How Markets Fail by Cassidy book notes PDF

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• Book notes PART 1- UTOPIAN ECONOMICS Chapter 1:Warnings ignored • Catastrophic events weren't considered low probability outcomes, they werent considered at all • 2003-06 house price accelerated, biggest bubble in history • Denial was a reason the warnings went unheeded e.g. Greenspan • Increasing competition had pushed banks into new fields e.g. MBSs and CDOs , helped diversify to protect small shocks but subjected system to large systemic shock • incentive based consumption- fuelled crisis- perverse incentives encouraged risks and herding perpetuated this Chapter 2: Adam Smith's invisible hand • 3 markets- goods, labour and financial • Market systems have proved durable because; provide specialisation, productive capacity and incentives • Specialisation- division of labour- increases productive powerscomplex web of mutual trade and dependency --> complicated global supply chain • In smiths idealised version of free market; competition forces businesses to supply what customers want --> prices gravitate to natural price • It is efficient and self correcting as negative feedback restores equilibrium • Laissez faire- strengthen property rights ad lower tariffs • Competition- most efficient use of resources for entire society, lower prices, more choice, better quality • Human selfishness keeps mechanism humming along • Economic order can emerge as the unintended consequence of actions of many people each seeking his own interest • Smith believed government had a duty to protect the public from he financial swindles and speculative panics

• Invisible hand allocates resources efficiently Chapter 3: Hayek's telecommunications systems • Right wing nut • he asked the question- in the absence of competition, how would the government know what price to set • Centralised systems look attractive in principle but cant deal with division of kmowldege • He believes the advantage of the market system is that prices transmit information on the market and what actions to take (system of telecommunications) • Only the most essential information is passed on and passed on only to those concerned • Market uses infinitely greater amount of information than autorities ever do • Hayek neglected serious failures Chapter 4: Perfect markets of Lausanne • Issue with Hayek- how can we be sure that price signals the market sends are the right ones? • Pricing problem is vast • As long as each industry has competing suppliers and firms cant decrease unit costs by merely raising output • Competitive markets are efficient- consumers get to buy the goods they value most highly • --> general equilibrium theory • Walras- individual will consume up to the point where the last franc he spends on it yields the same amount of satisfaction • Walras- everything in economics depends on everything else, prices are all determined simultaneously, economy is an organic whole • Pareto- Pareto improvement- define an economic outcome in which all moves have been exhausted as parteto efficient (makes two people better off) • Pareto- efficient- impossible to make anybody better off without

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making somebody else worse off Pareto efficiency0 minimum requirement for any satisfactory economic outcome BUT it cannot weigh gains and losses, cant deal with issues of equity Society or economy can be Pareto optimal and still be perfectly disgusting Free markets- enable people to make mutually advantageous deals Firms must Set prices to cover their marginal costs Planned economy - avoid much of social waste- more efficient? Competition tends to enforce rules of behaviour simmer to those in an ideal planned economy BUT capitalism fostered inequality and an assortment of other ills such as poverty and recession

Chapter 5- Mathematics of Bliss • Arrow 1995- proved that all competitive equilibriums are Paretoefficient: at the equilibrium prices, the market will deploy the economy's resources in such a way that it is impossible to make someone better off without making them worse off (more general than Pareto and pointed out issue of equity) • Society can select Pareto outcome it prefers by taxing some and providing benefits to others • Arrow suggests a society can redistribute resources in a just manner and then rely on the market to ensure an efficient outcome (bliss point) • Nordhaus- no hope of improving on efficiency of free market (prices provide the signals) • BUT economies of scale and monopolies--> undercut • But even if technical assumptions of general equilibrium are achivesdno guarantee that economy will be Pareto efficient - no assurance the economy's equibilibrum is unique, the whole cannot be derived from the parts • Prices don't necessarily always correct • Possible outcomes for the economy as a whole is simply vast and pinning down one of them or even a set of them is very difficult

