The Economics of Financial Markets

1 The Economics of Financial Markets

1.1 The Economic Function of a Financial Market

The economic function of a financial market is to increase the efficiency with which individuals can engage in mutually beneficial intertemporal exchanges with other individuals. 1 This book is an introductory exposition of the economics of financial markets.

We address three questions. First, we explain how financial markets enable individuals to make intertemporal exchanges. Second, we explain how economists assess how well a system of financial markets performs this function. Third, we develop the implications for public policy of our answers to the first two questions.

1.2 The Intended Readers for This Book

We address this book to students who have completed at least one course in economics. We assume that the reader has a rudimentary understanding of opportunity cost, marginal analysis, and how supply and demand produce equilibrium prices and quantities in perfectly competitive markets. A course in probability and statistics will be useful, but not necessary.

We provide in chapter 7 the instruction in probability and statistics that the reader will need. Students who have completed a course in probability and statistics can easily omit this chapter or use it for review.

The economic analysis of financial markets is essential for the effective management of either a firm or a portfolio of securities. There are several texts that develop these implications. The present book, however, addresses the economics of financial markets; our objective is to explain how, and to what extent, a system of financial markets assists individuals in their attempts to maximize personal levels of lifetime satisfaction (or utility) through intertemporal exchanges with other individuals. Even so, students interested in managerial topics can benefit from this book; after all, financial markets affect managers of firms and portfolios in many ways.

1.3 Three Kinds of Trade-Offs

Individuals allocate their scarce resources among alternative uses so as to maximize their levels of lifetime satisfaction. To accomplish this, each individual must make three kinds of trade-offs:

1. Each year individuals must allocate their resources between producing goods and services for current consumption, and producing (this year) goods for expanded future consumption. Economists call the latter kind of goods capital goods. A capital good is a produced good that can be used as an input for future production. Capital goods can be tangible, such as a railroad locomotive, or intangible, such as a computer language. It is primarily through the accumulation of capital goods that a society increases its standard of living over time.

2. Individuals must allocate among the production of current goods and services the resources that they have reserved this year to support current consumption. Students who have completed an introductory course in microeconomics will be familiar with this trade-off. In its simplest form, this is the problem of maximizing utility by allocating a fixed level of current income between the purchases of Goods X and Y. In any of its forms, this second kind of trade-off is not an intertemporal allocation, and thus it does not involve financial markets. Therefore, we do not discuss this question.

3. Each person who provides resources to produce capital goods faces a trade-off created by the interplay of risk and expected future return. In most cases, persons who finance the creation of capital goods do so with other persons. These persons jointly hold a claim on an uncertain future outcome. The future value of this claim, viewed from the day of its formation, is uncertain because the future productivity of the capital goods is uncertain. If the persons who finance the creation of capital goods differ in their willingness to tolerate uncertainty, then these persons can create mutually beneficial exchanges. Consider the following example. Ms. Lyons and Ms. Clyde jointly provide the capital goods for an enterprise, which produces an income of either $60 or $140 in any given year. These two outcomes are equally likely, and the outcome for any year is independent of the outcomes for all previous years. Consequently, the average annual income is $100. If the two women share the annual income equally, each woman’s average annual income will be $50; in any given year her income will be $30 or $70, with each possibility being equally likely. If Ms. Lyons is sufficiently averse to uncertainty, she will prefer a guaranteed annual income of $35 to an income that fluctuates unpredictably between $30 and $70. That is, Ms. Lyons will trade away $15 of average income in exchange for relief from uncertain fluctuations in that income. Ms. Clyde, on the other hand, might be willing to accept an increase in the unpredictable fluctuation of her income in exchange for a sufficiently large increase in her average income. Specifically, Ms. Clyde might prefer an income that fluctuates unpredictably between $25 and $105, which would mean an average of $65 per year, to an income that fluctuates unpredictably between $30 and $70, for an average of $50. If the two women’s attitudes toward uncertainty are as we have described them, the women can effect a mutually beneficial exchange. In exchange for a $15 increase in her own average income, Ms. Clyde will insulate Ms. Lyons against the uncertain fluctuations in her income.

