Micro Markets E-Book

Robert A. Schwartz

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 897

Veröffentlichungsjahr: 2010

Beschreibung

A timely guide that bridges the gap between microeconomic theoryand practice through real-world application in the marketplace Understanding how microeconomics affects the marketplace isessential for any investment professional, however most bookssimply address microeconomics in its pure theory-based form.Micro Markets helps bridge the gap between theory andpractice by defining microeconomics in terms of real-world, marketapplications. This timely guide elucidates basic microeconomic concepts withan emphasis on applicability. It establishes a common applicationfor all of the basic economic concepts that are reviewed, andprovides in-depth insights into an industry that is of majoreconomic importance in aggregate, and to most individuals. * Utilizes equity market realities to underscore the relevance ofeconomic theory * Each chapter includes informative practice problems and powerpoints * A companion Workbook, with practice problems andsolutions, is also available By taking microeconomic theory and making it applicable totoday's marketplace, Micro Markets builds a much-neededbridge between theory and practice.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Preface

OVERVIEW OF THE BOOK

RELATED PUBLICATIONS

Acknowledgements

CHAPTER 1 - Introduction to Market-Driven Economics

THEORY AND REALITY

PRIMARY AND SECONDARY MARKETS

FRICTIONLESS VERSUS NONFRICTIONLESS MARKETS

HOW WELL DO MARKETS FUNCTION?

