1 00:00:00,000 --> 00:00:02,520 The following content is provided under a Creative 2 00:00:02,520 --> 00:00:03,970 Commons license. 3 00:00:03,970 --> 00:00:06,360 Your support will help MIT OpenCourseWare 4 00:00:06,360 --> 00:00:10,660 continue to offer high-quality educational resources for free. 5 00:00:10,660 --> 00:00:13,320 To make a donation or view additional materials 6 00:00:13,320 --> 00:00:17,160 from hundreds of MIT courses, visit MIT OpenCourseWare 7 00:00:17,160 --> 00:00:18,370 at ocw.mit.edu. 8 00:00:21,350 --> 00:00:24,530 RICHARD SCHMALENSEE: Let me do a little bit of where we've been 9 00:00:24,530 --> 00:00:27,200 and where we're going, a little wayfinding. 10 00:00:27,200 --> 00:00:28,700 We did the last two-- 11 00:00:28,700 --> 00:00:33,080 the last two sessions were on individuals and households. 12 00:00:33,080 --> 00:00:38,330 We did a rational actor model, a little drive demand, 13 00:00:38,330 --> 00:00:40,550 maximized preferences. 14 00:00:40,550 --> 00:00:45,890 And then we talked about preferences being learned. 15 00:00:45,890 --> 00:00:49,040 We talked about preferences depending on others. 16 00:00:49,040 --> 00:00:52,050 And particularly in the last session, 17 00:00:52,050 --> 00:00:54,620 we talked about economic style, if you will. 18 00:00:54,620 --> 00:00:58,130 Maximization is only one form of cognition. 19 00:00:58,130 --> 00:01:00,410 That sometimes we all behave automatically 20 00:01:00,410 --> 00:01:03,270 rather than thoughtfully. 21 00:01:03,270 --> 00:01:05,480 I have a very large book to read over spring vacation 22 00:01:05,480 --> 00:01:08,150 by Kahneman called Thinking Fast and Thinking Slow that's 23 00:01:08,150 --> 00:01:09,140 all about this-- 24 00:01:09,140 --> 00:01:10,250 good stuff. 25 00:01:10,250 --> 00:01:13,520 And Max Weber's distinction between rational pursuit 26 00:01:13,520 --> 00:01:16,460 of ends, rational pursuit of an ideal or value. 27 00:01:16,460 --> 00:01:19,710 It feels good or we just do it out of habit. 28 00:01:19,710 --> 00:01:23,300 So we went from sort of a rational actor 29 00:01:23,300 --> 00:01:26,240 story about individuals and households 30 00:01:26,240 --> 00:01:30,080 to more complicated view of behavior. 31 00:01:30,080 --> 00:01:34,200 We're going to do the same thing with firms. 32 00:01:34,200 --> 00:01:37,560 So today is about a rational actor model 33 00:01:37,560 --> 00:01:40,230 about maximizing something-- we'll 34 00:01:40,230 --> 00:01:43,800 talk at the outset about what. 35 00:01:43,800 --> 00:01:47,130 And then we'll talk about behavioral complications. 36 00:01:47,130 --> 00:01:49,500 Whatever it is we think firms ought to maximize 37 00:01:49,500 --> 00:01:54,000 as demanders-- mainly of energy, that's the focus-- 38 00:01:54,000 --> 00:01:57,000 before the break. 39 00:01:57,000 --> 00:01:59,880 They don't necessarily maximize anything. 40 00:01:59,880 --> 00:02:01,800 First, they're full of people. 41 00:02:01,800 --> 00:02:04,320 And people don't necessarily maximize anything. 42 00:02:04,320 --> 00:02:06,560 And there's an additional layer of complication, 43 00:02:06,560 --> 00:02:08,310 which is what we'll spend most of our time 44 00:02:08,310 --> 00:02:10,590 on, because people in organizations 45 00:02:10,590 --> 00:02:13,680 are more complicated than people individually because 46 00:02:13,680 --> 00:02:15,990 of the structures, and incentives, and relationships, 47 00:02:15,990 --> 00:02:17,730 and so forth. 48 00:02:17,730 --> 00:02:21,250 After vacation, we'll spend a little bit-- 49 00:02:21,250 --> 00:02:23,340 and these are normative prescriptive sessions-- 50 00:02:23,340 --> 00:02:27,840 on supply-side strategy, how might one 51 00:02:27,840 --> 00:02:29,620 do an energy business. 52 00:02:29,620 --> 00:02:32,280 So that's where we're going. 53 00:02:32,280 --> 00:02:36,180 It's worth spending some time, though, on-- 54 00:02:36,180 --> 00:02:37,350 is this reasonably clear? 55 00:02:37,350 --> 00:02:39,190 Are the questions? 56 00:02:39,190 --> 00:02:41,180 Let me-- before I pass on-- 57 00:02:41,180 --> 00:02:41,680 OK. 58 00:02:44,780 --> 00:02:48,530 If households maximize utility, what should firms maximize? 59 00:02:48,530 --> 00:02:50,480 If it's your own firm-- 60 00:02:50,480 --> 00:02:51,860 my dad ran a garage. 61 00:02:51,860 --> 00:02:54,380 My dad could do whatever he wanted-- maximize utility, 62 00:02:54,380 --> 00:02:55,520 maximize profit-- 63 00:02:55,520 --> 00:02:56,700 who cares? 64 00:02:56,700 --> 00:03:01,160 There's nobody to tell him what to do. 65 00:03:01,160 --> 00:03:02,480 He aimed for profit, actually. 66 00:03:05,560 --> 00:03:09,140 But for corporations, it's different 67 00:03:09,140 --> 00:03:14,160 because modern corporations have diffuse ownership, right? 68 00:03:14,160 --> 00:03:17,850 The Exxon executives maybe own a reasonable fraction of Exxon, 69 00:03:17,850 --> 00:03:20,820 but that reasonable fraction might be 10%. 70 00:03:20,820 --> 00:03:22,710 Some other companies, it's higher-- 71 00:03:22,710 --> 00:03:24,720 some younger companies, it's higher. 72 00:03:24,720 --> 00:03:31,950 But in a lot of companies, the executives are not the owners. 73 00:03:31,950 --> 00:03:38,570 And the question is, what should the executives maximize-- 74 00:03:38,570 --> 00:03:41,030 if they should maximize anything? 75 00:03:41,030 --> 00:03:43,040 Milton Friedman was writing, when 76 00:03:43,040 --> 00:03:45,200 there were debates about imposing wage and price 77 00:03:45,200 --> 00:03:48,920 controls to deal with what seemed then 78 00:03:48,920 --> 00:03:51,140 like a lot of inflation-- 79 00:03:51,140 --> 00:03:53,450 we had much more later years, but it seemed like a lot 80 00:03:53,450 --> 00:03:57,410 of inflation in '70, '71, when, in '71, when Nixon did impose 81 00:03:57,410 --> 00:03:59,350 price controls-- 82 00:03:59,350 --> 00:04:01,320 which mostly failed. 83 00:04:01,320 --> 00:04:04,230 And Milton Friedman has a distinct point of view 84 00:04:04,230 --> 00:04:08,880 about what corporate executives should be told to maximize. 85 00:04:08,880 --> 00:04:11,460 Anybody? 86 00:04:11,460 --> 00:04:12,690 Columbus, what do you say? 87 00:04:12,690 --> 00:04:17,022 What does Milton Friedman say should be the instruction? 88 00:04:17,022 --> 00:04:17,850 AUDIENCE: Profits. 89 00:04:17,850 --> 00:04:19,017 RICHARD SCHMALENSEE: Profit. 90 00:04:19,017 --> 00:04:20,490 OK. 91 00:04:20,490 --> 00:04:24,390 Why not do some social good? 92 00:04:24,390 --> 00:04:28,320 What's the argument against saying to Exxon, oh, come on, 93 00:04:28,320 --> 00:04:30,090 you're a big, rich company. 94 00:04:30,090 --> 00:04:32,080 Do some good. 95 00:04:32,080 --> 00:04:34,390 AUDIENCE: Well, there's a few different reasons 96 00:04:34,390 --> 00:04:37,110 why, for the stockholders, they might not 97 00:04:37,110 --> 00:04:47,400 want to do that for the [INAUDIBLE] 98 00:04:47,400 --> 00:04:51,790 if they do that, they're not spending their own money. 99 00:04:51,790 --> 00:04:53,790 RICHARD SCHMALENSEE: Well, that's disappointing. 100 00:04:53,790 --> 00:04:54,750 You gave a complete answer. 101 00:04:54,750 --> 00:04:56,100 Now who am I going to call on next? 102 00:04:56,100 --> 00:04:57,720 Does anybody want to supplement that? 103 00:04:57,720 --> 00:04:59,220 I mean, that's the basic answer. 104 00:04:59,220 --> 00:05:01,710 It's taxation without representation. 105 00:05:01,710 --> 00:05:04,080 If the owners want to spend money on charity, fine. 106 00:05:04,080 --> 00:05:07,930 But-- and if they want to tell the executive to do that, fine. 107 00:05:07,930 --> 00:05:13,470 But if they don't, why should the executives of Exxon 108 00:05:13,470 --> 00:05:15,670 do social good? 109 00:05:15,670 --> 00:05:16,680 So Friedman says, nope. 110 00:05:16,680 --> 00:05:17,850 Their business is to make money. 111 00:05:17,850 --> 00:05:19,380 The owners can contribute to charity. 112 00:05:19,380 --> 00:05:20,838 We'll start the debate in a minute, 113 00:05:20,838 --> 00:05:22,530 but let's clarify his point of view. 114 00:05:22,530 --> 00:05:23,697 Did you want to add to that? 115 00:05:23,697 --> 00:05:26,197 AUDIENCE: I just wanted to add that corporations can get tax 116 00:05:26,197 --> 00:05:27,820 deductions for donating to charities, 117 00:05:27,820 --> 00:05:37,200 so it's kind of a way to pay money to get [INAUDIBLE] 118 00:05:37,200 --> 00:05:39,966 charitable, but really, you're just trying to-- 119 00:05:39,966 --> 00:05:43,160 I mean, you're just paying your taxes in a different direction. 120 00:05:43,160 --> 00:05:45,860 RICHARD SCHMALENSEE: So you're saying 121 00:05:45,860 --> 00:05:51,020 that a firm can do things that might not necessarily 122 00:05:51,020 --> 00:05:54,860 look to be profit maximization, like giving to charity, 123 00:05:54,860 --> 00:05:57,920 but might be thought through correctly 124 00:05:57,920 --> 00:06:02,030 contribute to their long-run success. 125 00:06:02,030 --> 00:06:05,560 So you wouldn't necessarily want to squeeze every nickel out. 126 00:06:05,560 --> 00:06:06,650 OK. 127 00:06:06,650 --> 00:06:08,610 So Friedman would let you do that. 128 00:06:08,610 --> 00:06:12,940 But Friedman would say, how do you choose what charity? 129 00:06:12,940 --> 00:06:15,570 Who chooses? 130 00:06:15,570 --> 00:06:16,980 The CEO's favorite charity. 131 00:06:16,980 --> 00:06:19,780 Maybe that's part of his or her compensation. 132 00:06:19,780 --> 00:06:22,910 Anybody else on Friedman. 133 00:06:22,910 --> 00:06:23,450 OK. 134 00:06:23,450 --> 00:06:24,970 What's handy-- Yeah, go ahead, Maxwell. 135 00:06:24,970 --> 00:06:25,595 AUDIENCE: Yeah. 136 00:06:25,595 --> 00:06:28,850 I was just going to say [INAUDIBLE] and then you have 137 00:06:28,850 --> 00:06:33,157 [INAUDIBLE] 138 00:06:33,157 --> 00:06:34,240 RICHARD SCHMALENSEE: Yeah. 139 00:06:34,240 --> 00:06:37,990 It becomes a political entity, except that there's no voting. 140 00:06:37,990 --> 00:06:41,560 That it's making collective decisions 141 00:06:41,560 --> 00:06:44,530 like a taxing authority. 142 00:06:44,530 --> 00:06:47,790 But it's basically taking money out of the owners' pockets. 143 00:06:47,790 --> 00:06:48,345 David? 144 00:06:48,345 --> 00:06:49,720 AUDIENCE: So basically, they just 145 00:06:49,720 --> 00:06:52,390 don't have any right to choose where to donate to. 146 00:06:52,390 --> 00:06:56,870 And they don't have that [INAUDIBLE] 147 00:06:56,870 --> 00:07:01,652 select CEOs that are good at policy [INAUDIBLE].. 148 00:07:01,652 --> 00:07:04,110 RICHARD SCHMALENSEE: Murray does make an interesting point, 149 00:07:04,110 --> 00:07:10,610 which is that if I give it to you in the form of dividends, 150 00:07:10,610 --> 00:07:12,470 it gets taxed at the corporate level 151 00:07:12,470 --> 00:07:14,270 as well as at the personal level. 152 00:07:14,270 --> 00:07:16,310 Yeah, you can get a tax deduction personally, 153 00:07:16,310 --> 00:07:18,290 but you get that corporate tax hit. 154 00:07:18,290 --> 00:07:21,480 So it's a little more efficient if the corporation contributes. 155 00:07:21,480 --> 00:07:24,550 But who's to let them decide what to contribute. 156 00:07:24,550 --> 00:07:25,050 OK. 157 00:07:25,050 --> 00:07:25,820 Yes? 158 00:07:25,820 --> 00:07:28,030 AUDIENCE: Also, a corporation's main responsibility 159 00:07:28,030 --> 00:07:31,310 is just to make a profit for itself and for shareholders. 160 00:07:31,310 --> 00:07:34,580 And so some corporations have it in their mission statement 161 00:07:34,580 --> 00:07:38,340 that they do good will and good work, and stuff like that. 162 00:07:38,340 --> 00:07:41,235 And so then I think it's more acceptable to have charity 163 00:07:41,235 --> 00:07:43,610 be part of the company because it's part of their mission 164 00:07:43,610 --> 00:07:44,160 statement. 165 00:07:44,160 --> 00:07:47,540 But the majority of corporations, their mission 166 00:07:47,540 --> 00:07:50,000 is to make a profit for the shareholders, so. 167 00:07:50,000 --> 00:07:50,900 RICHARD SCHMALENSEE: Well, they would usually 168 00:07:50,900 --> 00:07:53,630 have a mission statement that's a little more exalted than that 169 00:07:53,630 --> 00:07:55,670 if they have a mission statement-- 170 00:07:55,670 --> 00:07:58,110 unless they're explicitly charitable, and some are, 171 00:07:58,110 --> 00:07:58,610 right? 172 00:07:58,610 --> 00:08:00,852 There are these corporations-- 173 00:08:00,852 --> 00:08:02,810 which are very interesting-- that treat profits 174 00:08:02,810 --> 00:08:07,550 as a constraint, not an objective that are charitable. 