider the implications for
monetary policy, but they also must consider the fiscal situation at the time that
they intend to tighten. With so much at
stake, the Fed has a substantial amount
of factors to consider when making their
upcoming monetary policy decisions. n
Fall 2013
29
Unring the Bell?

The Threat to Deposit Insurance in Cyprus
Rahul Singh
Yale University
When the 2013 Cypriot banking crisis culminated in a proposal to tax insured deposits an unprecedented violation of Eurozone
deposit insurance, policymakers questioned
the sacrosanctity of deposit insurance, its role
in the macroeconomy, and how depositors
across Europe would interpret the unfulfilled
threat.
We attempt to answer these questions
using the popular framework proposed
by Diamond and Dybvig in 1983.1,2 The
Diamond-Dybvig model provides an explanation of how deposit insurance prevents bank runs if all depositors are fully
insured. But when the model is applied
to the Cypriot case, we find that it cannot
capture some essential features: strategic
uncertainty and bank run likelihood. For
these reasons, we call for an extension of
the Diamond-Dybvig model in that direction.
Diamond-Dybvig Model
Liquidity Creation
Banks create liquidity by investing in
an originally illiquid asset and offering
liquid deposits to consumers. We can de1
Diamond, Douglas W., and Philip H. Dybvig. Bank Runs,

Deposit Insurance, and Liquidity. Journal of Political Economy 91, no. 3 (1983): 401-19.
2
Diamond, Douglas W. Banks and Liquidity Creation:
A Simple Exposition of the Diamond-Dybvig Model. Federal Reserve Bank of Richmond Economic Quarterly 93, no.
2 (2007): 189-200.
scribe the original illiquid asset as (r1=1,
fraction of consumers r2 = [(1-
ers to pool the risk of liquidity shocksa

kind of indirect insurance.
Given this set up, a first best Nash equilibrium is possible. At T=1, the bank gives
Bank Run
Even so, there are multiple Nash equilibriums. Most importantly, there is an
equilibrium when both Type 1 and Type
2 consumers decide to withdraw at T=1,
causing a bank run. Suppose that a frac-
r2=R) and the new, more liquid deposit

as (r1>1, r2<R). The bank allows consum-
The Diamond-Dybvig model

provides an explanation of
how deposit insurance prevents bank runs if all depositors are fully insured. But
when the model is applied to
the Cypriot case, we find that
it cannot capture some essential features.
fraction of consumers r1. The remaining unliquidated assets (1-r1) become worth (1-
r1)R
by T=2. At this
point, the bank gives the remaining (1-)
r1)R]/(1-
tion f > of consumers decide to withdraw at T=1. From the perspective of a

consumer at T=0, that fraction must be
predicted; f <. If we substitute this
new element into our previous deriva-
tion, then r2 = [(1- f r1) R]/(1- f ).

Now, consider the decision made by a
Type 2 consumer about when she should
r1 then she should

wait until T=2; but if r2 (f ) r1 then
withdraw. If r2 (f )
she should run to the bank at T=1. Note

that the decision depends wholly on her
expectation about what fraction of consumers will withdraw at T=1. Formally,
the tipping point is when
> (R-r1) /
[r1(R-1)]. The change in expectations

must be large, and its cause must be common knowledge.
Deposit Insurance
A government has the power to elimi-
30
Fall 2013
bank at T=1 if
r 1. 7
tr2(f ) <
Type 2 consumers came

closer to the tipping point
when the return at T=2 became worth some fraction
t of what it had been. Furthermore, because media
outlets broadcasted details of the proposal, consumers revised their expectations upward of how
many would withdraw at
T=1. Thus, we model first
order and second order
effects in this strategic
environment via the introduction of t < 1 and the
nate the risk of a bank run via full deposit

insurance. Because only the government
has taxation authority, it is uniquely suited to offer such insurance. It can pass a
law that commits itself to pay the amount
consumers were promised at T=0. It is a
strictly dominant strategy for a Type 2
insured consumer to not run on the bank
if she is guaranteed r2>r1 in T=2. Full
deposit insurance redesigns the incentive structure for Type 1 and Type 2 consumers such that they always prefer to
act their type; Type 1s withdraw at T=1,
Type 2s withdraw at T=2, and the first
best Nash equilibrium is achieved.
Cyprus
Proposal
The financial sector of Cyprus suffered
greatly from the Greek sovereign debt
restructuring in 2011.3 After Greece, Ireland, Portugal, and Spain, it was the fifth
country to seek financial help from the
so-called troika: the International Monetary Fund, European Commission, and
European Central Bank.4 In accordance
with European Union standards, deposits
< 100,000 were insured by the state and
deposits 100,000 were not insured.5

On March 16, 2013, the troika proposed
a 10 billion bailout to the Cypriot financial system. The plan included an unprecedented measure: a one-off wealth tax of
9.9% on uninsured deposits andmore
radically6.7% on insured deposits.
Depositors would be compensated with
equivalent amounts of shares in those
banks, a kind of forced equity conversion.6
Bank Run
Our model can illustrate the consequent
bank run. We revert to analysis without
deposit insurance because the proposal
rendered all accounts vulnerable. Suppose Cypriot ratification of the proposal
will happen between T=1 and T=2. Consumers who withdraw at T=1 will not
face the one-off wealth tax while consumers who withdraw at T=2 will. This must
modify a Type 2 consumers decision
about when she should withdraw. Let 0
t < 1 be the fraction of deposits left after the troikas tax is imposed. Now, the
Type 2 consumer should wait until T=2 if
endogenous increase in f
, respectively.8 Note that

