Lecture 1 Valiante - PDF

Lecture 1 (part 2) Some market and bargaining theories Diego Valiante, Ph.D. Views are strictly personal and LEIF Master Programme cannot be attributed in any way 87507 - FOUNDATION...

Lecture 1 (part 2) Some market and bargaining theories Diego Valiante, Ph.D. Views are strictly personal and LEIF Master Programme cannot be attributed in any way 87507 - FOUNDATIONS OF RISK to the European Commission. REGULATION IN FINANCIAL MARKETS  Agenda The Robinson Crusoe’s economy – Why cooperation matter (vs self-interest)? Coase Theorem and its criticism – Law exists to remove barriers to cooperation Efficient financial markets theories – Are financial markets different? © Valiante Diego - 2  Study questions When is cooperation beneficial in economic terms? Why and when does the law matter? What should be the key objective of the law? What are conditions under which financial markets are ‘efficient’ and what are their ‘anomalies’? © Valiante Diego - 3  Where does cooperation take place? Markets are a form of organisation which, as reinforced by certain (normally private) legal institutions, is supposed to advance economic welfare, more specifically allocative efficiency. (A. Ogus) © Valiante Diego - 4  The benefits of cooperation: Robinson Crusoe’s economy (for more CH 32 H. Varian, Intermediate Microeconomics) © Valiante Diego - 5  The RC’s framework A Robinson Crusoe economy assumes an economy with one consumer, one producer. The character and title is from the novel authored by Daniel Defoe in 1719. Robinson Crusoe has shipwrecked on an island (3 assumptions): 1. Cut off from the rest of the world (so he cannot trade) 2. With only a single economic agent (Crusoe himself), who is both a consumer and a producer 3. All commodities on the island have to be produced or found from existing stocks © Valiante Diego - 6  The Robinson Crusoe’s economy (1) Let’s start with one person one good… The consumption/production function is usually concave with declining marginal returns of labour (ability to pick up coconuts for one hour more of work). The indifference curves depicts the preferences for labour and coconut. We want to take the one that is tangent to the consumption/production function, so the one that maximises RC’s utility. © Valiante Diego - 7  The Robinson Crusoe’s economy (2) Let’s introduce a second good… – Now it’s a choice of production/consumption between two goods © Valiante Diego - 8  The Robinson Crusoe’s economy (3) Let’s introduce a second person (Friday) and second product (fish)… – RC can produce at most 10 coconut or 5 fishes and viceversa for Friday (so RC has comparative advantage in coconut and Friday in fish) – They can bargain products without costs © Valiante Diego - 9  The Robinson Crusoe’s economy (4) Cooperation would lead to a superior outcome (RC and Friday only produce what they are best at, i.e. coconut for RC and fish for Friday). © Valiante Diego - 10  ‘Preliminary’ normative conclusions Cooperation (vs self-interest) leads to the optimal outcome. Market forces may be best placed to ensure resource allocation in a world where labour specialisation leads to the optimal outcome, © Valiante Diego - 11  What role for the law and, more specifically, for regulatory intervention? The Coase Theorem © Valiante Diego - 12  Coase’s criticism to dominant view on how to address market failures For most of the last century, the dominant theory was mainly based on Arthur Cecil Pigou’s work (in particular, The Economics of Welfare, 1932). Pigou’s central tenet is that – individuals, in pursuing their ‘self-interest’ (their natural tendency), may cause damage to others and only State action (and not changes in the legal system) can address that. The result, as interpreted by the dominant economic theory of that time is that – Governments should always tax (subsidise)commodities generating negative (positive) effects. → the so-called ‘polluter pays’ principle. © Valiante Diego - 13  Coase’s criticism to dominant view on how to address market failures While Coase does not necessarily dispute the risks of acting only based on ‘self-interest’, Coase challenges the dominant view that it will not always lead to a more favourable outcome in terms of total welfare. – especially if the cost of bargaining for the one causing the damage is too high, while the value for the society of producing that product is higher than putting the polluter out