The Competitive Market

In the previous analysis we assumed the individual moves freely along the line AB, and we ignored—and assumed that the individual ignored—any effect his borrowing or lending decisions might have on the equilibrium interest rate itself. What would happen, though, if the total amount of loans outstanding in the market when the person was doing no borrowing or lending was $10 million, and if our person then decided to lend, say, $5 million? His lending would be half as much as the rest of the market put together, and it would not be unreasonable to think that the equilibrium interest rate would fall to induce more borrowers into the market to take his additional loans. In such a situation the person would have some power in the market to influence the equilibrium rate significantly, and he would take this power into consideration in making his decisions.

In the modern financial market, however, the total amount of borrowing and lending is not $10 million; rather, as we saw in Chapter 1, it is closer to $10 trillion. In such a huge market no one investor or even any single company can have a significant effect (although a government might). We assume, then, in all of our subsequent discussions and analyses that the financial market is competitive. By that we mean no individuals or firms think they have any effect whatsoever on the interest rates that they face no matter how much borrowing, lending, or investing they do. In the language of economics, individuals who respond to rates and prices by acting as though they have no influence on them are called price takers, and this assumption is sometimes called the price-taking assumption. It is the condition of perfectly competitive financial markets (or, more simply, perfect markets). The following conditions are likely to lead to this:

3. Financial Markets and Net Present Value: First Principles of Finance (Adv.)

52 Part II Value and Capital Budgeting

1. Trading is costless. Access to the financial markets is free.

2. Information about borrowing and lending opportunities is available.

3. There are many traders, and no single trader can have a significant impact on market prices.

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