we obtained these results
in a framework that does
not enjoy the stability afforded by deposit insurance.
Cannot Unring the
Bell
Commitment Undone
While Cypriot citizens
queued at ATMs, Cypriot parliament rejected
the proposal on March
19, 2013.9 In its place, a different agreement was finalized on March 25. In the
words of IMF Managing Director Christine Lagarde, The plan focuses on dealing with the two problem banks and
fully protecting insured deposits in all
banks; the most radical measure was
eliminated.10,11,12 We argue, however, that
7
We assume for simplicity that consumers were certain that
Cypriot parliament would ratify the proposal. More properly,
consumers who withdraw at T=1 do not face the one-off wealth
tax while consumers who withdraw at T=2 might. We can reflect this risk with a weighted average.
8
To simplify our analysis, we only explain the intuition
behind the endogenous increase in fe. In fact, this increase implies a mechanism of signal transmission and belief formation.
Consumers receive signals that suggest the state of the world.
A consumer may expect that different consumers receive different signals. Probably, some other consumers received signals
worse than the one this consumer received. The likelihood that
those consumers who received worse signals will run on the
bank is what influences this consumer to revise up her fe.
9
Reuters. Cyprus Lawmakers Reject Bank Tax; Bailout in
Disarray. March 19, 2013.
10
International Monetary Fund. IMF Statement on Cyprus. News release. March 24, 2013.
3
The Guardian. Cyprus Eurozone Bailout Prompts Anger
as Savers Hand Over Possible 10% Levy. March 16, 2013.
5
Reuters. Cyprus Banks Remain Closed to Avert Run on
Deposits. March 25, 2013.
11
The problem banks to which Lagarde referred are Laiki
and Bank of Cyprus. Under the final agreement, policymakers
split Laiki into a good bank consisting of its insured deposits
and a bad bank consisting of its nonperforming loans and
uninsured deposits. The good bank assets will transfer to Bank
of Cyprus. Shareholders, bond holders, and uninsured depositors of Laiki will take losses as their frozen assets are used to
resolve Laikis debts. Uninsured depositors in Bank of Cyprus
will take forced equity conversions.
4
The New York Times. Cyprus Passes Parts of Bailout Bill,
but Delays Vote on Tax. March 22, 2013.
6
BBC News. Cyprus Bailout: Parliament Postpones Debate. March 17, 2013.
12
Eurogroup. Eurogroup Statement on Cyprus. News release. March 25, 2013.
tr2(f ) r1; but she should run to the
Fall 2013
FIGURE A: Deposit Insurance

demonstrating a legally easy way to destroy the value of deposit insurance set a
dangerous precedent nonetheless.
We model the signalthe ringing of the
bellas the revelation of a new possible
option for the troika at T=0. For simplicity, we consider the troika to be a force
of nature, so honor and violate are not
strategies but rather probabilistic outcomes. When the troika had only one option, its commitment was credible; now
that it has two options, its commitment
is not. There is a small probability that
the troika will violate deposit insurance.
Thus, even if there is full deposit insurance, it is dubious deposit insurance and
consumers may or may not run on the
bank. The possibility of the tax creates depositor uncertainty and in some sense increases the likelihood of bank runa notion that Diamond-Dybvig does not fully
articulate. Figure C presents the scenario
where consumers are uncertain whether
deposit insurance will be honored.
Risk to the Eurozone
The troika is the common arbiter of deposit insurance validity in the Eurozone.
Thus, we can think of Type 2 insured
depositors in not just Cyprus but any
Eurozone country. The new uncertainty
as to whether deposit insurance will be
honored or violated heightens the risk of
bank runs in each country with a weak
banking system. Moreover, the interregional claims that characterize Europes
financial system suggest that financial
crisis in one country of the Eurozone may
be contagious.13 Because of this amplification mechanism, we highlight the significance of our result.
Conclusion
The Diamond-Dybvig model does establish a first best equilibrium and a bank
run equilibrium, thereby laying a theoretical foundation. Yet it cannot describe
how likely a bank run may be, given that
depositors are uncertain whether their in-
FIGURE B: Violated Deposit Insurance
FIGURE C: Dubious Deposit Insurance

surance will be honored. Intuitively, the
troikas threat to Cypriot deposit insurance creates uncertainty and may destabilize other weak banking systems in European essential feature that still needs
to be incorporated into the Diamond-Dybvig model. n
13
Allen, Franklin, and Douglas Gale. Financial Contagion.

The Journal of Political Economy 108, no. 1 (2000): 1-33.
31
Fall 2013
32
Rounding It Out
The Effect of Round Number Bias in U.S. and Chinese Stock Markets
Tiansheng Guo
Princeton University
Introduction
The exploitation of round number
bias is ubiquitous in retail and grocery
markets (grocery retailing). Prices are
most often set just slightly less than a
round number ($9.99, $9.95), exploiting
the irrational way in which our minds
convert numerical symbols to analog
magnitudes for decision-making: prices
just below a round number will be perceived to be a lot smaller than the round
number price due to the change in the
evidence of barriers in gold prices due

to round number bias, with important
effects on the conditional mean and variance. Johnson, Johnson and Shanthikumar (2008) found significant differences
in returns following previous-day closing prices around round numbers in U.S.
stock markets. In China, retail investors

dominate the securities market, and we
expect round number bias to be more
pronounced. These studies suggest investors biases for round numbers are a
source of irrationality and affect the price
levels, which may result in excess returns.
investors biases for round

numbers are a source of irrationality and affect the price
levels, which may result in
excess returns.
leftmost digit (Thomas and Morwitz,
2005). Because this slight drop in price is
perceived by the mind to be proportionally more, price is perceived to be lower
than the value of a product, causing a discontinuity around round number prices.
These round number biases extend
beyond real assets into financial assets.
Aggarwal and Lucey (2005) presented
Figure 1
Fall 2013
Here, we will explore round number

bias by analyzing price clustering around
round numbers and excess returns conditional on previous-day round numbers, for U.S. and China during the time
period 2001-2011. We
compare the degree
of bias between U.S.
and Chinese large-cap
and small-cap stocks,
which few previous
studies have done,
especially after the
decimalization of U.S.
stock market in 2001.
In order to make the
comparison valid, we
will choose comparable US and Chinese
stocks and control
for varying amounts
of liquidity as well as
price levels in the different data sets that
may affect observed
bias.
The results of this
paper is interesting
both practically and
theoretically: a significant finding for an
uneven distribution
of price levels (e.g.
prices end in round
numbers more often)
would challenge the
price equals value
sense of market ef-
33
ficiency because there is no reason that

value should end in certain digits more
often than others; even if the effect of
round number bias on returns is too
small to present arbitrage opportunities,
Figure 2
the findings can still help the precisely

