Dec 192012
 

17 December 2012, the San Francisco Chronicle had a story—”Solar Power Adds to Non-Users’ Costs“—that provides background for a very good Microeconomics test question:

Q: Under what circumstances can the combination of a decrease in demand and an increase in supply lead to an increase in prices?

The short answer, of course, is, “When government interferes with the market process.”

If you are required to show your work, here’s what you do:

First, note that the own-price demand elasticity for electricity tends to be low for most consumers, meaning that one tends to consume the same quantity, seemingly regardless of the price. For example, one would not expect someone to throw open the windows in the middle of summer, with the air conditioner turned to its lowest setting, if the price of electricity fell substantially. More likely one would continue to consume electricity at approximately the same rate and use the cost savings on something that had a higher own-price elasticity of demand, like those things that collect in one’s shopping cart at Amazon.com, but one rarely gets around to ordering for delivery.

You can illustrate it this way:

Vertical Demand Curve in Equilibrium

Fig. 1 : Vertical Demand Curve in Equilibrium

This is very similar to the textbook Supply & Demand graph, but with the Demand curve at the same quantity demanded for every price. (Of course, this is not realistic for all prices, and the real world is not so well-behaved. Such is the nature of economic models.)

As indicated in the article above, the increase in solar panels being installed on the roofs of residential and commercial buildings in California is causing a decrease in overall demand for conventional electricity.

In an unregulated market, we might illustrate it this way:

Vertical Demand Curve with Shift in Demand

Fig. 2 : Vertical Demand Curve with Shift in Demand

As the demand decreases, due to the existence of solar-powered substitutes, price tends to fall.  In an unregulated market, executives and shareholders in waning industries receive signals in the form of accumulating inventories—unsold output—that they either should reduce their prices, reduce their output, or both.  If the trend continues—as happened with sailing ships, tools for making whale oil, steam locomotives, buggy whips, etc. in earlier generations—the executives and shareholders receive signals that they should consider whether liquidating and reallocating their existing resources might be more profitable than clinging to a dying firm or industry.  (Schumpeter referred to this as ‘creative destruction‘.)

However, in a regulated market, suppliers and regulators agree on a price and fix it ex ante.  Typically, the price is below the equilibrium, at least in the first iteration, so that consumers will be happy and express their gratitude to the politicians who oversee the regulators.  (This sometimes is referred to as ‘the iron triangle‘ of regulation, and it is related to the concept of ‘regulatory capture‘.)

We can illustrate it this way:

Vertical Demand Curve with Regulated Price

Fig. 3 : Vertical Demand Curve with Regulated Price

Here, the regulated price (Pr) is below the equilibrium price that would clear the market, but is at least as high as is needed to generate sufficient revenues to cover the costs of production.  The executives and shareholders of regulated firms generally are rewarded for their cooperation with monopoly rights in the form of franchises that grant them the exclusive right to serve a particular geographic region.

The firm’s total revenue is illustrated as area of the pink rectangle below, which is price * quantity.  It is possible that a firm’s executives and shareholders might want to increase output, so that the firm could sell the excess into neighboring markets, but the jurisdictions of most regulated industries do not adjoin jurisdictions where competitors are unregulated.  Most likely, every neighboring territory is served by a different monopolist franchisee.

Vertical Demand Curve with Regulated Price / Total Revenue

Fig. 4 : Vertical Demand Curve with Regulated Price / Total Revenue

Returning to Fig. 2, as solar panels reduce demand for conventional electricity, the demand curve shifts to the left.

Vertical Demand Curve with Regulated Price and Demand Shift

Fig. 5 : Vertical Demand Curve with Regulated Price and Demand Shift

Because the electricity providers’ prices are fixed by regulation, and they have very high fixed costs, they are loath to lower their prices.  In fact, the fixed costs of maintaining a capital base that consists of indivisible centralized facilities, power lines, poles and waterproof underground conduits, substations, and other large and expensive infrastructure can vastly exceed the variable costs of fuel and peak-time labor, and these large fixed costs are the primary drivers of the price that suppliers and regulators agreed to previously.