175 00:08:07,550 --> 00:08:10,310 Well, Newman's salad dressing, for instance. 176 00:08:10,310 --> 00:08:13,010 They maximize profits to give to charity. 177 00:08:13,010 --> 00:08:18,200 There are companies-- what's the term-- social enterprises that 178 00:08:18,200 --> 00:08:21,080 basically say, we're going to make just enough money 179 00:08:21,080 --> 00:08:21,928 to survive. 180 00:08:21,928 --> 00:08:23,970 And we're going to do good in the following ways. 181 00:08:23,970 --> 00:08:27,050 You can think about a number of things like that. 182 00:08:27,050 --> 00:08:28,430 What's Handy say? 183 00:08:28,430 --> 00:08:29,390 Handy disagrees. 184 00:08:29,390 --> 00:08:31,910 Handy's writing-- let me just see if we've got-- 185 00:08:31,910 --> 00:08:35,530 I think we've got the main points. 186 00:08:35,530 --> 00:08:37,240 Yup. 187 00:08:37,240 --> 00:08:40,100 Handy's writing after the dotcom bust. 188 00:08:40,100 --> 00:08:42,010 OK, Friedman's writing in a landscape 189 00:08:42,010 --> 00:08:46,780 where an issue of the day is, should the government 190 00:08:46,780 --> 00:08:49,600 step in and control prices? 191 00:08:49,600 --> 00:08:52,810 Handy's writing after the dotcom bust when stocks went up, 192 00:08:52,810 --> 00:08:57,160 stocks came down like a stone, lots of companies went broke. 193 00:08:57,160 --> 00:08:59,740 What's Handy say the firms should be about? 194 00:09:09,300 --> 00:09:12,090 Benzi, you're writing down, and I'm not saying anything. 195 00:09:12,090 --> 00:09:16,070 So you must be preparing your answer to this question. 196 00:09:16,070 --> 00:09:18,650 So what does Handy say that the firm 197 00:09:18,650 --> 00:09:20,608 should the firm should be about? 198 00:09:20,608 --> 00:09:22,400 AUDIENCE: I didn't get a chance to read it. 199 00:09:22,400 --> 00:09:22,970 RICHARD SCHMALENSEE: OK. 200 00:09:22,970 --> 00:09:23,580 OK. 201 00:09:23,580 --> 00:09:24,860 Thank you for your honesty. 202 00:09:24,860 --> 00:09:25,718 Matthew? 203 00:09:25,718 --> 00:09:27,260 AUDIENCE: I have the same [INAUDIBLE] 204 00:09:27,260 --> 00:09:28,190 RICHARD SCHMALENSEE: You have to same-- somebody 205 00:09:28,190 --> 00:09:28,790 must have read it. 206 00:09:28,790 --> 00:09:30,623 I'm sure there's somebody in this group that 207 00:09:30,623 --> 00:09:32,780 read the Handy paper-- doesn't summarize easily. 208 00:09:32,780 --> 00:09:33,740 Veronica? 209 00:09:33,740 --> 00:09:35,230 Fire away. 210 00:09:35,230 --> 00:09:36,590 AUDIENCE: It wasn't on Stellar. 211 00:09:36,590 --> 00:09:37,850 RICHARD SCHMALENSEE: Was it really not on Stellar? 212 00:09:37,850 --> 00:09:38,475 AUDIENCE: Yeah. 213 00:09:38,475 --> 00:09:42,210 It was only preview. 214 00:09:42,210 --> 00:09:44,271 RICHARD SCHMALENSEE: I got it. 215 00:09:44,271 --> 00:09:45,990 AUDIENCE: [INAUDIBLE] 216 00:09:45,990 --> 00:09:46,990 AUDIENCE: This morning-- 217 00:09:46,990 --> 00:09:49,157 RICHARD SCHMALENSEE: No, I printed it out last week. 218 00:09:49,157 --> 00:09:51,410 It wasn't up? 219 00:09:51,410 --> 00:09:53,840 Was it marked staff only? 220 00:09:53,840 --> 00:09:56,110 Did we screw it up and mark it staff only? 221 00:09:56,110 --> 00:09:58,803 AUDIENCE: [INAUDIBLE]. 222 00:09:58,803 --> 00:09:59,970 RICHARD SCHMALENSEE: No, no. 223 00:09:59,970 --> 00:10:00,553 It was posted. 224 00:10:00,553 --> 00:10:02,595 It was posted months ago. 225 00:10:02,595 --> 00:10:05,220 The only thing I can think of as it may have been inadvertently 226 00:10:05,220 --> 00:10:06,840 labeled staff only. 227 00:10:06,840 --> 00:10:10,200 Well, in which case, because I pulled it off to-- 228 00:10:10,200 --> 00:10:13,170 I mean, here it is, exactly from Stellar. 229 00:10:13,170 --> 00:10:18,090 So I'll tell you what Handy says and we can talk about it. 230 00:10:18,090 --> 00:10:20,400 Handy's a funny article, right? 231 00:10:20,400 --> 00:10:21,508 He's writing in the-- 232 00:10:21,508 --> 00:10:23,550 so you could have just said, you couldn't get it. 233 00:10:23,550 --> 00:10:24,967 And then you would have been good. 234 00:10:28,140 --> 00:10:32,250 It's a lot of criticism of the short-term focus in stock 235 00:10:32,250 --> 00:10:34,500 options and all of that. 236 00:10:34,500 --> 00:10:37,960 He says profits are a means not an end. 237 00:10:37,960 --> 00:10:41,310 It's a completely different vision. 238 00:10:41,310 --> 00:10:44,250 That a good firm is, "a community with a purpose." 239 00:10:44,250 --> 00:10:46,200 That's his phrase. 240 00:10:46,200 --> 00:10:49,740 And you should treat employees like-- 241 00:10:49,740 --> 00:10:51,030 as stakeholders. 242 00:10:51,030 --> 00:10:54,360 He's one of the coiners of the stakeholder view of the firm. 243 00:10:54,360 --> 00:10:57,330 That a firm doesn't exist to serve just its owners, 244 00:10:57,330 --> 00:11:00,570 it exists to serve the communities it operates in. 245 00:11:00,570 --> 00:11:07,230 It exists to serve its employees who've invested at least some-- 246 00:11:07,230 --> 00:11:09,330 made some investments of time and energy 247 00:11:09,330 --> 00:11:14,550 that will be lost if they leave the firm or if the firm fails. 248 00:11:14,550 --> 00:11:18,420 So he would say, a good firm is about something, 249 00:11:18,420 --> 00:11:21,270 not just about making money to shareholders. 250 00:11:21,270 --> 00:11:25,560 And a good firm will go beyond minimal legal requirements 251 00:11:25,560 --> 00:11:28,320 for something like things like environment, and safety, 252 00:11:28,320 --> 00:11:29,598 and so forth. 253 00:11:29,598 --> 00:11:31,140 So you have two very different views. 254 00:11:31,140 --> 00:11:35,070 You have a classical economic view from Friedman. 255 00:11:35,070 --> 00:11:36,630 You've been employed by the owners, 256 00:11:36,630 --> 00:11:39,780 you have a fiduciary responsibility for the owners. 257 00:11:39,780 --> 00:11:42,840 Don't spend the owners' money without authorization 258 00:11:42,840 --> 00:11:43,870 or instruction. 259 00:11:43,870 --> 00:11:47,310 And the Handy view that says, that's too simple. 260 00:11:47,310 --> 00:11:49,530 Lots of other people have a stake in the firm-- 261 00:11:49,530 --> 00:11:54,610 the community, the employees, the environment, et cetera, 262 00:11:54,610 --> 00:11:56,050 et cetera, et cetera. 263 00:11:56,050 --> 00:11:58,530 So you really need to take a broader 264 00:11:58,530 --> 00:11:59,910 view of what you're about. 265 00:12:02,640 --> 00:12:05,253 Now that you've had a complete clear exposition of what 266 00:12:05,253 --> 00:12:07,170 I must say is a little bit of a murky article, 267 00:12:07,170 --> 00:12:12,210 we'll make sure you can get it this afternoon. 268 00:12:12,210 --> 00:12:13,080 What do you think? 269 00:12:15,810 --> 00:12:18,050 Where do you come down? 270 00:12:18,050 --> 00:12:20,650 Sam? 271 00:12:20,650 --> 00:12:22,750 Handy's view is a little more humane, isn't it? 272 00:12:22,750 --> 00:12:23,780 Yeah. 273 00:12:23,780 --> 00:12:28,170 AUDIENCE: Also, like, we have the kind of a [INAUDIBLE] 274 00:12:28,170 --> 00:12:29,755 their employees will be more happy. 275 00:12:29,755 --> 00:12:31,880 And that would just make it a better place to work, 276 00:12:31,880 --> 00:12:33,460 which will in turn be-- 277 00:12:33,460 --> 00:12:34,750 make the firm more productive. 278 00:12:34,750 --> 00:12:36,310 Where if you're trying to just like 279 00:12:36,310 --> 00:12:38,757 have like a ruthless, cost-cutting machine type 280 00:12:38,757 --> 00:12:40,840 thing, it's going to be a miserable place to work. 281 00:12:40,840 --> 00:12:43,762 And it's not going to be just a flourishing environment. 282 00:12:43,762 --> 00:12:45,470 RICHARD SCHMALENSEE: Well, Friedman says, 283 00:12:45,470 --> 00:12:47,620 OK, I'll take that. 284 00:12:47,620 --> 00:12:48,460 I love that. 285 00:12:51,610 --> 00:12:54,520 We will be about something because that'll 286 00:12:54,520 --> 00:12:57,430 motivate people-- 287 00:12:57,430 --> 00:12:58,940 that's profit maximization. 288 00:12:58,940 --> 00:13:01,360 You've just given me profit maximization. 289 00:13:01,360 --> 00:13:06,210 I've given you-- a great example-- 290 00:13:06,210 --> 00:13:09,860 I'll mention two firms that I served on the boards of. 291 00:13:09,860 --> 00:13:12,830 The one was a startup, became the International 292 00:13:12,830 --> 00:13:13,880 Securities Exchange. 293 00:13:13,880 --> 00:13:16,730 It was the first all-electronic Options Exchange 294 00:13:16,730 --> 00:13:18,710 in the country. 295 00:13:18,710 --> 00:13:25,230 And everybody made money, but the mission-- 296 00:13:25,230 --> 00:13:27,330 not quite chiseled in stone, but the mission 297 00:13:27,330 --> 00:13:29,580 that everybody talked about was, we're 298 00:13:29,580 --> 00:13:31,320 going to upset this market. 299 00:13:31,320 --> 00:13:34,890 Trading is slow, commissions are ridiculously high, 300 00:13:34,890 --> 00:13:38,010 we could offer a much better product to the world. 301 00:13:38,010 --> 00:13:39,570 Well, you can go to work-- you can 302 00:13:39,570 --> 00:13:42,100 get up and go to work for that. 303 00:13:42,100 --> 00:13:44,790 The other is the International Data Group, which 304 00:13:44,790 --> 00:13:46,140 has a clear mission statement. 305 00:13:46,140 --> 00:13:48,960 It's to provide information about information technology 306 00:13:48,960 --> 00:13:51,900 so that technology can have more impact. 307 00:13:51,900 --> 00:13:54,600 Well, you can kind of go to work for that, too. 308 00:13:54,600 --> 00:13:58,370 The notion that we exist to make money for our owners 309 00:13:58,370 --> 00:14:00,880 a little hard to get up and get excited about. 310 00:14:00,880 --> 00:14:03,450 So Friedman said-- Friedman will come along with you 311 00:14:03,450 --> 00:14:04,335 and say, yes. 312 00:14:07,245 --> 00:14:08,370 And there's a nice example. 313 00:14:11,070 --> 00:14:12,690 Handy mentions Merck. 314 00:14:15,270 --> 00:14:19,890 Beginning in 1988, they had invented this drug 315 00:14:19,890 --> 00:14:21,330 that cures river blindness, which 316 00:14:21,330 --> 00:14:25,280 is a very nasty disease that infects people in Africa. 317 00:14:25,280 --> 00:14:27,870 I mean, young people go blind from swimming, basically, 318 00:14:27,870 --> 00:14:29,580 but getting in the water. 319 00:14:29,580 --> 00:14:32,970 And the stuff is reasonably expensive to make. 320 00:14:32,970 --> 00:14:36,330 They couldn't actually sell it into Africa. 321 00:14:36,330 --> 00:14:38,530 So they give it away. 322 00:14:38,530 --> 00:14:39,280 They give it away. 323 00:14:39,280 --> 00:14:39,940 It's free. 324 00:14:39,940 --> 00:14:42,100 They make it available free. 325 00:14:42,100 --> 00:14:45,370 And you say, how can that be profit maximizing? 326 00:14:45,370 --> 00:14:48,280 Well, if you walk into the Merck headquarters, 327 00:14:48,280 --> 00:14:53,740 there's a large statue of a young boy with-- 328 00:14:53,740 --> 00:14:57,130 as I remember it-- somebody in a white coat with his hand 329 00:14:57,130 --> 00:14:58,870 on the boy's shoulder. 330 00:14:58,870 --> 00:15:02,920 And you say to anybody at Merck, what's that about? 331 00:15:02,920 --> 00:15:05,770 They tell you this story. 332 00:15:05,770 --> 00:15:07,390 Well, you can get up and go to work 333 00:15:07,390 --> 00:15:09,010 for a company that says, yeah, we're 334 00:15:09,010 --> 00:15:10,840 about more than making money. 335 00:15:10,840 --> 00:15:14,410 We saw something that we could uniquely do for the world 336 00:15:14,410 --> 00:15:16,380 and we did it. 337 00:15:16,380 --> 00:15:18,130 We're not just about making money. 338 00:15:18,130 --> 00:15:19,710 So Friedman-- Friedman loves this. 339 00:15:22,300 --> 00:15:24,190 Anything-- would you go further? 340 00:15:26,840 --> 00:15:27,800 Julien. 341 00:15:27,800 --> 00:15:29,180 We've got your name corrected. 342 00:15:29,180 --> 00:15:30,400 That's fabulous. 343 00:15:30,400 --> 00:15:32,690 Good. 344 00:15:32,690 --> 00:15:33,890 Good. 345 00:15:33,890 --> 00:15:36,260 AUDIENCE: Well, I mean, I would disagree with Friedman 346 00:15:36,260 --> 00:15:39,140 because he may be right in some cases 347 00:15:39,140 --> 00:15:42,650 that perhaps some companies would find it in their best 348 00:15:42,650 --> 00:15:46,104 interest to do social good. 349 00:15:46,104 --> 00:15:49,550 However, let's say-- let's take a look at McDonald's. 350 00:15:49,550 --> 00:15:53,210 I'm sure their workers aren't happy about their wages. 