Table Of ContentIntroduction to the Economics of
Financial Markets
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Introduction to the
Economics of Financial
Markets
James Bradfield
1
2007
1
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Library of Congress Cataloging-in-Publication Data
Bradfield, James.
Introduction to the economics of financial markets / James Bradfield.
p. cm.
Includes bibliographical references and index.
ISBN-13 978-0-19-531063-4
ISBN 0-19-531063-2
1. Finance. 2. Capital market. I. Title.
HG173.B67 2007
332—dc22 2006011610
9 8 7 6 5 4 3 2 1
Printed in the United State of America
on acid-free paper
To my wife, Alice, to our children, and to their children
To the memory of Professor Edward Zabel,
a friend and mentor, who taught me the importance of
extracting the economic interpretations from
the mathematics, and who taught me much more.
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Acknowledgments
My greatest debt is to my wife, Alice, whose encouragement, understanding, and clear
thinking about choices are indefatigable.
Most professors owe much to their students; I am no exception. I have learned
much from the students who have taken the courses from which I have drawn this book.
Several of those students read many drafts of the book, eliminated errors, and made
valuable suggestions for additional examples and for clarity of exposition. I thank John
Balio, Tierney Boisvert, Katherine E. Brogan, Matt Clausen, Mike Coffey, Kaitie
Donovan, Matt Drescher, John Durland, Schuyler Gellatly, Young Han, Tom Heacock,
Jason Hong, Danielle Levine, Brendan Mahoney, Abhishek Maity, Katie Nedrow,
Quang Nguyen, Greg Noel, Cy Philbrick, Brad Polan, Eric Reile, Dan Rubin, Katie
Sarris, Kevin St. John, Gregory Scott, Joseph P. H. Sullivan, and Kimberly Walker. I
appreciate the work of Rachael Arnold, who used her skills as a graphic artist to create
computerized drawings of the several figures.
I thank Dawn Woodward for the numerous times that she assisted me with the
arcana of word processing, and for many other instances of secretarial assistance.
Five former students served (seriatim) as editorial and research assistants. I am
grateful to Mo Berkowitz, Jon Farber, Gregory H. Jaske, Kathleen McGrory, and Mac
Weiss for their industriousness, their intelligence, and their constant good cheer. Each
of them contributed significantly to this book.
I extend appreciation especially to Dr. Janette S. Albrecht, who watched the
progress of this book through periods of turbulence, and who added several dimen-
sions to my understanding of sunk costs.
Mrs. Ann Burns, a friend of long standing from my days in the dean’s office,
cheerfully, speedily, and accurately typed numerous drafts of the manuscript, many of
which I wrote by hand, with labyrinthian notes (in multiple colors) in the margins and
on the back sides of preceding and succeeding pages. I wish Ann and her family well.
I thank Mike Mercier for his editorial encouragement and guidance during an
earlier incarnation of this book.
My friend and colleague, Professor of English George H. Bahlke, who is an
expert on twentieth-century British literature, helped me to maintain a greater meas-
ure of equanimity than I would have had without his support.
I am also indebted to my friend and colleague, Professor of History Robert L.
Paquette, who has written extensively on the Atlantic slave trade, and with whom
viii Acknowledgments
I teach a seminar on property rights and the rise of the modern state. Among other valu-
able lessons, Professor Paquette reminded me on several occasions that the application
of theoretical models in economics is limited by the prejudices of the persons whose
behavior we are trying to explain.
I appreciate the confidence that Terry Vaughn, Executive Editor at Oxford
University Press, expressed in my work, which culminated in this book. Catherine
Rae, the assistant to Mr. Vaughn, helped me in numerous ways as I responded to
referees’ suggestions and prepared the manuscript. Stephania Attia, the Production
Editor for this book, supervised the compositing closely, and I thank her for doing so.
I also appreciate the attention to detail provided by Jean Blackburn of Bytheway
Publishing Services. Judith Kip, a professional indexer, contributed significantly by
constructing the index.
Preface
This book is an introductory exposition of the way in which economists analyze how,
and how well, financial markets organize the intertemporal allocation of scarce
resources. The central theme is that the function of a system of financial markets is to
enable consumers, investors, and managers of firms to effect mutually beneficial
intertemporal exchanges. I use the standard concept of economic efficiency (Pareto
optimality) to assess the efficacy of the financial markets. I present an intuitive devel-
opment of the primary theoretical and empirical models that economists use to analyze
financial markets. I then use these models to discuss implications for public policy.
The book presents the economicsof financial markets; it is not a text in corporate
finance, managerial finance, or investments in the usual senses of those terms. The
relationship between a course for which this book is written, and courses in corporate
finance and investments, is analogous to the relationship between a standard course in
microeconomics and a course in managerial economics.
I emphasize concrete, intuitive interpretations of the economic analysis. My
objective is to enable students to recognize how the theoretical and empirical results
that economists have established for financial markets are built on the central eco-
nomic principles of equilibrium in competitive markets, opportunity costs, diversifi-
cation, arbitrage, and trade-offs between risk and expected return. I develop carefully
the logic that supports and organizes these results, leaving the derivation of rigorous
proofs from first principles to advanced texts. (Some proofs and technical extensions
are presented in appendices to some of the chapters.) Students who use this text will
acquire an understanding of the economics of financial markets that will enable them
to read with some sophistication articles in the public press about financial markets
and about public policy toward those markets. Dedicated readers will be able to
understand the central issues and the results (if not the technical methods) in the schol-
arly literature.
I address the book primarily to undergraduate students. The selection and presen-
tation of topics reflect the author’s long experience teaching in the Department of
Economics at Hamilton College. Undergraduate and beginning graduate students in
programs of business administration who want an understanding of how economists
assess financial markets against the criteria of allocative and informational efficiency
will also find this book useful.