A MARKET IS AN ECOLOGY

BASIC MICROECONOMIC CONCEPTS

FRICTIONLESS MARKETS, THE GULF STREAM, AND A DAY AT THE RACES

CHAPTER SUMMARY

CHAPTER 2 - The Consumer Choice Model

THE CONSUMER CHOICE MODEL AND THE X, Y TRADE-OFF

THE CONSUMER CHOICE MODEL AND THE CURRENT CONSUMPTION, FUTURE CONSUMPTION TRADE-OFF

THE CONSUMER CHOICE MODEL AND THE RISK-RETURN TRADE-OFF

COMPARATIVE STATICS

CHAPTER SUMMARY

CHAPTER 3 - Demand Meets Supply

SHOULD HAVE, WOULD HAVE, AND DID: THE DECISIONS OF A REPRESENTATIVE CONSUMER

THE DEMAND CURVE FOR X

THE SENSITIVITY OF THE DEMAND FOR X TO THE PRICE OF X, THE PRICE OF Y, AND INCOME

FROM INDIVIDUAL DEMAND CURVES TO MARKET DEMAND CURVES

THE DEMAND TO HOLD SHARES OF A RISKY ASSET

THE INVESTOR’S DEMAND CURVE FOR THE RISKY ASSET

EQUILIBRIUM IN THE MARKET FOR X

EQUILIBRIUM IN THE MARKET FOR SHARES OF THE RISKY ASSET

MARKET EQUILIBRIUM

STOCKS, CAKES, AND SUBSTITUTABILITY

CHAPTER SUMMARY

CHAPTER 4 - Microeconomic Analysis Goes to Market

SHORT-RUN DEMAND AND SUPPLY FOR PRODUCT X

ADJUSTMENT COSTS

LIQUIDITY

MARKET STRUCTURE

THE GAINS FROM TRADING

STRATEGIC ORDER PLACEMENT

THE BIG PICTURE

CHAPTER SUMMARY

CHAPTER 5 - Supply and the Costs of Production

THE PRODUCTION FUNCTION FOR X

COST CURVES

DETERMINING THE BEST PROFIT OUTPUT

SUPPLY

APPLICATION TO A DEALER FIRM

FROM GENERAL PRINCIPLES TO THE DETAILS OF A SPECIFIC MARKET

CHAPTER SUMMARY

CHAPTER 6 - Sources and Nature of Competition

PERFECT COMPETITION

MONOPOLY

IMPERFECT COMPETITION: MONOPOLISTIC COMPETITION

IMPERFECT COMPETITION: OLIGOPOLY

HOW COMPETITION PLAYS OUT IN THE EQUITY MARKETS

IMPORTANCE OF PRICE AS A COMPETITIVE VARIABLE

CHAPTER SUMMARY

CHAPTER 7 - Market Efficiency

ALLOCATION EFFICIENCY

MARKET FAILURE

INFORMATION AND EXPECTATIONS

INFO ABOUT INFORMATION

FOUR DIMENSIONS OF INFORMATIONAL EFFICIENCY

A TEST OF MARKET EFFICIENCY

PRICE DISCOVERY EFFICIENCY

THE BIG PICTURE ON FINANCIAL MARKET EFFICIENCY

MARKETS AT RISK: THE FINANCIAL TURMOIL OF 2007-2009

THE GREATER GENERALITY OF THE FRICTIONS PROBLEM

CHAPTER SUMMARY

CHAPTER 8 - Public Policy and the Interplay between Competition, Technology, ...

GOVERNANCE STRUCTURE AND SELF-REGULATION

TECHNOLOGY, AUTOMATION, AND THE NASDAQ STOCK MARKET

THE EVOLVING REGULATORY FOCUS

GOVERNMENTAL REGULATORY INTERVENTION

REGULATION OF THE U.S. EQUITY MARKETS

CAVEATS FOR PUBLIC POLICY

CHAPTER SUMMARY

Glossary

About the Author

Index

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Copyright © 2010 by Robert A. Schwartz. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Schwartz, Robert A. (Robert Alan), 1937-

Micro markets : a market structure approach to microeconomic analysis / Robert A. Schwartz.

p. cm. - (Wiley finance series)

Includes index.

eISBN : 978-0-470-60285-0

1. Stock exchanges. 2. Microeconomics. I. Title.

HG4551.S3934 2010

338.5-dc22 2009042659

To my family, Jody, Emily, and Leigh

Preface

What is a micro market, and what is microeconomics all about? In a nutshell, a micro market is the market for a specific good, service, factor of production, or asset (in contrast to the macro market, which is all of a country’s micro markets in aggregate). Microeconomics is about how households, firms, and industries interact in the marketplace to determine the production, pricing, and distribution of society’s scarce resources.

This book is about how micro markets work. It is about the forces that drive production and consumption decisions. It is about the level of economic efficiency that markets and the people operating in them can achieve. While our focus is on micro markets, our subject is microeconomic theory. Microeconomic theory is a powerful and compelling body of thought that provides much insight into how the micro markets operate.

Here are some of the basic microeconomic issues that we will be addressing.

• Consumption decisions: How are these decisions made? That is, how can a household best allocate its scarce resources (its income and wealth) to maximize its well-being (or, as we like to call it, its utility).

• Production decisions: How are these decisions made? That is, how can a firm best use its factors of production, establish its output rate, and, if it has the power to do so, set a price for its product that will maximize its well-being (or, as we like to call it, its profits)?

• Industry output: How do the decisions of firms aggregate to the output of the industries that the firms are in?

• Firm and industry equilibrium: How does equilibria for firms and their industries depend on the competitive structure of the industry (meaning, is the industry very competitive, is it a monopoly, or is it something else)?

You will appreciate the tremendous importance that prices play in microeconomic analysis. Prices are the signals, the traffic lights, the force that the moral philosopher Adam Smith called “an invisible hand” that directs the allocation of resources in a free and competitive market. This invisible hand offers carrots: profits for successful firms and superior consumption choices for clever households. It also carries a stick, and it is a harsh taskmaster: inefficient firms fail, inefficient employees are fired, from time to time the macro economy will hit a speed bump and spiral down, and innocent firms and people suffer along with the guilty.

The U.S. economy survived a tech (dot-com) bubble at the start of the century, but by 2007 we were facing something far more serious: a housing bubble, a plethora of new and complex financial instruments that relatively few people really understood, and leverage rates that had reached sky-high levels. The storm clouds had started to gather in the summer of 2007. In early August, the first signs of a severe credit crunch appeared, as several major issuers of asset-backed commercial paper, which had provided prior funding of mortgage-backed securities, found that they were no longer able to refund their outstanding issues. This evaporation of liquidity spread to other sectors of the capital markets. Over the ensuing year, the illiquidity problem aggravated and, as it did, some major financial institutions, such as Bear Stearns, weakened. In the fall of 2008, a major financial crisis erupted, and it quickly spread to the broader markets in the United States and beyond.

