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Lecture IX

Lecture IX. Questions from last lecture Transaction Taxes Virtues of Prudential Regulation. Economic Rationale for Market Regulation Identifying the public interest

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Lecture IX

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  1. Lecture IX • Questions from last lecture • Transaction Taxes • Virtues of Prudential Regulation

  2. Economic Rationale for Market Regulation Identifying the public interest The market, the magic of the market, the infamous “invisible hand,” is so highly regarded these days that its limits are often overlooked, forgotten or otherwise misunderstood. The market can do some things very well: generally setting prices that function as signals and disciplining incentives to allocate resources between competing uses in an efficient manner. There are also things that the market does not do well, or perfectly or sometimes not at all. These things are called market failures, incomplete markets, or market imperfections. They are often analyzed in economics as externalities, economies of scale, non-competitive behavior, destructive competition, monopolistic or oligopolistic competition. These analytical categories are often not as well studied as others in economics. In order to bring greater rigor to this discussion, let’s delve into these ideas more carefully. Lecture IX

  3. Lecture IX • First consider some illustrative examples of market imperfections in the area of corporate governance. • Executive manipulate earning reports in order to boost stock prices so as to capture gains on stock options. Not only are investors ultimately cheated, but also investors in other firms that compete for resources with the cheating firm. It distorts prices in securities markets, thereby reducing their efficiency, and it threatens integrity of capital markets and thus the viability of overall economy. This imposes costs on people both inside and outside the firm, and market incentives do not adequately discourage but sometime encourage this activity. • A firm, or rogue traders within a firm, manipulates market prices. They have incentives to manipulate because it maximizes their profits. (For a brief description of market manipulation strategies read, "Learning Our Lessons: A Short History of Market Manipulation And The Public Interest” at http://www.financialpolicy.org/dscbriefs.htm) This price distortion, however, causes losses for others in the market and economic inefficiencies in the overall economy as resources are misdirected and the integrity of the marketplace is undermined. • A CEO of a financial institution pressures the firm’s research staff to produce overly optimistic assessment of another companies stock because the financial institution is acting a underwriter of its debt and securities. This generates profits for the financial institution and in turn for the CEO but it cheats investors and others in the market. • Consider a more general point about investors’ need for all relevant market information. Firms have an incentive to hoard information and not disclose to the markets any thing but good information about their activities, and even then they may not disclose good information on a timely basis but instead when it is advantageous for them. Individual firm incentives are in this way inconsistent for overall market efficiency.

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