Now, with a smaller consumer base, the utility operators have fewer customers to divide their fixed costs among.  In order to arrive at a rectangle with the same area as the pink one in Fig. 4, given that the utility operators not only cannot force consumers to buy conventional electricity, but are required to buy the excess electricity produced by the owners of the solar panels.  In other words, the suppliers are doubly pinched, and their only savings are in the form of electricity purchased at full retail from their customers, accompanied by a relatively slight decrease in variable fuel costs.

The only viable alternative in this situation is for the operators of the regulated conventional electricity utilities to petition the regulators for a price increase to be passed along to the remaining conventional electricity consumers.

Vertical Demand Curve with Regulated Price / Price Increase

Fig. 6 : Vertical Demand Curve with Regulated Price / Price Increase

Considering that solar energy becomes more economically viable, when its primary competitor—conventional electricity—becomes more expensive, the rising prices in this scenario create an incentive for even more consumers to adopt solar energy, thereby shifting the demand curve even further leftward toward zero… creating yet more upward price pressure.

And, in this way, regulation creates an environment, in which a decrease in demand can lead to an increase in price.

Invest accordingly.

Prof. Evans

Nov 262012
 

The vast majority of firms do not pay dividends, which renders the use of dividend discounting methods for estimating their values moot. In this case, one can use discounted expected cash flows: net income (NI), operating cash flows (OCF), or free cash flows (FCF), depending on the level of sophistication required by the analyst.  However, all of these require the analysis of the firm’s financial statements, which might involve more effort than one is willing to expend in a preliminary analysis.

With publicly traded firms that do not pay dividends, another option exists using the price/earnings ratio (P/E).

Remember that:

NI = Dividends + Retained Earnings

P/E = Equity/NI

NI is the pool of funds from which a firm would pay dividends if it paid dividends, and dividend discounting models assume that all of the value of the firm is paid out to shareholders in the form of a dividend (D).

In this way, we can see P/E = Equity/NI as being similar to P/E = price-of-equity (P) / D:

P/E = Price / Dividend = P / D

To use this in our dividend discount formula, we need to take the reciprocal:

P/E ratio discounting formula

where

re : return on equity / cost of equity
D : dividend
P : price
P/E : price/earnings ratio
g : growth rate

Start with the P/E ratio, take its reciprocal (1 ÷ P/E), multiply by (1+g), and then add g.

You can practice this in the WACC Quiz, by clicking the Practice link above.

I hope that this helps.

Prof. Evans

Oct 232011
 

An interesting pattern emerges, when we line up market structure from economics and finance with theories of developmental psychology and pedagogy, as in the table below. For more details than I describe here, click on the links at the head of each column to see the Wikipedia articles on these topics.

Admittedly, the alignment undoubtedly is not as precise as implied below, but the exercise is fruitful, at least in broad brushstrokes. The point here is to seek insights that might lead to testable hypotheses, rather than to present established conclusions concerning a detailed theory of society.

Brief Introduction of Each Column

Starting at the bottom, Maslow argued that the primary motive of all individuals is survival; where this is not assured, nothing else will occupy an individual’s mind. Once survival is assured, the individual will focus on safety. Only after survival and safety are fulfilled, can individuals focus on social needs. When survival, safety, and social needs are fulfilled, the individual can focus on self-esteem, which is a fundamental topic in itself, especially among those who grow up in dangerous or abusive environments. Finally, once all of these needs have been fulfilled, the individual can focus on self-actualization — ‘realizing one’s full potential’ or ‘going beyond oneself’ — which might manifest itself in the creation of works of art, volunteering, or any other activity that one feels compelled to do for its own sake

Kohlberg‘s focus was on morality. He argued that how an individual decides ‘right’ from ‘wrong’ starts at a primitive level and becomes more sophisticated as one matures. At the lowest level, the test is pain vs pleasure; if it hurts, it is wrong, and if it feels good, it is good. In time, this develops into egoism, in which the orientation is toward oneself to the exclusion of all others, often associated with young toddlers and their tantrums. As one develops — and corresponding to Maslow’s Social stage — one’s moral orientation becomes outward; first as ‘be nice’, and later as a law & order adherence to the rules. For a minority of the population, contradictions and other failings of the status quo lead to an moral orientation based on questioning authority and reconciling inconsistencies. Finally, some very few adopt a universal ethic, which manifests itself as a single principle that guides the individual’s sense of right and wrong. For some, this ethic might be non-aggression; for others, the superiority of one’s tribe; etc.