time high-frequency trades.
Literature Review
Round number bias is an innate human
cognitive bias, and is present in prices
Fall 2013
34
Figure 3
and other metrics. Pope and Simonsohn
(2010) found that in baseball, the proportion of batters who hit . 300 (1.4%) was
four times greater than those who hit
.299 (0.38%), and there were also more
instance of .301 than of .298. Thomas and
Morwitz (2005) found that nine-ending
prices affect perception when the leftmost digit changes, and that these effects
are not limited to certain types of prices
or products. In financial markets, if the
same preferences hold for certain numbers, we should see certain price levels
appear in trades more frequently than
numbers that have no preferences, and
perhaps even excess returns. In a 2003
paper more germane to our question,
Sonnemans examines the Ducth stock
exchange from 1990-2001 and concludes
that price levels cluster around round
numbers, and round numbers act as price
barriers. Finally, Johnson, Johnson and
Shanthikumar (2008) found that investors were trading differently depending
on whether closing prices were marginally below or above a round number.
In light of these encouraging findings
from past studies, we analyze how the effect of the bias differs in two drastically
different countries, U.S. and China. Although round number bias is caused by
an innate cognitive flaw that is present in
societies using Arabic numerals, U.S. and
China have very different sets of investors, laws, financial systems and culture,
all of which can influence the degree of
round number bias present in their respective stock markets.
Data
To analyze price clustering around
round numbers and next day returns
conditional on round number prices, we
will study daily closing prices and daily
returns with cash dividend reinvested,
of a set of 36 U.S. stocks traded on NYSE
and 36 Chinese stocks traded on the SSE
(A shares only), for the decade 6/1/2001 to
5/31/2011, which are all found on Wharton Research Data Services. The starting
date of 6/1/2001 is after the complete deci-
Figure 4
malization of the U.S. stock market. The

data sets exclude financial stock, are chosen randomly, and encompass a variety
of industries.
Among the 36 U.S. and 36 Chinese
stocks, half are large-cap stocks and half
are small-cap stocks. The 18 U.S. large
cap stocks are drawn from the 50 largest U.S. stocks, and the 18 Chinese large
cap stocks are drawn from the 50 largest
on the SSE. The 18 U.S. small cap stocks
are drawn from the market cap range
500M-800M, and the 18 Chinese small cap
stocks are drawn from stocks in the SSE
SmallCap Index (China Securities Index).
All closing prices that are 1.00 or below
were deleted to prevent cases where the
leading digits are also the ending digits,
to avoid complications with Benfords
Law, which states that leading digits in
naturally occurring data is not uniform.
Stocks go through mergers and acquisitions and become listed under another
ticker, yielding extra data, or as with
small stocks and Chinese stocks, data for
earlier time periods were not available
because those companies were not publicly traded as early as 2001. Missing or
extra data has little impact as long as all
observations belong in the correct category (US Large, Chinese small, etc.).
The reason for using price levels as opposed to other measures such as P/E, P/B
is that prices levels are the final numbers
seen when executing trades, although P/E
or P/B may have just as much evidence
for numerical pricing biases, since they
Fall 2013
are especially susceptible to security analysts rounding of forecasts or investors
targets. We use daily closing prices because they attract more investor attention
than a random price level during the day,
and can linger in the minds of investors
after a day of trading, capturing much of
the behavioral biases.
The reasons for drawing data from
U.S. or China and large cap or small
cap, are that there is plentiful data
from the two countries, and the financial markets of these two countries are
so different in terms of listed companies,
investors, and regulations, that many extensions and further studies can be done
based on this finding; we expect different
sets of investors to be trading in large cap
and small cap stocks, and different number of analysts covering the stocks, so we
expect the magnitude of round number
biases to differ across market caps and
countries. For Chinese stocks, we draw
from A shares listed on the SSE because
it has a large market capitalization and is
not open to foreign investors, unlike the
HKSE.
We choose the period June 2001 to June
2011 because the NYSE reported prices in
fractions (1/16) before 2001. The benefit of
this decade is that we see a rise out of the
dot-com bubble and another rise and fall
in prices from the Great Recession, which
would allow a larger range of price levels
and potential for certain prices to cluster.
This decade is interesting to analyze because the advent of online trading allows
many more unsophisticated traders to
participate in the stock market, but at the
same time, institutional investors become
more sophisticated.
Methodology
The paper will use a two-part analysis. The first part will analyze U.S. and
Chinese stock data for price clustering
around round numbers. The second part
will analyze next day returns conditioning on round number closing price.
Round number will be defined as prices
ending in one round decimal ($XY.Z0) or
two round decimals ($XY.00).
Price clustering is defined as prices lev-
35
Figure 5
els at which proportionally more trades
occur, and abnormal next day returns
as a significant regression coefficient on
a variable measuring round number.
If there were no price clustering, then
the decimals of stock prices should be
distributed uniformly from .00 to .99. If
there were no abnormal returns, then a
previous day closing price that ended in
a round number would have no significant explanatory power in the next day
returns.
The price clustering analysis will be
graphically presented in a frequency
chart, tallying the occurrences of round
number closing price, categorized by
country (U.S. vs. China) and size (large
cap vs. small cap), followed by a linear
regression (with binary dependent variable). The next day returns analysis will
be conducted with linear regressions, as
opposed to probit, for easier interpretation of the coefficients. It uses ifone as a
binary variable for the last decimal being
a round number, iftwo for both decimals, China for Chinese firms, and big
for large cap stocks. The two binary vari-
Table 1
ables ifone and iftwo will be interacted

with different combinations of the other
variables.
This paper makes a distinction between manifested and inherent bias. Due
to fundamental differences in market
conditions (liquidity, price levels) between China and the United States, the
observed round number bias may be an
amplified measure of investors inherent
bias. A second-round analysis takes this
into account and includes measures of liquidity and price levels to take out their
effects from price clustering and next day
returns. Due to inaccessibility of big-ask
spread data in China, we use volume as
a crude measure of liquidity for Chinese
stocks that may not be valid when comparing China and U.S., but can be used
for internal comparisons..
Figures 1-4 tally daily closing prices by
last ending-decimal only, compared to
a line of average representing the expected number of observations assuming
a uniform distribution of price levels.
In all four data sets, there is a robust
and persistent clustering around prices of
the form WX.Y0 and WX.Y5. Clustering
is much stronger in U.S. data sets than in
Chinese data sets, and slightly stronger in
small cap stocks than in large cap stocks.
For U.S. data sets, clustering is especially
pronounced in prices that end in 5s, or
WX.Y5, much more so than Chinese data
sets.
Next, we zoom in the same data sets
by tallying closing prices by the last two
ending-decimals, compared to a line rep-
36
Fall 2013
Table 2
resenting expected frequency given a uniform distribution. The findings of two
decimals analysis support that of one
decimal: round number bias in U.S. data
is manifested much more than in Chinese
data, and for Chinese data, bias in small
cap stocks is much more than in large
cap stocks. Most of the prices ending in
a 0 as the last decimal have another 0
or a 5 as the decimal before it, so that
much of the occurrences of WX.Y0 are
accounted for by WX.00 and WX.50. In
the U.S., round number bias is so strong
that prices ending in .00 occurred twice
as often as in a uniform distribution. Prices ending in .X0 (.10, .20, .30 etc.), and
especially .50 all occurred more than
the uniform distribution in both U.S. and
China, and additionally in U.S. only, all
prices ending in .X5 occurred more than
uniform.
Note that Chinese investors preferred
prices ending in .X0 and not .X5, while
U.S. investors strongly preferred both.
Additionally, in both U.S. large and small
caps, .25 and .75 had the greatest occurrences of all prices ending in .X5,
and are the only two price endings that
are greater than their round-number
counterparts, .20 and .70. This preference for quarter prices in the U.S. and
not China can be explained by the pervasive use of the Quarter coin as a currency, which is a foreign concept to the
Chinese. Frequent use of the Quarter
among the U.S. population strengthens
their familiarity and affinity for the .25
values. Another explanation for the clustering around quarter values is the lingering effects of the time period prior to
decimalization of stock prices, which occurred right before our sample period, so
U.S. investors are used to trading in 2/8,
12/16.
It is also interesting to see that Chinese
data, especially for small caps, had a preference for .99 and .98 and .88 that is
not seen at all in U.S. data. In Chinese
small cap data in particular, .88 had
more occurrences than any other non-
round number (except .99 and .98). This

