WEBVTT 00:00:00.000 --> 00:00:02.520 The following content is provided under a Creative 00:00:02.520 --> 00:00:03.970 Commons license. 00:00:03.970 --> 00:00:06.360 Your support will help MIT OpenCourseWare 00:00:06.360 --> 00:00:10.660 continue to offer high-quality educational resources for free. 00:00:10.660 --> 00:00:13.320 To make a donation or view additional materials 00:00:13.320 --> 00:00:17.160 from hundreds of MIT courses, visit MIT OpenCourseWare 00:00:17.160 --> 00:00:18.370 at ocw.mit.edu. 00:00:21.350 --> 00:00:24.530 RICHARD SCHMALENSEE: Let me do a little bit of where we've been 00:00:24.530 --> 00:00:27.200 and where we're going, a little wayfinding. 00:00:27.200 --> 00:00:28.700 We did the last two-- 00:00:28.700 --> 00:00:33.080 the last two sessions were on individuals and households. 00:00:33.080 --> 00:00:38.330 We did a rational actor model, a little drive demand, 00:00:38.330 --> 00:00:40.550 maximized preferences. 00:00:40.550 --> 00:00:45.890 And then we talked about preferences being learned. 00:00:45.890 --> 00:00:49.040 We talked about preferences depending on others. 00:00:49.040 --> 00:00:52.050 And particularly in the last session, 00:00:52.050 --> 00:00:54.620 we talked about economic style, if you will. 00:00:54.620 --> 00:00:58.130 Maximization is only one form of cognition. 00:00:58.130 --> 00:01:00.410 That sometimes we all behave automatically 00:01:00.410 --> 00:01:03.270 rather than thoughtfully. 00:01:03.270 --> 00:01:05.480 I have a very large book to read over spring vacation 00:01:05.480 --> 00:01:08.150 by Kahneman called Thinking Fast and Thinking Slow that's 00:01:08.150 --> 00:01:09.140 all about this-- 00:01:09.140 --> 00:01:10.250 good stuff. 00:01:10.250 --> 00:01:13.520 And Max Weber's distinction between rational pursuit 00:01:13.520 --> 00:01:16.460 of ends, rational pursuit of an ideal or value. 00:01:16.460 --> 00:01:19.710 It feels good or we just do it out of habit. 00:01:19.710 --> 00:01:23.300 So we went from sort of a rational actor 00:01:23.300 --> 00:01:26.240 story about individuals and households 00:01:26.240 --> 00:01:30.080 to more complicated view of behavior. 00:01:30.080 --> 00:01:34.200 We're going to do the same thing with firms. 00:01:34.200 --> 00:01:37.560 So today is about a rational actor model 00:01:37.560 --> 00:01:40.230 about maximizing something-- we'll 00:01:40.230 --> 00:01:43.800 talk at the outset about what. 00:01:43.800 --> 00:01:47.130 And then we'll talk about behavioral complications. 00:01:47.130 --> 00:01:49.500 Whatever it is we think firms ought to maximize 00:01:49.500 --> 00:01:54.000 as demanders-- mainly of energy, that's the focus-- 00:01:54.000 --> 00:01:57.000 before the break. 00:01:57.000 --> 00:01:59.880 They don't necessarily maximize anything. 00:01:59.880 --> 00:02:01.800 First, they're full of people. 00:02:01.800 --> 00:02:04.320 And people don't necessarily maximize anything. 00:02:04.320 --> 00:02:06.560 And there's an additional layer of complication, 00:02:06.560 --> 00:02:08.310 which is what we'll spend most of our time 00:02:08.310 --> 00:02:10.590 on, because people in organizations 00:02:10.590 --> 00:02:13.680 are more complicated than people individually because 00:02:13.680 --> 00:02:15.990 of the structures, and incentives, and relationships, 00:02:15.990 --> 00:02:17.730 and so forth. 00:02:17.730 --> 00:02:21.250 After vacation, we'll spend a little bit-- 00:02:21.250 --> 00:02:23.340 and these are normative prescriptive sessions-- 00:02:23.340 --> 00:02:27.840 on supply-side strategy, how might one 00:02:27.840 --> 00:02:29.620 do an energy business. 00:02:29.620 --> 00:02:32.280 So that's where we're going. 00:02:32.280 --> 00:02:36.180 It's worth spending some time, though, on-- 00:02:36.180 --> 00:02:37.350 is this reasonably clear? 00:02:37.350 --> 00:02:39.190 Are the questions? 00:02:39.190 --> 00:02:41.180 Let me-- before I pass on-- 00:02:41.180 --> 00:02:41.680 OK. 00:02:44.780 --> 00:02:48.530 If households maximize utility, what should firms maximize? 00:02:48.530 --> 00:02:50.480 If it's your own firm-- 00:02:50.480 --> 00:02:51.860 my dad ran a garage. 00:02:51.860 --> 00:02:54.380 My dad could do whatever he wanted-- maximize utility, 00:02:54.380 --> 00:02:55.520 maximize profit-- 00:02:55.520 --> 00:02:56.700 who cares? 00:02:56.700 --> 00:03:01.160 There's nobody to tell him what to do. 00:03:01.160 --> 00:03:02.480 He aimed for profit, actually. 00:03:05.560 --> 00:03:09.140 But for corporations, it's different 00:03:09.140 --> 00:03:14.160 because modern corporations have diffuse ownership, right? 00:03:14.160 --> 00:03:17.850 The Exxon executives maybe own a reasonable fraction of Exxon, 00:03:17.850 --> 00:03:20.820 but that reasonable fraction might be 10%. 00:03:20.820 --> 00:03:22.710 Some other companies, it's higher-- 00:03:22.710 --> 00:03:24.720 some younger companies, it's higher. 00:03:24.720 --> 00:03:31.950 But in a lot of companies, the executives are not the owners. 00:03:31.950 --> 00:03:38.570 And the question is, what should the executives maximize-- 00:03:38.570 --> 00:03:41.030 if they should maximize anything? 00:03:41.030 --> 00:03:43.040 Milton Friedman was writing, when 00:03:43.040 --> 00:03:45.200 there were debates about imposing wage and price 00:03:45.200 --> 00:03:48.920 controls to deal with what seemed then 00:03:48.920 --> 00:03:51.140 like a lot of inflation-- 00:03:51.140 --> 00:03:53.450 we had much more later years, but it seemed like a lot 00:03:53.450 --> 00:03:57.410 of inflation in '70, '71, when, in '71, when Nixon did impose 00:03:57.410 --> 00:03:59.350 price controls-- 00:03:59.350 --> 00:04:01.320 which mostly failed. 00:04:01.320 --> 00:04:04.230 And Milton Friedman has a distinct point of view 00:04:04.230 --> 00:04:08.880 about what corporate executives should be told to maximize. 00:04:08.880 --> 00:04:11.460 Anybody? 00:04:11.460 --> 00:04:12.690 Columbus, what do you say? 00:04:12.690 --> 00:04:17.022 What does Milton Friedman say should be the instruction? 00:04:17.022 --> 00:04:17.850 AUDIENCE: Profits. 00:04:17.850 --> 00:04:19.017 RICHARD SCHMALENSEE: Profit. 00:04:19.017 --> 00:04:20.490 OK. 00:04:20.490 --> 00:04:24.390 Why not do some social good? 00:04:24.390 --> 00:04:28.320 What's the argument against saying to Exxon, oh, come on, 00:04:28.320 --> 00:04:30.090 you're a big, rich company. 00:04:30.090 --> 00:04:32.080 Do some good. 00:04:32.080 --> 00:04:34.390 AUDIENCE: Well, there's a few different reasons 00:04:34.390 --> 00:04:37.110 why, for the stockholders, they might not 00:04:37.110 --> 00:04:47.400 want to do that for the [INAUDIBLE] 00:04:47.400 --> 00:04:51.790 if they do that, they're not spending their own money. 00:04:51.790 --> 00:04:53.790 RICHARD SCHMALENSEE: Well, that's disappointing. 00:04:53.790 --> 00:04:54.750 You gave a complete answer. 00:04:54.750 --> 00:04:56.100 Now who am I going to call on next? 00:04:56.100 --> 00:04:57.720 Does anybody want to supplement that? 00:04:57.720 --> 00:04:59.220 I mean, that's the basic answer. 00:04:59.220 --> 00:05:01.710 It's taxation without representation. 00:05:01.710 --> 00:05:04.080 If the owners want to spend money on charity, fine. 00:05:04.080 --> 00:05:07.930 But-- and if they want to tell the executive to do that, fine. 00:05:07.930 --> 00:05:13.470 But if they don't, why should the executives of Exxon 00:05:13.470 --> 00:05:15.670 do social good? 00:05:15.670 --> 00:05:16.680 So Friedman says, nope. 00:05:16.680 --> 00:05:17.850 Their business is to make money. 00:05:17.850 --> 00:05:19.380 The owners can contribute to charity. 00:05:19.380 --> 00:05:20.838 We'll start the debate in a minute, 00:05:20.838 --> 00:05:22.530 but let's clarify his point of view. 00:05:22.530 --> 00:05:23.697 Did you want to add to that? 00:05:23.697 --> 00:05:26.197 AUDIENCE: I just wanted to add that corporations can get tax 00:05:26.197 --> 00:05:27.820 deductions for donating to charities, 00:05:27.820 --> 00:05:37.200 so it's kind of a way to pay money to get [INAUDIBLE] 00:05:37.200 --> 00:05:39.966 charitable, but really, you're just trying to-- 00:05:39.966 --> 00:05:43.160 I mean, you're just paying your taxes in a different direction. 00:05:43.160 --> 00:05:45.860 RICHARD SCHMALENSEE: So you're saying 00:05:45.860 --> 00:05:51.020 that a firm can do things that might not necessarily 00:05:51.020 --> 00:05:54.860 look to be profit maximization, like giving to charity, 00:05:54.860 --> 00:05:57.920 but might be thought through correctly 00:05:57.920 --> 00:06:02.030 contribute to their long-run success. 00:06:02.030 --> 00:06:05.560 So you wouldn't necessarily want to squeeze every nickel out. 00:06:05.560 --> 00:06:06.650 OK. 00:06:06.650 --> 00:06:08.610 So Friedman would let you do that. 00:06:08.610 --> 00:06:12.940 But Friedman would say, how do you choose what charity? 00:06:12.940 --> 00:06:15.570 Who chooses? 00:06:15.570 --> 00:06:16.980 The CEO's favorite charity. 00:06:16.980 --> 00:06:19.780 Maybe that's part of his or her compensation. 00:06:19.780 --> 00:06:22.910 Anybody else on Friedman. 00:06:22.910 --> 00:06:23.450 OK. 00:06:23.450 --> 00:06:24.970 What's handy-- Yeah, go ahead, Maxwell. 00:06:24.970 --> 00:06:25.595 AUDIENCE: Yeah. 00:06:25.595 --> 00:06:28.850 I was just going to say [INAUDIBLE] and then you have 00:06:28.850 --> 00:06:33.157 [INAUDIBLE] 00:06:33.157 --> 00:06:34.240 RICHARD SCHMALENSEE: Yeah. 00:06:34.240 --> 00:06:37.990 It becomes a political entity, except that there's no voting. 00:06:37.990 --> 00:06:41.560 That it's making collective decisions 00:06:41.560 --> 00:06:44.530 like a taxing authority. 00:06:44.530 --> 00:06:47.790 But it's basically taking money out of the owners' pockets. 00:06:47.790 --> 00:06:48.345 David? 00:06:48.345 --> 00:06:49.720 AUDIENCE: So basically, they just 00:06:49.720 --> 00:06:52.390 don't have any right to choose where to donate to. 00:06:52.390 --> 00:06:56.870 And they don't have that [INAUDIBLE] 00:06:56.870 --> 00:07:01.652 select CEOs that are good at policy [INAUDIBLE].. 00:07:01.652 --> 00:07:04.110 RICHARD SCHMALENSEE: Murray does make an interesting point, 00:07:04.110 --> 00:07:10.610 which is that if I give it to you in the form of dividends, 00:07:10.610 --> 00:07:12.470 it gets taxed at the corporate level 00:07:12.470 --> 00:07:14.270 as well as at the personal level. 00:07:14.270 --> 00:07:16.310 Yeah, you can get a tax deduction personally, 00:07:16.310 --> 00:07:18.290 but you get that corporate tax hit. 00:07:18.290 --> 00:07:21.480 So it's a little more efficient if the corporation contributes. 00:07:21.480 --> 00:07:24.550 But who's to let them decide what to contribute. 00:07:24.550 --> 00:07:25.050 OK. 00:07:25.050 --> 00:07:25.820 Yes? 00:07:25.820 --> 00:07:28.030 AUDIENCE: Also, a corporation's main responsibility 00:07:28.030 --> 00:07:31.310 is just to make a profit for itself and for shareholders. 00:07:31.310 --> 00:07:34.580 And so some corporations have it in their mission statement 00:07:34.580 --> 00:07:38.340 that they do good will and good work, and stuff like that. 00:07:38.340 --> 00:07:41.235 And so then I think it's more acceptable to have charity 00:07:41.235 --> 00:07:43.610 be part of the company because it's part of their mission 00:07:43.610 --> 00:07:44.160 statement. 00:07:44.160 --> 00:07:47.540 But the majority of corporations, their mission 00:07:47.540 --> 00:07:50.000 is to make a profit for the shareholders, so. 00:07:50.000 --> 00:07:50.900 RICHARD SCHMALENSEE: Well, they would usually 00:07:50.900 --> 00:07:53.630 have a mission statement that's a little more exalted than that 00:07:53.630 --> 00:07:55.670 if they have a mission statement-- 00:07:55.670 --> 00:07:58.110 unless they're explicitly charitable, and some are, 00:07:58.110 --> 00:07:58.610 right? 