An individual can move up or down either hierarchy, but will tend to be grounded in a specific one at any particular time. Individuals generally can imagine the next developmental level up, but not beyond. Those operating at a very primitive level, for example, will be unable to distinguish a universal ethic from egoism. This, also, is not to say that a universal ethic will be viewed by others as ‘good’, as when one who has embraced non-aggression evaluates the morality of a tribalist who believes in the collective ‘superiority’ of his or her people.

Bloom‘s Taxonomy deals with pedagogy and the appropriate method of education. With very young children and those who are new to a subject, the first step is identification, which essentially is being able to point a thing when named. The next step is definition, which is when the learner is able to explain what something is without naming it. Next is application, which is using a tool, concept, or anything else in a prescribed fashion. Higher-order learning begins with analysis, which is breaking complex puzzles, concepts, or objects into simpler constituent units. There is some debate concerning the order of the last two steps: evaluation, which is judging a thing based on some standard, and synthesis, which is constructing something new from existing components, whether it is a structure, a work of art, story, etc.

Market structure is the relationship between the number of buyers and the number of sellers in a market. Here, we focus on the number of sellers and assume that the number of potential buyers is very large. The most restrictive market structure is the command economy, in which a central authority rations goods and services, and secondary trading is generally difficult if not forbidden outright. Next is monopoly, in which only one supplier exists. One of the hallmarks of monopoly markets is price discrimination which occurs when two buyers pay different prices for the same good or service; in any other market structure, buyers can shop among sellers and buy from the one with the lowest price. A market with a small number of sellers, each of whom represents a significant portion of the overall market is called an oligopoly. Oligopolies are distinguished by ‘interdependence’, in which a sale made by one oligopolist is a sale lost by each of the others; oligopolists often have very large advertising budgets. A market with imperfect competition has a large number of sellers — each of whom might have some amount of monopoly power based, most commonly, on geography — none of whom represents a significant fraction of the total market. Most of the sellers that each of us deals with in the real world are imperfect competitors, who might be able to price discriminate through coupons, early bird specials, happy hours, etc., but who do not have the market power of an electric, sewage, or water utility. A commodity market is one in which the good or service sold by one seller is economically identical to the others’. This includes things like wheat, gold, and financial assets that are sold on formal exchanges. At the furthest extreme are public goods*, which exist in such abundance that one’s consumption does not diminish anyone else’s ability to consume them, and one is unable to meter their consumption or stop others from consuming them. Common examples are breathable air at sea level, seawater, and anything else that one can consume in unlimited quantities for free.


Market Structure and Developmental Psychology
Maslow’s
Hierarchy
Kohlberg’s
Stages
Bloom’s
Taxonomy
Market
Structure
Self-Actualization Universal Ethic Synthesis Public Good
Self-Esteem “Question Authority” Evaluation Commodity
Social Law & Order Analysis Imperfect Competition
“Be Nice” Application Oligopoly
Safety Egoism Definition Monopoly
Survival Pain/Pleasure Identification Command


The Table Row-by-Row.

In general — and bearing in mind that the real world is much subtler than implied here — life in a command economy is brutish and mean. Individuals in such a society likely have little time for reflection on higher ideals, and instead focus their attention on survival and avoiding punishment.

In a society dominated by monopoly, the focus is on personal benefit to the exclusion of virtually all else. Corruption is a common feature in a society that has one provider for each category of goods and services, and innovation and entrepreneurship are essentially unknown — except, perhaps in the oligopolistic or imperfectly competitive underground economy — and daily life is highly bureaucratized.