of business with large Pigouvian taxes.. He shows that liability rules can lead to cooperation and be more effective in frequent situations. To show that, he has to prove that this natural tendency (self interest) does not always need the State to fix its negative externalities. – For more on liability vs property rules, see Calabresi and Melamed,1972 © Valiante Diego - 14  Coase Theorem – Main thesis (strong version) Thesis: if neighbours and factory can cooperate without frictions, the initial allocation of rights won’t affect the possibility to reach the efficient solution. The law does not matter! Please, note that here we ignore distributional effects (in that case the law would be necessary), but only consider outcome in terms of positive net total welfare (Kaldor-Hicks efficiency)! The ‘weak’ version, instead, only refers to cooperation (bargaining) leading to an efficient outcome (not necessarily the same with or without the law) © Valiante Diego - 15  Coase Theorem – Example 1 factory and 5 neighbouring houses Pollution (within the legal parameter) creates damages to neighbours’ peaceful lives for €75k each The factory has revenues for €300k & neighbours’ peace is worth €100k Two options: – Factory filter → €15k (efficient solution) – Special air purifier → €8k each → Total €40k © Valiante Diego - 16  Coase Theorem – Case 1 Case 1: Factory has the right to pollute OPTIONS Net gain (total welfare) Neighbours leave 0-100k+300k = 200k Neighbours buy the special APs 100k-40k+300k = 360k Neighbours buy the filter 100k-15k+300k = 385k Neighbours pay the factory to leave 100k-300k = -200k © Valiante Diego - 17  Coase Theorem – Case 2 Case 2: Neighbours have the right to always breathe the purest air OPTIONS Net gain (total welfare) The factory leaves 0-300k+100k = -200k The factory buys the special APs 300k-40k+100k = 360k The factory buys the filter 300k-15k+100k = 385k The factory pays the neighbours to leave 300k-500k = -200k © Valiante Diego - 18  Coase Theorem – Graphical representation X1 if right to pollute X2 if right to pure air X* if bargaining occurs © Valiante Diego - 19  Underlying assumptions 1. There are only few parties involved – Many parties would create additional coordination/strategic issues 2. They are perfectly independent from each other (no other relations among the parties involved that can impact decisions) 3. They have mutual full knowledge of gains and damages, which lead to act cooperatively and not so strategically to affect the efficient outcome 4. There is absence or negligible transaction costs (Coasian vacuum). The theorem is based on cooperation and it’s the starting point of economic investigation of legal norms. © Valiante Diego - 20  Positive (factual) conclusions 1. Given some externality and provided that parties fully cooperate (no transaction costs), the outcome of bargaining will be a social optimum irrespective of the initial allocation of rights – Also called the efficiency hypothesis 2. The efficient use of resources will depend on the allocation of rights only if transaction costs prevent bargaining. – Also called the invariance hypothesis. 3. If property rights are clearly specified (no matter to whom they are assigned and there are no friction to bargaining), the internalization of externalities won’t need legal remedies (like property or liability rules). © Valiante Diego - 21  Normative conclusions 1. If the positive conclusions are true, the first objective of the regulation thus is not the allocation of rights per se, but the elimination of barriers/frictions to the parties’ cooperation. – A Pigouvian tax (‘polluter pays’) is thus never a good option 2. If regulation fails in doing so, the law has to minimise the harm caused by failures in private bargaining via legal tools. – These tools include compensatory damages or equitable solutions [allocation of rights] (also called liability and property rules). © Valiante Diego - 22  Main criticisms 1. Efficiency HP → regardless of how rights are initially assigned, the resulting allocation of resources will be efficient – Ignores distributional effects, i.e. one of the two parties could actually execute the contractual obligation more efficiently. – It just looks at higher total welfare. 