00:07:58.610 --> 00:08:00.852 There are these corporations-- 00:08:00.852 --> 00:08:02.810 which are very interesting-- that treat profits 00:08:02.810 --> 00:08:07.550 as a constraint, not an objective that are charitable. 00:08:07.550 --> 00:08:10.310 Well, Newman's salad dressing, for instance. 00:08:10.310 --> 00:08:13.010 They maximize profits to give to charity. 00:08:13.010 --> 00:08:18.200 There are companies-- what's the term-- social enterprises that 00:08:18.200 --> 00:08:21.080 basically say, we're going to make just enough money 00:08:21.080 --> 00:08:21.928 to survive. 00:08:21.928 --> 00:08:23.970 And we're going to do good in the following ways. 00:08:23.970 --> 00:08:27.050 You can think about a number of things like that. 00:08:27.050 --> 00:08:28.430 What's Handy say? 00:08:28.430 --> 00:08:29.390 Handy disagrees. 00:08:29.390 --> 00:08:31.910 Handy's writing-- let me just see if we've got-- 00:08:31.910 --> 00:08:35.530 I think we've got the main points. 00:08:35.530 --> 00:08:37.240 Yup. 00:08:37.240 --> 00:08:40.100 Handy's writing after the dotcom bust. 00:08:40.100 --> 00:08:42.010 OK, Friedman's writing in a landscape 00:08:42.010 --> 00:08:46.780 where an issue of the day is, should the government 00:08:46.780 --> 00:08:49.600 step in and control prices? 00:08:49.600 --> 00:08:52.810 Handy's writing after the dotcom bust when stocks went up, 00:08:52.810 --> 00:08:57.160 stocks came down like a stone, lots of companies went broke. 00:08:57.160 --> 00:08:59.740 What's Handy say the firms should be about? 00:09:09.300 --> 00:09:12.090 Benzi, you're writing down, and I'm not saying anything. 00:09:12.090 --> 00:09:16.070 So you must be preparing your answer to this question. 00:09:16.070 --> 00:09:18.650 So what does Handy say that the firm 00:09:18.650 --> 00:09:20.608 should the firm should be about? 00:09:20.608 --> 00:09:22.400 AUDIENCE: I didn't get a chance to read it. 00:09:22.400 --> 00:09:22.970 RICHARD SCHMALENSEE: OK. 00:09:22.970 --> 00:09:23.580 OK. 00:09:23.580 --> 00:09:24.860 Thank you for your honesty. 00:09:24.860 --> 00:09:25.718 Matthew? 00:09:25.718 --> 00:09:27.260 AUDIENCE: I have the same [INAUDIBLE] 00:09:27.260 --> 00:09:28.190 RICHARD SCHMALENSEE: You have to same-- somebody 00:09:28.190 --> 00:09:28.790 must have read it. 00:09:28.790 --> 00:09:30.623 I'm sure there's somebody in this group that 00:09:30.623 --> 00:09:32.780 read the Handy paper-- doesn't summarize easily. 00:09:32.780 --> 00:09:33.740 Veronica? 00:09:33.740 --> 00:09:35.230 Fire away. 00:09:35.230 --> 00:09:36.590 AUDIENCE: It wasn't on Stellar. 00:09:36.590 --> 00:09:37.850 RICHARD SCHMALENSEE: Was it really not on Stellar? 00:09:37.850 --> 00:09:38.475 AUDIENCE: Yeah. 00:09:38.475 --> 00:09:42.210 It was only preview. 00:09:42.210 --> 00:09:44.271 RICHARD SCHMALENSEE: I got it. 00:09:44.271 --> 00:09:45.990 AUDIENCE: [INAUDIBLE] 00:09:45.990 --> 00:09:46.990 AUDIENCE: This morning-- 00:09:46.990 --> 00:09:49.157 RICHARD SCHMALENSEE: No, I printed it out last week. 00:09:49.157 --> 00:09:51.410 It wasn't up? 00:09:51.410 --> 00:09:53.840 Was it marked staff only? 00:09:53.840 --> 00:09:56.110 Did we screw it up and mark it staff only? 00:09:56.110 --> 00:09:58.803 AUDIENCE: [INAUDIBLE]. 00:09:58.803 --> 00:09:59.970 RICHARD SCHMALENSEE: No, no. 00:09:59.970 --> 00:10:00.553 It was posted. 00:10:00.553 --> 00:10:02.595 It was posted months ago. 00:10:02.595 --> 00:10:05.220 The only thing I can think of as it may have been inadvertently 00:10:05.220 --> 00:10:06.840 labeled staff only. 00:10:06.840 --> 00:10:10.200 Well, in which case, because I pulled it off to-- 00:10:10.200 --> 00:10:13.170 I mean, here it is, exactly from Stellar. 00:10:13.170 --> 00:10:18.090 So I'll tell you what Handy says and we can talk about it. 00:10:18.090 --> 00:10:20.400 Handy's a funny article, right? 00:10:20.400 --> 00:10:21.508 He's writing in the-- 00:10:21.508 --> 00:10:23.550 so you could have just said, you couldn't get it. 00:10:23.550 --> 00:10:24.967 And then you would have been good. 00:10:28.140 --> 00:10:32.250 It's a lot of criticism of the short-term focus in stock 00:10:32.250 --> 00:10:34.500 options and all of that. 00:10:34.500 --> 00:10:37.960 He says profits are a means not an end. 00:10:37.960 --> 00:10:41.310 It's a completely different vision. 00:10:41.310 --> 00:10:44.250 That a good firm is, "a community with a purpose." 00:10:44.250 --> 00:10:46.200 That's his phrase. 00:10:46.200 --> 00:10:49.740 And you should treat employees like-- 00:10:49.740 --> 00:10:51.030 as stakeholders. 00:10:51.030 --> 00:10:54.360 He's one of the coiners of the stakeholder view of the firm. 00:10:54.360 --> 00:10:57.330 That a firm doesn't exist to serve just its owners, 00:10:57.330 --> 00:11:00.570 it exists to serve the communities it operates in. 00:11:00.570 --> 00:11:07.230 It exists to serve its employees who've invested at least some-- 00:11:07.230 --> 00:11:09.330 made some investments of time and energy 00:11:09.330 --> 00:11:14.550 that will be lost if they leave the firm or if the firm fails. 00:11:14.550 --> 00:11:18.420 So he would say, a good firm is about something, 00:11:18.420 --> 00:11:21.270 not just about making money to shareholders. 00:11:21.270 --> 00:11:25.560 And a good firm will go beyond minimal legal requirements 00:11:25.560 --> 00:11:28.320 for something like things like environment, and safety, 00:11:28.320 --> 00:11:29.598 and so forth. 00:11:29.598 --> 00:11:31.140 So you have two very different views. 00:11:31.140 --> 00:11:35.070 You have a classical economic view from Friedman. 00:11:35.070 --> 00:11:36.630 You've been employed by the owners, 00:11:36.630 --> 00:11:39.780 you have a fiduciary responsibility for the owners. 00:11:39.780 --> 00:11:42.840 Don't spend the owners' money without authorization 00:11:42.840 --> 00:11:43.870 or instruction. 00:11:43.870 --> 00:11:47.310 And the Handy view that says, that's too simple. 00:11:47.310 --> 00:11:49.530 Lots of other people have a stake in the firm-- 00:11:49.530 --> 00:11:54.610 the community, the employees, the environment, et cetera, 00:11:54.610 --> 00:11:56.050 et cetera, et cetera. 00:11:56.050 --> 00:11:58.530 So you really need to take a broader 00:11:58.530 --> 00:11:59.910 view of what you're about. 00:12:02.640 --> 00:12:05.253 Now that you've had a complete clear exposition of what 00:12:05.253 --> 00:12:07.170 I must say is a little bit of a murky article, 00:12:07.170 --> 00:12:12.210 we'll make sure you can get it this afternoon. 00:12:12.210 --> 00:12:13.080 What do you think? 00:12:15.810 --> 00:12:18.050 Where do you come down? 00:12:18.050 --> 00:12:20.650 Sam? 00:12:20.650 --> 00:12:22.750 Handy's view is a little more humane, isn't it? 00:12:22.750 --> 00:12:23.780 Yeah. 00:12:23.780 --> 00:12:28.170 AUDIENCE: Also, like, we have the kind of a [INAUDIBLE] 00:12:28.170 --> 00:12:29.755 their employees will be more happy. 00:12:29.755 --> 00:12:31.880 And that would just make it a better place to work, 00:12:31.880 --> 00:12:33.460 which will in turn be-- 00:12:33.460 --> 00:12:34.750 make the firm more productive. 00:12:34.750 --> 00:12:36.310 Where if you're trying to just like 00:12:36.310 --> 00:12:38.757 have like a ruthless, cost-cutting machine type 00:12:38.757 --> 00:12:40.840 thing, it's going to be a miserable place to work. 00:12:40.840 --> 00:12:43.762 And it's not going to be just a flourishing environment. 00:12:43.762 --> 00:12:45.470 RICHARD SCHMALENSEE: Well, Friedman says, 00:12:45.470 --> 00:12:47.620 OK, I'll take that. 00:12:47.620 --> 00:12:48.460 I love that. 00:12:51.610 --> 00:12:54.520 We will be about something because that'll 00:12:54.520 --> 00:12:57.430 motivate people-- 00:12:57.430 --> 00:12:58.940 that's profit maximization. 00:12:58.940 --> 00:13:01.360 You've just given me profit maximization. 00:13:01.360 --> 00:13:06.210 I've given you-- a great example-- 00:13:06.210 --> 00:13:09.860 I'll mention two firms that I served on the boards of. 00:13:09.860 --> 00:13:12.830 The one was a startup, became the International 00:13:12.830 --> 00:13:13.880 Securities Exchange. 00:13:13.880 --> 00:13:16.730 It was the first all-electronic Options Exchange 00:13:16.730 --> 00:13:18.710 in the country. 00:13:18.710 --> 00:13:25.230 And everybody made money, but the mission-- 00:13:25.230 --> 00:13:27.330 not quite chiseled in stone, but the mission 00:13:27.330 --> 00:13:29.580 that everybody talked about was, we're 00:13:29.580 --> 00:13:31.320 going to upset this market. 00:13:31.320 --> 00:13:34.890 Trading is slow, commissions are ridiculously high, 00:13:34.890 --> 00:13:38.010 we could offer a much better product to the world. 00:13:38.010 --> 00:13:39.570 Well, you can go to work-- you can 00:13:39.570 --> 00:13:42.100 get up and go to work for that. 00:13:42.100 --> 00:13:44.790 The other is the International Data Group, which 00:13:44.790 --> 00:13:46.140 has a clear mission statement. 00:13:46.140 --> 00:13:48.960 It's to provide information about information technology 00:13:48.960 --> 00:13:51.900 so that technology can have more impact. 00:13:51.900 --> 00:13:54.600 Well, you can kind of go to work for that, too. 00:13:54.600 --> 00:13:58.370 The notion that we exist to make money for our owners 00:13:58.370 --> 00:14:00.880 a little hard to get up and get excited about. 00:14:00.880 --> 00:14:03.450 So Friedman said-- Friedman will come along with you 00:14:03.450 --> 00:14:04.335 and say, yes. 00:14:07.245 --> 00:14:08.370 And there's a nice example. 00:14:11.070 --> 00:14:12.690 Handy mentions Merck. 00:14:15.270 --> 00:14:19.890 Beginning in 1988, they had invented this drug 00:14:19.890 --> 00:14:21.330 that cures river blindness, which 00:14:21.330 --> 00:14:25.280 is a very nasty disease that infects people in Africa. 00:14:25.280 --> 00:14:27.870 I mean, young people go blind from swimming, basically, 00:14:27.870 --> 00:14:29.580 but getting in the water. 00:14:29.580 --> 00:14:32.970 And the stuff is reasonably expensive to make. 00:14:32.970 --> 00:14:36.330 They couldn't actually sell it into Africa. 00:14:36.330 --> 00:14:38.530 So they give it away. 00:14:38.530 --> 00:14:39.280 They give it away. 00:14:39.280 --> 00:14:39.940 It's free. 00:14:39.940 --> 00:14:42.100 They make it available free. 00:14:42.100 --> 00:14:45.370 And you say, how can that be profit maximizing? 00:14:45.370 --> 00:14:48.280 Well, if you walk into the Merck headquarters, 00:14:48.280 --> 00:14:53.740 there's a large statue of a young boy with-- 00:14:53.740 --> 00:14:57.130 as I remember it-- somebody in a white coat with his hand 00:14:57.130 --> 00:14:58.870 on the boy's shoulder. 00:14:58.870 --> 00:15:02.920 And you say to anybody at Merck, what's that about? 00:15:02.920 --> 00:15:05.770 They tell you this story. 00:15:05.770 --> 00:15:07.390 Well, you can get up and go to work 00:15:07.390 --> 00:15:09.010 for a company that says, yeah, we're 00:15:09.010 --> 00:15:10.840 about more than making money. 00:15:10.840 --> 00:15:14.410 We saw something that we could uniquely do for the world 00:15:14.410 --> 00:15:16.380 and we did it. 00:15:16.380 --> 00:15:18.130 We're not just about making money. 00:15:18.130 --> 00:15:19.710 So Friedman-- Friedman loves this. 00:15:22.300 --> 00:15:24.190 Anything-- would you go further? 00:15:26.840 --> 00:15:27.800 Julien. 00:15:27.800 --> 00:15:29.180 We've got your name corrected. 00:15:29.180 --> 00:15:30.400 That's fabulous. 00:15:30.400 --> 00:15:32.690 Good. 00:15:32.690 --> 00:15:33.890 Good. 00:15:33.890 --> 00:15:36.260 AUDIENCE: Well, I mean, I would disagree with Friedman 00:15:36.260 --> 00:15:39.140 because he may be right in some cases 00:15:39.140 --> 00:15:42.650 that perhaps some companies would find it in their best 00:15:42.650 --> 00:15:46.104 interest to do social good. 00:15:46.104 --> 00:15:49.550 However, let's say-- let's take a look at McDonald's. 00:15:49.550 --> 00:15:53.210 I'm sure their workers aren't happy about their wages. 