351 00:15:53,210 --> 00:15:56,150 And I'm pretty sure McDonald's could pay them a bit more 352 00:15:56,150 --> 00:16:01,100 But I mean, that might be seen as a social good 353 00:16:01,100 --> 00:16:03,540 to earn more than minimum wage for your workers-- 354 00:16:03,540 --> 00:16:05,360 or pay more than minimum wage-- and I'm 355 00:16:05,360 --> 00:16:08,930 sure McDonald's could probably afford it. 356 00:16:08,930 --> 00:16:14,000 But seeing as they generally don't pay that much, 357 00:16:14,000 --> 00:16:18,840 it's not really in their interest for social good. 358 00:16:18,840 --> 00:16:21,090 So it's generally about profit, I would say. 359 00:16:21,090 --> 00:16:25,910 And so Friedman, I would say, is incorrect in that firms 360 00:16:25,910 --> 00:16:28,892 don't always do like social good for profit. 361 00:16:28,892 --> 00:16:30,350 RICHARD SCHMALENSEE: Sometimes they 362 00:16:30,350 --> 00:16:32,180 do social good for social good. 363 00:16:32,180 --> 00:16:34,310 By the way, I think it's the local franchisee who 364 00:16:34,310 --> 00:16:37,460 makes the wage decisions, and whether that person can 365 00:16:37,460 --> 00:16:41,400 afford it or not depends. 366 00:16:41,400 --> 00:16:43,890 AUDIENCE: OK, different example then. 367 00:16:43,890 --> 00:16:48,630 Let's say coal mines back in the day-- 368 00:16:48,630 --> 00:16:51,780 or like during industrialization, 369 00:16:51,780 --> 00:16:52,650 clothing factories. 370 00:16:52,650 --> 00:16:55,765 Like weren't people-- the labor-- 371 00:16:55,765 --> 00:16:57,390 they were people in horrible conditions 372 00:16:57,390 --> 00:16:59,160 and paid them horrible wages-- 373 00:16:59,160 --> 00:17:00,827 RICHARD SCHMALENSEE: But remember, we're 374 00:17:00,827 --> 00:17:03,050 talking prescription, not description. 375 00:17:03,050 --> 00:17:05,810 Friedman says, that's OK. 376 00:17:05,810 --> 00:17:08,270 Handy says, that's not OK. 377 00:17:08,270 --> 00:17:08,990 What do you say? 378 00:17:08,990 --> 00:17:11,210 You say it's not OK. 379 00:17:11,210 --> 00:17:12,700 Or do you say it's OK? 380 00:17:12,700 --> 00:17:16,579 What would you tell the executives to do? 381 00:17:16,579 --> 00:17:18,260 AUDIENCE: Better working conditions. 382 00:17:18,260 --> 00:17:19,609 RICHARD SCHMALENSEE: OK. 383 00:17:19,609 --> 00:17:21,060 Do coal mines ever fail? 384 00:17:21,060 --> 00:17:23,200 Go out of business, go broke? 385 00:17:23,200 --> 00:17:24,130 Yeah. 386 00:17:24,130 --> 00:17:26,723 Even with those lousy working conditions. 387 00:17:26,723 --> 00:17:28,265 AUDIENCE: [INAUDIBLE] not necessarily 388 00:17:28,265 --> 00:17:30,540 an effect of the working conditions [INAUDIBLE] 389 00:17:30,540 --> 00:17:30,780 RICHARD SCHMALENSEE: No, no. 390 00:17:30,780 --> 00:17:31,350 It's not. 391 00:17:31,350 --> 00:17:31,850 It's not. 392 00:17:31,850 --> 00:17:34,320 But if you raise costs, you raise the probability. 393 00:17:34,320 --> 00:17:39,810 So here's another Merck example from-- 394 00:17:39,810 --> 00:17:41,160 that needs a paren-- 395 00:17:41,160 --> 00:17:46,080 from 1999 to 2004, close paren, Merck 396 00:17:46,080 --> 00:17:47,940 had information about the adverse health 397 00:17:47,940 --> 00:17:51,630 effects of a popular drug prescribed for arthritis. 398 00:17:51,630 --> 00:17:54,360 A friend of mine took it regularly. 399 00:17:54,360 --> 00:17:56,007 And it had very-- it had bad side 400 00:17:56,007 --> 00:17:57,840 effects they had information on the bad side 401 00:17:57,840 --> 00:17:59,580 effects-- they hid it. 402 00:17:59,580 --> 00:18:00,760 They hid the information. 403 00:18:00,760 --> 00:18:02,760 And during that period, they sold a lot of Vioxx 404 00:18:02,760 --> 00:18:05,050 and made a lot of money. 405 00:18:05,050 --> 00:18:09,270 Was that profit maximizing? 406 00:18:09,270 --> 00:18:10,528 Handy would oppose it. 407 00:18:10,528 --> 00:18:11,570 Would Friedman oppose it? 408 00:18:14,250 --> 00:18:15,080 Charlotte? 409 00:18:15,080 --> 00:18:16,708 AUDIENCE: But isn't that one illegal? 410 00:18:16,708 --> 00:18:18,000 RICHARD SCHMALENSEE: Well, yes. 411 00:18:18,000 --> 00:18:18,870 There is that. 412 00:18:18,870 --> 00:18:21,330 AUDIENCE: But are we talking about things that are illegal? 413 00:18:21,330 --> 00:18:22,788 Or are we just talking about things 414 00:18:22,788 --> 00:18:25,820 that could be or couldn't be, like depending on the decision 415 00:18:25,820 --> 00:18:27,960 by the owners, like the legality of it. 416 00:18:27,960 --> 00:18:30,502 RICHARD SCHMALENSEE: I actually don't know if it was illegal. 417 00:18:30,502 --> 00:18:31,620 They certainly were sued. 418 00:18:31,620 --> 00:18:33,410 I'm not sure of the legality. 419 00:18:33,410 --> 00:18:35,340 Suppose it was legal. 420 00:18:35,340 --> 00:18:38,750 AUDIENCE: [INAUDIBLE] to meet their legal requirements. 421 00:18:38,750 --> 00:18:40,500 RICHARD SCHMALENSEE: Suppose it was legal. 422 00:18:40,500 --> 00:18:41,610 Suppose it was legal. 423 00:18:41,610 --> 00:18:42,330 Bad law. 424 00:18:42,330 --> 00:18:45,690 The law didn't actually say, you got to disclose bad effects. 425 00:18:45,690 --> 00:18:49,740 The law was badly written, and it let them get away with it. 426 00:18:49,740 --> 00:18:50,740 Then, should they have-- 427 00:18:50,740 --> 00:18:52,250 AUDIENCE: I think they would both disagree with that 428 00:18:52,250 --> 00:18:54,950 because personally, if I were working for a firm that 429 00:18:54,950 --> 00:18:58,148 was hiding the adverse effects of a drug that someone I knew 430 00:18:58,148 --> 00:19:00,440 might be taking, that wouldn't be a reason for me to go 431 00:19:00,440 --> 00:19:01,190 to work every day. 432 00:19:01,190 --> 00:19:02,857 RICHARD SCHMALENSEE: That would be hard. 433 00:19:02,857 --> 00:19:03,450 Rachel? 434 00:19:03,450 --> 00:19:04,870 AUDIENCE: I feel like for in both cases, 435 00:19:04,870 --> 00:19:06,870 it just kind of depends for individual companies 436 00:19:06,870 --> 00:19:09,780 how much they value-- or how much consumer opinion of them 437 00:19:09,780 --> 00:19:11,490 matters to their business. 438 00:19:11,490 --> 00:19:13,370 I mean, this case, like it might not 439 00:19:13,370 --> 00:19:15,530 be profit maximizing if it's really, really 440 00:19:15,530 --> 00:19:17,860 important that the public have a good view of them 441 00:19:17,860 --> 00:19:18,610 in the first case. 442 00:19:18,610 --> 00:19:20,960 It might be that the amount of money that they're 443 00:19:20,960 --> 00:19:24,355 losing by giving away the drug is 444 00:19:24,355 --> 00:19:26,480 overcome by the amount of goodwill they're earning. 445 00:19:26,480 --> 00:19:28,510 So it just kind of depends on the firm. 446 00:19:28,510 --> 00:19:30,190 RICHARD SCHMALENSEE: Actually, one thing that's-- it'd be 447 00:19:30,190 --> 00:19:32,690 interesting to know there, and I don't know the details, is, 448 00:19:32,690 --> 00:19:36,430 at what level of the firm was the decision made to conceal? 449 00:19:36,430 --> 00:19:39,250 It could be the person whose bonus depended 450 00:19:39,250 --> 00:19:41,860 on sales as opposed to the CEO. 451 00:19:41,860 --> 00:19:42,460 Samantha? 452 00:19:42,460 --> 00:19:43,970 AUDIENCE: I was just going to I say 453 00:19:43,970 --> 00:19:47,660 that I think I'm more on the Handy side of things, 454 00:19:47,660 --> 00:19:51,050 that firms have an obligation-- a moral obligation, 455 00:19:51,050 --> 00:19:54,194 as well as an obligation to maximize profit. 456 00:19:54,194 --> 00:19:58,318 And something like hiding adverse of effects of a drug 457 00:19:58,318 --> 00:20:01,246 is, in my opinion, morally wrong. 458 00:20:01,246 --> 00:20:03,850 And it's not something that a firm-- 459 00:20:03,850 --> 00:20:06,743 I mean, I would think that Friedman 460 00:20:06,743 --> 00:20:09,160 would be OK with something like that, and Handy would not. 461 00:20:09,160 --> 00:20:12,980 AUDIENCE: [INAUDIBLE] companies do balance like PR 462 00:20:12,980 --> 00:20:14,950 and public opinion with them with profit 463 00:20:14,950 --> 00:20:17,020 maximizing because public opinion of them 464 00:20:17,020 --> 00:20:18,800 affects the profits. 465 00:20:18,800 --> 00:20:20,000 RICHARD SCHMALENSEE: And it's nice to have a mission when 466 00:20:20,000 --> 00:20:21,920 you can have a mission, but Wednesday, we're 467 00:20:21,920 --> 00:20:23,837 going to talk about a firm in upstate New York 468 00:20:23,837 --> 00:20:25,430 that makes formaldehyde. 469 00:20:25,430 --> 00:20:27,590 And I just don't know how-- 470 00:20:27,590 --> 00:20:30,010 it may be technically interesting to run the firm, 471 00:20:30,010 --> 00:20:31,610 to run the plant, but I don't see 472 00:20:31,610 --> 00:20:35,330 how you get socially charged by that one. 473 00:20:35,330 --> 00:20:37,100 Just one last, and than I do want 474 00:20:37,100 --> 00:20:39,500 to get on to capitol budgeting. 475 00:20:39,500 --> 00:20:41,540 And let's just think about this one 476 00:20:41,540 --> 00:20:46,910 because think about how much of an issue 477 00:20:46,910 --> 00:20:50,060 Romney's venture capital experience-- 478 00:20:50,060 --> 00:20:53,360 actually, a private equity experience-- 479 00:20:53,360 --> 00:20:58,100 has been in this campaign, where they closed plants, 480 00:20:58,100 --> 00:21:00,590 they closed firms. 481 00:21:00,590 --> 00:21:04,670 And it's portrayed as the wrong thing to do. 482 00:21:04,670 --> 00:21:07,280 Sometimes there's no choice. 483 00:21:07,280 --> 00:21:09,940 Sometimes there is a choice. 484 00:21:09,940 --> 00:21:11,920 Is there a moral issue involved here? 485 00:21:11,920 --> 00:21:13,990 Is there not a moral issue. 486 00:21:13,990 --> 00:21:15,850 I'm a McDonald's franchisee, just 487 00:21:15,850 --> 00:21:19,240 to go to Julien's favorite dining establishment. 488 00:21:19,240 --> 00:21:21,520 And I've got six stores-- 489 00:21:21,520 --> 00:21:24,460 and I'm losing money on one of them. 490 00:21:24,460 --> 00:21:26,200 Do I have a moral obligation to keep 491 00:21:26,200 --> 00:21:30,170 it open because of the people or can I shut it down? 492 00:21:32,960 --> 00:21:36,740 Or suppose, in fact, I'm not losing money on it. 493 00:21:36,740 --> 00:21:38,840 It's reasonably profitable. 494 00:21:38,840 --> 00:21:41,720 But I get a really good offer from somebody who 495 00:21:41,720 --> 00:21:43,820 wants to make it a parking lot. 496 00:21:43,820 --> 00:21:46,910 And I can take that money, open another restaurant 497 00:21:46,910 --> 00:21:48,650 in a better location across town, 498 00:21:48,650 --> 00:21:50,840 where, yeah, I could employ those people, 499 00:21:50,840 --> 00:21:53,300 but they won't be able to get there. 500 00:21:53,300 --> 00:21:54,200 So I'll take it. 501 00:21:54,200 --> 00:21:55,185 You had a reaction? 502 00:21:55,185 --> 00:21:55,810 AUDIENCE: Yeah. 503 00:21:55,810 --> 00:21:57,395 I mean, there could be another company 504 00:21:57,395 --> 00:22:00,650 that could come in and do more good to the community than just 505 00:22:00,650 --> 00:22:02,098 another parking lot. 506 00:22:02,098 --> 00:22:03,806 RICHARD SCHMALENSEE: Parking lot-- maybe. 507 00:22:03,806 --> 00:22:05,174 Maybe. 508 00:22:05,174 --> 00:22:07,250 Maybe the community is desperate for parking. 509 00:22:07,250 --> 00:22:09,680 Let me go to capital budgeting because I think this 510 00:22:09,680 --> 00:22:12,560 will take us a little while. 511 00:22:12,560 --> 00:22:16,790 We're about firms for the next several sessions. 512 00:22:16,790 --> 00:22:22,070 And the diagram-- my favorite diagram that we started with-- 513 00:22:22,070 --> 00:22:25,160 firms supply energy, supply energy services, 514 00:22:25,160 --> 00:22:28,520 firms use energy-- that's where going to focus for a while. 515 00:22:28,520 --> 00:22:30,980 Firms supply products that use energy, 516 00:22:30,980 --> 00:22:35,030 and firms supply products that help supply energy. 517 00:22:35,030 --> 00:22:43,520 In all of these cases, the firms make decisions involving 518 00:22:43,520 --> 00:22:46,190 costs and benefits phased out-- 519 00:22:46,190 --> 00:22:50,950 spread out over many years with uncertainty. 520 00:22:50,950 --> 00:22:56,110 I'm going to assume some version of Friedman 521 00:22:56,110 --> 00:23:00,490 because I don't know how to model Handy, other than as, 522 00:23:00,490 --> 00:23:03,440 you have to think carefully about the long term. 523 00:23:03,440 --> 00:23:05,860 And if I have a moral obligation, 524 00:23:05,860 --> 00:23:09,440 I'll add that on top of this. 525 00:23:09,440 --> 00:23:13,990 So the basic story is we're going to maximize value. 