Financial Economics, Article Critique Example

Traditionally in the field of financial economics, the rational decision making model and efficient market hypothesis held substantial way.  The rational decision making model posited that investors were essentially rational: that is, they would incorporate available information into their investment decision and buy and sell on a rational basis. As many behavioral economists discovered, however, this model does not hold up in practice.  Indeed, investors tend to display obviously non-rational behavior (defined as not utility maximizing) when they face a number of situations including uncertain and dynamic environments.  Investors tend to exhibit “herd behavior” if a stock increases in price rapidly or decreases rapidly; that is, without necessarily incorporating the implications of their decisions they join a group of investors that are selling or buying.

This paper attempts to model this type of (irrational) behavior that results from some of this phenomenon, typically known as informational cascades.  In particular, the paper is one of the first to model an “cascade” free equilibrium that is immune from the externalities that typically generalizes such behavior in the markets.  Through this model, the authors posit that “rational” actors will be able to find this equilibrium among the market chaos and restore (a semblance) of order to the market.  While the model is interesting and worthy of additional research, there is an even larger question that shadows its potential: how will the rational market-makers know they are rational enough to find the equilibrium.  Indeed, the problem with externalities is not only that they exist, but that others think they are operating in a rational framework that give rise to the externalities.  Thus, while the model is certainly a step in the right direction, the authors would also be wise to work with existing regulation in order to make sure that during a “chaotic” market event, that regulators can work hand-in-hand in order to help the “rational” actors find their bearing in a market emergency.