can be attributed to 8 as a lucky number in the Chinese culture, with 88 being
even luckier; however, its unlucky counterpart 4 did not show any difference
from the average (investors did not avoid
trading around that number). The Table
1 summarizes regression results. For example, in Chinese Big stocks, there is
a 0.11195 probability of seeing the last
decimal as round, and 0.01576 of seeing
both as round.
Discussion Simple Price Clustering
The manifested bias in the data is statistically significant, and we can rank the
strength of bias (from weak to strong):
Chinese large cap, Chinese small cap,
U.S. large cap, and U.S. small cap. The
result of this initial survey is not surprising, and the significantly more clustering
seen in U.S. data does not prove that U.S.
investors are inherently more biased than
Chinese investors. The probability of seeing a transaction on a round number is
tightly tied to the bid-ask spread: if the
bid-ask spread is wide, it has a greater
chance of including a round number,
giving the same investor more chances
of choosing a round price in the neighborhood of prices. Also, pure frequency
of seeing a round number does not accurately measure degree of bias. If the
price level of a share is higher, a one-cent
difference in price is a smaller fraction of
total value traded, so that a biased trader
is penalized less for his round number
bias. Therefore, greater clustering in U.S.
data sets may be explained by 1) high
bid-ask spread, due to low liquidity, and
2) high nominal price per share, meaning
U.S. investors incur less cost for being biased. This means that manifested bias
does not translate to inherent bias of
investors. The next section shows price
clustering analysis adjusting for liquidity and price levels, to analyze inherent
bias of investors.
Fig- Results Price Clustering Adjusted for Liquidity and Price
Fall 2013
Table 3
Levels
First, we show that liquidity and price
level effects can confound our price clustering analysis. More liquidity should
mean less round number bias, while
higher price levels should allow for more
The weighted variables reflect degree
bias. If data sets with lower liquidity
of bias more accurately: for smaller price
and higher price levels happen to have a
levels, weighted variables are greater,
higher level of round number bias, then
representing the higher percentage costs
bias can actually be driven by liquidity
that investors incur for being biased by
and price level effects, and not inherent
one-cent.
round number bias of investors. If there

Table 3 presents a measure of
are confounding effects, we need to adinherent bias in each of the four data
just for liquidity and price level. For insets:. The effects can be seen as a rescaled
stance, in Table 2 we demonstrate an inmeasure of degree of bias, with higher
terestingrelationship between US bid-ask
meaning more bias, though it is hard to
spreads and round number closing prices
interpret. The interpretation is as folfrom 2001-2011:
lows: given the same volume, being a
Consequently, to adjust for liquidity
U.S. small-cap stock (weightedifone =
and price level effects, we add volume
1.86229, weightediftwo = 0.26531) on
into the regression, and use frequency
average increases the chance of seeing
weighted by price level. The weighted
the last one (or two) decimals as round,
frequency variables weightedifone and
as a one-cent fraction of their closing
weightediftwo are calculated using the
price, by 1.86229% (or 0.26531%). For
following:
example, (holding constant volume), a
37
U.S. small stock trading around $23 has
an increased 10.60% chance of seeing a
first decimal round than if it were a U.S.
big stock:
weightedifone=(100*ifone)/
Pricelevel,
(1.86229-1.40144)=(100*ifo
ne)/23, ifone= .10600.
But if it were trading around $4, the
difference would be 1.8434% for a small
stock over a big stock. We also notice
that volume has a negative coefficient as
expected, since it reduces the amount of
bias through a tighter bid-ask spread. An
increase in a million shares per firm-day
on average reduces its weightedifone
and weightediftwo by 0.01464% and
0.00125%. This is a substantial impact
given that average volume of the four
data sets vary widely.
After controlling for liquidity and price
levels, Figure 16 shows that the ranking of degree of bias has changed: (from
weakest to strongest) U.S. large-cap, Chinese small-cap, Chinese large-cap, and
U.S. small-cap. The result suggest that in
the U.S., small-cap stocks exhibit more
bias than large-caps, but in China, it is
the reverse. This apparent contradiction
is explored in the later Discussion section.
Because volume may not have an equal
impact across U.S. and China, for the
U.S., we can use bid-ask spread data,
which directly measures the window
of prices surrounding a possible round
number. The variable usbidaskfrac and
its powers are calculated as:
Regression (2) in Table 4 takes into account that usbidaskfrac may have a nonlinear effect on degree of round number
bias. It also includes interaction variables
that accounts for the possibility that bidask window may not have an equal impact on U.S. large-caps and small-caps.
The results here support the previous
results that were found using volume as
a proxy for liquidity. The negative coefficient on big means that U.S. big stocks
exhibit less bias holding constant price
level and bid-ask ratio. Note that the coefficients on usbidaskfrac is positive as
expected, so that higher spread induces
more bias. However, the coefficients on
the interaction term bigxusbidask is
negative, so that higher bid-ask spread
induces bias for small stocks more so
than for big stocks, possibly due to the
already narrow spread in big stocks. All
this is consistent for prices that end in
two round decimals or just one.
In conclusion, U.S small-cap investors
seem to be inherently more biased to-
Figure 7
Fall 2013
38
Table 4
ward round numbers.
Discussion Price Clustering Adjusted for Liquidity and Price Levels
It seems contradictory that in the U.S.,
smaller stocks exhibit more bias, while
in China, smaller stocks exhibit less bias.
This finding can be explained by the fact
that investors of large-caps and smallcaps are different in U.S. and China, in
characteristics and motives. Kumar (2009)
shows that in U.S., individual investors
with lower income and less education
tend to gamble in small and local stocks,
giving small-cap stocks more speculative
qualities and more room for bias. Also
small-cap stocks are more likely to sellout or buy-in completely; their investors
are more likely to take a new position
or exit entirely, while turnover in largecaps are driven by existing holders who
are merely trading around their positions (Cevik, Thomson Reuters). U.S.
large-caps have more analyst coverage
(Bhushan, 1989) and more information
available than small-caps, with prices adjusting faster to new information (Hong,
Lim, Stein 2000), reducing round number bias. On the other hand, Hong, Jiang,
Zhao (2012) find that in China, small local stocks are traded more by richer, more
educated households in developed areas
for status reasons (Keeping up with the
Wangs). These investors may actually be
more sophisticated than investors who
trade large-caps, resulting in less bias in
Chinese small-caps.
Despite accounting for liquidity and
price level effects, it is surprising to see
how overall U.S. data would still be
as biased as Chinese data, even when
there should be more noise trading in