526 00:23:13,990 --> 00:23:16,990 That's not maximizing today's share price. 527 00:23:16,990 --> 00:23:20,830 There's a nice phrase in Brealey, Myers, and Allen 528 00:23:20,830 --> 00:23:24,870 that talks about the honest share price. 529 00:23:24,870 --> 00:23:28,730 They don't mean, by that, in the absence of fraud. 530 00:23:28,730 --> 00:23:33,330 They mean in the presence of very good information. 531 00:23:33,330 --> 00:23:36,440 So you want to maximize how much the firm is worth-- 532 00:23:36,440 --> 00:23:38,690 if everybody knows as much as you do and indeed 533 00:23:38,690 --> 00:23:41,750 knows that much about other firms. 534 00:23:41,750 --> 00:23:44,570 So in the case of Merck you'd want 535 00:23:44,570 --> 00:23:48,080 to assume they know about Vioxx. 536 00:23:48,080 --> 00:23:51,650 If I could go to the capital markets, and I can invest, 537 00:23:51,650 --> 00:23:53,960 and I can borrow, and I can raise stock, 538 00:23:53,960 --> 00:23:56,570 and it's a simple world-- 539 00:23:56,570 --> 00:23:58,160 isn't that a lovely picture-- 540 00:23:58,160 --> 00:24:01,410 the rule to do this is straightforward. 541 00:24:01,410 --> 00:24:03,620 Again, we're going to talk about investments-- 542 00:24:03,620 --> 00:24:07,400 not operating decisions, but investment decisions. 543 00:24:07,400 --> 00:24:09,500 You make all investments that have 544 00:24:09,500 --> 00:24:12,150 a positive net present value. 545 00:24:12,150 --> 00:24:18,000 This is net present value in discrete, not continuous terms. 546 00:24:18,000 --> 00:24:21,870 And we do this because continuous compounding doesn't 547 00:24:21,870 --> 00:24:23,490 simplify, particularly, when you've 548 00:24:23,490 --> 00:24:26,400 got flows that vary over time. 549 00:24:26,400 --> 00:24:29,070 It's nice in very simple cases. 550 00:24:29,070 --> 00:24:30,930 I love the elegance, but if you want 551 00:24:30,930 --> 00:24:34,260 to work out the net present value of something like this-- 552 00:24:34,260 --> 00:24:37,680 this is an oil lease, hypothetically. 553 00:24:37,680 --> 00:24:40,590 So CAPEX-- Capital Expenditures-- 554 00:24:40,590 --> 00:24:43,950 are incurred early on, oil production ramps, 555 00:24:43,950 --> 00:24:45,990 levels declines. 556 00:24:45,990 --> 00:24:49,740 And to value this opportunity, you've 557 00:24:49,740 --> 00:24:54,210 got to figure, what am I going to get from selling oil? 558 00:24:54,210 --> 00:24:55,920 What are the Operating Expenses-- 559 00:24:55,920 --> 00:24:59,580 OPEX-- associated with getting that oil out? 560 00:24:59,580 --> 00:25:02,670 What are the royalties I'm going to owe? 561 00:25:02,670 --> 00:25:05,670 And what are the taxes I'm going to have to pay? 562 00:25:05,670 --> 00:25:09,650 I take the net and I discount it. 563 00:25:09,650 --> 00:25:13,010 And the opportunity cost of capital-- 564 00:25:13,010 --> 00:25:15,350 we'll spend quite a while on-- 565 00:25:15,350 --> 00:25:17,990 is what I could make on an investment 566 00:25:17,990 --> 00:25:20,310 of comparable riskiness. 567 00:25:20,310 --> 00:25:21,360 What's that mean? 568 00:25:21,360 --> 00:25:22,870 I'll come back to it. 569 00:25:22,870 --> 00:25:27,440 But if I can do better investing in this oil lease, then 570 00:25:27,440 --> 00:25:30,020 anything else that's handy that's of comparable riskiness, 571 00:25:30,020 --> 00:25:33,230 I should make this investment. 572 00:25:33,230 --> 00:25:34,220 If I can make-- 573 00:25:34,220 --> 00:25:38,840 we'll see next time, the calculations for Wednesday 574 00:25:38,840 --> 00:25:42,450 have to do with an investment in energy conservation. 575 00:25:42,450 --> 00:25:43,940 So it's the same thing. 576 00:25:43,940 --> 00:25:46,430 I can invest in lots of things, but if I 577 00:25:46,430 --> 00:25:48,450 can invest in energy conservation, 578 00:25:48,450 --> 00:25:51,230 and it gives me a better return than an investment 579 00:25:51,230 --> 00:25:55,320 of comparable riskiness, I ought to do it. 580 00:25:55,320 --> 00:25:59,040 Now that's a pretty simple formula, right? 581 00:25:59,040 --> 00:26:02,430 You just did something that the-- 582 00:26:02,430 --> 00:26:07,230 cash flows that occur in period J, take a discount rate, 583 00:26:07,230 --> 00:26:10,230 discount it back to the present at interest rate R, 584 00:26:10,230 --> 00:26:13,170 and you do this on a spreadsheet. 585 00:26:13,170 --> 00:26:16,320 And you'll see a spreadsheet Wednesday. 586 00:26:16,320 --> 00:26:19,570 So a couple simple basics here. 587 00:26:19,570 --> 00:26:23,680 The first is cash matters. 588 00:26:23,680 --> 00:26:27,490 Profits don't matter, except insofar as they affect taxes. 589 00:26:27,490 --> 00:26:29,740 So this is-- when you do present value 590 00:26:29,740 --> 00:26:33,760 for a firm, the question is, what are my actual returns, 591 00:26:33,760 --> 00:26:37,540 not what does the accountant put on the bottom of the paper? 592 00:26:37,540 --> 00:26:41,010 And the main example is depreciation. 593 00:26:41,010 --> 00:26:43,600 Depreciation is not a cash expense. 594 00:26:43,600 --> 00:26:45,040 It affects your taxes. 595 00:26:45,040 --> 00:26:48,430 And you'll see for Wednesday, you have to consider that. 596 00:26:48,430 --> 00:26:52,750 But it doesn't directly impact the cash in the bank. 597 00:26:52,750 --> 00:26:55,180 It's something the accountant writes down. 598 00:26:55,180 --> 00:26:57,790 So you use cash flows-- 599 00:26:57,790 --> 00:27:01,262 relentlessly focus on cash flows. 600 00:27:01,262 --> 00:27:02,845 There are a couple of simple formulas. 601 00:27:06,670 --> 00:27:09,790 That's the formula for a perpetuity, something 602 00:27:09,790 --> 00:27:13,480 that starts with a constant payment one year out, 603 00:27:13,480 --> 00:27:14,270 goes forever. 604 00:27:14,270 --> 00:27:16,720 You'll see it's the same formulas 605 00:27:16,720 --> 00:27:19,810 for continuous compounding, but obviously, the interest rate's 606 00:27:19,810 --> 00:27:20,470 different. 607 00:27:20,470 --> 00:27:23,410 This is compounded once a period. 608 00:27:23,410 --> 00:27:26,560 And this is nice in Brealey, Myers, and Allen. 609 00:27:26,560 --> 00:27:32,020 Suppose you have a bond that pays c per year for capital T 610 00:27:32,020 --> 00:27:33,670 years, what's it worth? 611 00:27:33,670 --> 00:27:36,190 Well, if the interest rate's R, that's 612 00:27:36,190 --> 00:27:40,330 equivalent to a perpetuity starting today-- 613 00:27:40,330 --> 00:27:41,710 starting in one year-- 614 00:27:41,710 --> 00:27:46,900 minus a perpetuity starting in year T plus 1. 615 00:27:46,900 --> 00:27:50,598 I subtract that and I get this simple little formula 616 00:27:50,598 --> 00:27:51,140 on the right. 617 00:27:51,140 --> 00:27:56,440 I could also do a T period power series, but that's cleaner. 618 00:27:56,440 --> 00:27:58,990 This is the formula you'd use-- 619 00:27:58,990 --> 00:28:02,020 that's the formula for a mortgage, 620 00:28:02,020 --> 00:28:04,430 except you use a monthly interest rate. 621 00:28:04,430 --> 00:28:07,930 So if you know what the value of the mortgage 622 00:28:07,930 --> 00:28:11,590 is and you know the yield on the mortgage, R, 623 00:28:11,590 --> 00:28:13,850 you can solve for the monthly payment. 624 00:28:13,850 --> 00:28:20,200 That's a standard bond or mortgage formula. 625 00:28:20,200 --> 00:28:24,940 The last point I want to make on this slide is-- 626 00:28:24,940 --> 00:28:26,200 is all this clear? 627 00:28:26,200 --> 00:28:29,280 Questions, or comments, or reactions? 628 00:28:29,280 --> 00:28:29,780 OK. 629 00:28:34,220 --> 00:28:39,490 Suppose prices are going up at 10% and the bank is-- 630 00:28:39,490 --> 00:28:41,030 at 10% a year-- 631 00:28:41,030 --> 00:28:44,190 and the bank is paying 5% a year. 632 00:28:44,190 --> 00:28:47,790 You're not making money on the investment in the bank, right? 633 00:28:47,790 --> 00:28:50,250 You're losing purchasing power. 634 00:28:50,250 --> 00:28:54,190 The real interest rate, whatever it is, is negative. 635 00:28:54,190 --> 00:28:57,000 You put $100 in the bank today, a year from now, 636 00:28:57,000 --> 00:29:00,540 you get something that's worth less because of inflation 637 00:29:00,540 --> 00:29:02,580 than that $100. 638 00:29:02,580 --> 00:29:06,030 Even though it's $105, inflation's gone up. 639 00:29:06,030 --> 00:29:11,160 Well, to figure out the relation between the market 640 00:29:11,160 --> 00:29:14,620 or nominal interest rate, capital R, the inflation rate 641 00:29:14,620 --> 00:29:20,920 I and the real interest rate, it's pretty straightforward. 642 00:29:20,920 --> 00:29:25,920 I put the money in the bank at 5%, I get $1.05. 643 00:29:25,920 --> 00:29:29,060 I basically got to knock that down 644 00:29:29,060 --> 00:29:32,990 by the amount of inflation that's occurred. 645 00:29:32,990 --> 00:29:37,230 And this gives me the increase in purchasing power. 646 00:29:37,230 --> 00:29:39,890 So another way to think about it-- or another example, 647 00:29:39,890 --> 00:29:44,840 suppose the bank's paying 5%, inflation is 5%. 648 00:29:44,840 --> 00:29:47,540 I get $105, which is worth exactly, 649 00:29:47,540 --> 00:29:51,033 in terms of what I can buy, what $100 was today. 650 00:29:51,033 --> 00:29:52,700 So the interest rate-- the real interest 651 00:29:52,700 --> 00:29:57,770 rate, the increase in the purchasing power is zero. 652 00:29:57,770 --> 00:30:00,620 If those two are equal, this is zero, and that makes sense. 653 00:30:00,620 --> 00:30:04,220 Inflation has wiped out the earnings. 654 00:30:04,220 --> 00:30:07,010 If you just multiply this through, 655 00:30:07,010 --> 00:30:09,800 you get this relationship. 656 00:30:09,800 --> 00:30:15,230 Normally, the product of these two rates, I and little r, 657 00:30:15,230 --> 00:30:18,460 is negligible. 658 00:30:18,460 --> 00:30:22,570 Although, I'm told in periods of high inflation in Israel, 659 00:30:22,570 --> 00:30:24,970 people actually do carry this second term. 660 00:30:24,970 --> 00:30:26,620 It's normally very small. 661 00:30:26,620 --> 00:30:29,320 And you get the result that the real interest 662 00:30:29,320 --> 00:30:33,490 rate, in any sane circumstance, is the market interest 663 00:30:33,490 --> 00:30:36,460 rate minus the inflation rate. 664 00:30:36,460 --> 00:30:37,030 OK. 665 00:30:37,030 --> 00:30:40,690 And that's the relationship every everybody uses. 666 00:30:40,690 --> 00:30:45,213 It's important to understand which interest rates 667 00:30:45,213 --> 00:30:46,630 you're using, whether you're using 668 00:30:46,630 --> 00:30:48,670 a real rate or a nominal rate. 669 00:30:48,670 --> 00:30:51,300 But are we OK on this? 670 00:30:51,300 --> 00:30:53,850 Everybody nods, everybody's happy. 671 00:30:53,850 --> 00:31:00,287 Almost all interest rates are nominal, right? 672 00:31:00,287 --> 00:31:02,120 You look up interest rates in the newspaper, 673 00:31:02,120 --> 00:31:04,970 they are, here's what we'll pay you in a year. 674 00:31:04,970 --> 00:31:10,000 They don't depend on the rate of inflation. 675 00:31:10,000 --> 00:31:12,670 All else equal, of course, they're 676 00:31:12,670 --> 00:31:16,600 going to be higher the higher inflation is expected to be. 677 00:31:16,600 --> 00:31:18,910 We had breathtaking interest rates 678 00:31:18,910 --> 00:31:22,340 in the late '70s, early '80s when inflation was running. 679 00:31:22,340 --> 00:31:26,260 We had mortgage rates of 18%, for heaven's sake. 680 00:31:26,260 --> 00:31:28,960 If you expect high inflation, you're 681 00:31:28,960 --> 00:31:33,530 going to want to get more dollars back. 682 00:31:33,530 --> 00:31:36,710 Now you can look at real interest rates in the past, 683 00:31:36,710 --> 00:31:37,210 of course. 684 00:31:37,210 --> 00:31:39,430 You can look at what was the rate-- 685 00:31:39,430 --> 00:31:43,120 what was the one-year bond rate-- 686 00:31:43,120 --> 00:31:45,340 on a one-year bond rate, government bond rate, 687 00:31:45,340 --> 00:31:49,000 let's say, on January 1, 1956. 688 00:31:49,000 --> 00:31:52,390 What was the inflation between January of 1956 689 00:31:52,390 --> 00:31:54,340 and January of 1957? 690 00:31:54,340 --> 00:31:57,080 I can subtract and get the real interest rate. 691 00:31:57,080 --> 00:31:58,960 What do I do going forward? 692 00:31:58,960 --> 00:32:01,570 Going forward, it's a little trickier. 693 00:32:01,570 --> 00:32:04,900 There is a bond sold by the Treasury-- you can buy them-- 694 00:32:04,900 --> 00:32:08,260 called TIPS, Treasury Information Protected 695 00:32:08,260 --> 00:32:09,580 Securities. 