When people allocate resources in the present year to produce capital goods, they obtain a claim on goods and services to be produced in future years. This claim is a financial security. Financial markets offer several kinds of claims on the uncertain future outcomes that the capital goods will generate. Each kind of claim offers a different combination of risk and expected future return. Therefore, the persons who finance the creation of capital goods, and thereby acquire financial securities, must choose the combination of risk and expected future return to hold. We will restrict our attention to trade-offs between current and future consumption, in addition to trade-offs among various claims on uncertain future outcomes. These two kinds of trade-offs involve intertemporal allocation. Persons who conduct these two kinds of trade-offs use financial markets to identify and effect mutually beneficial intertemporal exchanges with other persons.

1.4 Mutually Beneficial Intertemporal Exchanges

A central proposition in economics is that persons who own resources can obtain higher levels of utility by engaging in mutually beneficial exchanges with other persons. Intertemporal exchanges are a subset of these exchanges. In part II, we explain how financial markets promote intertemporal exchanges by reducing the costs of organizing these exchanges. In this section, we describe three kinds of intertemporal exchanges that financial markets promote.

1.4.1 Mutually Beneficial Exchanges between Current and Future Consumption That Do Not Involve Net Capital Accumulation for the Economy 

Consider the following example, in which two persons exchange claims to current and future consumption without increasing the stock of capital goods in the economy. Both Mr. Black and Mr. Green are employed. Each man’s income for the current year is the value of his contribution to the production of goods and services this year.

Each man’s income entitles him to remove from the production sector of the economy a volume of goods and services that is equal in value to what he produced during the year. Economists define consumption as the removal of goods and services from the business sector by households. If every person spent his entire income every year, the economy would not be able to accumulate any capital goods in the business sector.

Now suppose that Mr. Black wants to spend this year $x more than his current income. That is, he wants to remove from the business sector a volume of goods and services whose value exceeds by $x the value of what he produced during the current year. If Mr. Black is to consume this year more than he produced this year, someone else must finance this “excess” consumption by consuming this year a volume of goods and services whose value is $x less than what he currently produced.

Suppose that Mr. Green agrees to do this, in exchange for the right to consume next year a volume of goods and services whose value exceeds the value of what he will produce next year. Mr. Black is now a borrower and Mr. Green is a lender. Typically, the agreement requires the borrower to repay the lender with interest. For example, in exchange for a loan this year equal to $x, Mr. Black will repay $y to Mr. Green next year, and $y-$x. But the payment of interest is beside the point here.  Both Mr. Black and Mr. Green can increase their levels of lifetime utility by undertaking his mutually beneficial exchange. Mr. Black gains utility by reducing his consumption next year by $y, and increasing his current consumption by $x. Were this not so, Mr. Black would not have agreed to the exchange. Similarly, Mr. Green gains utility by reducing his current consumption by $x and increasing his consumption next year by $y.

Both men gain utility because they are willing to substitute between current and future consumption at different rates. Consider the following numerical example. At the present allocation of his income between spending for current consumption and saving for future consumption,

Mr. Black is willing to decrease the rate of his consumption next year by as much as $125 in exchange for increasing his rate of consumption this year by $100. Mr. Green’s present allocation between current and future consumption is such that he will decrease his current rate of consumption by $100 in exchange for an increase in his rate of consumption next year by at least $115. That is, Mr. Black is willing to borrow at rates of interest up to 25%, and Mr. Green is willing to lend at rates of interest no less than 15%. Obviously, the two men can construct a mutually beneficial exchange.

The rate at which a person is willing to substitute between current and future consumption (or, more generally, between any two goods) depends on the present rates of current and future consumption. In particular, Mr. Black would be willing to increase his level of borrowing from its current level, with no change in his level of income, only if the rates of interest were to fall. The maximal rate of interest at which a person is willing to borrow, and the minimal rate of interest at which a person is willing to lend, depends on that person’s marginal value of future consumption in terms of current consumption foregone. Each person has his or her own schedule of these marginal values, which changes as that person’s patterns of current and future consumption change.

One of the functions of a financial market is to reduce the cost incurred by Messrs. Black and Green to organize this exchange. We consider this function in chapter 2, where we examine how financial markets increase the efficiency with which individuals can allocate their resources.

1.4.2 Mutually Beneficial Exchanges between Current and Future Consumption That Do Involve Net Capital

Accumulation for the Economy Consider again Mr. Green and Mr. Black. In the preceding example, Mr. Green is a lender; he agrees to remove from the business sector this year a volume of goods and services whose value is less than the value that he produced this year. Mr. Green finances Mr. Black’s “excess” consumption.

There is another possibility for Mr. Green to be a lender. If Mr. Green consumes less than his entire income this year, the economy can retain, in the production sector, some of the output that would otherwise be delivered to households. That is Mr. Green could finance the accumulation of capital goods in the production sector. Although the production sector could retain goods that are appropriate for households, this is not usually done.

Rather, if Mr. Green spends less than his current income, the economy can reallocate resources out of the production of goods and services intended for households and into the production of capital goods, such as railroad locomotives and computer languages. By accumulating these capital goods in the production sector, the economy can expand its ability to produce goods and services in the future, including goods and services intended for households.

We say that Mr. Green saves if he spends less than his current income. If his act of saving enables another person, like Mr. Black, to spend more than his current income, then Mr. Green can be repaid in the future when Mr. Black transfers some of his future income to Mr. Green. Alternatively, if Mr. Green’s saving enables the economy to accumulate capital goods, then Mr. Green can be repaid out of the net increase in future production that the expanded stock of capital goods will make possible.

1.4.3 Mutually Beneficial Exchanges of Claims to Uncertain Future Outcomes 

Intertemporal allocations always involve uncertainty because the future is uncertain. In this subsection, we present a simple example of how two persons, who differ in their willingness to tolerate uncertainty, can construct a mutually beneficial exchange. Ms. Tall and Ms. Short operate adjacent farms that are identical in all respects. In particular, the annual productivity of each farm is subject to the same vagaries of nature. Each year the output of corn on each farm is equal to either 800 tons or 1,200 tons, depending on whether nature is beneficial or detrimental that year. The state of nature for any particular year is unpredictable. Over the longer run, however, each of the two states occurs with a probability equal to 50%. Therefore, each woman’s annual product fluctuates unpredictably between 800 and 1,200 tons of corn. Her average annual product is 1,000 tons of corn.

The two women differ in their willingness to tolerate uncertainty. Ms. Tall is risk averse. She prefers to have a guaranteed annual product of 900 tons of corn, rather than tolerating unpredictable fluctuations between 800 and 1,200 tons of corn. That is, if Ms. Tall is guaranteed 900 tons of corn each year, she will accept a decrease of 100 tons of corn in her average annual product.

Ms. Short is risk preferring. She will accept an increase in the range over which her product fluctuates, if she can gain a sufficiently large increase in the average level of her product.

Ms. Tall and Ms. Short construct the following mutually beneficial exchange based on the difference in their attitudes toward uncertainty: they combine their farms into a single firm. In a year in which nature is beneficial, each farm will produce 1,200 tons of corn, so that output of the firm will be 2,400 tons. When nature is detrimental, each farm will produce only 800 tons, and the output of the firm will be 1,600 tons.

The risk-averse Ms. Tall will hold a contractual claim: she will receive 900 tons of corn each year regardless of the state of nature. Ms. Short will absorb the vagaries of nature by holding a residual claim: each year she will receive whatever is left over from the aggregate output after Ms. Tall is paid her contractual 900 tons.

When nature is beneficial, Ms. Short will receive 2(1200) tons_900 tons, or 1,500 tons. When nature is detrimental, Ms. Short will receive 2(800) tons_900 tons, or 700 tons. Therefore, Ms. Short’s annual income will fluctuate unpredictably between 700 tons and 1,500 tons; her average annual income is 1,100 tons.

In summary, the risk-averse Ms. Tall will reduce the level of her average annual income from 1,000 tons to 900 tons, in exchange for being insulated from unpredictable fluctuations in her income. The risk-preferring Ms. Short will accept an increase in the range over which her annual income will fluctuate, in exchange for an increase in the average level of her income. Notice that the average of the two women’s average incomes remains at 1,000, which is what each woman had before she entered the agreement.

Ms. Tall and Ms. Short have created a mutually beneficial exchange that involves levels of average income (or product) and levels of unpredictable variation in that income. Financial markets facilitate these exchanges by enabling firms to offer different kinds of securities. The contractual claim that Ms. Tall holds is similar to a bond; the residual claim that Ms. Short holds is similar to a common stock. We discuss the properties of these securities in detail in chapter 2.

1.5 Economic Efficiency and Mutually Beneficial Exchanges

In the preceding section, we described briefly the three kinds of mutually beneficial intertemporal exchanges that involve combinations of present and future outcomes. Unfortunately, before any two persons can conduct these exchanges, they must meet several conditions. First, the two persons must find each other. Then, they must agree on the terms of the exchange. These terms must specify the price of the good or service to be exchanged, the quantity and the quality of the good or service to be exchanged, and the time and place of its delivery. Moreover, the terms usually specify the recourse that each party will have if the other party defaults. Intertemporal exchanges are particularly complicated because they involve the purchase today of a claim on the uncertain outcome of a future event. Therefore, the terms for an intertemporal exchange must take into account the probabilities of the possible outcomes.

In an economy that uses a complex set of technologies, and that serves a large number of persons who have widely diverse preferences, meeting these conditions can be costly. An essential function of any system of markets, including financial markets, is to reduce the costs of meeting these conditions.

In this section, we address the question of how well a system of financial markets enables individuals to increase their utility by conducting intertemporal exchanges. The critical concept for the analysis of this question is economic efficiency.

Definition of Economic Efficiency

Economic efficiency is a criterion that economists use to evaluate a particular allocation of resources. Specifically, an allocation of resources is economically efficient if there is no alternative allocation that would increase at least one person’s utility without decreasing any other person’s utility.

Consequently, if an allocation of resources is economically efficient, there are no further opportunities for mutually beneficial exchanges. By extension f this definition, a system of markets is economically efficient if it enables persons who own resources to reach an economically efficient allocation of those resources.

We can also state the criterion of economic efficiency in terms of an equilibrium configuration of prices and quantities.

Definition of Equilibrium

An equilibrium configuration of prices and quantities (briefly, an equilibrium) is a set of prices and quantities at which no buyer or seller has an incentive to make further purchases or sales.

A system of markets contains forces that cause prices and quantities to move toward their equilibrium values. But the equilibrium is not necessarily economically efficient. To be economically efficient, the equilibrium must enable buyers and sellers to conduct all potential mutually beneficial exchanges, not just those that can be conducted at the equilibrium prices.

A simple example from introductory economics will demonstrate this point. Air Luker is an airline that offers passengers two direct, nonstop flights each day between Albany, New York, and Portland, Maine, in each direction. Air Luker has a monopoly on air service between these two cities. The willingness of consumers to pay for transportation by air between Albany and Portland constrains the profitability of Air Luker’s monopoly. Passengers who want to travel between Albany and Portland have alternatives to traveling by air. They can drive or ride the bus. They can also travel between Albany and Portland less frequently, substituting communication by telephone, e-mail, videoconferencing, or conventional mail for personal visits. The passengers can also forego the benefits of more frequent communication and spend their time and money on other things. None of these alternatives is a perfect substitute for travel by air between Albany and Portland.

