Chapter 9
Good Markets
Private Benefits of Trading
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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!)
Public Benefits of Trading
Public benefits of trading accrue to
everyone, regardless of they use the
markets. Positive externalities
 Fall into two classes
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Public benefits from informative prices
• Public benefits from liquid markets
Public Benefits from Informative
Prices
Well-functioning markets produce
informative prices: prices = fundamental
values
 Benefits from informative prices
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Production and allocation decisions
Capital allocation in the primary markets
Manager allocation in the secondary markets
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.
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Command Economies
Amount of information is too large.
 Receive low-quality information.
 Political forces and personal biases
 People may not implement plans.
 Accountability problems
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Market-based Economies
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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.
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.
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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
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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.
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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!
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Public Benefits of Liquid Markets
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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 informationbased trading →more informationally efficient markets.
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.
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