OHCh8 - Chapter 8: An Economic Analysis of Financial...

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Unformatted text preview: Chapter 8: An Economic Analysis of Financial Structure 1 Roles of the Government and Institutions See the Lecture Note on Roles of the Government and Institutions. 1.1 The Roles of the Markets in Promoting E&ciency & homo oeconomicus only cares about his consumption, forgetting about the other peoples welfare. & Available resources (physical assets, goods and services, time, etc.) are allocated to consumption and production of consumers and business &rms. & There are many ways to allocate resources: market transactions and a central planning. & An allocation is economically e&cient if there is no way to change it so that everyone gains or so that some people gain while no one else loses. & Mary likes oranges and Irving likes apples. If Mary has an apple and Irving has an orange, then the allocation is economically ine&cient. & After they trade, Mary has an orange and Irving has an apple. This situation is economically e&cient. & In an ideal situation (to be discussed later), an allocation obtained by an equilibrium in all markets (demand is equated with supply in each market) is economically e&cient. This is called the Invisible Hand Theorem . & In this ideal situation, there is no need for institutions such as nancial intermediaries. & In this ideal situation, there is no need for the government to regulate the economy to promote economic e&ciency. The government should leave everything to the markets to obtain an e&cient allocation. 1.2 The Roles of the Government and Institutions in Pro- moting E&ciency 1.2.1 Conditions for Markets to Work Well In reality, the government and institutions such as &nancial intermediaries have roles in promoting eciency because some conditions for the ideal situation are not met. The ideal situation where the market allocation is ecient satisfy the fol- lowing four conditions: & Market trading and private ownership are well established. Markets themselves do not establish private ownership, so the govern- ment should provide a legal system, police, etc. & Competition is perfect. A monopolist of a good (or a service) tends to produce a smaller quantity of the good than would be economically e&cient in order to raise the price of the good and to make more prots. The government should promote competition to avoid this. & There are no transaction costs. When there are transaction costs, market transactions are discouraged, and markets may fail to produce economically e&cient outcome. & There are no external economies or diseconomies. A beautiful garden An extreme example of a good with external economies is one which a&ects everyone in an economy and is called a public good . National defense is an example of a public good....
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OHCh8 - Chapter 8: An Economic Analysis of Financial...

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