As pointed out in Chapter 1, financial economics is concerned with explaining the nature of financial decision making and with determining the economic effects of those decisions. As the discussions of Chapters 2 through 8 have already suggested, financial economics explains decision making both in terms of how agents should decide, referred to as prescriptive theory, and in terms of how agents actually decide in practice, referred to as descriptive theory. In effect, financial economics attempts to combine the prescriptive and the descriptive to provide useful insights both as to how things can be explained in theory, and as to how things actually work in practice.1

Since financial economics is an empirically oriented discipline, the prescriptive and descriptive approaches are often used in combination. However, both approaches employ their own framework, and it is probably most helpful to understand each individually before attempting to consider their combination. Prescriptive financial economics has largely been developed using a framework known as the neoclassical paradigm in which rational agents interact in competitive markets under conditions of homogeneously distributed information and in the absence of transactions costs. (The neoclassical paradigm has been introduced in Chapter 8; further details are provided later in Section 9.2.1.)

The assumptions of the neoclassical paradigm have led to the development of an impressive, ...

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