China. It is very possible that because
of different market conditions and laws
around trading, volume in U.S. has different impact than volume in China, and
that volume may not be a good control
for liquidity effect in round number bias
(see Discussion- Abnormal Returns).
The most important explanation, however, is probably the time period we chose
Table 5
to examine. Most of clustering in U.S.

occurred earlier in the decade, and decreased dramatically over the years, with
the final few years exhibiting less bias
than in Chinese data. This can be due to
the narrowing bid-ask spread, or due to
investors slowly adjusting to the recent
decimal system for trading stocks, which
never affected Chinese investors. Further
studies can be done with bid-ask spread
data for this data set, even using future
data to avoid the lingering effects of decimalization.
Abnormal Returns
Like price clustering, abnormal returns
based on round numbers is complicated
due to the positive correlation between
bid-ask spread and probability of trading
on a round number: given that investors
gravitate toward round number prices,
having a larger bid-ask window (more
round numbers to choose from) will allow
for more biases. Like in the previous section, we use volumeCHN (measured in
millions of shares) as a measure of liquidity in Chinese stocks due to the inaccessibility of bid-ask spreads. Because daily
rate of return is small, we scale up to percentage return, ret =100 * RET , and then
take its next day lagged returns. Again,
we use weighted frequency, which is
frequency of seeing one or two round
decimals weighted by the inverse of their
closing price. Variables weightedifone
Fall 2013
39
Figure 8
and weightediftwo are meant to capture
degree of bias net of price levels, so that
the greater the variables, the more serious the biases.
The variables weightedifoneCHN and
weightediftwoCHN, are not statistically
significant in any of the regressions, and
has little explanatory power on next day
returns. Volume surprisingly has a positive effect on next day returns, and does
not seem to be capturing liquidity premium (see later Discussion).
For U.S. data sets, we use bid-ask fraction instead of volume, with next-day returns in percentages. Regression (2) in the
Table 6 illustrates that round number bias
variables have significant effects on next
day returns. For small-caps, more bias (in
both one and two decimals) means lower
next day returns, with two-decimals having even more effect. For large-caps, more
bias in one-decimal similarly means lower returns. However, for large-caps, the
effect of having both decimals as round
is surprisingly large and positive, strong
enough to overwhelm the usual negative
effect from round number bias, generating higher next day returns.
Due to weighing of the variables, coefficients may be hard to interpret. For example, holding constant bid-ask fraction,
a small-cap stock trading at $23.40 (only

last decimal as round) is expected to have
a -0.03487% lower next day return than if
it were not round. weightedifoneUS=(100
*ifone)/23.40, retUS= -0.00816weighted
ifoneUS,retUS= -0.03487%.
But if it were a large-cap stock: retUS=.00816weightedifoneUS-.01467weight
ediftwoUS+.03445weightediftwoUSb
ig=.01452%
We also observe that next day returns
are increasing in bid-ask spread fraction, so that our bid-ask measure have
captured liquidity premium. This was
the opposite when regressing Chinese
returns using volume as a liquidity measure, where more volume resulted in higher next day returns (see Discussion).
Discussion Abnormal Returns
In China, round number bias seemed
to have no explanatory power in next
day returns in our regression. This could
be explained by the use of volume, instead of bid-ask spreads, as an indicator
of liquidity. According to Mei, Scheinkman, and Xiong (2009), trading volume
of Chinese shares is not closely related
to liquidity. In our regression, volume
had positive and significant explanatory
power on next day returns, which failed
to take into account liquidity effect in
our data. Our findings on volume are

also inconsistent with previous studies.
Naughton, Truong, and Veeraraghavan
(2007) found no strong link between volume and returns, and Lee and Rui (2000)
found that trading volume does not
Granger-cause stock market returns on
any of Chinas four stock exchanges. This
analysis can be repeated in the future by
someone with access to data on Chinese
bid-ask spread as a measure of liquidity.
In the U.S., we saw negative excess
returns for round numbers, except for
large-cap stocks ending in two round decimals, for which it was positive. Negative
returns in U.S. small-caps is supported by
past literature. Wang (2011) finds psychological bias toward round numbers, and
finds positive return for prices ending in
$X.01, and negative return for prices just
below. It is also supported by Johnson,
Johnson, and Shanthikumar (2008), who
find returns following closing prices just
above a round number are significantly
higher than returns following prices just
below.
The higher return in large-caps can be
explained by disproportionate amount of
media attention that the big stocks attract
when surpassing an important barrier,
usually a round number, driving up senti-
40
Fall 2013
Table 6
ment. Donaldson and Kim (1993) found
support and resistance levels in round
numbers in DJIA, which is only an index
that is arbitrarily scaled and round numbers do not say much about fundamentals. They also found that there were no
support and resistance levels in less popular indices. Future studies can look into
this by taking more lagged returns- for
example, next day returns may be higher,
but excess returns two days or a week
later may be negative.
Conclusion
Although many previous studies have
found positive results with different data
sets and older time periods, we expected
to find similar robustness in clustering
in newer data. Yet, we were uncertain
whether the effect would be weaker or
greater. The increase in sophistication
and narrowing of bid-ask spread should
give investors less chances to manifest
round number bias, but may be countered by increase in noise trader participation.
Indeed, price clustering effect was
significant and robust, across China and
U.S., large and small caps. However, seeing how U.S. data clustered significantly
more than Chinese data indicated the
possibility that U.S. investors are inherently more biased. After observing each
year individually in the 2001-2011 data,
we saw that round number clustering

