Papers highlighted this week:

A culturally diverse workforce is a more productive workforce

DP3982 Cultural Diversity, Status Concerns and the Organization of Work

Authors: Chaim Fershtman (Tel Aviv University), Hans K Hvide (Norwegian School of Economics and Administration anc CEPR) and Yoram Weiss (Tel Aviv University)

July 2003

A well-documented human tendency is to compare outcomes with others, and trying to out-perform them. These tendencies vary across cultures and among different individuals in a given society. The workplace is an important source for social interaction. The conventional wisdom is that culturally mixed societies face a higher potential for conflict, as members of such societies will have different goals habits and attitudes. The authors of CEPR Discussion Paper No.3982 argue that diversity can also be beneficial because of the increased potential for trade amongst different members of society.

The authors believe that the willingness of workers to exert effort depends on the private and social rewards that they receive in the form of wages and esteem. In their study they assume that workers may differ in the importance that they give to status ranking and the reference group to which they compare themselves. Workers also try to outperform each other and thereby obtain esteem from co-workers and other members of society. Because of this social interaction, the organization of work, in particular the matching of workers with different status concerns has strong implications for economic welfare.

The main results of the study are: the most productive firms mix workers with different social concerns, provided that there is sufficient diversity among workers; although workers may have the same productivity, when firms achieve their highest level of output, workers will have different earning expectations as workers with status concerns will have more high-powered incentives, work more and earn more than workers who do not care about status; the authors find that a more diverse workforce can increase the total output of the economy. This increase in output is a result of the higher effort by workers who care about status that offsets the reduction in effort by those who do not and this must also mean an increased variability in wages.

Differences in beliefs have real effects and should be accounted for in financial contracts

DP3971 Financial Contracting with Optimistic Entrepreneurs: Theory and Evidence

Authors: Augustin Landier (University of Chicago GSB and CEPR) and David Thesmar (ENSAE-CREST and CEPR)

July 2003

This Paper looks at the effects of entrepreneurial optimism on financial contracting and corporate performance. Optimism increases effort, but is bad for judgment as the entrepreneur discounts bad information too strongly. When only debt contracts are possible, the authors show that insurance motives lead realists to prefer long-term debt, whereas short-term debt is the optimal contract for optimists.

With short-term debt contracts, the insurer: (1) gets cash-flow claims on bad outcomes that the optimistic entrepreneur finds relatively unlikely, and the entrepreneur gets as much as possible from the outcomes that they delude themselves to be likely to occur; (2) gets control in outcomes where the optimistic entrepreneur behaves inefficiently, which then lowers the cost of capital.

The authors test their theory with a large dataset of entrepreneurs. The dataset was compiled by merging two sources. The first is composed of the 1994 and 1998 waves of the SINE survey. In each of these years, the French statistical office (INSEE) sent questionnaires to between a sixth and a fourth of all entrepreneurs who started or took over a business in the current year. The accounting data was compiled from tax reports and includes firms making more than 110 00 euros of annual sales.

The study finds that firms run by optimists tend to grow less, die sooner and be less profitable, this confirms the study's measure of optimism . Finally, in line with the prediction of their theory, they find that optimists tend to put in more effort, and use more short-term debt to finance their ventures. This Paper, therefore argues that differences in beliefs exist, have real effects, and therefore matter in the design of financial contracts.

10 Discussion Papers by CEPR this week: