Chapter 9 Good Markets

1. Chapter 9 Good Markets

2. Private Benefits of Trading • Benefits accrue to traders when they trade. • Utilitarian traders – In liquid markets, these traders accomplish their goals cheaply. • Profit-motivated traders - Include dealers and speculators. • Zero-sum game – Profit-motivated traders can profit only if utilitarian traders are willing to trade. • Markets exist only when utilitarian traders exist. • Hence, the welfare of utilitarian traders is more important than the welfare of profit-motivated traders (You may disagree!)

3. Public Benefits of Trading • Public benefits of trading accrue to everyone, regardless of they use the markets. Positive externalities • Fall into two classes • Public benefits from informative prices • Public benefits from liquid markets

4. Public Benefits from Informative Prices • Well-functioning markets produce informative prices: prices = fundamental values • Benefits from informative prices • Production and allocation decisions • Capital allocation in the primary markets • Manager allocation in the secondary markets

5. Production and allocation decisions • Command economies vs. market-based economies • Allocating resources efficiently requires an extraordinary amount of information. • Command economies do poor jobs in information aggregation.

6. Command Economies • Amount of information is too large. • Receive low-quality information. • Political forces and personal biases • People may not implement plans. • Accountability problems

7. Market-based Economies • Decision making is distributed to many people throughout the economy. • Each person efficiently allocates his capital to best projects. • Aggregate allocations are globally efficient. • Informative prices play important roles. Prices in market-based economies generally reflect values because buyers and sellers trade when they are different.

8. Market-based Economies • Work poorly when transaction costs are large or when activities need to be highly coordinated. • Companies are the most important command organizations within a market economy. • People form companies to avoid the excessive negotiation costs.

9. Firms and Markets • Although firms are small command economies, they are related to the rest of the world through various markets. • Primary capital markets • Secondary capital markets

10. Primary Capital Markets (IPO) • New capital goes to the best investment ideas. • Pricing investment opportunities. • When prices are informative, good ideas command high prices. • New capital flows to the best ideas.

11. Secondary Capital Markets • Compensate managers based on share price. • Remove and replace poor managers. • Corporate control market disciplines. • These mechanisms break down when stock prices are noisy!

12. Public Benefits of Liquid Markets • Utilitarian traders produce positive externalities when they use liquid markets to conduct their businesses more efficiently. • Public benefits of exchange – Market-based economies ensure that resources go to the people who value them most. • Public benefits of hedging – When hedgers can cheaply transfer their risks, they specialize in the most efficient productive processes available to them. • Public benefits of risk sharing – Liquid markets benefit the public by allowing companies to raise new capital at low cost. • Public benefits of facilitated information-based trading. Liquid markets → low price impact → more information-based trading →more informationally efficient markets.

13. Policy Implications • First promote the private interests of utilitarian traders. • Strive to maximize the public benefits from liquid markets that produce informative prices. • Support the interests of profit-motivated traders that serve the above two. • Discourage profit-motivated traders who exploit other traders.