4Financial Theory

4Financial Theory - Financial Theory...

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Financial Theory: Lecture 4 Transcript September 15, 2009 << back Professor John Geanakoplos: So we have begun by talking about general equilibrium, and this was the background to the course so that you're all familiar. Those of you who haven't taken freshman economics or intermediate economics, what's the background that's required for the course? And the fact that general equilibrium is a part of finance is, as I say, a bit of an innovation because most finance courses are taught entirely independently of economic theory. But the two greatest Yale economists and two greatest Yale financial economists had finance and economics integrated, and I believe that's the only right way of looking at the problem. And as I said at the very beginning, I think the events of the last few years have confirmed that view. So let's take up the question today of why is the free market supposedly so good. So we worked out two examples last time, and the two examples are very similar to the first problem set that you did. In the first example you've got two agents A and B, and whenever we write agents A and B we really mean a million agents just like A and a million agents just like B. The heart of perfect competition in the economy is that there's lots of people, and so we can't--yeah, I think from now on hand them in at the end of class. So we mean a million people of type A and a million people type B. So the utility function of A, the welfare function of A is written there, and the welfare function of B is written and they each begin with endowments. So when these two million people come together they're going to be doing the same thing that you saw in the class on the first day. They're going to be haggling, and arguing, and the buyers are going to always say "the stuff's not worth very much and why should they pay you so much," and the sellers are going to say "it's worth a tremendous amount and they should pay even more," and eventually they're going to come to prices. And we discovered last time that the way of describing what prices and what final allocations they come to is by writing down a system of equations, and you did that all in your homework and we came up with this outcome. So similarly we did another problem in the last class and we wrote down different welfare functions or utility functions and different endowments and again we got the equilibrium. So we said that one of the amazing things is that these system of equations, the six equations for each economy that you solved in class always have a solution. So the people who discovered that discovered it at the Cowles Foundation. They were Ken Arrow, Gerard Debreu who was a Yale assistant professor, Ken Arrow who was visiting the Cowles Foundation in Chicago but was a Stanford professor, and Lionel McKenzie who actually taught at Rochester. The economic equations always have a solution. So what's so good about that economic solution?
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4Financial Theory - Financial Theory...

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