2. Invariance HP → The final allocation of resources is invariant to the assignment of rights, but… – Bargaining produces reallocation that can create an ‘income or wealth effect’ (see next slide) A right to pure air reduces the relative price of negative externality for the polluted for a given level of pure air considered acceptable (the polluter will pay for the filter) – ‘Quality of life’ as constraint function, ‘Y’ quantity of available money and ‘X’ quantity of pure air – Income effect comes from the perceived improvement in quality of life (more money in because not spent on APs anymore, keeping quality of life constant) This ‘income effect’ will de facto reduce the acceptable level of pollution for the polluted. © Valiante Diego - 23  The wealth effect (with right to pure air) Cost of enjoying pure air (inc. air purifier) A status quo without right to pure air B with right to pure air (no longer having to pay for air purifiers) C wealth effect, as you enjoy more the quality of life and your willingness (budget) to get even more pure air/quality of life (your preferences change; e.g. you might decide to still buy air purifiers on top) U2 Pure air © Valiante Diego - 24  Main criticisms 3. Endowment effect (Kahneman et al. 1990) Initial allocation of rights does matter for formation of reserve price Two consequences: 1. “Sellers” tends to value their items far more highly than potential buyers, so fewer deals take place. 2. People that received an item of value for free are more likely to overvalue it. Buyers, whose preferences were not influenced by the endowment, valued the items in the expected range. 4. Social norms Sometimes social norms develop without bargaining or laws or assignment of rights – E.g. A factory that is owned cooperatively by a local community that has always been taking care of the people and very caring about their needs © Valiante Diego - 25  Main criticisms 5. Long-run effects In the long-run the legal rule may matter in terms of output and prices, so affecting the final result – If we give ‘right to pollute’ to the factory, it will have a lower cost to bear, which may result in higher output and lower price over time (unless the victim pays off consumers to buy less and so keep output at the same level) 6. Assumes the existence of rents (no perfect competition) If liability to the polluter, no money for the filter in perfect competition © Valiante Diego - 26  Are financial markets different? © Valiante Diego - 27  Financial market efficiency theories Well, many argued ‘they are different’!! Bachelier (1900) → Stock price changes are random Fama (1965) → Stock prices are a random walk – Random walk theory suggests that changes in stock prices have the same distribution and are independent of each other. In other words, it assumes the past movement or trend of a stock price or market cannot be used to predict its future movement (based on Kendall 1953). – ‘in a random-walk-efficient market, on the average, a security chosen by an analyst will produce a return no better than that obtained from a randomly selected security of the same general riskiness.’ (Fama 1965) © Valiante Diego - 28  The Efficient Market Hypothesis (EMH) The theory of efficient markets (Efficient Market Hypothesis) says that the price of a financial asset always reflects all the information available and responds only to unexpected news. – Prices can be thus regarded as optimal estimates of true investment value at all times. In other words, the EMH is concerned with whether prices at any point in time "fully reflect" available information. (Fama 1965, 1970) – If anyone can predict prices (i.e. they are not a random walk), the expectation of that price move will cause the price to move before you can act. Only new information can move prices, but ‘new’ is unpredictable. So price changes are random! – Investors should only decide the risk-return profile (passive investment) → there is no mispricing (you cannot beat the market) – Fundamental and historical analyses are largely ineffective to predict price movements. © Valiante Diego - 29  The Efficient Market Hypothesis (EMH) Implications of EMH: 1. Markets act as if all the information is immediately and costlessly available (zero transaction costs) 2. New information, which will cause prices to change, is always reflected into prices (it matters the speed of response) 3. There is no ‘free lunch’ (higher returns only if you take more risks) 4. The more private information, the more somebody can profit trading on it (depending how efficient the market is). The EMH underpins arbitrage pricing theory, the