A society dominated by imperfect competition — “a nation of shopkeepers” as Karl Marx sneeringly described 19th Century England — is organized along the principles of ‘getting along’, ‘not rocking the boat’, and ‘observing established customs’. Perhaps, regulations exist to ensure that the peace is kept. At a personal level, social needs are the primary focus, along with ‘knowing one’s place’. Marginal improvements in techniques are tolerated, so long as they are not disruptive.

A society dominated by commodification — ‘McCulture’, if you will — will be one in which individuals’ social needs are fulfilled in general, and the quest for self-esteem is the primary focus. Rules are broken, norms are evaluated, old ways are cast aside by each new generation. Seen from the outside, such a culture might look superficial, made of plastic, and chaotic, but it operates by its own internal logic of creative destruction and disruptive innovation.

Finally, a society dominated by public goods is a society in which individuals seek self-actualization through the synthesis of what has never existed before, based on some universal ethic. For those locked into the habits of thought of lower stages of development, a public goods society is indistinguishable from a command or monopoly society (i.e., ‘communism’). But, whereas command and monopoly societies suffer from chronic shortage, public goods societies have so must stuff that they just give it away.

The Way Ahead

The wealthy parts of the world today are dominated by commodification, self-esteem, and social change. However, a small but growing subculture of open source, free culture, and ubiquitous charity already has had an impact on modern life. The move is away from command and monopoly in the form of patent and copyright. Granted, those with a vested interest in the status quo will not go quietly, but go they will.

This is not a ‘good’ thing or a ‘bad’ thing, as all value is subjective. It simply is. Some will love the change, others will hate the change, and the great majority will just roll with the tide.

We are in the latter stages of an epochal transition from the capital/labor dichotomy to the knowledge/service dichotomy in an increasingly integrated global community, where borders are largely meaningless, anything that can be encoded as information — whether software, music, texts, videos, title, or even money — flows freely, and emerging institutions are supplanting traditional forms of social coordination.

Invest accordingly.

Prof. Evans


*Note: The term ‘public good’ should not be confused with ‘government-provided good’. If the ability of an individual to consume a good or service is reduced by others’ consumption, or if it is possible to restrict access, then it is a private good, regardless of whether it is provided by government or no direct fee is charged for it. Thus, ‘public schools’, ‘public beaches’, ‘public roads’, etc. are government-provided private goods.

Oct 112011
 

Hogwarts in the 'Hood

BBC News has a wonderful article on a charter school in one of Chicago’s roughest neighborhoods that is modeled on an English private school (referred to as ‘public schools’ in British English, oddly enough), and billed by its operators as “Hogwarts in the ‘Hood“.

This reminds me of a John Stossel 20/20 special report from some years back called, provocatively, Stupid in America.

I see reports and articles like these from time to time, and I want to invest accordingly!

One part of me – the part that lives in South Florida – wants to start a school that caters to local high school pupils who would prefer to start their own businesses rather than seek employment in others’ businesses upon graduation.

Another part of me – the part that teaches Finance and Economics – recognizes that schools require physical facilities (expensive), insurance (expensive), and admissions/recruitment (expensive), and that Pecuniology.com can provide the online component of a hybrid program that focuses on business education at an established charter school anywhere in the world (time consuming, but not expensive).

Pecuniology.com has academically qualified instructors in Accounting, Economics, Finance, Information Technology, and Management, all of whom have many years of online teaching experience, and all of whom have experience with multi-ethnic and at-risk student populations.

We’re here.

Invest accordingly.

Prof. Evans

Oct 102011
 

In a recent blog post I addressed the Sapir-Whorf Hypothesis, which holds that language affects thought because humans think in terms of the languages that they speak.

Those of us who speak more than one language know firsthand that some ideas are easier to express in some languages than in others. The Sapir-Whorf Hypothesis implies that certain concepts should be easier for speakers of some languages to grasp than for the speakers of other languages that lack words or phrases to express those ideas naturally, and that by learning other languages one’s worldview can change.