00:15:53.210 --> 00:15:56.150 And I'm pretty sure McDonald's could pay them a bit more 00:15:56.150 --> 00:16:01.100 But I mean, that might be seen as a social good 00:16:01.100 --> 00:16:03.540 to earn more than minimum wage for your workers-- 00:16:03.540 --> 00:16:05.360 or pay more than minimum wage-- and I'm 00:16:05.360 --> 00:16:08.930 sure McDonald's could probably afford it. 00:16:08.930 --> 00:16:14.000 But seeing as they generally don't pay that much, 00:16:14.000 --> 00:16:18.840 it's not really in their interest for social good. 00:16:18.840 --> 00:16:21.090 So it's generally about profit, I would say. 00:16:21.090 --> 00:16:25.910 And so Friedman, I would say, is incorrect in that firms 00:16:25.910 --> 00:16:28.892 don't always do like social good for profit. 00:16:28.892 --> 00:16:30.350 RICHARD SCHMALENSEE: Sometimes they 00:16:30.350 --> 00:16:32.180 do social good for social good. 00:16:32.180 --> 00:16:34.310 By the way, I think it's the local franchisee who 00:16:34.310 --> 00:16:37.460 makes the wage decisions, and whether that person can 00:16:37.460 --> 00:16:41.400 afford it or not depends. 00:16:41.400 --> 00:16:43.890 AUDIENCE: OK, different example then. 00:16:43.890 --> 00:16:48.630 Let's say coal mines back in the day-- 00:16:48.630 --> 00:16:51.780 or like during industrialization, 00:16:51.780 --> 00:16:52.650 clothing factories. 00:16:52.650 --> 00:16:55.765 Like weren't people-- the labor-- 00:16:55.765 --> 00:16:57.390 they were people in horrible conditions 00:16:57.390 --> 00:16:59.160 and paid them horrible wages-- 00:16:59.160 --> 00:17:00.827 RICHARD SCHMALENSEE: But remember, we're 00:17:00.827 --> 00:17:03.050 talking prescription, not description. 00:17:03.050 --> 00:17:05.810 Friedman says, that's OK. 00:17:05.810 --> 00:17:08.270 Handy says, that's not OK. 00:17:08.270 --> 00:17:08.990 What do you say? 00:17:08.990 --> 00:17:11.210 You say it's not OK. 00:17:11.210 --> 00:17:12.700 Or do you say it's OK? 00:17:12.700 --> 00:17:16.579 What would you tell the executives to do? 00:17:16.579 --> 00:17:18.260 AUDIENCE: Better working conditions. 00:17:18.260 --> 00:17:19.609 RICHARD SCHMALENSEE: OK. 00:17:19.609 --> 00:17:21.060 Do coal mines ever fail? 00:17:21.060 --> 00:17:23.200 Go out of business, go broke? 00:17:23.200 --> 00:17:24.130 Yeah. 00:17:24.130 --> 00:17:26.723 Even with those lousy working conditions. 00:17:26.723 --> 00:17:28.265 AUDIENCE: [INAUDIBLE] not necessarily 00:17:28.265 --> 00:17:30.540 an effect of the working conditions [INAUDIBLE] 00:17:30.540 --> 00:17:30.780 RICHARD SCHMALENSEE: No, no. 00:17:30.780 --> 00:17:31.350 It's not. 00:17:31.350 --> 00:17:31.850 It's not. 00:17:31.850 --> 00:17:34.320 But if you raise costs, you raise the probability. 00:17:34.320 --> 00:17:39.810 So here's another Merck example from-- 00:17:39.810 --> 00:17:41.160 that needs a paren-- 00:17:41.160 --> 00:17:46.080 from 1999 to 2004, close paren, Merck 00:17:46.080 --> 00:17:47.940 had information about the adverse health 00:17:47.940 --> 00:17:51.630 effects of a popular drug prescribed for arthritis. 00:17:51.630 --> 00:17:54.360 A friend of mine took it regularly. 00:17:54.360 --> 00:17:56.007 And it had very-- it had bad side 00:17:56.007 --> 00:17:57.840 effects they had information on the bad side 00:17:57.840 --> 00:17:59.580 effects-- they hid it. 00:17:59.580 --> 00:18:00.760 They hid the information. 00:18:00.760 --> 00:18:02.760 And during that period, they sold a lot of Vioxx 00:18:02.760 --> 00:18:05.050 and made a lot of money. 00:18:05.050 --> 00:18:09.270 Was that profit maximizing? 00:18:09.270 --> 00:18:10.528 Handy would oppose it. 00:18:10.528 --> 00:18:11.570 Would Friedman oppose it? 00:18:14.250 --> 00:18:15.080 Charlotte? 00:18:15.080 --> 00:18:16.708 AUDIENCE: But isn't that one illegal? 00:18:16.708 --> 00:18:18.000 RICHARD SCHMALENSEE: Well, yes. 00:18:18.000 --> 00:18:18.870 There is that. 00:18:18.870 --> 00:18:21.330 AUDIENCE: But are we talking about things that are illegal? 00:18:21.330 --> 00:18:22.788 Or are we just talking about things 00:18:22.788 --> 00:18:25.820 that could be or couldn't be, like depending on the decision 00:18:25.820 --> 00:18:27.960 by the owners, like the legality of it. 00:18:27.960 --> 00:18:30.502 RICHARD SCHMALENSEE: I actually don't know if it was illegal. 00:18:30.502 --> 00:18:31.620 They certainly were sued. 00:18:31.620 --> 00:18:33.410 I'm not sure of the legality. 00:18:33.410 --> 00:18:35.340 Suppose it was legal. 00:18:35.340 --> 00:18:38.750 AUDIENCE: [INAUDIBLE] to meet their legal requirements. 00:18:38.750 --> 00:18:40.500 RICHARD SCHMALENSEE: Suppose it was legal. 00:18:40.500 --> 00:18:41.610 Suppose it was legal. 00:18:41.610 --> 00:18:42.330 Bad law. 00:18:42.330 --> 00:18:45.690 The law didn't actually say, you got to disclose bad effects. 00:18:45.690 --> 00:18:49.740 The law was badly written, and it let them get away with it. 00:18:49.740 --> 00:18:50.740 Then, should they have-- 00:18:50.740 --> 00:18:52.250 AUDIENCE: I think they would both disagree with that 00:18:52.250 --> 00:18:54.950 because personally, if I were working for a firm that 00:18:54.950 --> 00:18:58.148 was hiding the adverse effects of a drug that someone I knew 00:18:58.148 --> 00:19:00.440 might be taking, that wouldn't be a reason for me to go 00:19:00.440 --> 00:19:01.190 to work every day. 00:19:01.190 --> 00:19:02.857 RICHARD SCHMALENSEE: That would be hard. 00:19:02.857 --> 00:19:03.450 Rachel? 00:19:03.450 --> 00:19:04.870 AUDIENCE: I feel like for in both cases, 00:19:04.870 --> 00:19:06.870 it just kind of depends for individual companies 00:19:06.870 --> 00:19:09.780 how much they value-- or how much consumer opinion of them 00:19:09.780 --> 00:19:11.490 matters to their business. 00:19:11.490 --> 00:19:13.370 I mean, this case, like it might not 00:19:13.370 --> 00:19:15.530 be profit maximizing if it's really, really 00:19:15.530 --> 00:19:17.860 important that the public have a good view of them 00:19:17.860 --> 00:19:18.610 in the first case. 00:19:18.610 --> 00:19:20.960 It might be that the amount of money that they're 00:19:20.960 --> 00:19:24.355 losing by giving away the drug is 00:19:24.355 --> 00:19:26.480 overcome by the amount of goodwill they're earning. 00:19:26.480 --> 00:19:28.510 So it just kind of depends on the firm. 00:19:28.510 --> 00:19:30.190 RICHARD SCHMALENSEE: Actually, one thing that's-- it'd be 00:19:30.190 --> 00:19:32.690 interesting to know there, and I don't know the details, is, 00:19:32.690 --> 00:19:36.430 at what level of the firm was the decision made to conceal? 00:19:36.430 --> 00:19:39.250 It could be the person whose bonus depended 00:19:39.250 --> 00:19:41.860 on sales as opposed to the CEO. 00:19:41.860 --> 00:19:42.460 Samantha? 00:19:42.460 --> 00:19:43.970 AUDIENCE: I was just going to I say 00:19:43.970 --> 00:19:47.660 that I think I'm more on the Handy side of things, 00:19:47.660 --> 00:19:51.050 that firms have an obligation-- a moral obligation, 00:19:51.050 --> 00:19:54.194 as well as an obligation to maximize profit. 00:19:54.194 --> 00:19:58.318 And something like hiding adverse of effects of a drug 00:19:58.318 --> 00:20:01.246 is, in my opinion, morally wrong. 00:20:01.246 --> 00:20:03.850 And it's not something that a firm-- 00:20:03.850 --> 00:20:06.743 I mean, I would think that Friedman 00:20:06.743 --> 00:20:09.160 would be OK with something like that, and Handy would not. 00:20:09.160 --> 00:20:12.980 AUDIENCE: [INAUDIBLE] companies do balance like PR 00:20:12.980 --> 00:20:14.950 and public opinion with them with profit 00:20:14.950 --> 00:20:17.020 maximizing because public opinion of them 00:20:17.020 --> 00:20:18.800 affects the profits. 00:20:18.800 --> 00:20:20.000 RICHARD SCHMALENSEE: And it's nice to have a mission when 00:20:20.000 --> 00:20:21.920 you can have a mission, but Wednesday, we're 00:20:21.920 --> 00:20:23.837 going to talk about a firm in upstate New York 00:20:23.837 --> 00:20:25.430 that makes formaldehyde. 00:20:25.430 --> 00:20:27.590 And I just don't know how-- 00:20:27.590 --> 00:20:30.010 it may be technically interesting to run the firm, 00:20:30.010 --> 00:20:31.610 to run the plant, but I don't see 00:20:31.610 --> 00:20:35.330 how you get socially charged by that one. 00:20:35.330 --> 00:20:37.100 Just one last, and than I do want 00:20:37.100 --> 00:20:39.500 to get on to capitol budgeting. 00:20:39.500 --> 00:20:41.540 And let's just think about this one 00:20:41.540 --> 00:20:46.910 because think about how much of an issue 00:20:46.910 --> 00:20:50.060 Romney's venture capital experience-- 00:20:50.060 --> 00:20:53.360 actually, a private equity experience-- 00:20:53.360 --> 00:20:58.100 has been in this campaign, where they closed plants, 00:20:58.100 --> 00:21:00.590 they closed firms. 00:21:00.590 --> 00:21:04.670 And it's portrayed as the wrong thing to do. 00:21:04.670 --> 00:21:07.280 Sometimes there's no choice. 00:21:07.280 --> 00:21:09.940 Sometimes there is a choice. 00:21:09.940 --> 00:21:11.920 Is there a moral issue involved here? 00:21:11.920 --> 00:21:13.990 Is there not a moral issue. 00:21:13.990 --> 00:21:15.850 I'm a McDonald's franchisee, just 00:21:15.850 --> 00:21:19.240 to go to Julien's favorite dining establishment. 00:21:19.240 --> 00:21:21.520 And I've got six stores-- 00:21:21.520 --> 00:21:24.460 and I'm losing money on one of them. 00:21:24.460 --> 00:21:26.200 Do I have a moral obligation to keep 00:21:26.200 --> 00:21:30.170 it open because of the people or can I shut it down? 00:21:32.960 --> 00:21:36.740 Or suppose, in fact, I'm not losing money on it. 00:21:36.740 --> 00:21:38.840 It's reasonably profitable. 00:21:38.840 --> 00:21:41.720 But I get a really good offer from somebody who 00:21:41.720 --> 00:21:43.820 wants to make it a parking lot. 00:21:43.820 --> 00:21:46.910 And I can take that money, open another restaurant 00:21:46.910 --> 00:21:48.650 in a better location across town, 00:21:48.650 --> 00:21:50.840 where, yeah, I could employ those people, 00:21:50.840 --> 00:21:53.300 but they won't be able to get there. 00:21:53.300 --> 00:21:54.200 So I'll take it. 00:21:54.200 --> 00:21:55.185 You had a reaction? 00:21:55.185 --> 00:21:55.810 AUDIENCE: Yeah. 00:21:55.810 --> 00:21:57.395 I mean, there could be another company 00:21:57.395 --> 00:22:00.650 that could come in and do more good to the community than just 00:22:00.650 --> 00:22:02.098 another parking lot. 00:22:02.098 --> 00:22:03.806 RICHARD SCHMALENSEE: Parking lot-- maybe. 00:22:03.806 --> 00:22:05.174 Maybe. 00:22:05.174 --> 00:22:07.250 Maybe the community is desperate for parking. 00:22:07.250 --> 00:22:09.680 Let me go to capital budgeting because I think this 00:22:09.680 --> 00:22:12.560 will take us a little while. 00:22:12.560 --> 00:22:16.790 We're about firms for the next several sessions. 00:22:16.790 --> 00:22:22.070 And the diagram-- my favorite diagram that we started with-- 00:22:22.070 --> 00:22:25.160 firms supply energy, supply energy services, 00:22:25.160 --> 00:22:28.520 firms use energy-- that's where going to focus for a while. 00:22:28.520 --> 00:22:30.980 Firms supply products that use energy, 00:22:30.980 --> 00:22:35.030 and firms supply products that help supply energy. 00:22:35.030 --> 00:22:43.520 In all of these cases, the firms make decisions involving 00:22:43.520 --> 00:22:46.190 costs and benefits phased out-- 00:22:46.190 --> 00:22:50.950 spread out over many years with uncertainty. 00:22:50.950 --> 00:22:56.110 I'm going to assume some version of Friedman 00:22:56.110 --> 00:23:00.490 because I don't know how to model Handy, other than as, 00:23:00.490 --> 00:23:03.440 you have to think carefully about the long term. 00:23:03.440 --> 00:23:05.860 And if I have a moral obligation, 00:23:05.860 --> 00:23:09.440 I'll add that on top of this. 00:23:09.440 --> 00:23:13.990 So the basic story is we're going to maximize value. 