Here are some highlights: Lehman Brothers, the venerable investment banking firm, totally collapsed; the big insurance company, American International Group (AIG), along with the two giant mortgage companies, Fannie Mae and Freddie Mac, went on government life support; Merrill Lynch is now part of Bank of America, and Wachovia has been acquired by Wells Fargo. Goldman Sachs and Morgan Stanley are being regulated by the Federal Reserve as bank holding companies, while Citicorp and Bank of America increasingly have come under government control.

These developments profoundly impacted the broader economy. As credit lines froze and more nonfinancial firms headed toward bankruptcy, it became crystal clear that the financial sector is not simply a conduit for transmitting funds from those who save to those who invest. Rather, the finance function is complex, it is interconnected, and it pervades the micro markets. As one frightening development led to another and 2008 turned into 2009, systemic risk came to be widely feared.

What does this say about Adam Smith’s invisible hand, that unseeable force that guides people to do what is best for others while striving to do what is best for themselves? Technology changes, competition, and appropriate regulatory interventions can move a macro economy forward. Nevertheless, it is important also to recognize that change in a dynamically evolving environment forces many people (along with firms and government) to make big adjustments. How well do they do it? Are they adequately educated, sufficiently trained, mentally prepared, and financially capable of making the adjustments? Perhaps in the long run Adam Smith’s invisible hand moves society in a desirable direction but, as we live our lives in the short run, additional factors come into play. We must take a closer look at issues such as:

• Market frictions: When firms implement their production decisions and households implement their consumption decisions in real-world markets, choices that are made and the outcomes that are realized are affected by transaction costs, blockages, risks, uncertainties, imperfect knowledge, and other impediments. We call these impediments frictions. How do the frictions affect market outcomes?

• Efficiency of a free market: We will consider the ability of the micro markets to efficiently serve our needs in a free-market setting. Might the free market fail to deliver the results that we want from a public policy perspective? Are there causes of market failure and, if so, what are they?

• Efficiency of government intervention: If a market fails to perform with reasonable efficiency, what should a government regulatory authority do about it? How efficient is government intervention itself? What is the appropriate balance between free-market competition and government intervention? Do not expect a definitive answer to this one, but be assured that we will pay attention to this age-old public policy question.

Using microeconomic analysis to come to grips with these issues requires both science and art. It involves science because of the rigor that we demand of our theories and the precision of the econometric methods that we use to test our theories and to assess our predictions. It involves art because, all said and done, theories are based on simplifying assumptions and thus do not conform exactly to reality. Moreover, we run our econometric tests on data that, to at least some extent, are incomplete and imperfect. Thus judgment is called for and, in applying it, economists often disagree with one another (ask any three economists a question and you might get four opinions).

When personal judgment comes into play, personal biases enter the picture. That is fine, it is reality. Personal opinions should be put on the table and discussed. But it is best to be open about one’s biases. So, here is one of mine, and it is no doubt reflected in this book. Appropriate regulation is of course needed, but like many microeconomists I generally favor a free market stance. At times I have been rather critical of some of the government regulations that have been applied to the architectural structure of the U.S. securities markets (one of my primary fields of research). Why is this? While I believe that from a microeconomics perspective the securities markets are in some important respects quite imperfect, I also observe that government regulatory intervention can have its own undesired, unexpected, and unintended consequences. For this reason, I retain my faith in the comparative ability of freely competitive markets to produce desirable results in the long run.

There are of course no absolute answers for all of this. I hope that your study of microeconomics will help to sharpen your own thinking about these important issues that economics as a science has long been striving to come to grips with.

OVERVIEW OF THE BOOK

Microeconomic theory provides an excellent set of tools for addressing our list of issues and questions. As we present these tools, we set forth our analysis with regard to broadly defined, abstract resources (the representative household, for instance, consumes just two generic products, X and Y). We then apply a number of these tools to a specific market: a market where the already-issued shares of corporate stock trade (that is, an equity market).

