Businesses aren’t Consumers

On the list of popular conceptions that dumbfound economists is the notion that business decisions are analogous to personal consumption decisions.  Regularly businesses are described as being "rich" and various business decisions are attributed to businesses being "rich" or not being "rich."  That is simply not a sensible way to think about business decisions.  

As a strong first approximation, an investment will be made if it is expected to yield greater savings, or greater revenue, than it costs.  Whether or not the company is “rich” in any meaningful sense is entirely beside the point.  Even if a business isn’t particularly liquid, we have a very efficient corporate finance industry that will be able to loan the money necessary to make investments that will yield lower expenses or higher revenue in the future.  The best one can say is that corporate wealth might help incumbent managers hide inefficient investments from outsiders.   

John Siracusa is one of the most astute and assiduously logical commenters on the web, which is why his extended comments on Apple’s solar power initiatives, about 3 minutes into this podcast, are so peculiar.

At one point, Siracusa asks "Why doesn't every company use solar power?”  His answer is that solar power costs a lot of money.  

Not a good enough answer.  The question is “Does solar power hold the possibility of reducing electric bills by more than the solar power costs?”  The answer has to include costs.  Focussing only on the cost of solar power leads to the business decisions are made because businesses are or are not rich fallacy.  

Embracing the fallacy, Siracusa asks who can afford to make huge capital investments  if you can make it back slowly over the next 20 years, and answers Apple, because they have lots of money.  The economists' answer:  “Businesses who think it will save more that it will cost.”  Apple may be one of those companies, but the fact that it has $X billion in liquid(ish) assets doesn’t really have anything to do with it.  

Here’s another intriguing observation:  “Walmart’s razor thin margins wouldn’t let them think about doing this because that have to watch every penny.”  (Like every quotation in this post, this is a paraphrase).  Does Walmart’s "razor thin margins” say anything about whether employing solar power in their stores (or anywhere else) will lower their electric bills by enough to justify the investment?  I don't see how.

In fact, since Walmart's business model seems to revolve around exploiting every possible economy, they would be the first organization I'd expect to invest in solar power, if one of Siracusa's other assertions were true, namely, that the will make it back slowly over the next 20 years.  

Now, if they don't think it will pay it self back over 20 years, that's another matter.  Siracusa seems to think (although he doesn't come right out and say it) that Apple's solar power investment is a good thing even if it doesn't pay itself back.  Maybe, but what solar power enthusiasts (an environmentalists in general) don't seem to recognize, is that the effort and material that goes into building, installing, and maintaining solar panels are resources too, just like the electricity from the power grid that the solar panels is expected to replace.  

Too much of the solar power discussion seems to treat prices as some sort of arbitrary hurdle place in the way of the good guys trying to fix the world.  



Planet Money: Inflation Saviors

Planet Money is probably the best economics show on radio; consistently interesting and usually economically sophisticated in a way most other finance related shows aren’t.  This episode from several years ago, rebroadcast last December, is one of their most intriguing, but flawed in one serious and frustratingly unnecessary way.  

It tells a story, which I had never heard, of an episode in Brazilian inflation history in which the Brazilian government managed to bring down a large inflation without the normal dislocations (i.e., a big recession) associated with bringing down inflation.

In short, they introduced a new unit of measure…not a currency yet, but just a unit of measure...which was defined to be X units of currency, with X increasing at the current rate of inflation.  The government published the official value of this unit of measure in currency every day, and started doing their everyday business in the new unit of measure.  Eventually the rest of the country became accustomed to performing their everyday transactions in this new unit of measure, consulting that day’s conversion tables to determine what amount of currency to pay.

Once the rest of the country because so accustomed, they eliminated to old currency and introduced a new currency denominated in the new unit of measure.  

Clever, if you can pull it off, and a truly fascinating story.

The problem is that the story omitted the most important part of the economics, which is that while this was going on the Brazilian central bank went through the mundane, boring, but incredibly difficult task of fixing the dysfunctional monetary policies that caused the inflation in the first place. 

Inflation can be seen to have two parts:  a piece caused by inflationary expectations and a piece caused by underlying monetary policy.  High inflationary expectations can be self-fulfilling as people try to spend money to turn it into assets that aren’t rapidly depreciating in value, causing something of a vicious cycle.  Monetary policy can cause inflation by continually pumping more liquidity into the monetary system than is necessary to support current activity at current prices, which causes prices to increase.  The second is by far the most important of the two.  If the central bank does that, the country will experience inflation.  Period, full stop.  If the central bank stops doing that, inflation will subside.  Period, full stop.  

The Brazilian trick outlined in the story deals with the transitionary period between irresponsible and responsible central bank management, which typically causes an economic downturn as people misread lower inflation for reduced demand for their products and services, and reduce output.  But it doesn’t do anything to make the central bank behave responsibly.  The story only mentions changes in central bank behavior in a tiny codicil at the end.  It would not be surprising, even expected, if listeners came away from the story thinking that the way to “solve” inflation was to ease the populace into using a new unit of measure, when, in fact, it is still thecae that the only way to stop inflation is to adopt a responsible monetary policy.  


Douglas North

I was very fortunate to have taken Theory of Property Rights from Douglas North, in the last class he taught at the University of Washington.  Even though it was an undergraduate course, it seemed to be triply stocked with grad students sitting in.

Outside of the intro principles courses, this course contained more insight than the all of the other economics courses that I have taken, undergraduate and graduate, combined.  

After 30+ years of not being immersed in Economics, here are the highlights I remember:

Ronald Coase's The Problem of Social Cost.

Coase's The Nature of the Firm (why aren't all economic transactions piecework).  As eye-opening in a "permanently change the way you look a the world" way as was the The Problem of Social Cost.  

Steven N. S. Cheung, who had originated the course and the UW before departing for riches in Hong Kong.  His thoughts on "Will China Go Capitalist" permanently changed my thinking on how governments work.  (His answer was yes, because China's governing class want to get rich, and socialism is a way for them to remain poor.)

Oliver Williamson's work on the contractual nature of the firm.  Along with Coase, Williamson showed how the boundaries of the firm is not nearly as sharp as one might think.  His approach provides the framework, for example, of understanding what Apple is doing when it hires other firms to manufacture chips and devices that it designs, and highlights the issues around that business arrangement.  (He also illustrates why it's not as sharply distinguishable from Apple buying and running the factories themselves as one might think.)

Hayek's Use of Knowledge in Society

The concept of property rights as a stream of expected utility.  

The cost of defining property rights as well as the benefits.  

I still have two binders of photocopied articles for the reading list for that class, despite my wife's intermittent poking at me to get rid of stuff I'll "never look at again."  The calss was just too great an experience for that.