00:23:13.990 --> 00:23:16.990 That's not maximizing today's share price. 00:23:16.990 --> 00:23:20.830 There's a nice phrase in Brealey, Myers, and Allen 00:23:20.830 --> 00:23:24.870 that talks about the honest share price. 00:23:24.870 --> 00:23:28.730 They don't mean, by that, in the absence of fraud. 00:23:28.730 --> 00:23:33.330 They mean in the presence of very good information. 00:23:33.330 --> 00:23:36.440 So you want to maximize how much the firm is worth-- 00:23:36.440 --> 00:23:38.690 if everybody knows as much as you do and indeed 00:23:38.690 --> 00:23:41.750 knows that much about other firms. 00:23:41.750 --> 00:23:44.570 So in the case of Merck you'd want 00:23:44.570 --> 00:23:48.080 to assume they know about Vioxx. 00:23:48.080 --> 00:23:51.650 If I could go to the capital markets, and I can invest, 00:23:51.650 --> 00:23:53.960 and I can borrow, and I can raise stock, 00:23:53.960 --> 00:23:56.570 and it's a simple world-- 00:23:56.570 --> 00:23:58.160 isn't that a lovely picture-- 00:23:58.160 --> 00:24:01.410 the rule to do this is straightforward. 00:24:01.410 --> 00:24:03.620 Again, we're going to talk about investments-- 00:24:03.620 --> 00:24:07.400 not operating decisions, but investment decisions. 00:24:07.400 --> 00:24:09.500 You make all investments that have 00:24:09.500 --> 00:24:12.150 a positive net present value. 00:24:12.150 --> 00:24:18.000 This is net present value in discrete, not continuous terms. 00:24:18.000 --> 00:24:21.870 And we do this because continuous compounding doesn't 00:24:21.870 --> 00:24:23.490 simplify, particularly, when you've 00:24:23.490 --> 00:24:26.400 got flows that vary over time. 00:24:26.400 --> 00:24:29.070 It's nice in very simple cases. 00:24:29.070 --> 00:24:30.930 I love the elegance, but if you want 00:24:30.930 --> 00:24:34.260 to work out the net present value of something like this-- 00:24:34.260 --> 00:24:37.680 this is an oil lease, hypothetically. 00:24:37.680 --> 00:24:40.590 So CAPEX-- Capital Expenditures-- 00:24:40.590 --> 00:24:43.950 are incurred early on, oil production ramps, 00:24:43.950 --> 00:24:45.990 levels declines. 00:24:45.990 --> 00:24:49.740 And to value this opportunity, you've 00:24:49.740 --> 00:24:54.210 got to figure, what am I going to get from selling oil? 00:24:54.210 --> 00:24:55.920 What are the Operating Expenses-- 00:24:55.920 --> 00:24:59.580 OPEX-- associated with getting that oil out? 00:24:59.580 --> 00:25:02.670 What are the royalties I'm going to owe? 00:25:02.670 --> 00:25:05.670 And what are the taxes I'm going to have to pay? 00:25:05.670 --> 00:25:09.650 I take the net and I discount it. 00:25:09.650 --> 00:25:13.010 And the opportunity cost of capital-- 00:25:13.010 --> 00:25:15.350 we'll spend quite a while on-- 00:25:15.350 --> 00:25:17.990 is what I could make on an investment 00:25:17.990 --> 00:25:20.310 of comparable riskiness. 00:25:20.310 --> 00:25:21.360 What's that mean? 00:25:21.360 --> 00:25:22.870 I'll come back to it. 00:25:22.870 --> 00:25:27.440 But if I can do better investing in this oil lease, then 00:25:27.440 --> 00:25:30.020 anything else that's handy that's of comparable riskiness, 00:25:30.020 --> 00:25:33.230 I should make this investment. 00:25:33.230 --> 00:25:34.220 If I can make-- 00:25:34.220 --> 00:25:38.840 we'll see next time, the calculations for Wednesday 00:25:38.840 --> 00:25:42.450 have to do with an investment in energy conservation. 00:25:42.450 --> 00:25:43.940 So it's the same thing. 00:25:43.940 --> 00:25:46.430 I can invest in lots of things, but if I 00:25:46.430 --> 00:25:48.450 can invest in energy conservation, 00:25:48.450 --> 00:25:51.230 and it gives me a better return than an investment 00:25:51.230 --> 00:25:55.320 of comparable riskiness, I ought to do it. 00:25:55.320 --> 00:25:59.040 Now that's a pretty simple formula, right? 00:25:59.040 --> 00:26:02.430 You just did something that the-- 00:26:02.430 --> 00:26:07.230 cash flows that occur in period J, take a discount rate, 00:26:07.230 --> 00:26:10.230 discount it back to the present at interest rate R, 00:26:10.230 --> 00:26:13.170 and you do this on a spreadsheet. 00:26:13.170 --> 00:26:16.320 And you'll see a spreadsheet Wednesday. 00:26:16.320 --> 00:26:19.570 So a couple simple basics here. 00:26:19.570 --> 00:26:23.680 The first is cash matters. 00:26:23.680 --> 00:26:27.490 Profits don't matter, except insofar as they affect taxes. 00:26:27.490 --> 00:26:29.740 So this is-- when you do present value 00:26:29.740 --> 00:26:33.760 for a firm, the question is, what are my actual returns, 00:26:33.760 --> 00:26:37.540 not what does the accountant put on the bottom of the paper? 00:26:37.540 --> 00:26:41.010 And the main example is depreciation. 00:26:41.010 --> 00:26:43.600 Depreciation is not a cash expense. 00:26:43.600 --> 00:26:45.040 It affects your taxes. 00:26:45.040 --> 00:26:48.430 And you'll see for Wednesday, you have to consider that. 00:26:48.430 --> 00:26:52.750 But it doesn't directly impact the cash in the bank. 00:26:52.750 --> 00:26:55.180 It's something the accountant writes down. 00:26:55.180 --> 00:26:57.790 So you use cash flows-- 00:26:57.790 --> 00:27:01.262 relentlessly focus on cash flows. 00:27:01.262 --> 00:27:02.845 There are a couple of simple formulas. 00:27:06.670 --> 00:27:09.790 That's the formula for a perpetuity, something 00:27:09.790 --> 00:27:13.480 that starts with a constant payment one year out, 00:27:13.480 --> 00:27:14.270 goes forever. 00:27:14.270 --> 00:27:16.720 You'll see it's the same formulas 00:27:16.720 --> 00:27:19.810 for continuous compounding, but obviously, the interest rate's 00:27:19.810 --> 00:27:20.470 different. 00:27:20.470 --> 00:27:23.410 This is compounded once a period. 00:27:23.410 --> 00:27:26.560 And this is nice in Brealey, Myers, and Allen. 00:27:26.560 --> 00:27:32.020 Suppose you have a bond that pays c per year for capital T 00:27:32.020 --> 00:27:33.670 years, what's it worth? 00:27:33.670 --> 00:27:36.190 Well, if the interest rate's R, that's 00:27:36.190 --> 00:27:40.330 equivalent to a perpetuity starting today-- 00:27:40.330 --> 00:27:41.710 starting in one year-- 00:27:41.710 --> 00:27:46.900 minus a perpetuity starting in year T plus 1. 00:27:46.900 --> 00:27:50.598 I subtract that and I get this simple little formula 00:27:50.598 --> 00:27:51.140 on the right. 00:27:51.140 --> 00:27:56.440 I could also do a T period power series, but that's cleaner. 00:27:56.440 --> 00:27:58.990 This is the formula you'd use-- 00:27:58.990 --> 00:28:02.020 that's the formula for a mortgage, 00:28:02.020 --> 00:28:04.430 except you use a monthly interest rate. 00:28:04.430 --> 00:28:07.930 So if you know what the value of the mortgage 00:28:07.930 --> 00:28:11.590 is and you know the yield on the mortgage, R, 00:28:11.590 --> 00:28:13.850 you can solve for the monthly payment. 00:28:13.850 --> 00:28:20.200 That's a standard bond or mortgage formula. 00:28:20.200 --> 00:28:24.940 The last point I want to make on this slide is-- 00:28:24.940 --> 00:28:26.200 is all this clear? 00:28:26.200 --> 00:28:29.280 Questions, or comments, or reactions? 00:28:29.280 --> 00:28:29.780 OK. 00:28:34.220 --> 00:28:39.490 Suppose prices are going up at 10% and the bank is-- 00:28:39.490 --> 00:28:41.030 at 10% a year-- 00:28:41.030 --> 00:28:44.190 and the bank is paying 5% a year. 00:28:44.190 --> 00:28:47.790 You're not making money on the investment in the bank, right? 00:28:47.790 --> 00:28:50.250 You're losing purchasing power. 00:28:50.250 --> 00:28:54.190 The real interest rate, whatever it is, is negative. 00:28:54.190 --> 00:28:57.000 You put $100 in the bank today, a year from now, 00:28:57.000 --> 00:29:00.540 you get something that's worth less because of inflation 00:29:00.540 --> 00:29:02.580 than that $100. 00:29:02.580 --> 00:29:06.030 Even though it's $105, inflation's gone up. 00:29:06.030 --> 00:29:11.160 Well, to figure out the relation between the market 00:29:11.160 --> 00:29:14.620 or nominal interest rate, capital R, the inflation rate 00:29:14.620 --> 00:29:20.920 I and the real interest rate, it's pretty straightforward. 00:29:20.920 --> 00:29:25.920 I put the money in the bank at 5%, I get $1.05. 00:29:25.920 --> 00:29:29.060 I basically got to knock that down 00:29:29.060 --> 00:29:32.990 by the amount of inflation that's occurred. 00:29:32.990 --> 00:29:37.230 And this gives me the increase in purchasing power. 00:29:37.230 --> 00:29:39.890 So another way to think about it-- or another example, 00:29:39.890 --> 00:29:44.840 suppose the bank's paying 5%, inflation is 5%. 00:29:44.840 --> 00:29:47.540 I get $105, which is worth exactly, 00:29:47.540 --> 00:29:51.033 in terms of what I can buy, what $100 was today. 00:29:51.033 --> 00:29:52.700 So the interest rate-- the real interest 00:29:52.700 --> 00:29:57.770 rate, the increase in the purchasing power is zero. 00:29:57.770 --> 00:30:00.620 If those two are equal, this is zero, and that makes sense. 00:30:00.620 --> 00:30:04.220 Inflation has wiped out the earnings. 00:30:04.220 --> 00:30:07.010 If you just multiply this through, 00:30:07.010 --> 00:30:09.800 you get this relationship. 00:30:09.800 --> 00:30:15.230 Normally, the product of these two rates, I and little r, 00:30:15.230 --> 00:30:18.460 is negligible. 00:30:18.460 --> 00:30:22.570 Although, I'm told in periods of high inflation in Israel, 00:30:22.570 --> 00:30:24.970 people actually do carry this second term. 00:30:24.970 --> 00:30:26.620 It's normally very small. 00:30:26.620 --> 00:30:29.320 And you get the result that the real interest 00:30:29.320 --> 00:30:33.490 rate, in any sane circumstance, is the market interest 00:30:33.490 --> 00:30:36.460 rate minus the inflation rate. 00:30:36.460 --> 00:30:37.030 OK. 00:30:37.030 --> 00:30:40.690 And that's the relationship every everybody uses. 00:30:40.690 --> 00:30:45.213 It's important to understand which interest rates 00:30:45.213 --> 00:30:46.630 you're using, whether you're using 00:30:46.630 --> 00:30:48.670 a real rate or a nominal rate. 00:30:48.670 --> 00:30:51.300 But are we OK on this? 00:30:51.300 --> 00:30:53.850 Everybody nods, everybody's happy. 00:30:53.850 --> 00:31:00.287 Almost all interest rates are nominal, right? 00:31:00.287 --> 00:31:02.120 You look up interest rates in the newspaper, 00:31:02.120 --> 00:31:04.970 they are, here's what we'll pay you in a year. 00:31:04.970 --> 00:31:10.000 They don't depend on the rate of inflation. 00:31:10.000 --> 00:31:12.670 All else equal, of course, they're 00:31:12.670 --> 00:31:16.600 going to be higher the higher inflation is expected to be. 00:31:16.600 --> 00:31:18.910 We had breathtaking interest rates 00:31:18.910 --> 00:31:22.340 in the late '70s, early '80s when inflation was running. 00:31:22.340 --> 00:31:26.260 We had mortgage rates of 18%, for heaven's sake. 00:31:26.260 --> 00:31:28.960 If you expect high inflation, you're 00:31:28.960 --> 00:31:33.530 going to want to get more dollars back. 00:31:33.530 --> 00:31:36.710 Now you can look at real interest rates in the past, 00:31:36.710 --> 00:31:37.210 of course. 00:31:37.210 --> 00:31:39.430 You can look at what was the rate-- 00:31:39.430 --> 00:31:43.120 what was the one-year bond rate-- 00:31:43.120 --> 00:31:45.340 on a one-year bond rate, government bond rate, 00:31:45.340 --> 00:31:49.000 let's say, on January 1, 1956. 00:31:49.000 --> 00:31:52.390 What was the inflation between January of 1956 00:31:52.390 --> 00:31:54.340 and January of 1957? 00:31:54.340 --> 00:31:57.080 I can subtract and get the real interest rate. 00:31:57.080 --> 00:31:58.960 What do I do going forward? 