A standard proposition in economics is that consumers as a group will reduce the rate (per unit of time) at which they purchase any product if the price of that product increases relative to their incomes and the prices of imperfect substitutes for that product.

Succinctly, Air Luker faces a trade-off between the prices of its tickets and the number of tickets that consumers will purchase per day. The graph in figure 1.1 describes the choices available to the owners of Air Luker. On the horizontal axis, we measure the number of passengers per day between Albany and Portland. On the vertical axis, we measure the price of a ticket. We also measure marginal revenue and marginal cost on that axis. The demand curve defines the trade-off between ticket prices and passengers per day. Each point on the horizontal axis designates a specific number of passengers per day. The height of the demand curve above that point is the maximal price that consumers will pay per ticket to purchase that quantity of tickets per day. For example, Point A on the demand curve indicates that PA is the maximal price that Air Luker can charge per ticket and expect to sell QA tickets per day.

The marginal revenue and marginal cost curves in figure 1.1 measure the rates at which Air Luker’s total revenue and total cost (both measured per day) would change if Air Luker were to reduce the price of a ticket enough to sell one more ticket per day. For example, starting from Point A on its demand curve, if Air Luker were to reduce the price of a ticket enough so that daily ticket sales increased by one, Air Luker’s total (daily) revenue would increase by the height of the marginal revenue curve at the quantity QA, and total (daily) cost would increase by the height of the marginal cost curve at the quantity QA.4

Figure 1.1. The deadweight loss created by a monopolist who does not use discriminatory pricing.

Air Luker will maximize its profit by setting the price of a ticket so that marginal revenue is equal to marginal cost at the number of tickets sold per day. The profit maximizing price and quantity occur at Point B on the demand curve. At this point, the price paid by the consumers for a ticket exceeds the marginal cost incurred by Air Luker. Since the demand curve slopes downward, consumers would be willing to purchase tickets more frequently at a price that is both less than Air Luker’s current price and greater than its marginal cost. If Air Luker could sell these additional units without reducing the price of a ticket, both Air Luker and the consumers could benefit.

This potential, mutually beneficial, exchange requires that Air Luker charge (and the consumers pay) different prices for different units of the same good. For example, on each day Air Luker could charge PB per ticket for QB tickets, and a lower price, PC, for QC-QB tickets. For this scheme to work, Air Luker must be able to prevent those consumers who are willing to pay as much as PB for ticket (rather than not fly on that day) from purchasing tickets at the lower price, PC. That is, Air Luker must discriminate among consumers according to their willingness to pay. If the costs of doing this are too large, or if this is prohibited by law, then the equilibrium in the monopolist’s market is economically inefficient. To be economically efficient, a system of financial markets must do two things: generate information that will enable persons to identify all potential opportunities for mutually beneficial intertemporal exchanges, and provide mechanisms through which persons can make these exchanges. To a considerable extent, financial markets accomplish both tasks by organizing trading in financial securities. There are, however, situations in which financial markets fail to create an efficient allocation of resources. Economists call these situations market failures.

Definition of a Failure of a Financial Market

A failure of a financial market is an allocation of resources in which there are opportunities for mutually beneficial intertemporal exchanges that are not undertaken.

1.6 Examples of Market Failures

There are three kinds of market failures that occur in the intertemporal allocation of resources:

1. The problem of agency,

1. The problem of asymmetric information, and

1. The problem of asset substitution.

We describe these problems briefly here. In chapter 13, we analyse these failures in detail and examine some of the ways that firms and investors use to mitigate them.