For example, try explaining the difference between ‘freedom’ and ‘liberty’ to someone who does not speak English, or the difference between ‘greedy’ and ‘selfish’.  Alternatively, note that in German the word for ‘policy’ — Politik — is the same as the word for ‘politics’; and the word for ‘debt’ — Schuld — is the same as the word for ‘guilt’.  One can only wonder to what degree such linguistic differences affect differences in individuals’ perceptions of the world and each other, especially with languages as diverse as English and other Western European languages on the one hand and, e.g., Arabic, Chinese, and Persian on the other.

In other words, culture matters.

Related to this is the famous — though inaccurate — claim that Eskimos have an extremely large number of words for ‘snow’, because it is such an integral part of their lives, and subtle differences have significant impacts on their lives.  Similarly, financial managers have more than one term for ‘return on investment’, including return on equity (ROE), return on assets (ROA), return on sales (profit margin), and several others; and several terms for ‘profit’, including net income, earnings before tax (EBT), earnings before interest and tax (EBIT), earnings before interest, tax, depreciation, and amortization (EBITDA), and gross profit.  When one studies business, as opposed to economics, one comes to see instinctively that ‘return’ and ‘profit’ are vague terms; more categories than specific concepts.

Seen in this light, business education is largely a branch of language education. We are teaching concepts and terms with specific meanings as much as — if not more than — we are teaching particular skills. Granted, we use graphs and equations to illustrate the points that we are making, but these are shorthands for the underlying stories that we are telling.

Whether one is dealing with self-interest in economics, risk management in finance, the difference between assets and equity in accounting, or human resource psychology in management, one is telling stories.  As one tells those stories, and students begin to see the world in terms of those stories, one leads students to see the world differently.  If that worldview conforms to reality more accurately than conventional wisdom does, then students who embrace that worldview – learn that language or dialect, as it were – are in a position to benefit from that knowledge by almost literally seeing the world through different eyes.

Given that the vast majority of individuals in urban areas around the world are engaged in business at some level, it is a travesty that Accounting, Economics, Finance, and Management Psychology and Sociology are not standard features of the primary and secondary school curriculum.

If we are going to entrust individuals with the vote, then they should be able to tell legitimate policy proposals from populist magical thinking.  It is one thing to disagree over legitimate policy proposals, because all value is subjective, but it is another thing entirely, when political activists and candidates call for and promise dancing unicorns, singing bunnies, and rainbow fountains.  And, it is yet another thing when voters are unable to distinguish between the two categories.

Our goal here is to provide some tutorial services in the language of business.

Invest accordingly.

Prof. Evans

Oct 092011
 

Reuters via Yahoo! reports, “American[s]… are placed on a kill or capture list by a secretive panel of senior [US] government officials, which then informs the president of its decisions… There is no public record of the operations or decisions of the panel, which is a subset of the White House’s National Security Council… Neither is there any law establishing its existence or setting out the rules by which it is supposed to operate.” [emphasis added]

Naturally enough, some people have a problem with this.

One could rail against the unfairness of it all, post angry comments below blog posts, or even go to the extreme of sending a sharply worded email to someone in power. As an act of absolute desperation, one might wait two, four, or six years and… vote.  Alternatively, one could look for the investment implications.

Because I am neither licensed nor qualified to offer investment advice, and everything that I post here is for educational and entertainment purposes only, I will not make any speculative recommendations, but I will provide some guidelines for forming and testing your own hypotheses.

First, consider that the US Department of Homeland Security (DHS) has begun testing a project to predict future crimes on members of the public, called the Future Attribute Screening Technology (FAST) project.  FAST “is designed to track and monitor, among other inputs, body movements, voice pitch changes, prosody changes (alterations in the rhythm and intonation of speech), eye movements, body heat changes, and breathing patterns.” Best of all, a field test was performed at a large venue in the USA earlier this year.

The US Federal Bureau of Investigation (FBI) [i.e., national police] by mid-January 2012 will activate a nationwide facial recognition service in some US states that will allow local police to identify unknown subjects in photos.

In other words, privacy is dead.

Love it or hate it, ask yourself, “Who benefits?”

You might not be able to stop Rome from burning, but you can try to profit from it, so that you avoid being a burden on others.

Invest accordingly.

