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5Financial Theory

5Financial Theory - Financial Theory...

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Financial Theory: Lecture 5 Transcript September 17, 2009 << back Professor John Geanakoplos: I think I'm going to start. So this is really the beginning of the finance part of the course. So far we've reviewed general equilibrium, which I said Fisher invented or reinvented in order to do finance. And as you remember the main conclusions from general equilibrium are first that the market functioning by itself without interference from the outside, in other words a situation of laissez-faire, leads to allocations that are Pareto efficient. So they're in some sense good for the economy and good for the society. They don't maximize total welfare. That's not even a well-defined thing as we saw last time because how can you measure, how can you add one person's utility to another. It doesn't even make sense. So economists at first were wrong to think of that as the criterion for good allocations, but there's another better definition of efficiency that Pareto invented, called Pareto Efficiency, and the free market achieves Pareto Efficiency at least if there are no externalities and there's no monopoly. So that, lesson number one, was taken to mean that the government shouldn't interfere in the free market, especially shouldn't interfere in financial markets, and that's something we're going to come to examine. The second lesson we found was that the price is determined by marginal utility. It's not determined by total utility. So it may be that water is much more valuable than diamonds because it does a lot more good for everybody and for the world as a whole than diamonds do, but the last drop of water, really most people have as much water as they need, the last drop of water is not doing that much whereas the last diamond is a rare thing and not many people have them. So the last drop of water is worth less than the last equal weight of diamonds and therefore water is much cheaper than diamonds even though water's much more valuable as a whole than diamonds. The price of things depends on their marginal utility. A third implication of what we did is that there's no such thing as a just price. It depends on what peoples' utilities are and how much they like it. It depends on how much of the good there is. That's why diamonds are priced less than water [correction: that's why water is priced less than diamonds]. And it depends on how wealthy people are. If you transfer money from people who don't like apples compared to tomatoes, to people who like apples a lot compared to tomatoes, the price in the free market is going to reflect more the latter class of people than the former because they've got the money to spend, and so the price of apples is going to go up relative to the price of tomatoes. So those are the three basic lessons of general equilibrium.
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