1.6.1 The Problem of Agency

An agency is a relationship in which one person, called the agent, manages the interests of a second person, called the principal. Ideally, the agent subordinates his or her own interests completely to the interests of the principal. The problem of agency is that if the interests of the agent are not fully compatible with those of the principal, and if the principal cannot cost lessly monitor the actions of the agent, the agent might pursue his or her own interests to the detriment of the principal. The extent to which the principal suffers due to a problem of agency varies directly with the cost that the principal would incur to monitor the agent perfectly.

The problem of agency arises in a firm that is operated by a small number of professional managers who act as agents for a large number of diverse shareholders, none of whom owns a large proportion of the shares. It would be prohibitively costly for the shareholders to monitor perfectly the performance of their managers. First, the managers have superior access to relevant information. Second, it is difficult to organize a large number of diverse shareholders to act as a cohesive unit on every question.

Third, the smaller the proportion of the firm that a shareholder owns, the smaller is the cost that he or she would be willing to incur for the purpose of monitoring the managers more closely.

An obvious example of the problem of agency is that managers might use some of the shareholders’ resources to purchase excessively luxurious offices, memberships in clubs, travel on the firm’s aircraft, and other perquisites rather than investing these resources in projects that will generate wealth for the shareholders.

A less obvious example of a problem of agency occurs because the managers are more willing to accept a lower expected return on the firm’s investments in exchange for a lower level of risk than the shareholders would prefer to do. This problem arises if a significant proportion of the managers’ future wealth depends on their reputations as managers. These reputations would be diminished were the firm to produce mediocre results, let alone fail. Shareholders can reduce the risk of mediocre earnings in any one firm by holding a diversified portfolio of investments in several firms.

Clearly, managers cannot reduce the risk to their reputations by working simultaneously for many firms. Since the shareholders can use diversification to reduce the risks of mediocre earnings in a single firm, the shareholders are more willing to have their firm undertake risky projects that have higher expected returns than their managers’ less risky, reputation-preserving projects.

1.6.2 The Problem of Asymmetric Information

Both parties to a proposed transaction have information (and beliefs) about the possible future outcomes of that transaction. The information is asymmetric if one party has material information that the other party does not have. Material information is information that a person would pay to acquire before deciding whether to enter a proposed transaction. The problem of asymmetric information is that the inability of a party that possesses material information to transmit that information credibly to a second party can prevent what would otherwise be a mutually beneficial exchange.

An example of the problem of asymmetric information occurs if a firm lacks sufficient cash to finance a profitable new project. To raise cash for the project, the firm offers to sell newly created shares of stock. To the extent that investors who are not current shareholders purchase the new shares, the current shareholders will cede to the new shareholders a portion of the ownership of the firm. But the value of the firm will increase as a consequence of undertaking the new project. Whether the current shareholders gain or lose wealth depends on the amount by which the new project increases the value of the firm relative to the proportion of the firm that the new shareholders acquire.

Prospective new shareholders must decide what proportion of the firm they must acquire if they are to recover their investment. The larger the amount by which the new project will increase the value of the firm, the smaller the proportion of the firm the new investors must acquire. Further, the smaller the proportion of the firm that the new shareholders acquire, the larger the proportion of the firm that the current shareholders will retain, and the wealthier those current shareholders will be.

There is a conflict of interest between the current shareholders and the prospective new shareholders. If the firm’s managers act in the interests of the current shareholders, the managers have an incentive to overstate the value of the new project so as to induce the prospective new shareholders to finance the project in exchange for acquiring a small proportion of the firm. Knowing the incentives of the managers, the prospective new shareholders might insist on acquiring so large a proportion of the firm that, even with the new project, the current shareholders will lose wealth to the new shareholders. If the managers expect that their current shareholders will lose wealth as a consequence of financing the project by issuing new shares, the managers will forego the project. Foregoing the profitable project is economically inefficient.

By definition, a profitable project will generate sufficient earnings to allow the new shareholders who financed the project to recover their investment and to create a profit that can be shared by the current and the new shareholders.