The equity markets are vitally important to the broad economy, they are intriguing to study, they provide a unified set of applications that we use throughout the book, and microeconomic analysis offers much insight into their operations. As we proceed, we intersperse relatively abstract discussions of the fundamental microeconomic formulations with more concrete analyses of the equity markets.

The book comprises eight chapters:

Chapter 1: Introduction to Market-Driven Economics. In this chapter we present basic thoughts (theory versus reality, frictionless versus nonfrictionless markets, and the idea that a market can be viewed as an ecology) and concepts [ceteris paribus (all things being equal), fixed costs versus variable costs, long-run versus short-run analysis, equilibrium, marginal analysis, elasticity, and the difference between maximum, minimum, and optimum] that are needed for our subsequent analyses.

Chapter 2: The Consumer Choice Model: What Would You Really Like to Do? This chapter establishes the theoretical framework for obtaining a household’s demand for consumption goods and services, and its demand to hold shares of a risky financial asset. We present the analysis for our two generic goods (X and Y), for two more defined consumption bundles (present and future consumption), and for two attributes of a financial asset (risk and return).

Chapter 3: Demand Meets Supply. This chapter builds on the framework established in Chapter 2 to obtain the individual household’s demand curve and the aggregate market (industry) demand curve for the generic product X, and for shares of the risky financial asset. The chapter also shows how we use a measure of responsiveness called elasticity to represent the sensitivity of one variable (such as the quantity of X demanded) to another variable (such as the price of X). We introduce a supply curve and show how the intersection of demand and supply in a competitive market establishes equilibrium values for our two key variables (price and quantity).

Chapter 4: Microeconomic Analysis Goes to Market. We enter the nonfrictionless environment in this chapter. The following key concepts are put forth: short-run versus long-run analysis, the effect of adjustment costs on market outcomes, the liquidity (or lack thereof) of a marketplace, the architectural structure of a marketplace, the gains participants realize from trading, and their strategic order placement decisions.

Chapter 5: Supply and the Costs of Production. In this chapter we change our focus from households to firms and, in so doing, derive the supply curve for a competitive firm and industry. To do this, we delve into the production function for the generic product X and the cost curves for producing X, show how a firm determines the most profitable amount of X to produce and, knowing all of this, obtain the supply curve of X for the competitive firm. We then apply the analysis to a specific kind of firm: an equity dealer firm.

Chapter 6: Sources and Nature of Competition. Building further on the analysis developed in Chapter 5, we show in this chapter how the output and pricing decisions of firms and aggregate industry output depend on the competitive structure of the industry that the firms are operating in (highly competitive, a monopoly, or something else). We then take a look at how competition plays out in the equity markets. The chapter concludes with a consideration of the importance of price as a competitive variable in a fiercely competitive industry (other variables such as advertising and product quality also have major roles to play).

Chapter 7: Market Efficiency. By now, key building blocks have been put on the table. In this chapter we pull them together and ask a bottom-line question—how capable is the free market in getting us the outcomes that, as a body politic, we want? In other words, how efficient is a free, competitive market? We turn our attention to various causes of market failure, giving particular emphasis to the enormous complexity, imprecision, and incompleteness of much of the information that we base our production, consumption, and investment decisions on. We consider the financial market turmoil that started in 2007 and roared through the economy in 2008 and 2009, and we will possibly leave you pondering (perhaps with a favorable eye) the desirability of bringing additional government regulation into the picture.

Chapter 8: Public Policy and the Interplay between Competition, Technology, and Regulation. In this concluding chapter we turn primarily to issues concerning government involvement in market outcomes. We first pay attention to a firm’s governance structure (namely, whether it is a membership organization or a for profit operation) and to the self-regulatory obligations of a firm such as a securities exchange. We consider the impact of technology on the economy, underscore how technology change seriously challenges the regulators (by giving rise to new regulatory issues that are difficult to understand and not easy to keep up with), and turn to government’s role in regulating the micro markets. We summarize the evolving regulatory focus with reference to three items: honesty, the efficiency of the market for broker/dealer services, and a market’s efficiency with regard to the pricing of equity shares. The chapter sets forth various reasons why a government’s regulatory intervention can itself be flawed (this discussion parallels our focus in Chapter 7 on why the free market may itself fail to deliver fully efficient results). A substantial portion of the chapter is then devoted to six specific equity market initiatives that have been taken by the U.S. regulatory authorities since 1975.

