Financial Markets: Organization and Technology – Lecture Notes
Live lecture 1
Criticisms of the self-interest theory
The most important part of the neo-classical model is that markets behave in a way that
believes that people are self-interested.
Supply and demand are the meeting of the self-interest of different actors (seller and buyer).
Combining two selfish people to enter into a transaction doesn’t make a bad world, it makes a
better world. But is this true? We see conflicting evidence.
Evidence we see contradicts that people are inherently selfish.
The module overall
Examine economic behavior and how this underpins financial institutions
Look at markets from different views: trading, analysis and asset formation
Focus on ‘difficult to value’ situations, such as social impact
Develop ways to measure the social impact of an organization, design a security based on
monetizing this impact and identify how such a security can be traded.
Summary of tasks
The dominant model of economic behaviour assumes
– self-interested individuals and organisations drive behaviour in markets
– Their Interactions drive the behaviour of markets: prices, competition, quality of products
and services
Policy-making and teaching affected how markets behave rather than merely describe
it.
In the lecture we will review criticisms of the model and see what alternatives are
offered.
Assumptions of the neoclassical model – people are rational (make the optimal choice), they
have information and know everything, and they always think about themselves (Self-
interest)
Looking closely at whether each of these assumptions actually hold:
Are people really rational economic actors?
In spite of the influence the neoclassical model has, there is a large body of research
that indicates that actors do not behave always in ways that express their self-
interest
Let’s examine some of the evidence…
Do people actually know what they want?
• In an experiment, when students are asked every week to select from a list snack they
would want to eat right now, they tend to choose the same snack every time.
• But, when asked to select in advance, students tend to select a variety of snacks, thinking
that they will not want the same snack every week.
,• Same choice – different result. We have something that changes are mind with every
economic transaction we make.
It doesn’t look like people are very consistent with knowing what they really want, their mind
changes often.
Effects of information availability on choices
• Experiment students are ask to deciding which module to choose. First, they see a summary
of feedbacks from hundreds of other students indicating that a certain module is very good.
But then they watch a video interview of one student who gives a negative feedback.
• Even when students were told in advance the negative feedback was not typical, they tended
to be more influenced by the video than by the summary of feedbacks.
• Availability heuristic: giving more weight to easily understood information than to more
valid, but less vivid (less easily communicable) information.
We tend to calculate information that is easier for us to calculate and understand. Despite
having many students giving positive feedback they get demoralised with one video
Do people care about relevant information?
• A high-end kitchen equipment company offered a £219 bread maker. Sales were low
• But, when they offered also a “deluxe” model for £379, sales of the cheaper model almost
doubled. Customers indicated it was a relative bargain.
• Anchoring effect: relying on irrelevant information when making an economic decision.
Nothing about the bread maker changed, the price and quality remained the same, just a new
model was offered which changed customers’ perception.
But neo-classical perspective says you make a decision based on the deal that was offered,
not based on the deal that was not offered. People look at value when it stands next to another
value
Do individuals have perfect information?
• NCM assumes that economic actors have “perfect information”: people collect
information until the perceived costs of acquiring additional information exceed the
perceived benefits.
• But, people don’t know about the information they don’t collect and so cannot
estimate if they have perfect information.
• Essentially, we don’t know what perfect information is, so we don’t know whether
actors have perfect information or not
Bounded rationality vs. Rationality
• Simon: people select an outcome that would be satisfactory and then seek an option
that provides at least that outcome (known as satisficing)
• Bounded rationality: instead of considering all possible options, people focus on an
arbitrary subset of the all possibilities, this doesn’t mean you’re being irrational but its
just that you are not a perfectly rational actor.
• Let’s see some factors that affect economic decision-making
Path Dependency
,• Research also shows that people compare their current wellbeing with the recent past
and direct their actions accordingly.
• In particular, people are reluctant to accept a situation that they perceive as inferior to
previous situations.
• So, economic choices depend on the particular history of the economic actor (and, the
historical imprint is difficult to change…)
Loss Aversion
• Daniel Kahneman: People value losses much more than gains
• That is, people display loss aversion
• Experiments show that people value losses about twice as much as gains, on average.
A loss of £100 is valued about the same as a gain of £200, in terms of how much
perceived wellbeing changes.
• People are not symmetric economic agents. We do not take movements or prices
symmetrically.
The sadness of losing £100 is felt much stronger than the happiness of gaining £100.
People care less about gaining and more about losing.
Present bias
• People tend to value the presence more than the future.
• For example, most people, when not encouraged, fail to save adequately for their
retirement
• This is bounded rationality
• People tend to take decisions depending upon partial information, they are affected by
their experience, more susceptible to potential losses than gains, have different
perceptions of what is relevant to them
People (and organisations) have little experience in high-stakes economic decisions
We tend to be experienced in taking mundane decisions, but lesser experience in taking
high-staked decisions
• Most people ‘practice’ the management of food inventory continuously. They know
what food to buy, the quality of food, how much they want to spend on food etc.
• But people have much less ‘practice’ in buying cars or houses, making high-stake
strategic decisions.