00:31:58.960 --> 00:32:01.570 Going forward, it's a little trickier. 00:32:01.570 --> 00:32:04.900 There is a bond sold by the Treasury-- you can buy them-- 00:32:04.900 --> 00:32:08.260 called TIPS, Treasury Information Protected 00:32:08.260 --> 00:32:09.580 Securities. 00:32:09.580 --> 00:32:13.930 They adjust so they pay you in real dollars. 00:32:13.930 --> 00:32:17.560 So the interest rate is a real interest-- interest rate quoted 00:32:17.560 --> 00:32:19.370 is a real interest rate. 00:32:19.370 --> 00:32:24.280 So last Friday-- when I was able to download Handy-- 00:32:24.280 --> 00:32:29.560 last Friday, I checked the 20-year rate 00:32:29.560 --> 00:32:31.150 on regular government bonds. 00:32:31.150 --> 00:32:34.300 That was 2.83% from the Treasury's website. 00:32:34.300 --> 00:32:37.975 And the rate on 10-year TIPS was a half a percent. 00:32:37.975 --> 00:32:40.375 These are breathtaking numbers, historically. 00:32:40.375 --> 00:32:41.650 It's a half a percent. 00:32:41.650 --> 00:32:46.930 So I'd say the market in some sense has an inflation 00:32:46.930 --> 00:32:49.000 expectation over 10 years of just a little 00:32:49.000 --> 00:32:52.240 over 2%, which is sort of a reasonable number, 00:32:52.240 --> 00:32:54.930 historically. 00:32:54.930 --> 00:32:57.010 But it's a bit of a thin market, and TIPS 00:32:57.010 --> 00:33:00.040 have special characteristics, and not everybody buys them. 00:33:00.040 --> 00:33:04.090 So I wouldn't say you can always look up the market's inflation 00:33:04.090 --> 00:33:05.860 expectations this way. 00:33:05.860 --> 00:33:07.510 But it gives you a sense. 00:33:07.510 --> 00:33:09.220 It gives you a sense. 00:33:09.220 --> 00:33:12.010 Not a sharp tool, but a tool. 00:33:15.030 --> 00:33:17.960 The biggest mistake people make in doing 00:33:17.960 --> 00:33:20.840 present value in almost any setting 00:33:20.840 --> 00:33:24.880 is to confuse which interest rate they're using. 00:33:24.880 --> 00:33:27.040 Are you using a real rate or a nominal rate? 00:33:27.040 --> 00:33:32.800 Now the normal thing you do when you're doing a present value 00:33:32.800 --> 00:33:37.060 calculation, and it involves so many pounds of cement 00:33:37.060 --> 00:33:40.300 per year over 10 years, you use today's pound of-- 00:33:40.300 --> 00:33:41.860 today's price for cement. 00:33:41.860 --> 00:33:43.630 That's the normal thing to do. 00:33:43.630 --> 00:33:47.170 Today's price for steel, today's price for whatever, 00:33:47.170 --> 00:33:50.350 figure out physical quantities, and get cash flows. 00:33:50.350 --> 00:33:53.800 If you do that, you need to use a real discount 00:33:53.800 --> 00:33:57.210 rate because you've assumed zero inflation 00:33:57.210 --> 00:33:58.365 by using today's prices. 00:34:01.620 --> 00:34:05.550 If you use a nominal rate from the market, 00:34:05.550 --> 00:34:07.680 then you need to adjust-- 00:34:07.680 --> 00:34:11.250 then you need to say, well, the rates 00:34:11.250 --> 00:34:16.090 I use are 5%, 10%, whatever they are, but I expect 2% inflation. 00:34:16.090 --> 00:34:18.230 So I'll build in 2% inflation. 00:34:18.230 --> 00:34:19.980 I mean, you could do it either way, right? 00:34:19.980 --> 00:34:25.530 You can use today's prices, take 2% off the market. 00:34:25.530 --> 00:34:28.290 But what you can't do is mix. 00:34:28.290 --> 00:34:32.969 You can't take a rate from the capital market like that 2.83 00:34:32.969 --> 00:34:37.830 up there, and then assume price is constant 00:34:37.830 --> 00:34:42.090 because that 2.83 is based on people's expectation 00:34:42.090 --> 00:34:45.300 that prices will rise-- 00:34:45.300 --> 00:34:46.560 that prices will rise. 00:34:46.560 --> 00:34:48.874 So it's a very common mistake. 00:34:52.900 --> 00:34:54.170 Just don't do it. 00:34:54.170 --> 00:34:57.400 And know to look for it when people show you, 00:34:57.400 --> 00:35:02.020 as they will in later life, present values because it's 00:35:02.020 --> 00:35:03.940 common, it's easy to make. 00:35:03.940 --> 00:35:08.140 And it can certainly get you the wrong answer 00:35:08.140 --> 00:35:10.240 if there's any inflation going on 00:35:10.240 --> 00:35:14.890 or the time period is of any length at all. 00:35:14.890 --> 00:35:16.270 OK. 00:35:16.270 --> 00:35:20.170 That's issue one, get the rates right. 00:35:20.170 --> 00:35:23.190 The rates matter. 00:35:23.190 --> 00:35:26.950 Well, let's do this one first. 00:35:26.950 --> 00:35:29.930 The question is, where does that R come from? 00:35:29.930 --> 00:35:33.250 And I said it's an opportunity cost of capital. 00:35:33.250 --> 00:35:35.410 It's what you can get on an investment 00:35:35.410 --> 00:35:36.940 of comparable riskiness. 00:35:36.940 --> 00:35:39.190 Well, if there's no risk-- 00:35:39.190 --> 00:35:42.220 even though the US government was downrated-- 00:35:42.220 --> 00:35:47.860 it's normal to treat a riskless rate as the government 00:35:47.860 --> 00:35:49.720 borrowing rate. 00:35:49.720 --> 00:35:51.940 There's essentially no risk of repayment 00:35:51.940 --> 00:35:54.500 unless you're a real pessimist. 00:35:54.500 --> 00:35:58.060 And again, you'd use the US rate, not necessarily 00:35:58.060 --> 00:36:05.270 the Greek rate these days after the write-off. 00:36:05.270 --> 00:36:09.250 But suppose there is some risk. 00:36:09.250 --> 00:36:12.360 Well, as I say, it's an opportunity cost. 00:36:12.360 --> 00:36:15.920 So that says you would expect-- 00:36:15.920 --> 00:36:18.320 if you're going to bear more risk, 00:36:18.320 --> 00:36:23.120 your expectation of a return has to be higher to compensate. 00:36:23.120 --> 00:36:25.670 So you would expect a higher risk 00:36:25.670 --> 00:36:28.280 means a higher discount rate. 00:36:28.280 --> 00:36:30.600 That sort of makes sense. 00:36:30.600 --> 00:36:32.930 So-- that's cute-- 00:36:32.930 --> 00:36:37.430 so you normally discount the expected cash flows 00:36:37.430 --> 00:36:40.385 at a risk-adjusted discount rate-- 00:36:40.385 --> 00:36:42.260 I'm going to come to, what do I mean by risk? 00:36:42.260 --> 00:36:45.500 Because that's the $64,000 question here. 00:36:45.500 --> 00:36:48.530 But so far, I assume this is fairly intuitive. 00:36:48.530 --> 00:36:51.320 And if a project has some things that are certain 00:36:51.320 --> 00:36:52.880 and some things that are uncertain, 00:36:52.880 --> 00:36:56.540 you might want to use different discount rates. 00:36:56.540 --> 00:37:00.582 If part of the cash flows are returns on government bonds, 00:37:00.582 --> 00:37:02.540 those are riskless and I ought to discount them 00:37:02.540 --> 00:37:04.340 using the government bond rate. 00:37:04.340 --> 00:37:09.020 Part of it is sales of Teslas, I might use a higher discount 00:37:09.020 --> 00:37:14.000 rate for sales of Teslas, or Chevy Volts , 00:37:14.000 --> 00:37:17.585 or tickets to John Carter, or almost anything else. 00:37:17.585 --> 00:37:22.180 I'd use a use a higher rate. 00:37:22.180 --> 00:37:25.980 But what do I mean by that? 00:37:25.980 --> 00:37:27.830 How do I think about risk? 00:37:27.830 --> 00:37:29.570 OK, two points to make. 00:37:29.570 --> 00:37:31.115 One, it matters. 00:37:34.590 --> 00:37:36.950 This is not particularly on point, but I like it. 00:37:36.950 --> 00:37:40.460 It illustrates the importance of discount rate choices 00:37:40.460 --> 00:37:42.050 you go out in time. 00:37:42.050 --> 00:37:45.800 This equivalent cash-flow haircut says, 00:37:45.800 --> 00:37:56.870 OK, a dollar in one year at 7% is worth $0.71. 00:37:56.870 --> 00:37:59.360 At 10%, it's worth $0.62. 00:37:59.360 --> 00:38:04.580 That's equivalent to taking 13% off, right? 00:38:04.580 --> 00:38:06.890 Raising the discount rate from 7% to 10% 00:38:06.890 --> 00:38:10.730 is equivalent to a 13% haircut on what you're going to get. 00:38:10.730 --> 00:38:14.570 And 30 years out, it's a huge haircut. 00:38:14.570 --> 00:38:18.310 30 years out it, more than cuts it in half. 00:38:18.310 --> 00:38:21.050 So the discount rate matters. 00:38:21.050 --> 00:38:23.180 The choice-- again, a nice picture-- 00:38:23.180 --> 00:38:29.420 is you've got project A, Project B. Project B looks very safe, 00:38:29.420 --> 00:38:32.990 project A looks very risky, but has a higher-- 00:38:32.990 --> 00:38:34.950 let's take that to be the expected value. 00:38:34.950 --> 00:38:38.450 The distribution's a little asymmetric. 00:38:38.450 --> 00:38:39.560 Which do you choose? 00:38:39.560 --> 00:38:40.400 Which do you choose? 00:38:40.400 --> 00:38:43.020 How do you think about risk? 00:38:43.020 --> 00:38:44.630 Well, it turns out the right answer 00:38:44.630 --> 00:38:48.640 isn't variance or anything quite like variance. 00:38:48.640 --> 00:38:54.710 I'm going to walk you through a bit of finance 00:38:54.710 --> 00:38:57.650 much too quickly. 00:38:57.650 --> 00:39:02.860 So listen for the concepts, don't listen for the details. 00:39:02.860 --> 00:39:06.570 I just want you to get the basic notion here, not the mechanics. 00:39:06.570 --> 00:39:08.070 We're not going to do the mechanics. 00:39:08.070 --> 00:39:10.770 The mechanics will not be on the quiz. 00:39:10.770 --> 00:39:12.600 But the concept is important. 00:39:12.600 --> 00:39:13.270 Jessica? 00:39:13.270 --> 00:39:14.895 AUDIENCE: Which would you say is safer? 00:39:14.895 --> 00:39:15.180 RICHARD SCHMALENSEE: Hmm? 00:39:15.180 --> 00:39:16.800 AUDIENCE: Which one of these two would you say is safer? 00:39:16.800 --> 00:39:18.620 RICHARD SCHMALENSEE: B is safer. 00:39:18.620 --> 00:39:19.120 Sure. 00:39:19.120 --> 00:39:21.250 Much less spread in the possible outcomes. 00:39:21.250 --> 00:39:23.590 A's got huge spreads in the possible outcomes. 00:39:23.590 --> 00:39:27.710 And we don't even know where the zero point is on that graph. 00:39:30.240 --> 00:39:33.000 So just looking at it, you'd say A is safer. 00:39:33.000 --> 00:39:34.860 That says, well, a nice measure might 00:39:34.860 --> 00:39:39.840 be the dispersion, the variance, the range, whatever-- 00:39:39.840 --> 00:39:40.980 not quite. 00:39:40.980 --> 00:39:43.425 So here's the basic story. 00:39:49.280 --> 00:39:53.540 I can't believe I set this to fly in, I hate that. 00:39:53.540 --> 00:39:57.070 It's distracting. 00:39:57.070 --> 00:40:04.360 It's easy to show that investors should always diversify. 00:40:04.360 --> 00:40:06.670 If you read anything about investment-- 00:40:06.670 --> 00:40:09.010 you can make it mathematical, but if you read anything 00:40:09.010 --> 00:40:14.150 about investment, it says you should diversify. 00:40:14.150 --> 00:40:14.650 OK. 00:40:14.650 --> 00:40:18.550 This was made very fancy in the '50s by Harry Markowitz. 00:40:18.550 --> 00:40:21.130 Second step, was Tobin-- 00:40:21.130 --> 00:40:23.410 Jim Tobin-- James Tobin-- let's be fair-- 00:40:23.410 --> 00:40:27.370 in the '60s, who said, well, if you have really 00:40:27.370 --> 00:40:31.000 well-functioning capital markets that every investor 00:40:31.000 --> 00:40:35.620 should hold some of all risky securities and then 00:40:35.620 --> 00:40:37.250 some safe security. 00:40:37.250 --> 00:40:39.460 So let's suppose I've got a bunch of risky stocks, 00:40:39.460 --> 00:40:42.530 let's say, and US government debt. 00:40:42.530 --> 00:40:44.960 Then everybody's portfolio should be composed 00:40:44.960 --> 00:40:46.610 of some of all the stocks-- 00:40:46.610 --> 00:40:49.250 that is, to say the market portfolio-- 00:40:49.250 --> 00:40:51.290 and then some government debt. 00:40:51.290 --> 00:40:53.450 And how much of each you hold would depend 00:40:53.450 --> 00:40:56.170 on your tolerance for risk. 00:40:56.170 --> 00:40:56.670 All right. 00:40:56.670 --> 00:41:00.750 So that says you want to think about-- again, everybody's 00:41:00.750 --> 00:41:02.550 efficient, everybody's optimizing, 00:41:02.550 --> 00:41:06.480 nobody listens to my broker, everybody's very efficient 00:41:06.480 --> 00:41:11.160 and holds the market portfolio, right? 