capital asset pricing model and concepts such as the ‘beta’. © Valiante Diego - 30  Market efficiency taxonomy Different forms of market efficiency, according to how we define ‘available information’ (Fama 1970): 1. Strong form → markets have monopolistic access to any information necessary to price discovery (which includes inside information) (‘available information’ is everything) 2. Semi-strong form → the ‘available information’ subset is all publicly available information (e.g. includes information on fundamentals) 3. Weak form → the ‘available information’ subset is just historical prices or return sequences (i.e. trend analysis is always useless) Depending on the form of efficiency, the time to reach the efficient price equilibrium will be different. But the ‘full reflection’ in price will always take place! – We will talk about these mechanisms in the next lectures. The EMH is just a theoretical model to look at financial markets with the objective to judge the relative efficiency of one market compared to another (ie their ability to incorporate all available information). © Valiante Diego - 31  Stock price reaction Source: Google Image © Valiante Diego - 32  Main criticisms 1. There are anomalies in empirical evidence – Stocks can exhibit momentum and reversal (vs weak form) – Value stocks (low market to book value) can beat the market (vs semi- strong form) – Slow response to new earning announcements (vs strong form) 2. investors are not always fully rational – Behavioural biases affecting decision-making and evaluation). 3. Information collection is a costly process, – …so it is unlikely that all already available information will be reflected in prices (in all forms). – Arbitrage can be costly or even not possible (e.g. ban on short selling). – Arbitrage can also become costlier (requiring a deep pocket), and thus less likely, the further away from fundamentals prices move. So the price may not be always ‘fair’. 4. The initial distribution of information is relevant – Information invariance hypothesis is wrong News immediately reflected into prices depending on who is acting on it. © Valiante Diego - 33  The inevitable role of arbitrage Arbitrage is the competitive nature of human beings lurking behind the EMH. 1. Suppose a share of Unicredit bank is worth €20. 2. Suppose a group of excessively pessimist traders push the price to €15. 3. Buying opportunity for the rational arbitrageurs emerges. 4. Buy and short a ‘substitute’ security (with similar cash flows) to hedge (e.g. BNP Paribas). 5. Buying pressure would thus correct the mispricing. …but this is not risk free…i.e. there might be times where there is not enough trading to fill the evaluation gap. © Valiante Diego - 34  The never-ending debate https://www.youtube.com/watch?v=bM9bYOBuKF4 (first 14-15 min.) © Valiante Diego - 35  Key assumptions that we will challenge (A. Ogus) 1. Individualism – Social welfare is only as a sum of all individual welfare, so no value for collective action. 2. Individuals only care about utility maximization 3. Information to maximize that utility is readily available 4. Absence of externalities – All costs are internalised 5. Competitive markets © Valiante Diego - 36  Recommended readings H. Varian, Intermediate MicroEconomics, Chapter 32 Ogus A. Regulation: Legal Form and Economic Theory (Chapters 2, 3, 4, 7 and 8) Cooter, R. & T. Ulen, Law and Economics, Pearson (Chapter 1 and 4.4) A. Mitchell Polinsky, An Introduction to Law and Economics, Wolters Kluwer, 2019 (Chapters 3 and 4) Michael C. Jensen, ’Some Anomalous Evidence Regarding Market Efficiency’, Journal of Finacnial Economics, Vol. 6, n. 2/3, 1978, pp. 95-101 Ronald J. Gilson, ‘The Mechanisms of Market Efficiency’, 70 VA. L. REV. 549 (1984). Available here Additional readings – Coase, R. (1960), “The Problem of Social Cost”, The Journal of Law and Economics, Vol 3, October. – Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, The Journal of Finance, Vol. 25, No. 2, May 1970 – On Pareto efficiency, G. Calabresi,’The Pointlessness of Pareto’, https://digitalcommons.law.yale.edu/fss_papers/2014/ © Valiante Diego - 37  Study questions (next week) What are key sources of market failures? What are examples that we can identify from financial markets and banking practice? What are the main remedies for such failures? © Valiante Diego - 38  Diego Valiante LEIF Master Programme [email protected] www.unibo.it