• Similarly, with firms: strategic decisions appear infrequently.
• So, economic actors have less experience in the most impactful decisions…
Much better at buying milk than buying a house
Are individuals naturally kind?
• Results from functional magnetic resonance imaging (fMRI), which indicates which
parts of one’s brain are activated in different circumstances show that when people
are being treated fairly or engaging in cooperative behaviour, regions of the brain
associated with positive emotions and are activated.
• But even when observing others being treated unfairly, our brains react in a similar
manner as if we had been treated unfairly or suffered pain.
, Evidence for non-selfish behaviour
• Actors are not completely selfish, even to strangers, even where the stakes are over
£10,000 (van den Assem, van Dolder, and Thaler 2012).
• People cooperate even when the rational selfish strategy is to give nothing. (Rabin
1993; Fehr &Schmidt 1999).
We are not necessarily homo economicus, not self-interested actors selfish, we act in a
way that calls for cooperation rather than utility maximisation, i.e., we tend to behave in a
way that way would like to be behaved towards.
Even though this contradicts the assumption of taking the best decision for oneself.
Reconciling the different approaches to self-interest and economic behaviour
• People often behave selfishly, but they also care about the welfare of others. People
may care about others to increase their own well-being or out of concern for the
common good.
• The result is that the assumption about exclusive self-interested actors is inaccurate.
Summary
- People are kinder than the NCM assumes. Specifically, people tend to cooperate as
long as they expect others to do likewise.
- We don’t have actors have make decisions based on full info, their decisions ae based
on the way information is presented, they don’t always make decisions in self-interest
and they are affected by their experiences (path dependency)
Asynchronous WEEK 1
Video 1
The module overall
• First, we will examine economic behaviour and how this underpins financial institutions.
• Second, we will look at markets from different views: trading, analysis and asset formation.
• Third, we will focus on ‘difficult to value’ situations, such as social impact.
• As a final assignment, we will develop ways to measure the social impact of an
organisation, design a security based on monetising this impact and identify how such a
security can be traded.
How is the module taught?
Every week, before the live lecture and seminar, watch the relevant videos, do the
assigned readings and complete the quiz. Ask yourself Do I understand the main
ideas?
In the lecture session, we will discuss the techniques and concepts from the reading.
Do I understand how the techniques works?
In the seminars we will use the techniques and ideas and discussion. Can I use the
techniques myself?
How to succeed in this module
• Do the readings and show up to all lectures and seminars.
• Important: students’ performance from previous years shows that it is difficult to attend
only few of the lectures and still do well in this module. So, if this module clashes with
another one, you are advised to choose which one you prefer.
Live lecture 1
Criticisms of the self-interest theory
The most important part of the neo-classical model is that markets behave in a way that
believes that people are self-interested.
Supply and demand are the meeting of the self-interest of different actors (seller and buyer).
Combining two selfish people to enter into a transaction doesn’t make a bad world, it makes a
better world. But is this true? We see conflicting evidence.
Evidence we see contradicts that people are inherently selfish.
The module overall
Examine economic behavior and how this underpins financial institutions
Look at markets from different views: trading, analysis and asset formation
Focus on ‘difficult to value’ situations, such as social impact
Develop ways to measure the social impact of an organization, design a security based on
monetizing this impact and identify how such a security can be traded.
Summary of tasks
The dominant model of economic behaviour assumes
– self-interested individuals and organisations drive behaviour in markets
– Their Interactions drive the behaviour of markets: prices, competition, quality of products
and services
Policy-making and teaching affected how markets behave rather than merely describe
it.
In the lecture we will review criticisms of the model and see what alternatives are
offered.
Assumptions of the neoclassical model – people are rational (make the optimal choice), they
have information and know everything, and they always think about themselves (Self-
interest)
Looking closely at whether each of these assumptions actually hold:
Are people really rational economic actors?
In spite of the influence the neoclassical model has, there is a large body of research
that indicates that actors do not behave always in ways that express their self-
interest
Let’s examine some of the evidence…
Do people actually know what they want?
• In an experiment, when students are asked every week to select from a list snack they
would want to eat right now, they tend to choose the same snack every time.
• But, when asked to select in advance, students tend to select a variety of snacks, thinking
that they will not want the same snack every week.
,• Same choice – different result. We have something that changes are mind with every
economic transaction we make.
It doesn’t look like people are very consistent with knowing what they really want, their mind
changes often.
Effects of information availability on choices
• Experiment students are ask to deciding which module to choose. First, they see a summary
of feedbacks from hundreds of other students indicating that a certain module is very good.
But then they watch a video interview of one student who gives a negative feedback.
• Even when students were told in advance the negative feedback was not typical, they tended
to be more influenced by the video than by the summary of feedbacks.
• Availability heuristic: giving more weight to easily understood information than to more
valid, but less vivid (less easily communicable) information.
We tend to calculate information that is easier for us to calculate and understand. Despite
having many students giving positive feedback they get demoralised with one video
Do people care about relevant information?
• A high-end kitchen equipment company offered a £219 bread maker. Sales were low
• But, when they offered also a “deluxe” model for £379, sales of the cheaper model almost
doubled. Customers indicated it was a relative bargain.