00:41:11.160 --> 00:41:12.450 Some shares of each one. 00:41:12.450 --> 00:41:16.440 Now you can sort of do that, index funds come close. 00:41:16.440 --> 00:41:18.810 But of course, in theory, the market portfolio 00:41:18.810 --> 00:41:21.060 isn't just the stock market. 00:41:21.060 --> 00:41:24.000 It also would include real estate, and gold, and anything 00:41:24.000 --> 00:41:25.650 else you think of as an asset you 00:41:25.650 --> 00:41:28.060 might hold in your portfolio. 00:41:28.060 --> 00:41:31.510 But if you think about rational investors holding 00:41:31.510 --> 00:41:36.190 diversified portfolios, and the risky part of the portfolio 00:41:36.190 --> 00:41:40.550 having the same composition for everybody, 00:41:40.550 --> 00:41:45.530 then you would expect-- 00:41:45.530 --> 00:41:51.510 again, if you're dividing your holdings between government 00:41:51.510 --> 00:41:54.870 securities that are riskless, and a bunch of stocks 00:41:54.870 --> 00:41:58.170 and whatever else that's risky, the more 00:41:58.170 --> 00:42:02.070 you tilt toward that risky portfolio, 00:42:02.070 --> 00:42:04.860 you better get a higher expected return. 00:42:04.860 --> 00:42:07.680 You better have a higher average expected return 00:42:07.680 --> 00:42:10.660 to compensate for bearing the risk. 00:42:10.660 --> 00:42:12.690 So this was Sharpe-- 00:42:12.690 --> 00:42:15.000 and we'll jump to his answer. 00:42:15.000 --> 00:42:18.870 That's just a general statement of the expectation-- 00:42:18.870 --> 00:42:24.790 that the market portfolio, all the risky stuff, 00:42:24.790 --> 00:42:27.730 should yield a better return in expectation-- 00:42:27.730 --> 00:42:30.220 not every day, as we know. 00:42:30.220 --> 00:42:33.880 But in expectation, it better do better than government debt 00:42:33.880 --> 00:42:35.710 or why would you ever hold it? 00:42:35.710 --> 00:42:37.350 It's risky? 00:42:37.350 --> 00:42:41.400 So you would expect there to be a risk premium. 00:42:41.400 --> 00:42:51.030 What this goes to, if you think about this world in which 00:42:51.030 --> 00:42:55.230 people are holding mixtures of government securities and lots 00:42:55.230 --> 00:43:01.440 of risky stuff, then comes another asset. 00:43:01.440 --> 00:43:04.250 Is it risky or not? 00:43:04.250 --> 00:43:05.640 How do I think about its risk? 00:43:05.640 --> 00:43:07.880 Well, I think about its risk in terms of what 00:43:07.880 --> 00:43:10.230 it does to my portfolio. 00:43:10.230 --> 00:43:12.390 I don't care what it does by itself. 00:43:12.390 --> 00:43:14.130 I'm holding all these other assets 00:43:14.130 --> 00:43:16.950 because I'm a rational diversified investor. 00:43:16.950 --> 00:43:19.440 So what matters to me if I'm going 00:43:19.440 --> 00:43:23.370 to buy it is, what difference does it make to my portfolio 00:43:23.370 --> 00:43:26.490 before and after? 00:43:26.490 --> 00:43:30.030 That's not just a question of variance. 00:43:30.030 --> 00:43:32.790 That's a question of correlation. 00:43:32.790 --> 00:43:37.950 And the example here is a stock that moves against everything 00:43:37.950 --> 00:43:44.180 else, even if it moves a lot, can be a great thing to own. 00:43:44.180 --> 00:43:46.058 Because if I own some of this and something 00:43:46.058 --> 00:43:47.600 that moves in the opposite direction, 00:43:47.600 --> 00:43:49.880 I can construct a risk-free security. 00:43:49.880 --> 00:43:52.720 That's pretty good. 00:43:52.720 --> 00:43:56.350 So it doesn't matter that-- 00:43:56.350 --> 00:44:00.580 in this view of the world, what matters 00:44:00.580 --> 00:44:04.690 is how the returns on an asset, returns on a security, 00:44:04.690 --> 00:44:08.430 relate to the returns on everything else. 00:44:08.430 --> 00:44:11.780 Basically, that two-fund theorem says, 00:44:11.780 --> 00:44:15.380 you're going to hold something of everything else. 00:44:15.380 --> 00:44:17.990 That's going to be the risky part of your portfolio. 00:44:17.990 --> 00:44:19.430 That's going to move. 00:44:19.430 --> 00:44:23.180 And if I pick up another risky asset, 00:44:23.180 --> 00:44:27.080 what matters is, how does that affect the movement 00:44:27.080 --> 00:44:29.240 of that whole bundle? 00:44:29.240 --> 00:44:32.840 Which says that the picture I had before-- 00:44:32.840 --> 00:44:38.360 this one-- asks the wrong question. 00:44:38.360 --> 00:44:40.970 That just tells me maybe something about variance. 00:44:40.970 --> 00:44:42.920 It doesn't tell me anything about correlation. 00:44:46.790 --> 00:44:51.380 If the world consists of Apple stock-- 00:44:51.380 --> 00:44:56.300 blast-- if the world consists of US government debt and Apple 00:44:56.300 --> 00:45:01.860 stock, then the question of whether an oil well is risky 00:45:01.860 --> 00:45:05.310 or not is, does it move with Apple stock? 00:45:05.310 --> 00:45:07.530 Does it move against Apple stock? 00:45:07.530 --> 00:45:10.380 If it moves against Apple stock, I can reduce my risk. 00:45:10.380 --> 00:45:11.880 If it moves with Apple stock, I'll 00:45:11.880 --> 00:45:17.150 increase it by adding it to my portfolio. 00:45:17.150 --> 00:45:23.120 So that's the sort of key insight that-- 00:45:23.120 --> 00:45:26.120 now I made a lot-- there are a lot of assumptions floating 00:45:26.120 --> 00:45:28.790 around here, and I'm going to relax them orally 00:45:28.790 --> 00:45:29.970 in a little bit. 00:45:29.970 --> 00:45:38.990 I can't relax them mathematically and get done. 00:45:38.990 --> 00:45:41.480 But the assumption here is we're dealing 00:45:41.480 --> 00:45:44.900 with a world in which there are very few transactions costs, 00:45:44.900 --> 00:45:46.850 investors are behaving rationally, 00:45:46.850 --> 00:45:49.700 everything is smooth, it's a very competitive world-- 00:45:49.700 --> 00:45:53.210 in the financial market. 00:45:53.210 --> 00:45:56.120 That's probably wrong. 00:45:56.120 --> 00:45:59.690 But it's not clear where you would go from there to a better 00:45:59.690 --> 00:46:00.780 model. 00:46:00.780 --> 00:46:02.632 So let me not defend this model as truth, 00:46:02.632 --> 00:46:04.340 let me just defend this model is the best 00:46:04.340 --> 00:46:05.870 one we have at the moment. 00:46:05.870 --> 00:46:08.210 And it says to a reasonable approximation, 00:46:08.210 --> 00:46:09.980 smart people diversify. 00:46:09.980 --> 00:46:13.370 When smart people diversify, what matters isn't just, 00:46:13.370 --> 00:46:16.520 does it move, but what does it move with? 00:46:16.520 --> 00:46:20.530 So the Sharpe model has this implication-- 00:46:20.530 --> 00:46:21.030 oh, sorry. 00:46:21.030 --> 00:46:24.410 I need to go back to that last point. 00:46:24.410 --> 00:46:31.630 This is a very interesting point that comes out of this model. 00:46:31.630 --> 00:46:35.260 It says not only do I care-- 00:46:35.260 --> 00:46:41.200 if the world is a risk-less asset and Apple stock, 00:46:41.200 --> 00:46:46.790 comes another investment that has uncertain returns, if it 00:46:46.790 --> 00:46:49.910 moves with Apple stock, getting it would increase my risk. 00:46:49.910 --> 00:46:53.240 If it moves against Apple stock, getting it 00:46:53.240 --> 00:46:54.350 would decrease my risk. 00:46:54.350 --> 00:46:57.200 What if it's uncorrelated? 00:46:57.200 --> 00:46:59.930 What if it's uncorrelated with the other risk 00:46:59.930 --> 00:47:03.340 in the economy-- in that case, with the market? 00:47:03.340 --> 00:47:12.110 Well, if it's uncorrelated and it's on the market, 00:47:12.110 --> 00:47:15.000 everybody holds a little bit of it, 00:47:15.000 --> 00:47:19.302 it doesn't affect the movement of your portfolio much. 00:47:19.302 --> 00:47:20.760 I'm just going to have to let you-- 00:47:20.760 --> 00:47:22.920 you're going to have to take that one on faith. 00:47:22.920 --> 00:47:28.900 But risk uncorrelated with the market can be diversified away. 00:47:28.900 --> 00:47:32.020 It doesn't justify a risk premium 00:47:32.020 --> 00:47:35.920 in this world, where what matters is the portfolio. 00:47:35.920 --> 00:47:38.020 Holding it by itself would be risky. 00:47:38.020 --> 00:47:41.020 Holding a little piece of it, uncorrelated 00:47:41.020 --> 00:47:46.390 with anything else, turns out to have effectively 00:47:46.390 --> 00:47:49.640 zero impact on portfolio risk. 00:47:49.640 --> 00:47:51.430 So we talk about risk that's uncorrelated 00:47:51.430 --> 00:47:54.300 with the market as diversifiable. 00:47:54.300 --> 00:47:56.310 And it doesn't demand a risk premium-- 00:47:56.310 --> 00:47:57.602 in this world. 00:47:57.602 --> 00:48:00.060 I'll give you a little bit about another world in a minute. 00:48:00.060 --> 00:48:05.200 But in this world, it doesn't demand a risk premium. 00:48:05.200 --> 00:48:08.910 So we're flying along-- 00:48:08.910 --> 00:48:12.300 concepts, concepts, portfolio is what matters, 00:48:12.300 --> 00:48:14.190 correlations matter. 00:48:14.190 --> 00:48:21.210 This is Sharpe's model that, again, 00:48:21.210 --> 00:48:25.020 under reasonable assumptions widely used, 00:48:25.020 --> 00:48:27.270 if something has a zero-- 00:48:27.270 --> 00:48:31.620 it turns out the measure of risk now is beta. 00:48:31.620 --> 00:48:34.680 The whole market has a beta of 1 by definition, 00:48:34.680 --> 00:48:38.490 risk-free rate has a beta of zero because it doesn't move, 00:48:38.490 --> 00:48:40.512 it has no risk. 00:48:40.512 --> 00:48:41.970 Things that move against the market 00:48:41.970 --> 00:48:47.010 have negative betas, things that move toward the market-- 00:48:47.010 --> 00:48:50.370 with the market depending on the correlation and the movement, 00:48:50.370 --> 00:48:53.380 will have a positive beta. 00:48:53.380 --> 00:48:56.560 Beta is the measure of covariance 00:48:56.560 --> 00:49:01.140 is not quite right-- of covariance with the market. 00:49:01.140 --> 00:49:06.240 And higher beta securities have a higher required or expected 00:49:06.240 --> 00:49:09.530 return, higher beta assets. 00:49:09.530 --> 00:49:14.660 So an example-- this is the cost of equity for BP. 00:49:14.660 --> 00:49:15.811 It's an estimate. 00:49:18.400 --> 00:49:23.090 Basically, by definition, it got identically equal. 00:49:23.090 --> 00:49:27.580 By definition, the beta on the market as a whole is 1. 00:49:27.580 --> 00:49:30.670 It turns out that BP and other major oil 00:49:30.670 --> 00:49:35.440 producers are less risky in this regard than the average stock. 00:49:35.440 --> 00:49:37.930 Beta is 0.8 for BP. 00:49:37.930 --> 00:49:42.190 You can estimate it, and here would 00:49:42.190 --> 00:49:47.790 be an example of calculating the required-- or the opportunity 00:49:47.790 --> 00:49:51.540 cost for investments that look like BP's investments. 00:49:51.540 --> 00:49:56.080 So we look at what the market requires from BP. 00:49:56.080 --> 00:49:57.330 Well, we know it's beta. 00:49:57.330 --> 00:49:58.950 We can estimate that-- 00:49:58.950 --> 00:50:00.840 no point going into it here. 00:50:00.840 --> 00:50:04.750 Suppose the risk free rate is 3%. 00:50:04.750 --> 00:50:10.960 The market as a whole has a risk premium of 5.4%-- 00:50:10.960 --> 00:50:14.860 that, again, you can calculate-- that gives a cost of equity 00:50:14.860 --> 00:50:15.820 for BP-- 00:50:15.820 --> 00:50:19.300 opportunity cost-- of 7.3%. 00:50:19.300 --> 00:50:25.610 That's what investors would take to own BP stock in terms 00:50:25.610 --> 00:50:28.160 of expected return or another investment 00:50:28.160 --> 00:50:29.660 of comparable riskiness. 00:50:29.660 --> 00:50:33.140 Comparable riskiness-- beta 0.8. 00:50:33.140 --> 00:50:39.580 So the measure of riskiness becomes a simple number, beta. 00:50:39.580 --> 00:50:45.380 Now that's-- again, it's a simple model. 