A profitable project provides the potential for a mutually beneficial exchange. To realize the potential, the parties to the exchange must agree on terms that will be mutually beneficial. In the example described above, if the managers cannot credibly inform the prospective new shareholders about the value of the project, the current shareholders, acting through their managers, will be unable to effect a mutually beneficial exchange with the prospective new shareholders, even though the new project would be profitable.

1.6.3 The Problem of Asset Substitution

The problem of asset substitution is the incentive that a firm’s managers have to transfer wealth from the firm’s bondholders to its shareholders by substituting riskier projects for less risky ones. In section 1.4.3 of this chapter, we examined a simple model in which investors who differ in their willingness to tolerate uncertainty could effect a mutually beneficial exchange by choosing between contractual and residual claims to an uncertain outcome. In that example, there is no risk of default on the contractual claims because even in a bad year the output of the combined farms is sufficient to pay the contractual claims.

In a more realistic example, the residual claimants would be the shareholders, who would control the firm through their managers. The contractual claimants would be bondholders, who would have no right to participate in the management of the firm unless there is a default on the bonds. The market value of the bonds depends on the probability that the firm will default.

Suppose that the managers of the firm sell the two farms that comprise the firm, and use the proceeds to invest in a new project that has the same expected payoff as the former firm but a higher probability of a default on the bonds. For example, the minimal and maximal payoffs of the new project might be 400 tons and 3,600 tons of corn, respectively. The average payoff would remain at 2,000 tons ([400_3600])/2_2000), but there is now a positive probability that the firm will not be able to make the contractual payment of 900 tons to the bondholders. The increase (from zero) of the probability of a default on the bonds will reduce the market value of those bonds. Since the average value of the annual payoff to the firm remains at 2,000 tons of corn, the market value of the entire firm will not change. Since the claims of the bondholders and the claims of shareholders constitute the entirety of the claims on the firm, the market value of the shareholders’ claim must increase.

We conclude that (at least under some conditions) the firm’s managers can transfer wealth from the bondholders to the shareholders by substituting a riskier project for a less risky one.

Now suppose that a firm attempts to finance a risky new project by selling bonds.

Recognizing that the firm’s managers have an incentive to transfer wealth from bondholders to shareholders by substituting a riskier project for the project that the bondholders intended to finance, the bondholders might refuse to purchase the bonds. If the firm has no other way to finance the new project, the opportunity for a mutually beneficial exchange (between prospective bondholders and current shareholders) will be foregone, creating an economic inefficiency. Nevertheless, financial markets operate within a set of regulations imposed by law. One example of these regulations is the set of information that a firm must provide if its securities are to be publicly traded on organized exchanges. A second example is the regulation of trading on inside information. An important part of the assessment of the performance of financial markets is, therefore, an analysis of the effect of public policy on the economic efficiency of financial markets.

1.7 Issues in Public Policy

Governments regulate financial markets in many ways. Economists can evaluate each regulation against the criterion of economic efficiency by determining how that regulation is likely to affect the market’s ability to promote mutually beneficial intertemporal exchanges. Here are a few examples of important questions in the regulation of financial markets:

1. Should the government regulate the fluctuation of the prices of financial securities?

For example, should there be a limit on the amount by which a price can change during a day (or an hour) before trading in that security is suspended?

2. Should investors be allowed to use borrowed money to finance mergers and acquisitions? Should hostile takeovers be permitted? Should firms be allowed to adopt super majority provisions or poison pill provisions as defences against takeovers?

3. Should persons with inside information be allowed to trade on that information?

4. Corporations are allowed to deduct from their taxable income the interest paid to their bondholders. Should corporations be allowed to deduct dividends also?

5. Many firms compensate their senior executives in part by giving those options to purchase the firm’s stock at a predetermined price. The firms assert that the existence of these options makes the executive’s interests more compatible with the interests of the shareholders, thus mitigating the problem of agency.

In what way, if any, should firms be required to include the costs of these options when reporting their earnings?