Chapter 6: the Evangelist - Friedman • 4 major contributions- championed individual measures- e.g. reduce tax, deregulation • Revolutionist explanation of depression- government failure- 14 unnecessary interventions • Argued problem of monopoly was exaggerated • Not all recommendations were economically sound - opposed all types of regulation • Linked economic freedom to political freedom • He was aware of dangers of unregulated financial system - vicious cycle on pressure of recalling loans • Argued best way to stabilise financial sector and entire economy was a specified growth rate in monetary stock • He said cutting taxes led to more inflation and disagreed with Phillips curve (if Ut falls below natural Nate, workings bid up wages and firms raise prices, inflation would then pick up) • Friedman said there is always a temporary trade off but not a permanent • Stagflation • He did not believe you could spend yourself out of a recession (fiscal policy doesn't work) • He believed the only type of regulation that works is self regulation e..g drug companies wouldn't distribute dangerous products if honest competitors existed • Chile case study- 1975- sweeping free market reforms- at beginning inflation was 50% per year- Friedman encouraged them to accelerate reformation process and control money supply, slash G and remove free market barriers--> abolished wage controls, sold state owned firms, deregulated ffinancialsector --> reduced inflation to 10% and GDP increased • BUT 1982- deep recession, 1985- second wave of reforms and generally speaking outperforms South American countermarks demonstrated beyond out the efficacy of free market policies (social and economically) • Invisible hand is far more powerful than hidden hand

Chapter 7- Coin tossing view of finance • Country's prosperity was how effectively it mobilised its natural resources • Fama- efficiente market hypothesis- financial markets always generate correct prices, taking into account all available information - stock price reflects best guess of analysts • BUT this efficiency alludes tot he fact prices reflect all available info (p. 90) • Invoking bell cure which is normal distribution doesn't make individual events easier to forecast but does allow you to make some predictions about overall rate of occurrence • Mean and SD make is possible to make precise statements about likelihood of extreme outcomes • Mandelbrot- large changes tend to be followed by more large changes and small changes • Volatility clustering- financial markets contain element of predictability. However it also raises the possibility the the causal relationships that determine market movements aren't fixed and vary overtime Chapter 8: Triumph of Utopian Economics • Lucas- mathematical analysis is the only way of doing economic analysis • Keynes- emphasized the logic of individual behaviour doesn't apply to entire economy - paradox of thrift (for one person it may make sense to cut back on spending but if every does it then the effects are vast -> depression) • Lucas- rational expectations hypothesis - assume that everyone knows how the economy works • Lucas predicties anticipated changes in monetary policy would not impact output or employment - policy ineffectiveness preposition taxes will do full circle • Lucas assumed only imperfection in entire economy was hat individual workers couldn't distinguish between rises in their own wages and increases in overall price level • Unemployment was a matter of choice- unwilling to work for

prevailing wage • Explanation of economic ups and downs- random fluctuations in productivity • Rational expectations approach was just triumph was just incarnation of utopian economics • When things are going well it is much easier to sell people on latest position of invisible hand Reality based economicsChapter 9: Prof and Polar Bear • Stearn, 2006- climate change presents a unique challenge for economics, it is the greatest and widest ranging market failure ever and its root is economic • All to do with social and private costs • Private benefits and existence are reflected in the fares of the users are willing to pay • Private costs highlighted in the prices it charges • Utopian economics- free market --> prices that equate PC and PB --> efficient outcome BUT from social SB & SC need to be balanced • Hayek's supercomputer forgets social aspect • Pigou- taxes and subsides - restraints and encouragements • Pigou pinpointed social cost as the fundamental problem with invisible hand • Coase, 1960- conflicting property rights- private bargaining between affected parties would ensure economically efficient outcome • BUT pigou believed private bargaining was impractical given higliy complex inter-relations of the various private persons affected government intervention best • GE episode of dumping PCBs into Hudson River shows folly of relying on Coase theory • Large scale problem- government only way forward • Prices don't reflect environmental damage • Another option is caps • Monopoly power = another type of market failure