00:50:45.380 --> 00:50:48.620 I'm not expecting you to understand anything other 00:50:48.620 --> 00:50:50.780 than that beta involves not variance, 00:50:50.780 --> 00:50:53.660 but covariance and correlation-- it involves 00:50:53.660 --> 00:50:55.385 comovements with other assets. 00:50:58.520 --> 00:51:01.550 As I say, this is the opportunity cost 00:51:01.550 --> 00:51:05.510 of investing in projects is risky as BP. 00:51:05.510 --> 00:51:12.250 So if you-- are we semi-OK so far? 00:51:14.860 --> 00:51:16.090 The concept here. 00:51:16.090 --> 00:51:19.180 We're in a world where everybody diversifies, 00:51:19.180 --> 00:51:22.060 everybody diversifies as much as they can. 00:51:22.060 --> 00:51:23.650 It turns out the rational way to do 00:51:23.650 --> 00:51:26.350 that is for everybody to hold the same proportion 00:51:26.350 --> 00:51:28.500 of risky assets. 00:51:28.500 --> 00:51:33.560 So if you have two shares of Apple and one share of GM, 00:51:33.560 --> 00:51:37.760 I might have four shares of Apple and two shares of GM. 00:51:37.760 --> 00:51:39.350 But I don't reverse the proportions 00:51:39.350 --> 00:51:42.650 because we're both owning pieces of the market 00:51:42.650 --> 00:51:44.480 in the same percentage. 00:51:44.480 --> 00:51:46.340 And in that world, what matters is 00:51:46.340 --> 00:51:48.770 how things correlate with the market 00:51:48.770 --> 00:51:51.700 and also how big the moves are. 00:51:51.700 --> 00:51:53.560 And beta captures both of those. 00:51:53.560 --> 00:51:58.510 As that earlier slide says, it captures both the correlation 00:51:58.510 --> 00:51:59.440 and the volatility. 00:51:59.440 --> 00:52:02.830 It captures the correlation and the standard deviation 00:52:02.830 --> 00:52:04.670 of its own movements. 00:52:04.670 --> 00:52:09.520 So if we're going to do discounting, 00:52:09.520 --> 00:52:14.140 figure out what the cash flows are, probably 00:52:14.140 --> 00:52:15.633 use the expected cash flows. 00:52:15.633 --> 00:52:17.300 We might want to be conservative and use 00:52:17.300 --> 00:52:21.550 the lower bounds of revenues and upper bounds of costs, 00:52:21.550 --> 00:52:23.590 or be optimistic. 00:52:23.590 --> 00:52:26.320 Figure out how risky the thing is-- 00:52:26.320 --> 00:52:28.840 and frankly, this is very-- 00:52:28.840 --> 00:52:30.400 it's very easy for common stocks. 00:52:30.400 --> 00:52:33.640 It's a little harder for an investment project. 00:52:33.640 --> 00:52:38.530 If I say, well, I think this project has a beta of 0.8, 00:52:38.530 --> 00:52:40.870 how do I get there? 00:52:40.870 --> 00:52:47.080 You could see that the key thing that people usually 00:52:47.080 --> 00:52:54.870 do-- so this is the split of a particular project. 00:52:54.870 --> 00:52:58.890 The first thing you ask is, is the risk diversifiable or not? 00:52:58.890 --> 00:53:01.740 Is it correlated to a first approximation 00:53:01.740 --> 00:53:05.350 with movements in the rest of the economy or not? 00:53:05.350 --> 00:53:07.620 So there's some uncertainty. 00:53:07.620 --> 00:53:10.230 We're going to put in-- let's say it's a wind farm. 00:53:10.230 --> 00:53:13.060 We're going to build a wind farm. 00:53:13.060 --> 00:53:14.830 There is some uncertainty-- we've 00:53:14.830 --> 00:53:16.870 got the we've got the equipment under contract. 00:53:16.870 --> 00:53:18.847 There's uncertainty about how difficult it's 00:53:18.847 --> 00:53:21.430 going to be to put the thing in place, to do the installation, 00:53:21.430 --> 00:53:23.620 to do the construction. 00:53:23.620 --> 00:53:25.082 That's not going to be correlated 00:53:25.082 --> 00:53:26.290 with the rest of the economy. 00:53:26.290 --> 00:53:27.610 That's just local. 00:53:27.610 --> 00:53:28.660 That's a local risk. 00:53:28.660 --> 00:53:30.160 That's diversifiable. 00:53:30.160 --> 00:53:32.973 If I can get enough people to hold that risk, 00:53:32.973 --> 00:53:35.140 it's not going to matter to anybody because it's not 00:53:35.140 --> 00:53:37.420 going to move their portfolio. 00:53:37.420 --> 00:53:40.660 The wages I have to pay will be correlated 00:53:40.660 --> 00:53:42.410 with the rest of the economy. 00:53:42.410 --> 00:53:43.990 So if I haven't fixed wages and I 00:53:43.990 --> 00:53:48.280 haven't fixed prices for materials, then maybe that does 00:53:48.280 --> 00:53:50.800 need to be discounted because it is correlated. 00:53:50.800 --> 00:53:53.800 Again, it's diversifiable versus nondiversifiable. 00:53:53.800 --> 00:53:55.540 Is it correlated with the market, 00:53:55.540 --> 00:53:57.910 with the rest of the economy? 00:53:57.910 --> 00:54:02.088 Or is it just something random that's going to happen to me? 00:54:02.088 --> 00:54:03.880 I don't know the wind conditions very well, 00:54:03.880 --> 00:54:07.150 or the reservoir conditions, or a variety of things like that. 00:54:07.150 --> 00:54:10.300 Is that going to be correlated with the rest of the economy? 00:54:10.300 --> 00:54:12.230 Probably not. 00:54:12.230 --> 00:54:14.230 That's probably diversifiable risk, 00:54:14.230 --> 00:54:15.940 and I shouldn't worry about the beta 00:54:15.940 --> 00:54:18.070 because it's probably zero. 00:54:18.070 --> 00:54:22.190 It's not correlated with other things. 00:54:22.190 --> 00:54:25.550 Oh, how much am I going to get out in terms of kilowatt hours? 00:54:25.550 --> 00:54:26.542 The wind is uncertain. 00:54:26.542 --> 00:54:28.250 I don't know what my annual production is 00:54:28.250 --> 00:54:29.542 going to be from the wind farm. 00:54:29.542 --> 00:54:34.070 That's probably diversifiable. 00:54:34.070 --> 00:54:37.923 That is to say it, whether the wind blows or doesn't blow 00:54:37.923 --> 00:54:40.340 isn't going to be correlated with the rest of the economy, 00:54:40.340 --> 00:54:41.000 probably. 00:54:41.000 --> 00:54:42.860 Unless I have a long-term contract, 00:54:42.860 --> 00:54:46.970 the price at which I sell power will for sure 00:54:46.970 --> 00:54:49.900 be correlated with everything else. 00:54:49.900 --> 00:54:53.120 That's not diversifiable, right? 00:54:53.120 --> 00:54:55.130 The market moves up, the economy moves up, 00:54:55.130 --> 00:54:58.490 the wholesale price of electricity goes up. 00:54:58.490 --> 00:55:01.900 So that's going to have a significant beta. 00:55:01.900 --> 00:55:04.330 This other stuff, not so much, so I'm 00:55:04.330 --> 00:55:07.950 not going to worry too much about the risk. 00:55:07.950 --> 00:55:12.980 So I would treat the two differently. 00:55:12.980 --> 00:55:14.000 OK so far? 00:55:18.740 --> 00:55:25.850 Now-- let's do slightly different. 00:55:25.850 --> 00:55:28.480 There are different degrees when you're doing this exercise. 00:55:28.480 --> 00:55:31.810 We will see a cost-saving project on Wednesday. 00:55:31.810 --> 00:55:35.550 We'll do the spreadsheet. 00:55:35.550 --> 00:55:37.420 We won't come back to beta again, 00:55:37.420 --> 00:55:40.830 but you need to see it and hear it. 00:55:40.830 --> 00:55:44.160 We come back for a while, at least. 00:55:44.160 --> 00:55:48.480 That exercise, you will see it's done 00:55:48.480 --> 00:55:52.830 assuming there's a certain level of activity in the plant. 00:55:52.830 --> 00:55:56.490 Well, how else are you going to do it, really? 00:55:56.490 --> 00:55:58.888 You could simulate other levels of activity, 00:55:58.888 --> 00:56:00.930 but it's done in a pretty straightforward, pretty 00:56:00.930 --> 00:56:01.740 standard fashion. 00:56:04.950 --> 00:56:06.810 If you have the wind farm and you've 00:56:06.810 --> 00:56:13.436 presold the power, then, again, the revenue-- 00:56:13.436 --> 00:56:16.400 revenue's fixed. 00:56:16.400 --> 00:56:20.230 You don't need to discount the revenue to allow for risk. 00:56:20.230 --> 00:56:24.620 And the cost risks are probably diversifiable per the example 00:56:24.620 --> 00:56:25.120 I said. 00:56:25.120 --> 00:56:28.720 And you probably don't want to treat costs 00:56:28.720 --> 00:56:30.100 as a high beta item. 00:56:33.080 --> 00:56:35.222 Suppose you don't know the revenues. 00:56:35.222 --> 00:56:37.430 Suppose you're going to build a gas-fired power plant 00:56:37.430 --> 00:56:39.305 and you're going to sell into the New England 00:56:39.305 --> 00:56:41.060 wholesale market. 00:56:41.060 --> 00:56:44.593 Oh, well, now your revenues are definitely 00:56:44.593 --> 00:56:46.260 correlated with the rest of the economy. 00:56:46.260 --> 00:56:48.052 Your revenues will have a significant beta. 00:56:51.450 --> 00:56:54.760 Now suppose you're developing a new widget. 00:56:54.760 --> 00:57:00.746 Well, the game changes now completely, right? 00:57:00.746 --> 00:57:06.630 It's a new toy, it's a new video game, it is whatever it is. 00:57:06.630 --> 00:57:10.020 You worry much less-- and we'll get to this after vacation-- 00:57:10.020 --> 00:57:12.540 you worry much less about the beta 00:57:12.540 --> 00:57:15.060 on the revenue from your video game 00:57:15.060 --> 00:57:18.300 than on whether you're actually making something worth selling, 00:57:18.300 --> 00:57:23.070 and can you retain the value? 00:57:23.070 --> 00:57:27.060 Lots of great ideas do not enrich their owners. 00:57:27.060 --> 00:57:30.328 The person who invented the-- 00:57:30.328 --> 00:57:31.620 I always pronounce it "kor-ig". 00:57:31.620 --> 00:57:32.730 It's pronounced something differently. 00:57:32.730 --> 00:57:34.560 The little thing that you use to make 00:57:34.560 --> 00:57:37.530 bad coffee with the capsules-- 00:57:37.530 --> 00:57:40.310 made essentially nothing. 00:57:40.310 --> 00:57:45.160 So created value, didn't capture value. 00:57:45.160 --> 00:57:47.440 Then all of this stuff about beta, 00:57:47.440 --> 00:57:50.230 and discounting, and so on, takes a back seat 00:57:50.230 --> 00:57:53.920 to strategic considerations about, well, 00:57:53.920 --> 00:57:55.690 how to do I ensure I-- 00:57:55.690 --> 00:57:57.100 how do I ensure I sell something? 00:57:57.100 --> 00:57:58.970 How do I ensure I capture value? 00:57:58.970 --> 00:58:01.910 How do I ensure that my strategy makes sense? 00:58:01.910 --> 00:58:05.770 And finally, suppose you're a small business with limited 00:58:05.770 --> 00:58:06.850 capital market access. 00:58:06.850 --> 00:58:09.790 You can't do this borrowing, and lending, and raising money, 00:58:09.790 --> 00:58:12.180 and alternative investments. 00:58:12.180 --> 00:58:13.780 Do you know that first acronym? 00:58:13.780 --> 00:58:16.680 Has anybody ever heard it? 00:58:16.680 --> 00:58:19.500 This used to be the mantra of the former head 00:58:19.500 --> 00:58:21.660 of the Entrepreneurship Center here. 00:58:21.660 --> 00:58:25.110 And it's short for Cash Is More Important Than Your Mother. 00:58:28.890 --> 00:58:35.520 Which, for small businesses, is often true, right? 00:58:35.520 --> 00:58:37.890 We didn't talk about cash constraints in all this. 00:58:37.890 --> 00:58:40.270 We didn't talk about project size in any of this stuff 00:58:40.270 --> 00:58:40.770 I did. 00:58:40.770 --> 00:58:43.710 Take positive net present value projects, it's all swell. 00:58:43.710 --> 00:58:49.170 Well, that assumes you can basically diversify risk. 00:58:49.170 --> 00:58:51.420 It assumes you have access to the market. 00:58:51.420 --> 00:58:53.370 It assumes you can borrow and lend. 00:58:53.370 --> 00:58:57.090 It assumes if you have a bad day, you can get a loan. 00:58:57.090 --> 00:59:03.420 It assumes diversifiable zero beta risks don't matter really. 00:59:03.420 --> 00:59:07.530 If you're a small business, however, a zero beta risk 00:59:07.530 --> 00:59:09.720 can kill you, right? 00:59:09.720 --> 00:59:13.740 I mean, you're building this plant. 00:59:13.740 --> 00:59:15.192 The construction is uncertain. 00:59:15.192 --> 00:59:17.400 You don't know whether you're going to get it online. 