696 00:32:09,580 --> 00:32:13,930 They adjust so they pay you in real dollars. 697 00:32:13,930 --> 00:32:17,560 So the interest rate is a real interest-- interest rate quoted 698 00:32:17,560 --> 00:32:19,370 is a real interest rate. 699 00:32:19,370 --> 00:32:24,280 So last Friday-- when I was able to download Handy-- 700 00:32:24,280 --> 00:32:29,560 last Friday, I checked the 20-year rate 701 00:32:29,560 --> 00:32:31,150 on regular government bonds. 702 00:32:31,150 --> 00:32:34,300 That was 2.83% from the Treasury's website. 703 00:32:34,300 --> 00:32:37,975 And the rate on 10-year TIPS was a half a percent. 704 00:32:37,975 --> 00:32:40,375 These are breathtaking numbers, historically. 705 00:32:40,375 --> 00:32:41,650 It's a half a percent. 706 00:32:41,650 --> 00:32:46,930 So I'd say the market in some sense has an inflation 707 00:32:46,930 --> 00:32:49,000 expectation over 10 years of just a little 708 00:32:49,000 --> 00:32:52,240 over 2%, which is sort of a reasonable number, 709 00:32:52,240 --> 00:32:54,930 historically. 710 00:32:54,930 --> 00:32:57,010 But it's a bit of a thin market, and TIPS 711 00:32:57,010 --> 00:33:00,040 have special characteristics, and not everybody buys them. 712 00:33:00,040 --> 00:33:04,090 So I wouldn't say you can always look up the market's inflation 713 00:33:04,090 --> 00:33:05,860 expectations this way. 714 00:33:05,860 --> 00:33:07,510 But it gives you a sense. 715 00:33:07,510 --> 00:33:09,220 It gives you a sense. 716 00:33:09,220 --> 00:33:12,010 Not a sharp tool, but a tool. 717 00:33:15,030 --> 00:33:17,960 The biggest mistake people make in doing 718 00:33:17,960 --> 00:33:20,840 present value in almost any setting 719 00:33:20,840 --> 00:33:24,880 is to confuse which interest rate they're using. 720 00:33:24,880 --> 00:33:27,040 Are you using a real rate or a nominal rate? 721 00:33:27,040 --> 00:33:32,800 Now the normal thing you do when you're doing a present value 722 00:33:32,800 --> 00:33:37,060 calculation, and it involves so many pounds of cement 723 00:33:37,060 --> 00:33:40,300 per year over 10 years, you use today's pound of-- 724 00:33:40,300 --> 00:33:41,860 today's price for cement. 725 00:33:41,860 --> 00:33:43,630 That's the normal thing to do. 726 00:33:43,630 --> 00:33:47,170 Today's price for steel, today's price for whatever, 727 00:33:47,170 --> 00:33:50,350 figure out physical quantities, and get cash flows. 728 00:33:50,350 --> 00:33:53,800 If you do that, you need to use a real discount 729 00:33:53,800 --> 00:33:57,210 rate because you've assumed zero inflation 730 00:33:57,210 --> 00:33:58,365 by using today's prices. 731 00:34:01,620 --> 00:34:05,550 If you use a nominal rate from the market, 732 00:34:05,550 --> 00:34:07,680 then you need to adjust-- 733 00:34:07,680 --> 00:34:11,250 then you need to say, well, the rates 734 00:34:11,250 --> 00:34:16,090 I use are 5%, 10%, whatever they are, but I expect 2% inflation. 735 00:34:16,090 --> 00:34:18,230 So I'll build in 2% inflation. 736 00:34:18,230 --> 00:34:19,980 I mean, you could do it either way, right? 737 00:34:19,980 --> 00:34:25,530 You can use today's prices, take 2% off the market. 738 00:34:25,530 --> 00:34:28,290 But what you can't do is mix. 739 00:34:28,290 --> 00:34:32,969 You can't take a rate from the capital market like that 2.83 740 00:34:32,969 --> 00:34:37,830 up there, and then assume price is constant 741 00:34:37,830 --> 00:34:42,090 because that 2.83 is based on people's expectation 742 00:34:42,090 --> 00:34:45,300 that prices will rise-- 743 00:34:45,300 --> 00:34:46,560 that prices will rise. 744 00:34:46,560 --> 00:34:48,874 So it's a very common mistake. 745 00:34:52,900 --> 00:34:54,170 Just don't do it. 746 00:34:54,170 --> 00:34:57,400 And know to look for it when people show you, 747 00:34:57,400 --> 00:35:02,020 as they will in later life, present values because it's 748 00:35:02,020 --> 00:35:03,940 common, it's easy to make. 749 00:35:03,940 --> 00:35:08,140 And it can certainly get you the wrong answer 750 00:35:08,140 --> 00:35:10,240 if there's any inflation going on 751 00:35:10,240 --> 00:35:14,890 or the time period is of any length at all. 752 00:35:14,890 --> 00:35:16,270 OK. 753 00:35:16,270 --> 00:35:20,170 That's issue one, get the rates right. 754 00:35:20,170 --> 00:35:23,190 The rates matter. 755 00:35:23,190 --> 00:35:26,950 Well, let's do this one first. 756 00:35:26,950 --> 00:35:29,930 The question is, where does that R come from? 757 00:35:29,930 --> 00:35:33,250 And I said it's an opportunity cost of capital. 758 00:35:33,250 --> 00:35:35,410 It's what you can get on an investment 759 00:35:35,410 --> 00:35:36,940 of comparable riskiness. 760 00:35:36,940 --> 00:35:39,190 Well, if there's no risk-- 761 00:35:39,190 --> 00:35:42,220 even though the US government was downrated-- 762 00:35:42,220 --> 00:35:47,860 it's normal to treat a riskless rate as the government 763 00:35:47,860 --> 00:35:49,720 borrowing rate. 764 00:35:49,720 --> 00:35:51,940 There's essentially no risk of repayment 765 00:35:51,940 --> 00:35:54,500 unless you're a real pessimist. 766 00:35:54,500 --> 00:35:58,060 And again, you'd use the US rate, not necessarily 767 00:35:58,060 --> 00:36:05,270 the Greek rate these days after the write-off. 768 00:36:05,270 --> 00:36:09,250 But suppose there is some risk. 769 00:36:09,250 --> 00:36:12,360 Well, as I say, it's an opportunity cost. 770 00:36:12,360 --> 00:36:15,920 So that says you would expect-- 771 00:36:15,920 --> 00:36:18,320 if you're going to bear more risk, 772 00:36:18,320 --> 00:36:23,120 your expectation of a return has to be higher to compensate. 773 00:36:23,120 --> 00:36:25,670 So you would expect a higher risk 774 00:36:25,670 --> 00:36:28,280 means a higher discount rate. 775 00:36:28,280 --> 00:36:30,600 That sort of makes sense. 776 00:36:30,600 --> 00:36:32,930 So-- that's cute-- 777 00:36:32,930 --> 00:36:37,430 so you normally discount the expected cash flows 778 00:36:37,430 --> 00:36:40,385 at a risk-adjusted discount rate-- 779 00:36:40,385 --> 00:36:42,260 I'm going to come to, what do I mean by risk? 780 00:36:42,260 --> 00:36:45,500 Because that's the $64,000 question here. 781 00:36:45,500 --> 00:36:48,530 But so far, I assume this is fairly intuitive. 782 00:36:48,530 --> 00:36:51,320 And if a project has some things that are certain 783 00:36:51,320 --> 00:36:52,880 and some things that are uncertain, 784 00:36:52,880 --> 00:36:56,540 you might want to use different discount rates. 785 00:36:56,540 --> 00:37:00,582 If part of the cash flows are returns on government bonds, 786 00:37:00,582 --> 00:37:02,540 those are riskless and I ought to discount them 787 00:37:02,540 --> 00:37:04,340 using the government bond rate. 788 00:37:04,340 --> 00:37:09,020 Part of it is sales of Teslas, I might use a higher discount 789 00:37:09,020 --> 00:37:14,000 rate for sales of Teslas, or Chevy Volts , 790 00:37:14,000 --> 00:37:17,585 or tickets to John Carter, or almost anything else. 791 00:37:17,585 --> 00:37:22,180 I'd use a use a higher rate. 792 00:37:22,180 --> 00:37:25,980 But what do I mean by that? 793 00:37:25,980 --> 00:37:27,830 How do I think about risk? 794 00:37:27,830 --> 00:37:29,570 OK, two points to make. 795 00:37:29,570 --> 00:37:31,115 One, it matters. 796 00:37:34,590 --> 00:37:36,950 This is not particularly on point, but I like it. 797 00:37:36,950 --> 00:37:40,460 It illustrates the importance of discount rate choices 798 00:37:40,460 --> 00:37:42,050 you go out in time. 799 00:37:42,050 --> 00:37:45,800 This equivalent cash-flow haircut says, 800 00:37:45,800 --> 00:37:56,870 OK, a dollar in one year at 7% is worth $0.71. 801 00:37:56,870 --> 00:37:59,360 At 10%, it's worth $0.62. 802 00:37:59,360 --> 00:38:04,580 That's equivalent to taking 13% off, right? 803 00:38:04,580 --> 00:38:06,890 Raising the discount rate from 7% to 10% 804 00:38:06,890 --> 00:38:10,730 is equivalent to a 13% haircut on what you're going to get. 805 00:38:10,730 --> 00:38:14,570 And 30 years out, it's a huge haircut. 806 00:38:14,570 --> 00:38:18,310 30 years out it, more than cuts it in half. 807 00:38:18,310 --> 00:38:21,050 So the discount rate matters. 808 00:38:21,050 --> 00:38:23,180 The choice-- again, a nice picture-- 809 00:38:23,180 --> 00:38:29,420 is you've got project A, Project B. Project B looks very safe, 810 00:38:29,420 --> 00:38:32,990 project A looks very risky, but has a higher-- 811 00:38:32,990 --> 00:38:34,950 let's take that to be the expected value. 812 00:38:34,950 --> 00:38:38,450 The distribution's a little asymmetric. 813 00:38:38,450 --> 00:38:39,560 Which do you choose? 814 00:38:39,560 --> 00:38:40,400 Which do you choose? 815 00:38:40,400 --> 00:38:43,020 How do you think about risk? 816 00:38:43,020 --> 00:38:44,630 Well, it turns out the right answer 817 00:38:44,630 --> 00:38:48,640 isn't variance or anything quite like variance. 818 00:38:48,640 --> 00:38:54,710 I'm going to walk you through a bit of finance 819 00:38:54,710 --> 00:38:57,650 much too quickly. 820 00:38:57,650 --> 00:39:02,860 So listen for the concepts, don't listen for the details. 821 00:39:02,860 --> 00:39:06,570 I just want you to get the basic notion here, not the mechanics. 822 00:39:06,570 --> 00:39:08,070 We're not going to do the mechanics. 823 00:39:08,070 --> 00:39:10,770 The mechanics will not be on the quiz. 824 00:39:10,770 --> 00:39:12,600 But the concept is important. 825 00:39:12,600 --> 00:39:13,270 Jessica? 826 00:39:13,270 --> 00:39:14,895 AUDIENCE: Which would you say is safer? 827 00:39:14,895 --> 00:39:15,180 RICHARD SCHMALENSEE: Hmm? 828 00:39:15,180 --> 00:39:16,800 AUDIENCE: Which one of these two would you say is safer? 829 00:39:16,800 --> 00:39:18,620 RICHARD SCHMALENSEE: B is safer. 830 00:39:18,620 --> 00:39:19,120 Sure. 831 00:39:19,120 --> 00:39:21,250 Much less spread in the possible outcomes. 832 00:39:21,250 --> 00:39:23,590 A's got huge spreads in the possible outcomes. 833 00:39:23,590 --> 00:39:27,710 And we don't even know where the zero point is on that graph. 834 00:39:30,240 --> 00:39:33,000 So just looking at it, you'd say A is safer. 835 00:39:33,000 --> 00:39:34,860 That says, well, a nice measure might 836 00:39:34,860 --> 00:39:39,840 be the dispersion, the variance, the range, whatever-- 837 00:39:39,840 --> 00:39:40,980 not quite. 838 00:39:40,980 --> 00:39:43,425 So here's the basic story. 839 00:39:49,280 --> 00:39:53,540 I can't believe I set this to fly in, I hate that. 840 00:39:53,540 --> 00:39:57,070 It's distracting. 841 00:39:57,070 --> 00:40:04,360 It's easy to show that investors should always diversify. 842 00:40:04,360 --> 00:40:06,670 If you read anything about investment-- 843 00:40:06,670 --> 00:40:09,010 you can make it mathematical, but if you read anything 844 00:40:09,010 --> 00:40:14,150 about investment, it says you should diversify. 845 00:40:14,150 --> 00:40:14,650 OK. 846 00:40:14,650 --> 00:40:18,550 This was made very fancy in the '50s by Harry Markowitz. 847 00:40:18,550 --> 00:40:21,130 Second step, was Tobin-- 848 00:40:21,130 --> 00:40:23,410 Jim Tobin-- James Tobin-- let's be fair-- 849 00:40:23,410 --> 00:40:27,370 in the '60s, who said, well, if you have really 850 00:40:27,370 --> 00:40:31,000 well-functioning capital markets that every investor 851 00:40:31,000 --> 00:40:35,620 should hold some of all risky securities and then 852 00:40:35,620 --> 00:40:37,250 some safe security. 853 00:40:37,250 --> 00:40:39,460 So let's suppose I've got a bunch of risky stocks, 854 00:40:39,460 --> 00:40:42,530 let's say, and US government debt. 855 00:40:42,530 --> 00:40:44,960 Then everybody's portfolio should be composed 856 00:40:44,960 --> 00:40:46,610 of some of all the stocks-- 857 00:40:46,610 --> 00:40:49,250 that is, to say the market portfolio-- 858 00:40:49,250 --> 00:40:51,290 and then some government debt. 859 00:40:51,290 --> 00:40:53,450 And how much of each you hold would depend 860 00:40:53,450 --> 00:40:56,170 on your tolerance for risk. 861 00:40:56,170 --> 00:40:56,670 All right. 862 00:40:56,670 --> 00:41:00,750 So that says you want to think about-- again, everybody's 863 00:41:00,750 --> 00:41:02,550 efficient, everybody's optimizing, 864 00:41:02,550 --> 00:41:06,480 nobody listens to my broker, everybody's very efficient 865 00:41:06,480 --> 00:41:11,160 and holds the market portfolio, right? 866 00:41:11,160 --> 00:41:12,450 Some shares of each one. 867 00:41:12,450 --> 00:41:16,440 Now you can sort of do that, index funds come close. 