Our discussion in Chapter 8 emphasizes that public policy issues can be enormously complex, and that government intervention is far from an easy and complete panacea. For those who favor government intervention in the workings of the micro markets, we offer a number of caveats. We then end the book with this thought: While the free market may be far from perfect, we should not lose faith in its comparative efficacy to ultimately deliver socially desirable results.

Three items are included at the end of each chapter: a chapter summary, an application that includes questions for you to think about, and a computer exercise that you can do if you are in possession of Mastering the Art of Equity Trading Through Simulation: The TraderEx Course (John Wiley & Sons, 2010). These items are purposed to further your comprehension of the material and to give you additional experience applying the thoughts and analyses that we present in this book. Further, with Mastering the Art of Equity Trading, you will be able to access the TraderEx simulation software via a Wiley web site.

A glossary of key terms is included at the end of the book.

RELATED PUBLICATIONS

Micro Markets Workbook, by Robert A. Schwartz, Michael G. Carew, and Tatiana Maksimenko provides a means for reviewing the materials presented in the text and for enhancing your understanding of the principles of microeconomic theory.

Our text, as we have pointed out, devotes considerable attention to the equity markets. Hands-on experience with trading in an equity market can be obtained with the use of Mastering the Art of Equity Trading Through Simulation: The TraderEx Course, by Robert A. Schwartz, Gregory Sipress, and Bruce Weber (John Wiley & Sons, 2010). TraderEx is a computerized model of an equity market that enables a user to trade in a simulated environment, and the TraderEx book and the software that comes with it allows you to actually experience market operations. As noted in the previous section, the end of chapter material in each of the eight chapters of our Micro Markets text includes a computer simulation exercise that can be undertaken with the software and additional instructions that are provided in the TraderEx book.

Some of the material in this book draws from Robert A. Schwartz and Reto Francioni, Equity Markets in Action: The Fundamentals of Liquidity, Market Structure, and Trading (John Wiley & Sons, 2004) and from Robert A. Schwartz, Reto Francioni, and Bruce Weber, The Equity Trader Course (John Wiley & Sons, 2006). Both of these books provide further information about equity market structure, the role and operations of exchanges, and a spectrum of other topics including trading costs, trading strategies, public policy, and government regulatory intervention.

Acknowledgments

My first and greatest thanks are extended to Michael Carew, my colleague at Baruch, and to Tatiana Maksimenko a doctoral student at Baruch, who have in many ways participated in the production of this book, and have provided me with continual support and encouragement during the production process. I am also deeply grateful to Antoinette Colaninno, my assistant at Baruch, for all the help that she has given me. My friend and coauthor, Jacob Paroush, and my colleague, Norman Klienberg, have carefully reviewed the manuscript and have offered very helpful feedback. One other Baruch doctoral student, Sila Saylak, has spent long hours carefully reading the manuscript, giving me excellent feedback and advice, and helping with the production of the exhibits. Pamela van Giessen and Emilie Herman, my editors at John Wiley & Sons, have been a delight to work with, and I am most appreciative of the excellent advice and support that they have consistently given me. I also extend my heartfelt thanks to a number of other people, including two excellent research assistants, Bhavesh Dalal and Deepak Mulani, and participants in my doctoral seminar at Baruch, Mert Demir, Yalan Feng, Huajing Hu, Jeff Hu, Jun Jiang, Sibel Korkmaz, Jin Lei, Yili Lian, Scott Murray, Ko Woon Oh, Jangwon Suh, Ti-Jen Tsao, and Sha Zhao. One other person must be mentioned: I am unendingly thankful for the knowledge provided to me many years ago by my professor, dissertation advisor, and mentor, Gary Becker.