Chapter 10: Taxonomy of failure • Uncertainty and Imperfect information are fundamental features of any economy • Monopoly power is failure- prices set above costs which violates conditions for ecobnomic efficiency • Problem of public goods- non excusable, non rivalry, non ejectable • Provision is neccary to ensure Pareto efficient outcome • Bator, 1960- market prices fail to approximate true scarcity values in terms of wants • Scientific knowledge and R&D is good example of public good • High technology sector- monopoly power is endemic- number of people using goods is endemic- if network of established users is large --> network externalities --> more attractive --> monopoly • Microsoft e.g. of monopoly • Need middle ground, mixed economy • Baxtor's taxonomy of market failures remains useful- increasing returns to scale, monopoly power and issue f providing public goods are essential elements Chapter 10- Prisoner's Dilemma • All to do with human interdependence • Usually bottom right is dominant strategy as temptation of trying to get ahead and threat of other doing the same is too great • BUT non-cooperative solution (coffees, confess) cant possibly be rational as rational decision maker wouldn't choose inferior outcome BUT collusion is ruled out and the essence is in the independent decision making • Ignores element of conflict • Assumes it is a one shot game • Prisoners dilemmas are always bad- prevent cartels and keep prices pad e.g. OPEC • Prisoners dilemma can head to over supply as increase output isn't always desirable • In reality it is not a two person game

• Bin more on tragedy of the commons Chapter 11: Hidden info and lemons • Unemployed people often discover to their cost that the labour market is one such area. Easier to get a job when you have one otherwise you are viewed as a lemon • Productivity correlated with producivity in other areas of life • Health insurance is place with big issue of hidden information- could get around by introducing universal coverage and tax breaks • Freemarket assumes that everyone has neccearry info to make the right decisions • Moral hazard - overcome by putting limits on consumption • Financial insitutions also effected -Moral hazard • Moral hazard exists in a market where an individual or organisation takes many more risks than they should do because they know that they are either covered by insurance, or that the government will protect them from any damage incurred as a result of those risks. • Asymmetric information-This type of market failure exists when one individual or party has much more information than another individual or party, and uses that advantage to exploit the other party. • Finance is a market in information – often a potential borrower (such as a small business) has better information on the likelihood that they will be able to repay a loan than the lender • Smith- banking is different and Seidman- financial systems are not and never will be totally free market systems • Information issues are key to many different types are market failureinformation is more like air - adequate preconsiditon for other things to happen • The assumption of Pareto efficiency is perfect information • When info is lacking standard theories of economics often don't apply • Present more of a challenge than visible market failure Chapter 13- Keynes beauty contest • To buttress his point, he noted the fact that shares of ice companies were higher in summer months when sales are higher. This fact is

surprising because in an efficient market, stock prices reflect the longrun value of a company, and do not rise in good seasons. Recent academic studies show this pattern is still true. Keynes was also sceptical that professional money managers would perform the role of the “smart money†that EMH defenders rely upon to keep markets efficient. Rather, he thought they were more likely to ride a wave of irrational exuberance than to fight it. One reason is that it is risky to be a contrarian. “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.†• • He likened it to a common newspaper game akin which the competitors have to pick out the six prettiest faces from 100 photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole: so that each competitor has to pick, not those faces that he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view Individual self interest led to socially desirable outcomes --> forget fallacy of composition (confusing sum with parts) • Paradox of thrift is based on this- lay off workers etc, ut rises--> multiplier effect • Shiller- Keynes theories pivot on rational irrationality, rationality that is rational at the individual level but that leads us to socially irrational outcomes • human decisions cannot depend on strict mathematical expectation Chapter 14- Rational Herd • In economics and finance, rational herding is a situation in which market participants react to information about the behavior of other market agents or participants rather than the behavior of the market, and the fundamental transactions • Rational herding in financial markets can take place because some investors believe others to be better informed than themselves, and

