On Economics and Finance

THE FIELDS OF ECONOMICS and finance are allied. Indeed finance is sometimes defined as the subfield of economics concerned with intertemporal and portfolio decisions. And yet we are increasingly witnessing the development of two cultures. Researchers in economics examine questions involving financial markets, in ways which seem to researchers in finance to be hopelessly misguided. Much research in finance is regarded by many economists as doctrinaire or trivial. The paper presented by Marsh [1] at these meetings on Euler equation tests of asset pricing models is not atypically partisan. All references to papers written by reearchers located in economics departments are critical. All reference to research by scholars located in finance departments are favorable. Even critical comment by one group of researchers on the work of the other is not terribly common. In many areas, parallel literatures have developed in economics and finance regarding the same questions with virtually no points of contact. There is a public finance and a "regular finance" literature on the role of dividend taxes. There are enormous largely unconnected literatures in both economics and finance about the effects of inflation on interest rates. Parallel literatures on agency theory and the structure of contracts have also emerged in recent years. Industrial organization and financial economists treat the phenomenon of mergers and takeovers in very different ways. The list could be multiplied. Casual observation suggests that most researchers operating in one tradition are almost entirely ignorant of basic concepts in the rival tradition. Researchers in finance who doubt this claim should ask themselves how frequently they have encountered concepts such as the "q < 1" theory of the effects of dividend taxes," "the Mundell-Tobin effect," or self-selection constraints. Economists who doubt this claim might note that several papers are published each year discovering in some particular context the standard finance result that increased variance raises option values. Or they might note how few events studied appear in mainline economics journals. The differences I am discussing may be clarified by considering a field of economics which could but does not exist: ketchup economics. There are two groups of researchers concerned with ketchup economics. Some general economists study the market for ketchup as part of the broader economic system. The other group is comprised of ketchup economists located in Department of Ketchup where they receive much higher salaries than do general economists. Each group has a research program. General economists are concerned with the fundamental determinants of prices and quantities in the ketchup market. They attempt to examine various factors