• Anchoring effect: relying on irrelevant information when making an economic decision.
Nothing about the bread maker changed, the price and quality remained the same, just a new
model was offered which changed customers’ perception.
But neo-classical perspective says you make a decision based on the deal that was offered,
not based on the deal that was not offered. People look at value when it stands next to another
value
Do individuals have perfect information?
• NCM assumes that economic actors have “perfect information”: people collect
information until the perceived costs of acquiring additional information exceed the
perceived benefits.
• But, people don’t know about the information they don’t collect and so cannot
estimate if they have perfect information.
• Essentially, we don’t know what perfect information is, so we don’t know whether
actors have perfect information or not
Bounded rationality vs. Rationality
• Simon: people select an outcome that would be satisfactory and then seek an option
that provides at least that outcome (known as satisficing)
• Bounded rationality: instead of considering all possible options, people focus on an
arbitrary subset of the all possibilities, this doesn’t mean you’re being irrational but its
just that you are not a perfectly rational actor.
• Let’s see some factors that affect economic decision-making
Path Dependency
,• Research also shows that people compare their current wellbeing with the recent past
and direct their actions accordingly.
• In particular, people are reluctant to accept a situation that they perceive as inferior to
previous situations.
• So, economic choices depend on the particular history of the economic actor (and, the
historical imprint is difficult to change…)
Loss Aversion
• Daniel Kahneman: People value losses much more than gains
• That is, people display loss aversion
• Experiments show that people value losses about twice as much as gains, on average.
A loss of £100 is valued about the same as a gain of £200, in terms of how much
perceived wellbeing changes.
• People are not symmetric economic agents. We do not take movements or prices
symmetrically.
The sadness of losing £100 is felt much stronger than the happiness of gaining £100.
People care less about gaining and more about losing.
Present bias
• People tend to value the presence more than the future.
• For example, most people, when not encouraged, fail to save adequately for their
retirement
• This is bounded rationality
• People tend to take decisions depending upon partial information, they are affected by
their experience, more susceptible to potential losses than gains, have different
perceptions of what is relevant to them
People (and organisations) have little experience in high-stakes economic decisions
We tend to be experienced in taking mundane decisions, but lesser experience in taking
high-staked decisions
• Most people ‘practice’ the management of food inventory continuously. They know
what food to buy, the quality of food, how much they want to spend on food etc.
• But people have much less ‘practice’ in buying cars or houses, making high-stake
strategic decisions.
• Similarly, with firms: strategic decisions appear infrequently.
• So, economic actors have less experience in the most impactful decisions…
Much better at buying milk than buying a house
Are individuals naturally kind?
• Results from functional magnetic resonance imaging (fMRI), which indicates which
parts of one’s brain are activated in different circumstances show that when people
are being treated fairly or engaging in cooperative behaviour, regions of the brain
associated with positive emotions and are activated.
• But even when observing others being treated unfairly, our brains react in a similar
manner as if we had been treated unfairly or suffered pain.
, Evidence for non-selfish behaviour
• Actors are not completely selfish, even to strangers, even where the stakes are over
£10,000 (van den Assem, van Dolder, and Thaler 2012).
• People cooperate even when the rational selfish strategy is to give nothing. (Rabin
1993; Fehr &Schmidt 1999).
We are not necessarily homo economicus, not self-interested actors selfish, we act in a
way that calls for cooperation rather than utility maximisation, i.e., we tend to behave in a
way that way would like to be behaved towards.
Even though this contradicts the assumption of taking the best decision for oneself.
Reconciling the different approaches to self-interest and economic behaviour
• People often behave selfishly, but they also care about the welfare of others. People
may care about others to increase their own well-being or out of concern for the
common good.
• The result is that the assumption about exclusive self-interested actors is inaccurate.
Summary
- People are kinder than the NCM assumes. Specifically, people tend to cooperate as
long as they expect others to do likewise.
- We don’t have actors have make decisions based on full info, their decisions ae based
on the way information is presented, they don’t always make decisions in self-interest
and they are affected by their experiences (path dependency)
Asynchronous WEEK 1
Video 1
The module overall
• First, we will examine economic behaviour and how this underpins financial institutions.
• Second, we will look at markets from different views: trading, analysis and asset formation.
• Third, we will focus on ‘difficult to value’ situations, such as social impact.
• As a final assignment, we will develop ways to measure the social impact of an
organisation, design a security based on monetising this impact and identify how such a
security can be traded.
How is the module taught?
Every week, before the live lecture and seminar, watch the relevant videos, do the
assigned readings and complete the quiz. Ask yourself Do I understand the main
ideas?
In the lecture session, we will discuss the techniques and concepts from the reading.
Do I understand how the techniques works?
In the seminars we will use the techniques and ideas and discussion. Can I use the
techniques myself?
How to succeed in this module
• Do the readings and show up to all lectures and seminars.
• Important: students’ performance from previous years shows that it is difficult to attend
only few of the lectures and still do well in this module. So, if this module clashes with
another one, you are advised to choose which one you prefer.