follow them, disregarding their own information or market fundamentals Reliance on rational herding can be a source of instability in financial markets • Links in with beauty contest model • Asch line test 1951 • Information cascades - deliberate and purposeful behaviour on part of individual leads to collectively irrational results Chapter 15: psychology returns • Overconfidence- inability to estimate risks • Smith- myopia is basic element of human condition hence what interests us today is is alot more pertinent compared to that of 10 years time • Pigou- telescopic faculty is defective • Kahneman- when people are faced with uncertain outcomes, they opt to use heuristics and biases • Representative heuristic- generalise on basis of insufficient information e.g. stereotypes, e.g. tossing coin 5 times--> 4 heads --> think coin is biased - extreme outcomes are a lot more probable in small sample sizes but human brain ignores statistics • Representativeness heuristic e.g. law of small numbers • In finance '' --> predictions that short term trends will continue and under ration of prospects of major reversal • People ignore outliers--> regression to the mean • Too much weight on own experiences (availability bias) e.g Icelandic bankers • Judged to reference group • When economy is growing strongly a disastrous possibility is difficult to imagine (availability heuristic) and bankers downplay it= disaster myopia • Sytem 1 and system 2 • People have intense dislike of unambiguous situations and rather than plunging into unknown they gamble with known odds • People don't really know where their best interests lie, it is an external and internal problem

Chapter 16- Hyman MInksy and Ponzi finance • Minksy warned against dangers of little regulation and thus was considered radical • Great Depression inspired his interests in economics minks set out to fill the lacuna of Keynesian economics that stipulated that the financial sector had no place for stock market bubbles or credit markets etc • Financial capitalism began from the observation that it usually involves the advancing of money today in return for the promise of money in the future BUT future is uncertain and expansion of economy depends on willingness of people to speculate • Speculation is done through banking system • Prosperity fuels more risk taking and 'new' forms of miney --> easier to borrow --> more investment --> increase stock prices • This process is due to stability leading to expansion of debt financing • BUT minksy argument is that stability is dstabilizing • At beginning banks only lend to businesses that generate sufficient cash and repay on principal of amortisation = hedge finance • Then boom proceeds --> competition --> less caution --> make loans to people who can only cover interest --> speculative finance • Then banks lend to people who cant even cover interest = negative amortisation = PONZI FINANCE (depends of borrower getting access to more income_ • Negative amortisation was very prevalent in real estate industry as increased house prices fuel dubious lending • Unless financial authorities intervene lending public money freely to whomever could lead to a deep depression and a traumatic debt deflation • Minksy credited schumpeter for his views- first them of financial instability hypothesis is that economy has financing regimes under which it is stable and regimes under which it is unstable • Financial instability hypothesis = theory of rational irrationality • Bankers have incentives to operate in their best interest, not the best interests of the entire company • Bank can increase return by increasing leverage

• bUT more leverage is more risk • Traditional view of banking doesn't account for financial innovation e.g. securitisation - residential mortgage backed security (RMBS) • bond= loan- promises lender set of interest repayments over a certain period • Assest backed security (ABS) • Securitised products enabled investors to diversify their holdings across assets classes and geographic boundaries • Minksy note that banking industry's eager embrace of securitisation was a reflection of the increased competition it was facing for deposits and borrowers • Securitisation allowed banks ti keep loans off balance sheets --> didnt need as much capital reserve --> profits and they do not worry so much about creditworthiness of borrowers • Failure of big bank or investment bank can lead to catastrophic panic and is up to bank to prevent such an outcome • Federal reserve should be Stability enhancing and discouraging instability augmenting Part 3- THE GREAT CRUNCH Chapter 17- Greenspan Shrugs • Evolution of bubble has 5 stages- displacement, boom, euphoria, peak and bust • Displacement- gets it all started = dramatic fall in IR 6.5% in 2000 to 1.25% in Nov 2002 - wanted to avoid Japense style deflation --> cost of ST borrowing was well below zero • Greenspan's word was law- group think • Many interest rates- prime lendin...