This is an electronic version of an Article published in the Quarterly journal of economics, 118 (3). AbstractWe propose a boundedly-rational model of opinion formation in which individuals are subject to persuasion bias; that is, they fail to account for possible repetition in the information they receive. We show that persuasion bias implies the phenomenon of social influence, whereby one's influence on group opinions depends not only on accuracy, but also on how well-connected one is in the social network that determines communication. Persuasion bias also implies the phenomenon of unidimensional opinions; that is, individuals' opinions over a multidimensional set of issues converge to a single "left-right" spectrum. We explore the implications of our model in several natural settings, including political science and marketing, and we obtain a number of novel empirical implications. * DeMarzo and Zwiebel: Graduate School of Business, Stanford University, Stanford CA 94305, Vayanos: MIT Sloan School of Management, 50 Memorial Drive E52-437, Cambridge MA 02142. This paper is an extensive revision of our paper, "A Model of Persuasion -With Implication for Financial Markets," (first draft, May 1997). We are grateful to Nick Barberis, Gary Becker, Jonathan Bendor, Larry Blume, Simon Board, Eddie Dekel, Stefano DellaVigna, Darrell Duffie, David Easley, Glenn Ellison, Simon Gervais, Ed Glaeser, Ken Judd, David Kreps, Edward Lazear, George Loewenstein, Lee Nelson, Anthony Neuberger, Matthew Rabin, José Scheinkman, Antoinette Schoar, Peter Sorenson, Pietro Veronesi, Richard Zeckhauser, three anonymous referees, and seminar participants at the American Finance Association Annual Meetings, Boston University, Cornell, Carnegie-Mellon, ESSEC, the European Summer Symposium in Financial Markets at Gerzensee, HEC, the Hoover Institution, Insead, MIT, the NBER Asset Pricing Conference, the Northwestern Theory Summer Workshop, NYU, the Stanford Institute for Theoretical Economics, Stanford, Texas A&M, UCLA, U.C. Berkeley, Université Libre de Bruxelles, University of Michigan, University of Texas at Austin, University of Tilburg, and the Utah Winter Finance Conference for helpful comments and discussions. All errors are our own. I IntroductionIn this paper, we propose a model of opinion formation in which individuals are subject to persuasion bias, failing to adjust properly for possible repetitions of information they receive. We argue that persuasion bias provides a simple explanation for several important phenomena that are otherwise hard to rationalize, such as propaganda, censorship, marketing, and the importance of air-time. We show that persuasion bias implies two additional phenomena. First, that of social influence, whereby one's influence on group opinions depends not only on accuracy, but also on how well-connected one is in the social network according to which communication takes place. Second, that of unidimensional opinions, whereby individuals' opinions over a multidimensional set of issues can be represented by...

We derive the optimal dynamic contract in a continuous-time principal-agent setting, and implement it with a capital structure (credit line, long-term debt, and equity) over which the agent controls the payout policy. While the project's volatility and liquidation cost have little impact on the firm's total debt capacity, they increase the use of credit versus debt. Leverage is nonstationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line. Surprisingly, the usual conflicts between debt and equity (asset substitution, strategic default) need not arise. Copyright 2006 by The American Finance Association.

We examine the pervasive view that "equity is expensive," which leads to claims that high capital requirements are costly and would affect credit markets adversely. We find that arguments made to support this view are either fallacious, irrelevant, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. Any desirable public subsidies to banks' activities should be given directly and not in ways that encourage leverage. And while debt's informational insensitivity may provide valuable liquidity, increased capital (and reduced leverage) can enhance this benefit. Finally, suggestions that high leverage serves a necessary disciplining role are based on inadequate theory lacking empirical support. We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, deposittaking and issuing money-like securities. To the contrary, better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks. Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy.

We consider the problem of the design and sale of a security backed by specified assets. Given access to higher-return investments, the issuer has an incentive to raise capital by securitizing part of these assets. At the time the security is issued, the issuer's or underwriter's private information regarding the payoff of the security may cause illiquidity, in the form of a downward-sloping demand curve for the security. The severity of this illiquidity depends upon the sensitivity of the value of the issued security to the issuer's private information. Thus, the security-design problem involves a tradeoff between the retention cost of holding cash flows not included in the security design, and the liquidity cost of including the cash flows and making the security design more sensitive to the issuer's private information. We characterize the optimal security design in several cases. We also demonstrate circumstances under which standard debt is optimal and show that the riskiness of the debt is increasing in the issuer's retention costs for assets.

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