| In this paper, we derive a model to explain both excess volatility and extraordinary persistence. To do so, we draw from the literatures of medicine, psychology, and behavioral economics. Our basic framework is that people have adaptive emotions and that these adaptive emotions create adaptive risk-aversion. This process is called sensitization, which implies that people become more risk-averse after negative shocks (Kandel 2000).;To conduct our analysis, we construct an overlapping generations model of the macroeconomy to study the effect of allowing agents to be sensitized to risk. We find two main results. First, the adaptive nature of risk preferences combined with the finite horizons of agents imply that economic activities, such as investment, are too risky on the intensive margin. Second, excess risk-intensity combined with the availability heuristic implies that agents undertake too little risk (too little investment) on the extensive margin. In order to characterize the optimal monetary policy, we follow Tirole (2006), who models risk through liquidity shocks, and we derive three policy implications for policymakers. First, diversification blunts the impact of time-varying risk aversion. As a result, there is a reason to think that equity financing, under which risk diversification is easier to achieve, leads to fewer risk distortions and faster steady-state growth. Second, countercyclical risk-aversion favors countercyclical monetary policy. Third, short-term asset purchases are shown to exacerbate risk distortions. In our model, monetary policy results in greater stabilization and faster growth when conducted through long-term asset purchases such as Quantitative Easing and Operation Twist.;We present three general findings. First, organizations that rely on production metrics have incentives at least as strong as those relying on cost metrics. Second, the impact of acclimation depends critically on the type of metric used. Under cost metrics, higher acclimation leads to stronger incentives. Under production metrics, higher acclimation leads to weaker incentives. Third, the optimal culture is characterized by production metrics and unacclimating reference points, which we show have implications regarding organizational tenure policies. We conclude with a discussion of testable implications. We refer to the psychology literature and argue that production metrics are most likely to emerge when production is characterized by a high degree of uncertainty, such as in sales. Our model's main prediction is that in these types of environments, we would expect to have rapid production and low tenure in order to lower acclimation. In contrast, environments in which costs are more uncertain are more likely to have cost metrics, which favor longer tenure and loose deadlines in order to generate more acclimating reference points.;The Precautionary Principle in Product Markets: There any many differences between the U.S. and European regulation, but one notable difference concerns assessments of risk. U.S. and European regulation are concerned about different sources of risk and these sources of risk do not always overlap. As noted by Vogel (2003), U.S. regulation gives more consideration to risk concerning environmental harms, carcinogens in food, and endangered species, whereas European regulation emphasizes risks inherent in biotechnology and carbon emissions. In fact, to justify the regulation of biotechnology, Europeans give explicit emphasis to the Precautionary Principle: faced with an irreversible choice, it is better to presume significant harm. However, when it comes to carcinogens in food, Europeans are relatively more willing to bear the risks.;In this paper, we use an agency setting to determine how regulators should manage the risks inherent in new products while not placing an undue burden on potential innovators. Faced with a product quality, they can adhere to the Precautionary Principle and presume harm. Alternatively, they can adhere to the Presumption of Innocence and presume the product is harmless. This paper analyzes which is better. There are two assumptions that separate our analysis from the literature. First, we consider a static framework in which no new information arises. Second, we assume that the equilibrium risk is endogenous. Entrepreneurs' can mitigate harm if given the appropriate incentives and their choices to mitigate harm will be influenced by the regulatory framework chosen by the regulators. (Abstract shortened by UMI.). |
