Wednesday, November 16, 2011

The Purpose of Corporations II

Every once in a while I get a comment that can be used as a teaching tool. Here is a comment I received on my post on “The Purpose of Corporations.” It may be crossing the line of proper etiquette, but I could not help myself. I have basically gone line-by-line examining the comment. The comment is in red and my responses are below them.

I can't believe a supposed doctor wrote this.

Starting an anonymous response with an attack like this is always a sign of class.

It's so woefully shortsighted and is pretty much everything wrong about the modern economy.

Then I hope that you clearly explain how shortsightedness creates an error that encompasses the whole of the modern economy.

Is the system working as you describe right now? A resounding NO!

Actually, I agree that the current system is not working as I described it. I described how a system would work in a free market. We do not live in a free market. We live in a world permeated with government rules and regulations that tip the scales in favor of some at the expense of others. I am very much in favor in getting rid of the government’s ability to intervene in the economy. Please join me in rejecting crony capitalism and crony socialism. No more bail-outs for businesses. And no bail-outs for students either.

Profits are being made with no real resource being managed.

What does this mean? Why is a real resource needed to gain a profit? The problem with this point is the word “real,” meaning that there is a dividing line between the tangible and intangible, where only the tangible matters. This idea of an objective value is simple-minded. Providing information can be a very profitable business. Education might be considered to be a business in which no real resource is being managed, so does this mean that there are no gains to education? (Remember: Profits are the surplus of the gains over opportunity costs.)

It's profit being made off of profit itself, leeching away the value of real labor resources from the working classes. That's the problem!

The idea that value comes from the labor of the working classes is clearly a labor theory of value reference. While this theory has been smashed time and again, it keeps coming back in different incarnations--like a bad zombie film. Value does not stem from any class nor does it stem from the time or effort of the labor involved. To say otherwise is to say that the amount of time working is directly related with value or the amount of effort has a direct relationship with value. (“Directly related” in this sense means the opposite of “inversely related.”) In other words, my anonymous friend is saying that the longer one works, the more valuable the output. A watch that has 1,000 labor hours is twice as valuable as a watch made with 500 labor hours. Or “he” is saying that a watch made with twice the effort is twice as valuable as another watch.

Of course, both of these propositions are ridiculous. My students earn their grade based upon the correctness of the answer and nothing else. If one student studies twice as long or works twice as hard has no bearing on the grade received. All that matters is what is put on the answer sheet. The same is true when it comes to goods and services. It does not matter if one producer worked twice as long or twice as hard as another. All that matters is the judgment of the consumer. The value of the good is a product of the consumer’s mind and nothing else. If the consumer values the good at $5, then he will be willing to pay up to $5 for it. If the consumer values the good at $0, then the amount of time and effort of the producer is irrelevant. It is all wasted.

Prices do not simply function as pieces of information, they are extremely powerful implements of social control.

“Implements of social control?” In a sense, yes of course they are. They signal to any one who wishes to use a resource its relative scarcity. It allows the user to calculate the opportunity cost of using that resource. When the price rises, it tells the users of such resources that the resource in question is more scarce. It gets users of the resource to reduce their use, conserve. The least important uses of the resource are dispensed with first. It gets users to look for substitutes. It is in this sense that prices “control” society. But in saying this it is no more control than a red stop light saying, “Stop.” If the entrepreneur ignores the price signals, he will be out of business. If I ignore the red stop light, I will likely get into a car accident.

If fact, prices are such important signals that without them very little economic calculation could be done. Society could not exist without prices. Indeed, prices are what allow societies to exist. So I suppose that in this sense, there could be no “social” to control without prices.

Who is the consumer in a stock transaction?

The buyer of the share of stock.

The answer today is really no one, there is no person deriving use from a good that is sold. The primary "use" of stocks today is as placeholders of value -- their prices.

The owner of the share derives a dividend, a portion of the profit generated by the company serving its customers. The cash flow, the dividend, is the benefit of the stock and is the reason for its ownership. The cash flow is the return on the money saved. The money saved was invested into the company. The company combines resources to serve customers. The extent to which people trade with the company is a reflection of how well it is combining resources to meet consumers’ needs, wants and desires. And not just random or trivial needs, wants and desires, but the most intense needs, wants and desires first. The value of the company is reflected in the stock, the equity. Call it a “placeholder” if you want, it does not change its nature as the reflection of how well a specific group of people are pleasing customers.

How then does a "good" get priced when its value is its price? The answer is that it cannot be priced in any way that is beneficial to an economy, by any system that makes any sense.

Again this is naïve. Here is a quick lesson in Corporate Finance…. A firm looks into the future and must project what it will do to combine resources to meet future needs, wants and desires of its customers. It creates a pro forma statement. It looks at the projected revenues and the projected costs. It creates a projection of cash flows occurring in future periods. Then it uses its opportunity cost, the Weighted Average Cost of Capital (WACC) to discount all of those future cash flows to the present. Then it subtracts the upfront costs of the endeavor. This process yields a Net Present Value (NPV) of the project. If the NPV is positive, the endeavor should be undertaken. If the NPV is negative, the firm looks for something else. The greater the NPV, the more valuable is the company’s endeavor. As the company announces its future plans, the eyes of the world evaluate the firm’s decision. If they agree that this project adds value (or more precisely will add value) to the firm, then this increase in value is reflected in the share price of the firm. Bad decisions (in the eyes of the market) lower the price of the company. The benefit of these capital markets is merely the efficient allocation scarce resources to good decision makers and away from bad decision makers. Without profit and loss, without economic calculation, without the ability to value projects and companies, there is no ability to efficiently allocate scarce resources. The opposite of the stock market is evaluating which is a better user of resources: the DMV, the Post Office, or the Judicial System? There is no method to know. But I can easily tell you which for-profit company is a better user of resources. And I can do it at a glance. We can’t even come close with bureaucracies.

This is how the global financial system has essentially turned into a gigantic casino game. And that is not good at ALL.

The idea that the financial world is the same as a casino game is an argument by analogy and wrong on its face. There is no house. When I win a chip, someone must lose a chip. It’s all just random luck based upon probabilities. Apple Inc. was not random chance. Successful corporations are not just random luck based upon probabilities. Creating a successful company is hard work and long hours. It is being “others focused.”

You have to know what will please your customers and then constantly strive to please them. And customers are fickle. They don’t tell that they are coming to your store in advance. They just show up and you have to be ready. They don’t tell you what they are looking for, but you had better have it on your shelves. They don’t tell you what they think is a good price, but if you don’t meet their price, they walk out without a word. Running a business is hard. Being successful is harder. Going global, that’s mindboggling!

And yet, we take it for granted. I expect to walk into a Walmart at 2am in the middle of rural North Carolina and buy Kiwi 3/$1! How insane is that? We need to take the time and marvel at this economic system, which has built the highest standard of living ever known in the last 5,000 years of recorded human history. Before we tear it down and decry the free market and the role of corporations, we had better take a very close look at what it is that we intend to do away with. I absolutely know that if we tear down the market economy, we sentence ourselves to a life of future poverty. I cannot and will not sentence my children to that fate.


Nathan said...

I appreciate this, Dr. Cwik. In particular, I like the way you wrote that a person must be "others-focused" in order to be rewarded by others in the market. A mutual coincidence of wants: that's the market. You put the emphasis on the right syllable: cooperation, not competition. Though both are important and occur in the market, cooperation had to have come first in establishing free exchange and is far more prevalent in everyday life. Unfortunately, Gordon Gekko and other Hollywood caricatures belie this otherwise overwhelmingly obvious reality.

Post a Comment