In late 2007, the Shanghai stock market was going through a boom. A Professor of Economics was visiting China and there he learnt that everyone, everyone was expecting the stock market to crash after the Olympics in September 2008. In other words, they assumed the market to keep rising like a Diwali rocket till then, and then fall dramatically.
The professor was amused that no one had reasoned backwards from there. Everyone expected the market to fall in September. So, what would happen in August? Wouldn’t they think, “Hey, I don’t want to get too greedy. I know that the index will rise another month, but what if it suddenly starts falling and I am caught short? I had better sell right now and book my profits.”
Now, if many people think so, prices will fall, not in September, but in August. But if everyone knows that everyone else is thinking that way, why would they wait till August? Won’t they start selling in July? And so on, by induction, if people expect the market to tank in September, prices should fall right now.
This is what traditional economics suggests. Behavioural economics argues that the professor’s analysis is incomplete. Obviously, not everyone will decide to sell in August, but some people will. What will happen in the market is the classic battle between greed and fear. Some people, overcome by greed, will hold on in the hope of making even more gains, while some people, overcome with fear, will sell. At some point, fear will overcome greed and the market will crash.
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At Food Bazaar yesterday, there was a notice that said “Stocks Hypothecated to:” followed by a list of banks that the stocks were hypothecated to. I know that many retailers are in trouble because of falling demand and difficulties in finance, and I can understand hypothecating your stocks to get working capital finance. But why announce that fact to your customers? What possible relevance can it have to a customer who has shown up with cash to buy toor dal to learn that the toor dal is in fact hypothecated to State Bank of India? Obviously, once he buys the toor dal, it is his. SBI will not raid his kitchen to recover money from Big Bazaar. It looks like some legal requirement or some requirement imposed by the creditors, but I don’t see why it makes sense to the creditors either. If at all the notice has an effect, it will make the customer unnecessarily panic, driving him away and making it less likely that Big Bazaar will make enough money to return its loan. So why put up those notices? Any ideas?
“Yes, you can lend money as many times as you wish, but what interest do you charge for the money?” The cabbie asked.
“Well, I charge whatever I can get. ”
“In the beginning, it was quite high. There had been no development in the village for years. I checked out the first entrepreneur’s business proposal and saw that his factory, because it would be the first factory to produce whatever it was producing, would make obscene profits. So I adjusted my cut accordingly.”
“What happened then?”
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Long long ago, nestled among the mountains, there was a village perfectly isolated from the rest of civilization. Its inhabitants led a hand to mouth existence. Because this village always behaved according to our macroeconomic models, it was called “The Model”.
Now, in The Model, villagers used gold coins, and only gold coins for trading. They used gold for nothing else. The total number of gold coins in The Model was fixed.
But gold coins were cumbersome to lug around and exchange with each other. So one day, a wise villager named Arjun Banker (or AB for short) made them an offer. He told them to deposit all their gold coins with him. He would maintain their titles to the gold coins. Whenever they wished to make a transaction, they could inform him and he would transfer the titles to the gold as needed.
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