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Optimum choice from change of income to price change

Дипломная работа 2010 г.

Contents

Introduction……………………………………………………………………….1

1 Giffen Goods……………………………………………………………………3

1.1 Problem Statement…………………………………………………………….3

1.2 Giffen Goods-Prestige Pricing………………………………………………….4

1.3 Market Making………………………………………………………………..12

2 Theoretical Problem Statement…………………………………………………20

2.1 Behavioral Economics…………………………………………………………20

2.1.1 The Behaviour of Individuals……………………………………………….23

2.1.2 The Social Behaviour……………………………………………………….24

2.1.3 Optimum choice from change of income to price change………………….29

2.1.4 Consequences of price change………………………………………………33

2.2 Back-Bending Demand……………………………………………………….40

2.2.1 Prices and Demand………………………………………………………….40

2.2.1.1 Normal Goods……………………………………………………………42

2.2.1.2 Inferior Goods……………………………………………………………50

2.2.1.3 Giffen Goods……………………………………………………………..53

2.2.2 Substitution Effect………………………………………………………….56

3 Case Study……………………………………………………………………..60

3.1 Real Life……………………………………………………………………..60

Conclusion……………………………………………………………………….62

Bibliography……………………………………………………………………..65

Appendices………………………………………………………………………67

Introduction

This paper shows that information effects per se are not responsible for the Giffen goods anomaly affecting traders’ demands in multi asset noisy, rational expectations equilibrium markets. The role that information plays in traders’strategies also matters. In a market with risk averse, uninformed traders, informed agents have a dual trading motive: speculation and market making. The former entails using prices to assess the effect of error terms; the latter requires employing them to disentangle noise traders’ demands within aggregate orders. In a correlated environment this complicates the signal extraction problem and may generate upward sloping demand curves. Assuming (i) that competitive, risk neutral market makers price the assets or that (ii) uninformed traders’ risk tolerance coefficient grows unboundedly, removes the market making component from informed traders’demands rendering them well behaved in prices.

In a well known paper [1] showed that multi asset noisy rational expectations equilibrium (NREE) markets display a number of anomalies. In particular, owing to correlation effects, traders’ demand functions could be upward sloping in prices.

Support from the Barcelona Economics Program of CREA and the Ente per gli Studi Monetari Finanziari “Luigi Einaudi,” are gratefully acknowledged. I thank Anat Admati, Jordi Caball.e, Giacinta Cestone, and Xavier Vives for useful suggestions. The comments provided by the Associate Editor and an anonymous referee greatly improved the paper’s exposition.

This “Giffen good” anomaly was attributed to the contemporaneous workings of an information and a substitution effect generated by prices in an economy with asymmetric information. Indeed, a price increase in a NREE could either signal an increase in the value of the asset pay-off or be the effect of a demand pressure from noise traders. For some parameter configurations, traders could then interpret such a price increment as good news about the asset’s fundamental and increase their (long) position in the asset. Recently, Giffen goods anomalies have been related to market behavior around crashes.

Upward sloping demand curves make traders shy away from assets whose price plummets and increase their long position in assets whose price rockets, eventually amplifying market movements. In this perspective, understanding the extent to which information effects per se determine such anomalies is therefore relevant. This paper shows that information effects alone are not responsible for Giffen goods anomalies: the role that information plays in traders’ strategies also matters.

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