868 00:41:16,440 --> 00:41:18,810 But of course, in theory, the market portfolio 869 00:41:18,810 --> 00:41:21,060 isn't just the stock market. 870 00:41:21,060 --> 00:41:24,000 It also would include real estate, and gold, and anything 871 00:41:24,000 --> 00:41:25,650 else you think of as an asset you 872 00:41:25,650 --> 00:41:28,060 might hold in your portfolio. 873 00:41:28,060 --> 00:41:31,510 But if you think about rational investors holding 874 00:41:31,510 --> 00:41:36,190 diversified portfolios, and the risky part of the portfolio 875 00:41:36,190 --> 00:41:40,550 having the same composition for everybody, 876 00:41:40,550 --> 00:41:45,530 then you would expect-- 877 00:41:45,530 --> 00:41:51,510 again, if you're dividing your holdings between government 878 00:41:51,510 --> 00:41:54,870 securities that are riskless, and a bunch of stocks 879 00:41:54,870 --> 00:41:58,170 and whatever else that's risky, the more 880 00:41:58,170 --> 00:42:02,070 you tilt toward that risky portfolio, 881 00:42:02,070 --> 00:42:04,860 you better get a higher expected return. 882 00:42:04,860 --> 00:42:07,680 You better have a higher average expected return 883 00:42:07,680 --> 00:42:10,660 to compensate for bearing the risk. 884 00:42:10,660 --> 00:42:12,690 So this was Sharpe-- 885 00:42:12,690 --> 00:42:15,000 and we'll jump to his answer. 886 00:42:15,000 --> 00:42:18,870 That's just a general statement of the expectation-- 887 00:42:18,870 --> 00:42:24,790 that the market portfolio, all the risky stuff, 888 00:42:24,790 --> 00:42:27,730 should yield a better return in expectation-- 889 00:42:27,730 --> 00:42:30,220 not every day, as we know. 890 00:42:30,220 --> 00:42:33,880 But in expectation, it better do better than government debt 891 00:42:33,880 --> 00:42:35,710 or why would you ever hold it? 892 00:42:35,710 --> 00:42:37,350 It's risky? 893 00:42:37,350 --> 00:42:41,400 So you would expect there to be a risk premium. 894 00:42:41,400 --> 00:42:51,030 What this goes to, if you think about this world in which 895 00:42:51,030 --> 00:42:55,230 people are holding mixtures of government securities and lots 896 00:42:55,230 --> 00:43:01,440 of risky stuff, then comes another asset. 897 00:43:01,440 --> 00:43:04,250 Is it risky or not? 898 00:43:04,250 --> 00:43:05,640 How do I think about its risk? 899 00:43:05,640 --> 00:43:07,880 Well, I think about its risk in terms of what 900 00:43:07,880 --> 00:43:10,230 it does to my portfolio. 901 00:43:10,230 --> 00:43:12,390 I don't care what it does by itself. 902 00:43:12,390 --> 00:43:14,130 I'm holding all these other assets 903 00:43:14,130 --> 00:43:16,950 because I'm a rational diversified investor. 904 00:43:16,950 --> 00:43:19,440 So what matters to me if I'm going 905 00:43:19,440 --> 00:43:23,370 to buy it is, what difference does it make to my portfolio 906 00:43:23,370 --> 00:43:26,490 before and after? 907 00:43:26,490 --> 00:43:30,030 That's not just a question of variance. 908 00:43:30,030 --> 00:43:32,790 That's a question of correlation. 909 00:43:32,790 --> 00:43:37,950 And the example here is a stock that moves against everything 910 00:43:37,950 --> 00:43:44,180 else, even if it moves a lot, can be a great thing to own. 911 00:43:44,180 --> 00:43:46,058 Because if I own some of this and something 912 00:43:46,058 --> 00:43:47,600 that moves in the opposite direction, 913 00:43:47,600 --> 00:43:49,880 I can construct a risk-free security. 914 00:43:49,880 --> 00:43:52,720 That's pretty good. 915 00:43:52,720 --> 00:43:56,350 So it doesn't matter that-- 916 00:43:56,350 --> 00:44:00,580 in this view of the world, what matters 917 00:44:00,580 --> 00:44:04,690 is how the returns on an asset, returns on a security, 918 00:44:04,690 --> 00:44:08,430 relate to the returns on everything else. 919 00:44:08,430 --> 00:44:11,780 Basically, that two-fund theorem says, 920 00:44:11,780 --> 00:44:15,380 you're going to hold something of everything else. 921 00:44:15,380 --> 00:44:17,990 That's going to be the risky part of your portfolio. 922 00:44:17,990 --> 00:44:19,430 That's going to move. 923 00:44:19,430 --> 00:44:23,180 And if I pick up another risky asset, 924 00:44:23,180 --> 00:44:27,080 what matters is, how does that affect the movement 925 00:44:27,080 --> 00:44:29,240 of that whole bundle? 926 00:44:29,240 --> 00:44:32,840 Which says that the picture I had before-- 927 00:44:32,840 --> 00:44:38,360 this one-- asks the wrong question. 928 00:44:38,360 --> 00:44:40,970 That just tells me maybe something about variance. 929 00:44:40,970 --> 00:44:42,920 It doesn't tell me anything about correlation. 930 00:44:46,790 --> 00:44:51,380 If the world consists of Apple stock-- 931 00:44:51,380 --> 00:44:56,300 blast-- if the world consists of US government debt and Apple 932 00:44:56,300 --> 00:45:01,860 stock, then the question of whether an oil well is risky 933 00:45:01,860 --> 00:45:05,310 or not is, does it move with Apple stock? 934 00:45:05,310 --> 00:45:07,530 Does it move against Apple stock? 935 00:45:07,530 --> 00:45:10,380 If it moves against Apple stock, I can reduce my risk. 936 00:45:10,380 --> 00:45:11,880 If it moves with Apple stock, I'll 937 00:45:11,880 --> 00:45:17,150 increase it by adding it to my portfolio. 938 00:45:17,150 --> 00:45:23,120 So that's the sort of key insight that-- 939 00:45:23,120 --> 00:45:26,120 now I made a lot-- there are a lot of assumptions floating 940 00:45:26,120 --> 00:45:28,790 around here, and I'm going to relax them orally 941 00:45:28,790 --> 00:45:29,970 in a little bit. 942 00:45:29,970 --> 00:45:38,990 I can't relax them mathematically and get done. 943 00:45:38,990 --> 00:45:41,480 But the assumption here is we're dealing 944 00:45:41,480 --> 00:45:44,900 with a world in which there are very few transactions costs, 945 00:45:44,900 --> 00:45:46,850 investors are behaving rationally, 946 00:45:46,850 --> 00:45:49,700 everything is smooth, it's a very competitive world-- 947 00:45:49,700 --> 00:45:53,210 in the financial market. 948 00:45:53,210 --> 00:45:56,120 That's probably wrong. 949 00:45:56,120 --> 00:45:59,690 But it's not clear where you would go from there to a better 950 00:45:59,690 --> 00:46:00,780 model. 951 00:46:00,780 --> 00:46:02,632 So let me not defend this model as truth, 952 00:46:02,632 --> 00:46:04,340 let me just defend this model is the best 953 00:46:04,340 --> 00:46:05,870 one we have at the moment. 954 00:46:05,870 --> 00:46:08,210 And it says to a reasonable approximation, 955 00:46:08,210 --> 00:46:09,980 smart people diversify. 956 00:46:09,980 --> 00:46:13,370 When smart people diversify, what matters isn't just, 957 00:46:13,370 --> 00:46:16,520 does it move, but what does it move with? 958 00:46:16,520 --> 00:46:20,530 So the Sharpe model has this implication-- 959 00:46:20,530 --> 00:46:21,030 oh, sorry. 960 00:46:21,030 --> 00:46:24,410 I need to go back to that last point. 961 00:46:24,410 --> 00:46:31,630 This is a very interesting point that comes out of this model. 962 00:46:31,630 --> 00:46:35,260 It says not only do I care-- 963 00:46:35,260 --> 00:46:41,200 if the world is a risk-less asset and Apple stock, 964 00:46:41,200 --> 00:46:46,790 comes another investment that has uncertain returns, if it 965 00:46:46,790 --> 00:46:49,910 moves with Apple stock, getting it would increase my risk. 966 00:46:49,910 --> 00:46:53,240 If it moves against Apple stock, getting it 967 00:46:53,240 --> 00:46:54,350 would decrease my risk. 968 00:46:54,350 --> 00:46:57,200 What if it's uncorrelated? 969 00:46:57,200 --> 00:46:59,930 What if it's uncorrelated with the other risk 970 00:46:59,930 --> 00:47:03,340 in the economy-- in that case, with the market? 971 00:47:03,340 --> 00:47:12,110 Well, if it's uncorrelated and it's on the market, 972 00:47:12,110 --> 00:47:15,000 everybody holds a little bit of it, 973 00:47:15,000 --> 00:47:19,302 it doesn't affect the movement of your portfolio much. 974 00:47:19,302 --> 00:47:20,760 I'm just going to have to let you-- 975 00:47:20,760 --> 00:47:22,920 you're going to have to take that one on faith. 976 00:47:22,920 --> 00:47:28,900 But risk uncorrelated with the market can be diversified away. 977 00:47:28,900 --> 00:47:32,020 It doesn't justify a risk premium 978 00:47:32,020 --> 00:47:35,920 in this world, where what matters is the portfolio. 979 00:47:35,920 --> 00:47:38,020 Holding it by itself would be risky. 980 00:47:38,020 --> 00:47:41,020 Holding a little piece of it, uncorrelated 981 00:47:41,020 --> 00:47:46,390 with anything else, turns out to have effectively 982 00:47:46,390 --> 00:47:49,640 zero impact on portfolio risk. 983 00:47:49,640 --> 00:47:51,430 So we talk about risk that's uncorrelated 984 00:47:51,430 --> 00:47:54,300 with the market as diversifiable. 985 00:47:54,300 --> 00:47:56,310 And it doesn't demand a risk premium-- 986 00:47:56,310 --> 00:47:57,602 in this world. 987 00:47:57,602 --> 00:48:00,060 I'll give you a little bit about another world in a minute. 988 00:48:00,060 --> 00:48:05,200 But in this world, it doesn't demand a risk premium. 989 00:48:05,200 --> 00:48:08,910 So we're flying along-- 990 00:48:08,910 --> 00:48:12,300 concepts, concepts, portfolio is what matters, 991 00:48:12,300 --> 00:48:14,190 correlations matter. 992 00:48:14,190 --> 00:48:21,210 This is Sharpe's model that, again, 993 00:48:21,210 --> 00:48:25,020 under reasonable assumptions widely used, 994 00:48:25,020 --> 00:48:27,270 if something has a zero-- 995 00:48:27,270 --> 00:48:31,620 it turns out the measure of risk now is beta. 996 00:48:31,620 --> 00:48:34,680 The whole market has a beta of 1 by definition, 997 00:48:34,680 --> 00:48:38,490 risk-free rate has a beta of zero because it doesn't move, 998 00:48:38,490 --> 00:48:40,512 it has no risk. 999 00:48:40,512 --> 00:48:41,970 Things that move against the market 1000 00:48:41,970 --> 00:48:47,010 have negative betas, things that move toward the market-- 1001 00:48:47,010 --> 00:48:50,370 with the market depending on the correlation and the movement, 1002 00:48:50,370 --> 00:48:53,380 will have a positive beta. 1003 00:48:53,380 --> 00:48:56,560 Beta is the measure of covariance 1004 00:48:56,560 --> 00:49:01,140 is not quite right-- of covariance with the market. 1005 00:49:01,140 --> 00:49:06,240 And higher beta securities have a higher required or expected 1006 00:49:06,240 --> 00:49:09,530 return, higher beta assets. 1007 00:49:09,530 --> 00:49:14,660 So an example-- this is the cost of equity for BP. 1008 00:49:14,660 --> 00:49:15,811 It's an estimate. 1009 00:49:18,400 --> 00:49:23,090 Basically, by definition, it got identically equal. 1010 00:49:23,090 --> 00:49:27,580 By definition, the beta on the market as a whole is 1. 1011 00:49:27,580 --> 00:49:30,670 It turns out that BP and other major oil 1012 00:49:30,670 --> 00:49:35,440 producers are less risky in this regard than the average stock. 1013 00:49:35,440 --> 00:49:37,930 Beta is 0.8 for BP. 1014 00:49:37,930 --> 00:49:42,190 You can estimate it, and here would 1015 00:49:42,190 --> 00:49:47,790 be an example of calculating the required-- or the opportunity 1016 00:49:47,790 --> 00:49:51,540 cost for investments that look like BP's investments. 1017 00:49:51,540 --> 00:49:56,080 So we look at what the market requires from BP. 1018 00:49:56,080 --> 00:49:57,330 Well, we know it's beta. 1019 00:49:57,330 --> 00:49:58,950 We can estimate that-- 1020 00:49:58,950 --> 00:50:00,840 no point going into it here. 1021 00:50:00,840 --> 00:50:04,750 Suppose the risk free rate is 3%. 1022 00:50:04,750 --> 00:50:10,960 The market as a whole has a risk premium of 5.4%-- 1023 00:50:10,960 --> 00:50:14,860 that, again, you can calculate-- that gives a cost of equity 1024 00:50:14,860 --> 00:50:15,820 for BP-- 1025 00:50:15,820 --> 00:50:19,300 opportunity cost-- of 7.3%. 1026 00:50:19,300 --> 00:50:25,610 That's what investors would take to own BP stock in terms 1027 00:50:25,610 --> 00:50:28,160 of expected return or another investment 1028 00:50:28,160 --> 00:50:29,660 of comparable riskiness. 1029 00:50:29,660 --> 00:50:33,140 Comparable riskiness-- beta 0.8. 1030 00:50:33,140 --> 00:50:39,580 So the measure of riskiness becomes a simple number, beta. 1031 00:50:39,580 --> 00:50:45,380 Now that's-- again, it's a simple model. 1032 00:50:45,380 --> 00:50:48,620 I'm not expecting you to understand anything other 1033 00:50:48,620 --> 00:50:50,780 than that beta involves not variance, 1034 00:50:50,780 --> 00:50:53,660 but covariance and correlation-- it involves 1035 00:50:53,660 --> 00:50:55,385 comovements with other assets. 