in the U.S. has decreased substantially
as the bid-ask spread has narrowed, to
match that of the Chinese. After controlling for liquidity and price level effects
that have amplified bias for U.S. data, we
see that the degree of round number bias
is similar for U.S. and China. However, a
contradictory finding is that there is more
round number clustering for small-caps
in the U.S., but large-caps in China. This
suggests that small-cap traders in China
may be more sophisticated than large-cap
traders, but small-cap traders in U.S. may
be more speculative than large-cap traders.
As for excess returns, our findings were
inconclusive for Chinese stocks, but for
U.S. stocks, findings were consistent with
past literature. Generally, small-cap and
large-cap stocks showed negative nextday excess return around round numbers, with the exception of large-caps
ending in two round decimals, which
was positive. This can justify short-term
momentum strategies for U.S. large-caps
when they hit significant barriers. The
positive excess return can be explained
by the disproportionate amount of media
attention it receives and the resulting sentiment.
The findings of this paper open up interesting topics for future research. We
have only looked at excess returns for

numbers ending in 0s, and future studies can expand the definition of round
number to include $X.50 or $X.25, and
even X.88 for China, which showed clustering in our analysis. It would be more
interesting to extend past the decimal
point, for prices in $X00.00, or X88.88 for
China. At the same time, analysis can be
done with leading digits to see which attracts more bias. Given that clustering
in U.S. has decreased dramatically after
the decimalization of stock markets, it
would be interesting to see whether it is
due to increased sophistication of institutional traders, due to decreased bid-ask
spread due to increased liquidity, or due
to steady adjustment to the new decimal
system. n
Fall 2013
41
Mixed Messages
How Firms Should Utilize Private Information
Jian Jiao
University of Pennsylvania
Introduction
The strategic interaction between firms
and consumers can be considered a signaling game, in which consumers are not
completely aware of the quality of the
goods or services they get from a firm. It
is worthwhile to study the conditions under which firms have enough incentive to
fully reveal private information.
The firm has private information about the true quality

of the product, and the price
level at which it starts to
sell the product is a signal to
consumers.
The combination of signaling and the
real option framework is appropriate for
most business situations. The concept
behind the real option approach is that
a firms investment in a project can be
characterized as an American call option,
where the firm has the right to buy a share
of stock at a pre-specified price. The best
time to invest in the project is comparable
to the optimal time to exercise the option.

Analyzing an asymmetric information
game using the real option approach allows us to capture firms behavior under
uncertainty and understand the economic incentives behind their strategies.
In this paper, I examine the effect of
private information and market volatility
on the firms optimal timing decision in
the nondurable goods market. Consider
a firm that is able to produce apple juice
and then sell it in the market. The price
of apple juice is a stochastic factor that
changes exogenously, and the firms objective is to maximize profit by entering
the market at the first time the random
price reaches a certain level. The firm has
private information about the true quality of the product, and the price level at
which it starts to sell the product is a signal to consumers. This paper intends to
provide a theoretical analysis of and understand the economic intuition behind
different equilibriums and market conditions. It also serves as a guide to help
firms behave properly under different
scenarios.
Literature Review
The investment and financing decisions
for companies under asymmetric information have been discussed frequently in
the literature. Furthermore, the literature
has increasingly emphasized the real option and its application in financial economics. The real option approach states
that having an opportunity to take on
an investment project is similar to holding a perpetual American call option.
Moreover, it has been demonstrated that
the timing of investment is equivalent to
the timing of exercise. Both McDonald
and Siegel and Dixit and Pindyck show
the optimal timing of an irreversible investment project when future cash flows
and investment cost follow geometric
Brownian motion (McDonald & Siegel,
Dixit & Pindyck). Under the real option
setup, the decision no longer depends directly on comparing the present value of
the benefits with the present value of the
total cost. Rather, one of the models suggests that it is optimal to undertake the
project when the present value of the
benefits from a project is double the investment cost (McDonald & Siegel). Research done by McDonald and Siegel and
by Dixit and Pindyck solves the optimal
timing quantitatively under both the riskneutral and risk-averse cases. However,
they do not pursue any signaling game in
which firms have various options regarding the timing decision.
Grenadier and Wang argue that both
the standard NPV rule and the real op-
42
tion rule described above fail to take
into account the presence of information
asymmetries. They introduce the idea
of optimal contracting into real option
studies; in their model, the firms owner
and manager are two separated interest groups. The manager has a contract
with the owner, under which he provides
costly effort when exercising the option.
He also has private information about the
true value of the underlying project. The
conclusion differs greatly from the case
in which there is a single agent. Since
the manager only receives part of the options payoff, he will exercise the option
later than earlier models suggest. My research differs from that of Grenadier and
Wang since I model the companys interactions with outside buyers rather than
the interaction between two parties inside the company. Even so, their research
provides solid background for the interaction between the information provider
and the firm.
Compared to Morellec and Schurhoff,
Grenadier and Malenko provide a brand
new perspective for the real option signaling game. In their model, the firm has
private information on the true value of
the project while outsiders have to interpret the firms true type. The company
cares about outsiders beliefs and will
take them into account when making
investment decisions. The whole model
characterizes the optimal timing of the
exercise under both perfect information
and asymmetric information. Using the
standard real option framework depicted
by Dixit and Pindyck, the paper suggests
that the optimal timing depends on the
sign of a belief function, which quantifies the firms concern about outsiders
belief of its type.
This paper is the benchmark of my research; however, the outsiders in my
model are a group of consumers, who
make decisions after observing the firms
behavior. Grenadier first does such an
analysis in his paper Information Revelation Through Option Exercise, where he
introduces the component that directly
affects the stochastically evolved value,
which is also an important factor in my
model. The major difference is that his
paper characterizes the strategic interactions between N > 2 firms, where the
signal sent by each individual agent distorts other agents exercise triggers. In
contrast, my research designs a scenario
where only one firm and one group of
consumers exist. This distinction sheds
light on the essence of the real option approach to investment and other corporate
finance decisions in financial economics.
Fall 2013
The Model Setup
A simple market is designed in which
there exists one firm and a number of
consumers. The firm possesses an investment opportunity to obtain some non-
Under the real option setup,