CHAPTER 1

Introduction to Market-Driven Economics

Markets are all around us. They lie at the center of our economic lives. They tie people together, they tie countries together, and, today more than ever, they are tying the world together in one global economy. Our subject, microeconomics, is about the functioning of a market. Along with being of critical importance to all of us, markets are exciting to study.

The book’s title is Micro Markets. By “micro” we are referring to the individual markets that comprise a broad economy. In contrast, the term “macro” refers to markets in the aggregate (that is, the broad economy). A micro market may be the market for a specific product (such as the book that you are now holding), or for a specific service (education, for example), or for a financial asset (e.g., a stock or bond). Have you ever considered how a micro market might operate? Have you ever thought about the forces that drive the micro markets, about how the markets can interact with each other, about who the key players in a marketplace might be, about how output might be set, consumption or asset holdings determined, and prices established? I bet you have. The objective of this book is to help formalize your insights into the dynamic behavior of the micro markets.

It is easy to take many of our markets for granted. When going to the supermarket with a shopping list, most of us simply buy our butter, eggs, and beer. But when the price of gas at the pump more than triples or falls by over thirty percent, we start asking questions. We ask questions when a bubble in the housing market bursts. And many of us scratch our heads when the Dow Jones Industrial average drops over 300 points or soars over 300 points in a single day. The fact is, markets are complex, the forces that impact them are intricate, and market breakdowns can occur. Just how efficiently a market operates depends on how it is structured. Very importantly, alternative structures exist. A marketplace can be designed, and the people who do this can be thought of as market architects. The market architects can get guidance from microeconomic theory.

In this introductory chapter we consider the relationship between theory and reality, between frictionless and nonfrictionless markets, and suggest that a market can be viewed as an ecology. We identify important economic vocabulary that is needed for our subsequent analyses: ceteris paribus (a Greek term meaning “all else constant” that we explain shortly), fixed versus variable costs and returns, long-run versus short-run analysis, the concept of an equilibrium, marginal analysis, elasticity (a measure of responsiveness that we explain shortly), and the difference between “maximum,” “minimum,” and “optimum.”

THEORY AND REALITY

Microeconomic theory is just that, it is theory. As such, it may appear to be a highly abstract, overly simplified, unpalatably unrealistic representation of any actual market. Imagine if a Martian’s first sighting of a human being was a Picasso portrait. Quite startling, wouldn’t you say? So why was Picasso a great painter? Here is one reason: his abstractions were great. He was able to capture the essence of a person without delivering an exact replication of the subject. That too is the goal of microeconomic theory: via the use of simplifying (and albeit often unrealistic assumptions), to capture the essence of an issue.

Real-world markets can be extremely intricate. Their many subtleties and extensive institutional detail make them almost impossible to understand in all their glory. Those who have worked in an industry can start to understand it, but even then their comprehension is typically intuitive. Ask somebody who has had the requisite experience in an industry to describe it and you will generally get just that—a great deal of description. What can we learn from the description? How can we classify thinking, generalize, and apply the knowledge more broadly to other industries and markets? That is where theory has a role to play.

The process of theorizing involves making the simplifying abstractions so as to get to the heart of the matter without being overwhelmed with unnecessary detail. The hallmark of a good theory is that, through the intelligent use of assumptions and analysis, it has honed in on the question that we are interested in. In other words, a good theory has sliced away inconsequential detail so as to gain the insights that we want.

You might appreciate microeconomic theory with real interest only when you see it being applied to an actual market. So let’s do that. Throughout much of this book, we present microeconomic theory with reference to one specific, real-world micro market: the equity market. This is an excellent market to analyze. Equities are a critically important financial asset for scores of investors, corporations, and the macro economy. Corporate equities (also referred to as “stocks”) represent shares of ownership in public companies and, as such, equity financing is a major source of the financial capital that firms must have to undertake their operations. On a national level, equities comprise a major part of the portfolios of both individual investors and institutional investors such as mutual funds and pension funds. Well-functioning equity markets are essential to the vibrancy and growth of a macro economy. And in light of its dynamic properties, an equity market is a particularly intriguing micro market to study.