Prof. Evans

Oct 082011
 

The Sapir-Whorf Hypothesis holds that language affects thought, in part because we tend to think in terms of the languages that we speak. Whether thought is constrained by language or merely influenced is a matter of some debate beyond the scope of this post.

The point here relates to Methodological Individualism, which is the theory or practice of ascribing all human action to individual action, rather than amorphous collectives like races, genders, nationalities, countries, companies, etc. In other words, one would look at the motives of the individuals within a major Wall Street bank for explanations of the causes of the 2007-2008 market meltdown, rather than at ‘Wall Street’, ‘Wall Street banks’, ‘the government’, ‘capitalism’, or whatever.

Employing Methodological Individualism leads one to ask, “If I want to communicate with X, what is his or her email address?” Try it.

“If I want to communicate with the CEO of Citibank, what is his or her email address?”

See? No big deal.

Now, try these:

“If I want to communicate with Wall Street, what is his or her email address?”

“If I want to communicate with Main Street, what is his or her email address?”

“If I want to communicate with blacks, what is their email address?”

“If I want to communicate with Latino voters, what is their email address?”

Silly, right?

Now, let’s apply the same principle to an essay that is making the rounds among the technorati. Neal Stephenson writes in “Innovation Starvation,” “My lifespan encompasses the era when the United States of America was capable of launching human beings into space.”

Sounds gloomy, bordering on nihilistic. If I want to communicate with the United States of America, what is its email address?

Unlike Mr. Stephenson’s, my lifespan encompasses the era when a seeming army of NASA employees — who were provided with a clear mandate and huge sums of money confiscated from working Americans through taxation — were capable of launching human beings into space. It now includes the era of the first commercial space flight companies in human history, all of which are based in the USA.

An interesting assignment would be to rewrite Mr. Stephenson’s essay from the perspective of Methodological Individualism, replacing all collectivistic references to ‘America’, ‘us’, etc. with identifiable individuals, even if those individuals are archetypes and not actual living personages.

Invest accordingly.

Prof. Evans

Oct 072011
 

The graph above depicts the supply of US dollars from January 1975 through September 2011. The gray bars represent periods recognized by US government statisticians as recessions. Note the swell in the 1990s, during the Clinton Administration, when the supply of US dollars fell. Ah… the good ol’ days!

Now, come over to 2008 or so, and hold onto your hat!

In general, and all other things held constant (or, as we say in the business, ceteris paribus), prices can rise for three reasons: demand increases (e.g., an auction or a popular restaurant), supply decreases (e.g., lower efficiency, war, or natural disaster), or the number of units of currency increases faster than the rate of increase of goods and services (inflation).

Today, we are witnessing a lack of consumer confidence bordering on panic (demand down; prices down), increasing efficiency (supply up; prices down), and a massive increase of the currency base (inflation; prices up). In other words, sagging consumer confidence and increasing productive efficiency are putting a lid on inflationary price increases.

However, efficiency can increase at a high rate for only so long before leveling off (supply stops increasing), and eventually people will go shopping again (demand stops decreasing). When that happens, the downward pressure on prices will weaken. Use your favorite analogy here: a pressure cooker, a plunger, a spring, whatever.

It is reasonable to expect that the downward pressure eventually will be released. Coupled with the inflation depicted in the graph above, this could lead to a period of large and swift price increases.

Invest accordingly.

Prof. Evans

Oct 052011
 

Please take a few moments to review the New Steam Age Curriculum (NSAC) page at Pecuniology Research.

I am especially interested in working with students, professors, and entrepreneurs in Middle Income Countries, in order to ensure the widest global relevance possible.

Invest accordingly.

Prof. Evans

Oct 032011
 

The Mail Online, a newspaper, reports, “Mexico City lawmakers want to help newlyweds avoid the hassle of divorce by giving them an easy exit strategy: temporary marriage licenses.”

Mexican wedding

Apparently, about half of marriages in Mexico end in divorce, and this is an attempt to adapt to that reality.

Gay marriage, drug policy, now this.  Keep an eye on Mexico.

Invest accordingly.

Prof. Evans