the decision no longer depends directly on comparing
the present value of the benefits with the present value of
the total cost. Rather, one of
the models suggests that it is
optimal to undertake the project when the present value
of the benefits from a project
is double the investment cost
durable goods at certain cost and then
sell them in the market. The firm could
be either low type or high type, meaning
that the quality of their product is either
low or high. The companys type is denoted by , which is privately known to
the firm. After observing the signal sent
by the company, consumers update their
belief about the true quality of the product. Their belief is denoted by
. The
whole game is broken down into the following steps:
The nature decides which type the company is, with probability distribution:
[0.5, 0.5]. This means the company has
equal chance of being either type.
The company learns its type. It will
then enter the market and begin to sell
the product at some price level P*. This
action is defined as exercising the option..
Consumers are also able to observe the
market price P*, which serves as a signal.
Immediately afterwards, they update
their belief, and decide how many units
to purchase.
To simplify the model, the company is
assumed to receive lump-sum revenue.
The game ends.
At any time t, if the nondurable goods
have not become spoiled yet and the
company chooses to exercise the option,
it will get the profit:
is the quantity demanded by conColumbia Economics Review
sumers, C denotes the per-unit cost, and

is a zero-mean noise term that reflects
the uncertainty over the value of the project (Grenadier and Malenko 2011). The
following assumptions are also made:
It is reasonable to assume that QH > QL
and CH > CL. Obviously, consumers prefer
a high quality product to a low quality
one, but the production of a higher quality product is usually more costly. This
investment opportunity is regarded as a
perpetual American call option. In this
model, the firm will face a random price
that evolves based on geometric Brownian motion:
(2)
where
represents the deterministic
trend of this stochastic process, denotes
the market volatility, and is the increment of a standard Brownian motion
over time. It is assumed that and are
constants throughout the game and that
the evolution of price is publicly observable.
Since the company invests in nondurable goods, the spoil rate of such goods
is denoted:
Since time is a continuous variable, the

spoil probability is assumed to follow
an exponential distribution with parameter with cumulative density function
. As a result, the firms
objective is to maximize the expected present value of the project:
(3)
In equation (3), E denotes expectation and T represents the unknown future time of exercise. The maximization
of profit is subject to equation (2) for P,
so the optimal strategy for the firm is to
exercise the option when P crosses some
level P*. Furthermore, must be less than
. Otherwise the firm will choose to wait
forever and never invest. It is assumed
that
.
The Perfect Information Case
Now the firms objective is clear and
the goal is to solve equation (3). Note
that under perfect information,
. Methods for solving the maximization
problem are taken from (Shreve, 2010).
In this case, the only benefit from hold-
Fall 2013
ing the perpetual American call option is

the positive trend of the stochastic price.
Meanwhile, if the firm chooses to wait for
longer time, the risk of losing the option
or of capital depreciation increases dramatically.
Equation (2) leads to the following
equation, presenting the relationship between the current price and any future
price:
(4)
So that,
(5)
Let T* denote the first time X(t) hits certain level L:
Then by the Laplace transform of drifted Brownian motion, Theorem 8.3.2 in
(Shreve, 2010):
(6)
Note that T* is interpreted to be infinite
if X(t) never hits L.
Now return to the maximization problem. The firms objective is to choose the
optimal investment trigger P*. As soon
as the stochastic market price hits P*, the
firm will exercise the option. Let P0 de-
With private information, the

company might fool consumers by exercising at a different
output price
note the current price (assumed to be a
nonzero, small value1). As a result, equation (3) becomes:
1
This means the firm will not exercise the option at t =
0, regardless of its type.
43
(7)
where,
(8)
Note that is the positive root of the
quadratic equation:
(9)
By the pre-specified requirement on
parameters in Part II, the positive root of
this equation is always greater than 1.
Now the maximization problem in
the perfect information case becomes
straightforward. Taking the FOC of (P*)
Fall 2013
44
in equation (7) with respect to P* gives:
yields:
company, or
(10)
Meanwhile, the following conditions
must be satisfied in order to obtain an optimal investment trigger,
(15)
and,
The first condition implies that the

initial market price of the product is not
zero. Equation (2) shows that once the
price hits zero, it will stay there forever. The second and third conditions put
constraints on both quantity and cost. It
is obvious that the number of units sold
and the cost generated are both positive.
Based on the property of discussed before, all these conditions are satisfied.
These conditions lead us to the solution
of optimality. By solving equation (10),
the following solution is obtained:
(16)
Therefore, as quality increases, will
decrease, causing a decrease in and a
higher critical investment trigger. Meanwhile, CH > CL because the per-unit cost
of producing these nondurable goods
should increase along with quality improvement. In other words, the firm
should spend more on each unit of the
product it invests if the product is of
higher quality.
Other comparative statics cases are also
interesting to study, as in the following
set of equations:

(11)
Note that the optimal investment trigger depends only on the companys true
type and the per-unit production cost. It
is not affected by the interaction between
the firm and consumers, so this optimal
trigger can perfectly reveal the companys type. Plug this result back into equation (7) gives the expected present value
of profit,
(12)
Now let us compare the optimal solution for high type and low type respectively under perfect information:
(17)
(18)
Remember in section II, it is assumed
that
.
Therefore,
(19)
Proposition 3: The steeper the upward
trend of the stochastic price, the higher
the optimal investment trigger.
Proposition 4: The more volatile the
stochastic price, the higher the optimal
investment trigger.
The intuition behind proposition 2 is
quite clear. The high type company must
pay a larger amount of money to obtain
this call option, so it would like to wait for
longer time, expecting a higher market
price to recover its cost. Meanwhile, its
lower spoil/depreciation rate gives it the
opportunity to do so. Proposition 3 implies that if the price grows more rapidly
over time, company can obtain a higher
price without waiting for too long and
letting their goods get exposed to the risk
of being spoiled. Furthermore, proposition 4 suggests that the firm is not against
high volatility because larger variance in
price gives the firm opportunity to reach
a higher price level in advance. Similar to
proposition 3, it also does not necessarily
request the firm to wait for longer period.
The classic NPV rule no longer applies
in the real option framework. By the NPV
rule, the firm should investment as long
as > 0, which implies P (t) > C. However, in the real option framework, exercising the option in advance incurs a loss
in opportunity benefit. These benefits
stem from the uncertainty of the market
price. By waiting for a shorter period of
time, the firm also sacrifices the possibility of obtaining a higher market price.
The Asymmetric Information Case
With private information, the company
might fool consumers by exercising at a
different output price. In particular, a low
type company could pretend to be a high
type company if it exercises the option
at higher price. The firms objective is to
maximize:
in which,
(13)
(14)
So which type of company has a higher
investment trigger under perfect information? As for the coefficient , differentiating equation (8) with respect to
Together with equation (16), it is now