1036 00:50:58,520 --> 00:51:01,550 As I say, this is the opportunity cost 1037 00:51:01,550 --> 00:51:05,510 of investing in projects is risky as BP. 1038 00:51:05,510 --> 00:51:12,250 So if you-- are we semi-OK so far? 1039 00:51:14,860 --> 00:51:16,090 The concept here. 1040 00:51:16,090 --> 00:51:19,180 We're in a world where everybody diversifies, 1041 00:51:19,180 --> 00:51:22,060 everybody diversifies as much as they can. 1042 00:51:22,060 --> 00:51:23,650 It turns out the rational way to do 1043 00:51:23,650 --> 00:51:26,350 that is for everybody to hold the same proportion 1044 00:51:26,350 --> 00:51:28,500 of risky assets. 1045 00:51:28,500 --> 00:51:33,560 So if you have two shares of Apple and one share of GM, 1046 00:51:33,560 --> 00:51:37,760 I might have four shares of Apple and two shares of GM. 1047 00:51:37,760 --> 00:51:39,350 But I don't reverse the proportions 1048 00:51:39,350 --> 00:51:42,650 because we're both owning pieces of the market 1049 00:51:42,650 --> 00:51:44,480 in the same percentage. 1050 00:51:44,480 --> 00:51:46,340 And in that world, what matters is 1051 00:51:46,340 --> 00:51:48,770 how things correlate with the market 1052 00:51:48,770 --> 00:51:51,700 and also how big the moves are. 1053 00:51:51,700 --> 00:51:53,560 And beta captures both of those. 1054 00:51:53,560 --> 00:51:58,510 As that earlier slide says, it captures both the correlation 1055 00:51:58,510 --> 00:51:59,440 and the volatility. 1056 00:51:59,440 --> 00:52:02,830 It captures the correlation and the standard deviation 1057 00:52:02,830 --> 00:52:04,670 of its own movements. 1058 00:52:04,670 --> 00:52:09,520 So if we're going to do discounting, 1059 00:52:09,520 --> 00:52:14,140 figure out what the cash flows are, probably 1060 00:52:14,140 --> 00:52:15,633 use the expected cash flows. 1061 00:52:15,633 --> 00:52:17,300 We might want to be conservative and use 1062 00:52:17,300 --> 00:52:21,550 the lower bounds of revenues and upper bounds of costs, 1063 00:52:21,550 --> 00:52:23,590 or be optimistic. 1064 00:52:23,590 --> 00:52:26,320 Figure out how risky the thing is-- 1065 00:52:26,320 --> 00:52:28,840 and frankly, this is very-- 1066 00:52:28,840 --> 00:52:30,400 it's very easy for common stocks. 1067 00:52:30,400 --> 00:52:33,640 It's a little harder for an investment project. 1068 00:52:33,640 --> 00:52:38,530 If I say, well, I think this project has a beta of 0.8, 1069 00:52:38,530 --> 00:52:40,870 how do I get there? 1070 00:52:40,870 --> 00:52:47,080 You could see that the key thing that people usually 1071 00:52:47,080 --> 00:52:54,870 do-- so this is the split of a particular project. 1072 00:52:54,870 --> 00:52:58,890 The first thing you ask is, is the risk diversifiable or not? 1073 00:52:58,890 --> 00:53:01,740 Is it correlated to a first approximation 1074 00:53:01,740 --> 00:53:05,350 with movements in the rest of the economy or not? 1075 00:53:05,350 --> 00:53:07,620 So there's some uncertainty. 1076 00:53:07,620 --> 00:53:10,230 We're going to put in-- let's say it's a wind farm. 1077 00:53:10,230 --> 00:53:13,060 We're going to build a wind farm. 1078 00:53:13,060 --> 00:53:14,830 There is some uncertainty-- we've 1079 00:53:14,830 --> 00:53:16,870 got the we've got the equipment under contract. 1080 00:53:16,870 --> 00:53:18,847 There's uncertainty about how difficult it's 1081 00:53:18,847 --> 00:53:21,430 going to be to put the thing in place, to do the installation, 1082 00:53:21,430 --> 00:53:23,620 to do the construction. 1083 00:53:23,620 --> 00:53:25,082 That's not going to be correlated 1084 00:53:25,082 --> 00:53:26,290 with the rest of the economy. 1085 00:53:26,290 --> 00:53:27,610 That's just local. 1086 00:53:27,610 --> 00:53:28,660 That's a local risk. 1087 00:53:28,660 --> 00:53:30,160 That's diversifiable. 1088 00:53:30,160 --> 00:53:32,973 If I can get enough people to hold that risk, 1089 00:53:32,973 --> 00:53:35,140 it's not going to matter to anybody because it's not 1090 00:53:35,140 --> 00:53:37,420 going to move their portfolio. 1091 00:53:37,420 --> 00:53:40,660 The wages I have to pay will be correlated 1092 00:53:40,660 --> 00:53:42,410 with the rest of the economy. 1093 00:53:42,410 --> 00:53:43,990 So if I haven't fixed wages and I 1094 00:53:43,990 --> 00:53:48,280 haven't fixed prices for materials, then maybe that does 1095 00:53:48,280 --> 00:53:50,800 need to be discounted because it is correlated. 1096 00:53:50,800 --> 00:53:53,800 Again, it's diversifiable versus nondiversifiable. 1097 00:53:53,800 --> 00:53:55,540 Is it correlated with the market, 1098 00:53:55,540 --> 00:53:57,910 with the rest of the economy? 1099 00:53:57,910 --> 00:54:02,088 Or is it just something random that's going to happen to me? 1100 00:54:02,088 --> 00:54:03,880 I don't know the wind conditions very well, 1101 00:54:03,880 --> 00:54:07,150 or the reservoir conditions, or a variety of things like that. 1102 00:54:07,150 --> 00:54:10,300 Is that going to be correlated with the rest of the economy? 1103 00:54:10,300 --> 00:54:12,230 Probably not. 1104 00:54:12,230 --> 00:54:14,230 That's probably diversifiable risk, 1105 00:54:14,230 --> 00:54:15,940 and I shouldn't worry about the beta 1106 00:54:15,940 --> 00:54:18,070 because it's probably zero. 1107 00:54:18,070 --> 00:54:22,190 It's not correlated with other things. 1108 00:54:22,190 --> 00:54:25,550 Oh, how much am I going to get out in terms of kilowatt hours? 1109 00:54:25,550 --> 00:54:26,542 The wind is uncertain. 1110 00:54:26,542 --> 00:54:28,250 I don't know what my annual production is 1111 00:54:28,250 --> 00:54:29,542 going to be from the wind farm. 1112 00:54:29,542 --> 00:54:34,070 That's probably diversifiable. 1113 00:54:34,070 --> 00:54:37,923 That is to say it, whether the wind blows or doesn't blow 1114 00:54:37,923 --> 00:54:40,340 isn't going to be correlated with the rest of the economy, 1115 00:54:40,340 --> 00:54:41,000 probably. 1116 00:54:41,000 --> 00:54:42,860 Unless I have a long-term contract, 1117 00:54:42,860 --> 00:54:46,970 the price at which I sell power will for sure 1118 00:54:46,970 --> 00:54:49,900 be correlated with everything else. 1119 00:54:49,900 --> 00:54:53,120 That's not diversifiable, right? 1120 00:54:53,120 --> 00:54:55,130 The market moves up, the economy moves up, 1121 00:54:55,130 --> 00:54:58,490 the wholesale price of electricity goes up. 1122 00:54:58,490 --> 00:55:01,900 So that's going to have a significant beta. 1123 00:55:01,900 --> 00:55:04,330 This other stuff, not so much, so I'm 1124 00:55:04,330 --> 00:55:07,950 not going to worry too much about the risk. 1125 00:55:07,950 --> 00:55:12,980 So I would treat the two differently. 1126 00:55:12,980 --> 00:55:14,000 OK so far? 1127 00:55:18,740 --> 00:55:25,850 Now-- let's do slightly different. 1128 00:55:25,850 --> 00:55:28,480 There are different degrees when you're doing this exercise. 1129 00:55:28,480 --> 00:55:31,810 We will see a cost-saving project on Wednesday. 1130 00:55:31,810 --> 00:55:35,550 We'll do the spreadsheet. 1131 00:55:35,550 --> 00:55:37,420 We won't come back to beta again, 1132 00:55:37,420 --> 00:55:40,830 but you need to see it and hear it. 1133 00:55:40,830 --> 00:55:44,160 We come back for a while, at least. 1134 00:55:44,160 --> 00:55:48,480 That exercise, you will see it's done 1135 00:55:48,480 --> 00:55:52,830 assuming there's a certain level of activity in the plant. 1136 00:55:52,830 --> 00:55:56,490 Well, how else are you going to do it, really? 1137 00:55:56,490 --> 00:55:58,888 You could simulate other levels of activity, 1138 00:55:58,888 --> 00:56:00,930 but it's done in a pretty straightforward, pretty 1139 00:56:00,930 --> 00:56:01,740 standard fashion. 1140 00:56:04,950 --> 00:56:06,810 If you have the wind farm and you've 1141 00:56:06,810 --> 00:56:13,436 presold the power, then, again, the revenue-- 1142 00:56:13,436 --> 00:56:16,400 revenue's fixed. 1143 00:56:16,400 --> 00:56:20,230 You don't need to discount the revenue to allow for risk. 1144 00:56:20,230 --> 00:56:24,620 And the cost risks are probably diversifiable per the example 1145 00:56:24,620 --> 00:56:25,120 I said. 1146 00:56:25,120 --> 00:56:28,720 And you probably don't want to treat costs 1147 00:56:28,720 --> 00:56:30,100 as a high beta item. 1148 00:56:33,080 --> 00:56:35,222 Suppose you don't know the revenues. 1149 00:56:35,222 --> 00:56:37,430 Suppose you're going to build a gas-fired power plant 1150 00:56:37,430 --> 00:56:39,305 and you're going to sell into the New England 1151 00:56:39,305 --> 00:56:41,060 wholesale market. 1152 00:56:41,060 --> 00:56:44,593 Oh, well, now your revenues are definitely 1153 00:56:44,593 --> 00:56:46,260 correlated with the rest of the economy. 1154 00:56:46,260 --> 00:56:48,052 Your revenues will have a significant beta. 1155 00:56:51,450 --> 00:56:54,760 Now suppose you're developing a new widget. 1156 00:56:54,760 --> 00:57:00,746 Well, the game changes now completely, right? 1157 00:57:00,746 --> 00:57:06,630 It's a new toy, it's a new video game, it is whatever it is. 1158 00:57:06,630 --> 00:57:10,020 You worry much less-- and we'll get to this after vacation-- 1159 00:57:10,020 --> 00:57:12,540 you worry much less about the beta 1160 00:57:12,540 --> 00:57:15,060 on the revenue from your video game 1161 00:57:15,060 --> 00:57:18,300 than on whether you're actually making something worth selling, 1162 00:57:18,300 --> 00:57:23,070 and can you retain the value? 1163 00:57:23,070 --> 00:57:27,060 Lots of great ideas do not enrich their owners. 1164 00:57:27,060 --> 00:57:30,328 The person who invented the-- 1165 00:57:30,328 --> 00:57:31,620 I always pronounce it "kor-ig". 1166 00:57:31,620 --> 00:57:32,730 It's pronounced something differently. 1167 00:57:32,730 --> 00:57:34,560 The little thing that you use to make 1168 00:57:34,560 --> 00:57:37,530 bad coffee with the capsules-- 1169 00:57:37,530 --> 00:57:40,310 made essentially nothing. 1170 00:57:40,310 --> 00:57:45,160 So created value, didn't capture value. 1171 00:57:45,160 --> 00:57:47,440 Then all of this stuff about beta, 1172 00:57:47,440 --> 00:57:50,230 and discounting, and so on, takes a back seat 1173 00:57:50,230 --> 00:57:53,920 to strategic considerations about, well, 1174 00:57:53,920 --> 00:57:55,690 how to do I ensure I-- 1175 00:57:55,690 --> 00:57:57,100 how do I ensure I sell something? 1176 00:57:57,100 --> 00:57:58,970 How do I ensure I capture value? 1177 00:57:58,970 --> 00:58:01,910 How do I ensure that my strategy makes sense? 1178 00:58:01,910 --> 00:58:05,770 And finally, suppose you're a small business with limited 1179 00:58:05,770 --> 00:58:06,850 capital market access. 1180 00:58:06,850 --> 00:58:09,790 You can't do this borrowing, and lending, and raising money, 1181 00:58:09,790 --> 00:58:12,180 and alternative investments. 1182 00:58:12,180 --> 00:58:13,780 Do you know that first acronym? 1183 00:58:13,780 --> 00:58:16,680 Has anybody ever heard it? 1184 00:58:16,680 --> 00:58:19,500 This used to be the mantra of the former head 1185 00:58:19,500 --> 00:58:21,660 of the Entrepreneurship Center here. 1186 00:58:21,660 --> 00:58:25,110 And it's short for Cash Is More Important Than Your Mother. 1187 00:58:28,890 --> 00:58:35,520 Which, for small businesses, is often true, right? 1188 00:58:35,520 --> 00:58:37,890 We didn't talk about cash constraints in all this. 1189 00:58:37,890 --> 00:58:40,270 We didn't talk about project size in any of this stuff 1190 00:58:40,270 --> 00:58:40,770 I did. 1191 00:58:40,770 --> 00:58:43,710 Take positive net present value projects, it's all swell. 1192 00:58:43,710 --> 00:58:49,170 Well, that assumes you can basically diversify risk. 1193 00:58:49,170 --> 00:58:51,420 It assumes you have access to the market. 1194 00:58:51,420 --> 00:58:53,370 It assumes you can borrow and lend. 1195 00:58:53,370 --> 00:58:57,090 It assumes if you have a bad day, you can get a loan. 1196 00:58:57,090 --> 00:59:03,420 It assumes diversifiable zero beta risks don't matter really. 1197 00:59:03,420 --> 00:59:07,530 If you're a small business, however, a zero beta risk 1198 00:59:07,530 --> 00:59:09,720 can kill you, right? 1199 00:59:09,720 --> 00:59:13,740 I mean, you're building this plant. 1200 00:59:13,740 --> 00:59:15,192 The construction is uncertain. 1201 00:59:15,192 --> 00:59:17,400 You don't know whether you're going to get it online. 1202 00:59:17,400 --> 00:59:19,442 That's uncorrelated with the rest of the economy. 