00:59:17.400 --> 00:59:19.442 That's uncorrelated with the rest of the economy. 00:59:19.442 --> 00:59:22.240 But if it fails, you're done. 00:59:22.240 --> 00:59:29.020 So for small businesses with limited capital market access, 00:59:29.020 --> 00:59:32.080 all of this beta stuff is lovely. 00:59:32.080 --> 00:59:34.570 Large corporations do it, lots of companies do it, 00:59:34.570 --> 00:59:36.580 consultants do it. 00:59:36.580 --> 00:59:38.770 It's a lot of fun. 00:59:38.770 --> 00:59:40.713 If you're a small business, however, cash 00:59:40.713 --> 00:59:42.130 is more important-- well, not more 00:59:42.130 --> 00:59:45.160 important than your mother, but it's very important. 00:59:45.160 --> 00:59:50.260 And worrying about running out of it will dominate. 00:59:50.260 --> 00:59:52.330 And to say to a small business owner, 00:59:52.330 --> 00:59:56.770 well, it's true that you go broke if this thing fails, 00:59:56.770 --> 00:59:58.870 but that's a zero beta risk. 00:59:58.870 --> 01:00:01.240 It's not correlated with the rest of the economy. 01:00:01.240 --> 01:00:03.340 You shouldn't treat it as risky. 01:00:03.340 --> 01:00:04.990 That's nuts, right? 01:00:04.990 --> 01:00:10.630 So the story about beta and the appropriate measure of risk 01:00:10.630 --> 01:00:14.215 for which we have good theory applies to large-- 01:00:14.215 --> 01:00:16.540 it applies to ventures with capital market access, 01:00:16.540 --> 01:00:18.820 large or small. 01:00:18.820 --> 01:00:21.550 How you think about risk for a small business 01:00:21.550 --> 01:00:24.040 with limited or no capital market access 01:00:24.040 --> 01:00:26.260 really depends on the exact circumstances 01:00:26.260 --> 01:00:28.320 of the small business. 01:00:28.320 --> 01:00:32.580 If you've raised $1,000 from venture capital 01:00:32.580 --> 01:00:35.700 and you think it's going to take you 01:00:35.700 --> 01:00:39.450 $900 to bring the thing to market, 01:00:39.450 --> 01:00:42.960 you better get it to market for $900 or you 01:00:42.960 --> 01:00:47.040 either go broke or give away a large part of your ownership 01:00:47.040 --> 01:00:49.320 to raise additional money. 01:00:49.320 --> 01:00:50.910 So I just want-- 01:00:50.910 --> 01:00:54.360 I don't want anybody dealing with a small business 01:00:54.360 --> 01:00:56.280 to say, yes, but what really matters 01:00:56.280 --> 01:00:58.800 is diversifiable and not diversifiable risk. 01:00:58.800 --> 01:01:01.110 It does for a big company, it does for a company 01:01:01.110 --> 01:01:03.270 with capital market access. 01:01:03.270 --> 01:01:04.920 It's not the dominant consideration 01:01:04.920 --> 01:01:05.980 for a small business. 01:01:05.980 --> 01:01:09.210 And it's not the dominant consideration 01:01:09.210 --> 01:01:14.190 in evaluating a project that really is innovative 01:01:14.190 --> 01:01:17.760 because there the real question is, can I capture value? 01:01:17.760 --> 01:01:20.640 And that's a post-vacation question. 01:01:20.640 --> 01:01:23.070 So I'll take questions. 01:01:23.070 --> 01:01:27.960 Let me say a little bit about Wednesday. 01:01:27.960 --> 01:01:29.110 Wednesday's a case. 01:01:29.110 --> 01:01:32.680 We're going to spend almost all the time on the case. 01:01:32.680 --> 01:01:37.550 I hope you can get the spreadsheet down from Stellar. 01:01:37.550 --> 01:01:41.050 It involves an actual decision-- 01:01:41.050 --> 01:01:46.050 an engineer, a plant manager, finds a solution that 01:01:46.050 --> 01:01:48.060 will save energy, he thinks. 01:01:48.060 --> 01:01:49.950 Well, solution will save energy, the question 01:01:49.950 --> 01:01:51.960 is, is it a good investment? 01:01:51.960 --> 01:01:57.810 You will see a spreadsheet that lays out a net present value 01:01:57.810 --> 01:01:59.160 analysis. 01:01:59.160 --> 01:02:01.800 I invite you to look at that spreadsheet, 01:02:01.800 --> 01:02:04.290 look closely at the formulas. 01:02:04.290 --> 01:02:05.550 Is it right? 01:02:05.550 --> 01:02:06.990 Is the analysis right? 01:02:10.720 --> 01:02:13.668 Then the question is-- 01:02:13.668 --> 01:02:19.260 you will also see in the case a bunch of objections. 01:02:19.260 --> 01:02:23.160 I think the spreadsheet has mistakes. 01:02:23.160 --> 01:02:26.220 I think the spreadsheet fixed shows 01:02:26.220 --> 01:02:29.400 it to be a positive net present value investment. 01:02:29.400 --> 01:02:31.870 You will also see in the case-- 01:02:31.870 --> 01:02:35.040 so it's all the stuff we all like. 01:02:35.040 --> 01:02:38.500 It's an investment that will save energy, 01:02:38.500 --> 01:02:40.990 no animals will be harmed. 01:02:40.990 --> 01:02:43.570 They won't be venting steam into the environment. 01:02:43.570 --> 01:02:45.580 They won't have an icing problem. 01:02:45.580 --> 01:02:47.140 Life will be good. 01:02:47.140 --> 01:02:49.360 But there are a long list of objectors-- 01:02:49.360 --> 01:02:51.280 a long list of objections, and probably 01:02:51.280 --> 01:02:55.180 a long list of objectors, also. 01:02:55.180 --> 01:03:02.110 And read that and answer the question, given those concerns, 01:03:02.110 --> 01:03:03.670 what's he do? 01:03:03.670 --> 01:03:05.350 Here's a positive net present value 01:03:05.350 --> 01:03:06.847 investment in all probability. 01:03:06.847 --> 01:03:08.680 Again, we'll go through the spreadsheet just 01:03:08.680 --> 01:03:10.600 to see how it's done. 01:03:10.600 --> 01:03:12.370 It's a positive net present value 01:03:12.370 --> 01:03:14.200 investment that will save energy, 01:03:14.200 --> 01:03:16.300 be good for the environment-- 01:03:16.300 --> 01:03:21.090 more ducks, whatever-- but he may not get to do it. 01:03:21.090 --> 01:03:23.310 He may not-- and not because they 01:03:23.310 --> 01:03:26.100 don't have any capital in the bank, any cash in the bank. 01:03:26.100 --> 01:03:27.940 He may not get to do it. 01:03:27.940 --> 01:03:31.590 So think about what he should say. 01:03:31.590 --> 01:03:37.620 And think about how the firm from the top management 01:03:37.620 --> 01:03:41.130 might want to structure things so that projects 01:03:41.130 --> 01:03:43.200 like that don't get blocked. 01:03:43.200 --> 01:03:44.190 So take a look at that. 01:03:44.190 --> 01:03:46.440 And let me take questions for a few minutes. 01:03:46.440 --> 01:03:49.260 And again, I'll let you go-- let you go early. 01:03:49.260 --> 01:03:50.070 Yes? 01:03:50.070 --> 01:03:50.695 AUDIENCE: Yeah. 01:03:50.695 --> 01:03:52.290 Related to this, when people talk 01:03:52.290 --> 01:03:55.540 about having compensation for executives 01:03:55.540 --> 01:04:01.200 and people on the board be based on like a risk-adjusted income? 01:04:01.200 --> 01:04:04.945 Would that be based on nondiversifiable risk as well, 01:04:04.945 --> 01:04:05.445 or? 01:04:07.885 --> 01:04:08.760 I mean, that's like-- 01:04:08.760 --> 01:04:12.030 RICHARD SCHMALENSEE: Well, they don't do formal adjustments. 01:04:12.030 --> 01:04:14.280 When people talk about compensation 01:04:14.280 --> 01:04:18.030 to try to avoid a focus on today's share price, 01:04:18.030 --> 01:04:20.610 they usually do things like, OK, we'll compensate you 01:04:20.610 --> 01:04:22.080 in stock options. 01:04:22.080 --> 01:04:26.400 But you can't cash the options until five years 01:04:26.400 --> 01:04:29.020 after you've left the company. 01:04:29.020 --> 01:04:32.910 Things like that to say the stock price 01:04:32.910 --> 01:04:35.550 is $100 today, that's great. 01:04:35.550 --> 01:04:37.530 What we care about isn't what it is tomorrow, 01:04:37.530 --> 01:04:40.230 we care about what it is in five years. 01:04:40.230 --> 01:04:43.530 So we want to take away from you the incentive 01:04:43.530 --> 01:04:47.700 to boost profits today if it's going to hurt profits tomorrow. 01:04:47.700 --> 01:04:50.460 So it's not a matter of risk-adjusted compensation. 01:04:50.460 --> 01:04:53.490 It's a matter from the point of view of the top executives 01:04:53.490 --> 01:04:56.970 to give them incentives not to add to risk, right? 01:04:56.970 --> 01:04:59.820 I mean, one of the issues with all the investment banks 01:04:59.820 --> 01:05:09.170 was if there is no downside-- 01:05:09.170 --> 01:05:12.450 right-- you take a huge position, 01:05:12.450 --> 01:05:14.970 that position comes through, you make a lot of money, 01:05:14.970 --> 01:05:16.230 you get a lot of profits. 01:05:16.230 --> 01:05:18.330 That position doesn't come through, they fire you. 01:05:18.330 --> 01:05:19.950 OK, you go to another company. 01:05:19.950 --> 01:05:21.480 Well, that's not a great-- 01:05:21.480 --> 01:05:23.370 that's not a great model. 01:05:23.370 --> 01:05:25.050 The idea is we ought to compensate 01:05:25.050 --> 01:05:28.080 you based on performance over time, not on performance 01:05:28.080 --> 01:05:33.180 last week because if the worst outcome is you lose the company 01:05:33.180 --> 01:05:35.310 a billion dollars, you get fired, 01:05:35.310 --> 01:05:36.750 you go to another company-- 01:05:36.750 --> 01:05:38.883 where you do it again. 01:05:38.883 --> 01:05:41.050 So they want to-- you want to give people incentives 01:05:41.050 --> 01:05:43.630 not to put companies at risk. 01:05:43.630 --> 01:05:45.970 You want to give executives incentives 01:05:45.970 --> 01:05:49.150 not just to think about the short term. 01:05:49.150 --> 01:05:50.525 It's a difficult matter. 01:05:50.525 --> 01:05:52.400 We will talk a little bit about compensation, 01:05:52.400 --> 01:05:55.960 but I will say, one of my favorite sayings from Jack 01:05:55.960 --> 01:05:58.900 Welch when he taught here was any fool can 01:05:58.900 --> 01:06:02.640 manage for the short term only. 01:06:02.640 --> 01:06:06.030 And it's also true that any fool can manage for the long term 01:06:06.030 --> 01:06:07.650 only. 01:06:07.650 --> 01:06:11.000 The difficulty is balance. 01:06:11.000 --> 01:06:11.750 Anything else? 01:06:11.750 --> 01:06:14.440 That's the wisdom for today. 01:06:14.440 --> 01:06:16.390 Yeah, Julien. 01:06:16.390 --> 01:06:18.325 AUDIENCE: If there's like net market growth, 01:06:18.325 --> 01:06:22.930 [INAUDIBLE] is for an entire market normalized for 1. 01:06:22.930 --> 01:06:24.560 RICHARD SCHMALENSEE: Yeah. 01:06:24.560 --> 01:06:26.630 Yeah. 01:06:26.630 --> 01:06:31.100 Because remember, in a well-diversified-- 01:06:31.100 --> 01:06:35.110 if you are well-diversified, you own a piece of everything. 01:06:35.110 --> 01:06:36.310 That's the best you can do. 01:06:36.310 --> 01:06:40.660 You could hold less of that risky stuff. 01:06:40.660 --> 01:06:43.270 But the best you can do in terms of holding risky stuff 01:06:43.270 --> 01:06:45.860 is to hold a little bit of everything. 01:06:45.860 --> 01:06:49.095 And if you do that, then the risky part of your portfolio 01:06:49.095 --> 01:06:50.470 moves up and down with the market 01:06:50.470 --> 01:06:52.540 by definition because you're holding it, 01:06:52.540 --> 01:06:58.450 so you normalize that to 1 and the riskless part doesn't move, 01:06:58.450 --> 01:07:00.760 so that's zero. 01:07:00.760 --> 01:07:03.580 You could normalize it to 16.7 if you wanted to, 01:07:03.580 --> 01:07:06.520 but normalizing it to 1 is the simplest thing. 01:07:06.520 --> 01:07:09.760 And then intermediate-- then mixtures of the two 01:07:09.760 --> 01:07:12.800 will have values between zero and 1. 01:07:12.800 --> 01:07:13.790 Yeah. 01:07:13.790 --> 01:07:18.780 I mean, the 1's the normalization, zero is natural. 01:07:18.780 --> 01:07:20.430 Anything else? 01:07:20.430 --> 01:07:22.590 Deep philosophical questions? 01:07:22.590 --> 01:07:26.590 I will need to talk more slowly in the future. 01:07:26.590 --> 01:07:27.420 And I will do that. 01:07:27.420 --> 01:07:28.720 But I'm done. 01:07:28.720 --> 01:07:30.470 Thank you.