safe to conclude the following propositions.
Proposition 1: In the perfect information case, the firm exercises the option as
soon as the stochastic price crosses the
critical level P*, as shown in equation (13)
and (14).
Proposition 2: High type company has
higher investment trigger than low type
(20)
and B(P*) is the outsiders belief funtion.
Separating Equilibrium
In a separating Perfect Bayesian Equilibrium (PBE), each type of company
uses a strategy that fully reveals its own
type. It is reasonable to assume that the
Fall 2013
high type company distinguishes itself
from the low type company by waiting
longer and exercises the option at PH*.
Meanwhile, the low type firm does not
have enough of an incentive to mimic the
high type in case the nondurable goods
in which it considers investing spoil or
depreciate too much. It will exercise the
option at PL*. Therefore, by Bayes rule,
the consumers belief is derived:
(22)
Equation (22) specifies the condition
under which neither type has enough
incentive to deviate from the original
optimal investment trigger. To further
demonstrate the separating equilibrium
constraint, the numerical example is provided here. Suppose there is a corn market in which the stochastic price in equation (2) has parameter.
As a result, we have .
With these values, inequality (22) becomes:
And similarly,
What if consumers observe some price

between PH*and PL*? Since such strategy
is not specified in the separating equilibrium, Bayes rule no longer applies.
The off-equilibrium belief is usually arbitrary. In this game, however, as long
as consumers observe some price below
PH*, they will regard the firm as low type.
This assumption is consistent with the
logic behind the separating equilibrium.
Consumers believe that high quality firm
will not exercise the option at price lower
than PH*. Otherwise, the high quality firm
will not be able to fully maximize its profit. Therefore, the belief function is summarized as the following:
(21)
Consumers are willing to buy QH units
of product if the price they observe corresponds to the high type optimal trigger.
Any lower trigger will be considered as
low type.
Constraints for obtaining separating
equilibria are of the following:
Use the result obtained in equation (12),
(23)
Both conditions put strict constraints
on the relationship between the quantities demanded ratio and the per-unit production cost. It has been assumed in the
model that low type company sells less
than high type company, so the inequality above suggests that the difference in
quantities demanded between low type
and high type firm should not be too
large. Otherwise, the first condition in
(22) fails and low type firm will try to
mimic the high type by exercising the option later. In fact, if CL is normalized to
be 1, the relationship between quantities
ratio and per-unit cost ratio can be plotted (fig. 1).
For any given value of , as long as
ies in the region between two bounds, we
will be able to obtain a separating equilibrium. If
is too low, the low type
firm will benefit more from waiting because it will be able to sell a much higher
quantity than before if it imitates the high
quality firm. Note that the upper bound
is always 1. This is because
is
the assumption of our model. Furthermore, the upper bound shows that the
high quality firm will never have incentive to deviate from PH*. because for them
high trigger strategy strictly dominates
the low trigger strategy2.
Conclusion
In this paper, the real option approach
2
Unlike low type firm that can sell more if deviate,
high quality firm does not enjoy such advantage. It will
stick to the original optimal trigger.
45
and the signaling game framework are
combined to study how uncertainty affects firms behavior under perfect and
asymmetric information cases. The geometric Brownian progression of price is
implemented throughout the paper, and
it is particularly popular for nondurable goods that are frequently traded in
the market, such as corn, wheat, etc. As
hypothesized in section IV, uncertainty
is seen to give firms the opportunity to
explore higher prices and allows them
to make decisions later. It is also discovered that under perfect information, high
type firms wait longer, primarily because
of the lower risk of losing the option associating with waiting and the firms incentive to obtain higher prices in order
to recover cost. Note that under perfect
information, firms do not need to consider the quantity demanded when making
decisions.
With asymmetric information, however, firms behavior might be distorted
due to consumers belief. As pointed out
in section V, if the quantity demanded by
consumers fails to meet the equilibrium
constraints, a low type firm will deviate
from its original optimal strategy and
choose to mimic a high type firm.
This paper provides rigorous quantitative tools for companys decision making.
It gives theoretical suggestions for the
company about how to utilize the advantage of private information, with the goal
of maximizing profits. Further research
should explore the empirical side of this
real option signaling model to decide
what specific factors might affect firms
strategy in the real world. n
Environmental Competition
Congratulations to the winners of the 2014 National Environmental Policy Competition: Raymond de Oliveira, Andy Zhang, and Francesca
Audia of Columbia University.
Taking second-place is the team of Wina Huang,
Scott Chen, Caroline Chiu, and Chengkai Hu
from Columbia University. Receiving third-place
is the team of Andrew Tan and Peter Giraudo
from Columbia University.
Forty-six individual and team participants from
universities across the United States competed
for a grand prize of $500, a second prize of $250,
and a third prize of $125 by setting forth a robust
policy model on addressing present climate and
energy challenges.
The competition took place between December 24th and January 15th. Each team of 1-5 submit ted a
15-minute presentation and an extensive commentary outlining the state of climate change, the economic
Special thanks for the generous support of the Columbia University Economics Department, the Program for Economics Research, and The Earth Institute.
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Columbia

a free lunch on tips?

How Revolving Door Lobbyists

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A Free Lunch on Tips?

Law and Political Economy

The $25,000 Steak

Monetary and Fiscal Policy

Unring the Bell?

Columbia Economics Review

A Free Lunch on Tips?

In an individual tip policy, servers are

Pooled houses, are based on

long term, servers do have an incentive to

tion affects the quality of service in restaurants, I designed and implemented

diner observations such as cost range

taurants capacity increases, and hence

Columbia Economics Review

Lynn (2001) performs a meta-analysis

where is an agents ability. In the

where E1A represents the effort of server

where (theta)i represents the ability

These solutions make sense as the cost

As MacLeod (Forthcoming) writes the

The optimal [Bp Bs] can be computed by

The optimal contract is defined by [Bp

averse, r1, r2 >> 1, then the denominators

timal contract most closely resembles.

compensation structure both within the

Columbia Economics Review

ing problem could be less of an issue in

Increased visibility within a

Pooled and Non-Pooled Restaurants

The $25,000 Steak

How Revolving Door Lobbyists Gain From Political Connections

The authors find that a lost

nection to a senator results in a 24% decrease in revenue and a lost connection to

Independents are reported as members of the party

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The chamber of Congress the

the estimates of the parameters of interest will

Columbia Economics Review

under the assumption that the unobservable attribute of interest is time-invariant.

where Rit is the log of revenue; i is the

time, for party and chamber; and it is the

variable Rank makes this adjustment according to the following equation:

Being connected to a member

licans controlled the House and Senate,

being connected to a Democrat in either

Columbia Economics Review

its purpose of protecting valuable innovation,

Columbia Economics Review

indicator of the success of a future appeal and

to the defendant firm. Thus, the claimants

Though new ideas resulting

that publicly traded claimant and defendant

We have seen a steady rise in