1203 00:59:19,442 --> 00:59:22,240 But if it fails, you're done. 1204 00:59:22,240 --> 00:59:29,020 So for small businesses with limited capital market access, 1205 00:59:29,020 --> 00:59:32,080 all of this beta stuff is lovely. 1206 00:59:32,080 --> 00:59:34,570 Large corporations do it, lots of companies do it, 1207 00:59:34,570 --> 00:59:36,580 consultants do it. 1208 00:59:36,580 --> 00:59:38,770 It's a lot of fun. 1209 00:59:38,770 --> 00:59:40,713 If you're a small business, however, cash 1210 00:59:40,713 --> 00:59:42,130 is more important-- well, not more 1211 00:59:42,130 --> 00:59:45,160 important than your mother, but it's very important. 1212 00:59:45,160 --> 00:59:50,260 And worrying about running out of it will dominate. 1213 00:59:50,260 --> 00:59:52,330 And to say to a small business owner, 1214 00:59:52,330 --> 00:59:56,770 well, it's true that you go broke if this thing fails, 1215 00:59:56,770 --> 00:59:58,870 but that's a zero beta risk. 1216 00:59:58,870 --> 01:00:01,240 It's not correlated with the rest of the economy. 1217 01:00:01,240 --> 01:00:03,340 You shouldn't treat it as risky. 1218 01:00:03,340 --> 01:00:04,990 That's nuts, right? 1219 01:00:04,990 --> 01:00:10,630 So the story about beta and the appropriate measure of risk 1220 01:00:10,630 --> 01:00:14,215 for which we have good theory applies to large-- 1221 01:00:14,215 --> 01:00:16,540 it applies to ventures with capital market access, 1222 01:00:16,540 --> 01:00:18,820 large or small. 1223 01:00:18,820 --> 01:00:21,550 How you think about risk for a small business 1224 01:00:21,550 --> 01:00:24,040 with limited or no capital market access 1225 01:00:24,040 --> 01:00:26,260 really depends on the exact circumstances 1226 01:00:26,260 --> 01:00:28,320 of the small business. 1227 01:00:28,320 --> 01:00:32,580 If you've raised $1,000 from venture capital 1228 01:00:32,580 --> 01:00:35,700 and you think it's going to take you 1229 01:00:35,700 --> 01:00:39,450 $900 to bring the thing to market, 1230 01:00:39,450 --> 01:00:42,960 you better get it to market for $900 or you 1231 01:00:42,960 --> 01:00:47,040 either go broke or give away a large part of your ownership 1232 01:00:47,040 --> 01:00:49,320 to raise additional money. 1233 01:00:49,320 --> 01:00:50,910 So I just want-- 1234 01:00:50,910 --> 01:00:54,360 I don't want anybody dealing with a small business 1235 01:00:54,360 --> 01:00:56,280 to say, yes, but what really matters 1236 01:00:56,280 --> 01:00:58,800 is diversifiable and not diversifiable risk. 1237 01:00:58,800 --> 01:01:01,110 It does for a big company, it does for a company 1238 01:01:01,110 --> 01:01:03,270 with capital market access. 1239 01:01:03,270 --> 01:01:04,920 It's not the dominant consideration 1240 01:01:04,920 --> 01:01:05,980 for a small business. 1241 01:01:05,980 --> 01:01:09,210 And it's not the dominant consideration 1242 01:01:09,210 --> 01:01:14,190 in evaluating a project that really is innovative 1243 01:01:14,190 --> 01:01:17,760 because there the real question is, can I capture value? 1244 01:01:17,760 --> 01:01:20,640 And that's a post-vacation question. 1245 01:01:20,640 --> 01:01:23,070 So I'll take questions. 1246 01:01:23,070 --> 01:01:27,960 Let me say a little bit about Wednesday. 1247 01:01:27,960 --> 01:01:29,110 Wednesday's a case. 1248 01:01:29,110 --> 01:01:32,680 We're going to spend almost all the time on the case. 1249 01:01:32,680 --> 01:01:37,550 I hope you can get the spreadsheet down from Stellar. 1250 01:01:37,550 --> 01:01:41,050 It involves an actual decision-- 1251 01:01:41,050 --> 01:01:46,050 an engineer, a plant manager, finds a solution that 1252 01:01:46,050 --> 01:01:48,060 will save energy, he thinks. 1253 01:01:48,060 --> 01:01:49,950 Well, solution will save energy, the question 1254 01:01:49,950 --> 01:01:51,960 is, is it a good investment? 1255 01:01:51,960 --> 01:01:57,810 You will see a spreadsheet that lays out a net present value 1256 01:01:57,810 --> 01:01:59,160 analysis. 1257 01:01:59,160 --> 01:02:01,800 I invite you to look at that spreadsheet, 1258 01:02:01,800 --> 01:02:04,290 look closely at the formulas. 1259 01:02:04,290 --> 01:02:05,550 Is it right? 1260 01:02:05,550 --> 01:02:06,990 Is the analysis right? 1261 01:02:10,720 --> 01:02:13,668 Then the question is-- 1262 01:02:13,668 --> 01:02:19,260 you will also see in the case a bunch of objections. 1263 01:02:19,260 --> 01:02:23,160 I think the spreadsheet has mistakes. 1264 01:02:23,160 --> 01:02:26,220 I think the spreadsheet fixed shows 1265 01:02:26,220 --> 01:02:29,400 it to be a positive net present value investment. 1266 01:02:29,400 --> 01:02:31,870 You will also see in the case-- 1267 01:02:31,870 --> 01:02:35,040 so it's all the stuff we all like. 1268 01:02:35,040 --> 01:02:38,500 It's an investment that will save energy, 1269 01:02:38,500 --> 01:02:40,990 no animals will be harmed. 1270 01:02:40,990 --> 01:02:43,570 They won't be venting steam into the environment. 1271 01:02:43,570 --> 01:02:45,580 They won't have an icing problem. 1272 01:02:45,580 --> 01:02:47,140 Life will be good. 1273 01:02:47,140 --> 01:02:49,360 But there are a long list of objectors-- 1274 01:02:49,360 --> 01:02:51,280 a long list of objections, and probably 1275 01:02:51,280 --> 01:02:55,180 a long list of objectors, also. 1276 01:02:55,180 --> 01:03:02,110 And read that and answer the question, given those concerns, 1277 01:03:02,110 --> 01:03:03,670 what's he do? 1278 01:03:03,670 --> 01:03:05,350 Here's a positive net present value 1279 01:03:05,350 --> 01:03:06,847 investment in all probability. 1280 01:03:06,847 --> 01:03:08,680 Again, we'll go through the spreadsheet just 1281 01:03:08,680 --> 01:03:10,600 to see how it's done. 1282 01:03:10,600 --> 01:03:12,370 It's a positive net present value 1283 01:03:12,370 --> 01:03:14,200 investment that will save energy, 1284 01:03:14,200 --> 01:03:16,300 be good for the environment-- 1285 01:03:16,300 --> 01:03:21,090 more ducks, whatever-- but he may not get to do it. 1286 01:03:21,090 --> 01:03:23,310 He may not-- and not because they 1287 01:03:23,310 --> 01:03:26,100 don't have any capital in the bank, any cash in the bank. 1288 01:03:26,100 --> 01:03:27,940 He may not get to do it. 1289 01:03:27,940 --> 01:03:31,590 So think about what he should say. 1290 01:03:31,590 --> 01:03:37,620 And think about how the firm from the top management 1291 01:03:37,620 --> 01:03:41,130 might want to structure things so that projects 1292 01:03:41,130 --> 01:03:43,200 like that don't get blocked. 1293 01:03:43,200 --> 01:03:44,190 So take a look at that. 1294 01:03:44,190 --> 01:03:46,440 And let me take questions for a few minutes. 1295 01:03:46,440 --> 01:03:49,260 And again, I'll let you go-- let you go early. 1296 01:03:49,260 --> 01:03:50,070 Yes? 1297 01:03:50,070 --> 01:03:50,695 AUDIENCE: Yeah. 1298 01:03:50,695 --> 01:03:52,290 Related to this, when people talk 1299 01:03:52,290 --> 01:03:55,540 about having compensation for executives 1300 01:03:55,540 --> 01:04:01,200 and people on the board be based on like a risk-adjusted income? 1301 01:04:01,200 --> 01:04:04,945 Would that be based on nondiversifiable risk as well, 1302 01:04:04,945 --> 01:04:05,445 or? 1303 01:04:07,885 --> 01:04:08,760 I mean, that's like-- 1304 01:04:08,760 --> 01:04:12,030 RICHARD SCHMALENSEE: Well, they don't do formal adjustments. 1305 01:04:12,030 --> 01:04:14,280 When people talk about compensation 1306 01:04:14,280 --> 01:04:18,030 to try to avoid a focus on today's share price, 1307 01:04:18,030 --> 01:04:20,610 they usually do things like, OK, we'll compensate you 1308 01:04:20,610 --> 01:04:22,080 in stock options. 1309 01:04:22,080 --> 01:04:26,400 But you can't cash the options until five years 1310 01:04:26,400 --> 01:04:29,020 after you've left the company. 1311 01:04:29,020 --> 01:04:32,910 Things like that to say the stock price 1312 01:04:32,910 --> 01:04:35,550 is $100 today, that's great. 1313 01:04:35,550 --> 01:04:37,530 What we care about isn't what it is tomorrow, 1314 01:04:37,530 --> 01:04:40,230 we care about what it is in five years. 1315 01:04:40,230 --> 01:04:43,530 So we want to take away from you the incentive 1316 01:04:43,530 --> 01:04:47,700 to boost profits today if it's going to hurt profits tomorrow. 1317 01:04:47,700 --> 01:04:50,460 So it's not a matter of risk-adjusted compensation. 1318 01:04:50,460 --> 01:04:53,490 It's a matter from the point of view of the top executives 1319 01:04:53,490 --> 01:04:56,970 to give them incentives not to add to risk, right? 1320 01:04:56,970 --> 01:04:59,820 I mean, one of the issues with all the investment banks 1321 01:04:59,820 --> 01:05:09,170 was if there is no downside-- 1322 01:05:09,170 --> 01:05:12,450 right-- you take a huge position, 1323 01:05:12,450 --> 01:05:14,970 that position comes through, you make a lot of money, 1324 01:05:14,970 --> 01:05:16,230 you get a lot of profits. 1325 01:05:16,230 --> 01:05:18,330 That position doesn't come through, they fire you. 1326 01:05:18,330 --> 01:05:19,950 OK, you go to another company. 1327 01:05:19,950 --> 01:05:21,480 Well, that's not a great-- 1328 01:05:21,480 --> 01:05:23,370 that's not a great model. 1329 01:05:23,370 --> 01:05:25,050 The idea is we ought to compensate 1330 01:05:25,050 --> 01:05:28,080 you based on performance over time, not on performance 1331 01:05:28,080 --> 01:05:33,180 last week because if the worst outcome is you lose the company 1332 01:05:33,180 --> 01:05:35,310 a billion dollars, you get fired, 1333 01:05:35,310 --> 01:05:36,750 you go to another company-- 1334 01:05:36,750 --> 01:05:38,883 where you do it again. 1335 01:05:38,883 --> 01:05:41,050 So they want to-- you want to give people incentives 1336 01:05:41,050 --> 01:05:43,630 not to put companies at risk. 1337 01:05:43,630 --> 01:05:45,970 You want to give executives incentives 1338 01:05:45,970 --> 01:05:49,150 not just to think about the short term. 1339 01:05:49,150 --> 01:05:50,525 It's a difficult matter. 1340 01:05:50,525 --> 01:05:52,400 We will talk a little bit about compensation, 1341 01:05:52,400 --> 01:05:55,960 but I will say, one of my favorite sayings from Jack 1342 01:05:55,960 --> 01:05:58,900 Welch when he taught here was any fool can 1343 01:05:58,900 --> 01:06:02,640 manage for the short term only. 1344 01:06:02,640 --> 01:06:06,030 And it's also true that any fool can manage for the long term 1345 01:06:06,030 --> 01:06:07,650 only. 1346 01:06:07,650 --> 01:06:11,000 The difficulty is balance. 1347 01:06:11,000 --> 01:06:11,750 Anything else? 1348 01:06:11,750 --> 01:06:14,440 That's the wisdom for today. 1349 01:06:14,440 --> 01:06:16,390 Yeah, Julien. 1350 01:06:16,390 --> 01:06:18,325 AUDIENCE: If there's like net market growth, 1351 01:06:18,325 --> 01:06:22,930 [INAUDIBLE] is for an entire market normalized for 1. 1352 01:06:22,930 --> 01:06:24,560 RICHARD SCHMALENSEE: Yeah. 1353 01:06:24,560 --> 01:06:26,630 Yeah. 1354 01:06:26,630 --> 01:06:31,100 Because remember, in a well-diversified-- 1355 01:06:31,100 --> 01:06:35,110 if you are well-diversified, you own a piece of everything. 1356 01:06:35,110 --> 01:06:36,310 That's the best you can do. 1357 01:06:36,310 --> 01:06:40,660 You could hold less of that risky stuff. 1358 01:06:40,660 --> 01:06:43,270 But the best you can do in terms of holding risky stuff 1359 01:06:43,270 --> 01:06:45,860 is to hold a little bit of everything. 1360 01:06:45,860 --> 01:06:49,095 And if you do that, then the risky part of your portfolio 1361 01:06:49,095 --> 01:06:50,470 moves up and down with the market 1362 01:06:50,470 --> 01:06:52,540 by definition because you're holding it, 1363 01:06:52,540 --> 01:06:58,450 so you normalize that to 1 and the riskless part doesn't move, 1364 01:06:58,450 --> 01:07:00,760 so that's zero. 1365 01:07:00,760 --> 01:07:03,580 You could normalize it to 16.7 if you wanted to, 1366 01:07:03,580 --> 01:07:06,520 but normalizing it to 1 is the simplest thing. 1367 01:07:06,520 --> 01:07:09,760 And then intermediate-- then mixtures of the two 1368 01:07:09,760 --> 01:07:12,800 will have values between zero and 1. 1369 01:07:12,800 --> 01:07:13,790 Yeah. 1370 01:07:13,790 --> 01:07:18,780 I mean, the 1's the normalization, zero is natural. 1371 01:07:18,780 --> 01:07:20,430 Anything else? 1372 01:07:20,430 --> 01:07:22,590 Deep philosophical questions? 1373 01:07:22,590 --> 01:07:26,590 I will need to talk more slowly in the future. 1374 01:07:26,590 --> 01:07:27,420 And I will do that. 1375 01:07:27,420 --> 01:07:28,720 But I'm done. 1376 01:07:28,720 --> 01:07:30,470 Thank you.