No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Sixteen: Valuing the Future - Concepts in Capital & Finance 406 participants. How does this work? Let’s say that Samsung comes up with a revolutionary new phone that amazes consumers. As the phone starts flying off the shelves at Best Buy and off the virtual shelves at Amazon, Samsung’s profits rise dramatically. Millions of investors seeking only their own personal gain quickly sell shares of less highly valued firms and bid up the shares of Samsung. In the minds of investors, the expected future cash flows from equation 4 have risen, increasing the present value of a share of Samsung’s stock. Samsung’s stock price will be bid up by the new speculative purchasers until the share price equals the social valuation as determined by the combined expectations of millions of market participants (see the “Making a Market” example). Other astute investors will also begin anticipating firms that may be able to successfully duplicate Samsung’s consumer experience in their products—thus the market allocates capital from less promising ventures toward more promising ventures. Others will begin bidding up shares of Samsung’s supply chain, since those companies likewise will benefit from expanded demand of Samsung phones. The market process thus steers capital away from firms that are less successful in meeting consumer demands, and into the hands of those more successful. Just as prices in goods and services markets serve as information to help guide production and consumption decisions, so also do profits and losses (communicated through the discounting process of present value calculations into a stock’s price) guide allocation of capital decisions. The information role of profits and losses should not be missed: should there be distortions in the price signals in stock markets, we will see capital misallocation. From a social perspective, capital will be allocated towards less highly valued social uses (as socially valued by consumers). How does that happen? Remember our discussion of public choice economics? We may find special interests that successfully obtain government sinecures (benefits) through their rent seeking activities. For example, if farmers are able to get Congress to pass a law mandating corn ethanol in every gallon of gas, there will be increased profits in growing corn and more farmers will expand production in corn. Of course, given that we live in a world of scarcity, every acre of expanded corn production is less acreage available for other agricultural products. If President Obama successfully pushes a green energy initiative, investors will expect higher profits in those firms producing politically desired outputs (as opposed to consumer desired outputs), and will bid up share prices of green energy companies. This capital will come from other firms—firms that may be meeting consumer demand rather than political demand. Shares of stock ownership, since they represent ownership of a fraction of the company, entitle an owner of the share to that fraction of any upside in profits. If profits of a company double, owners have a right to a doubling of any yield on their investment (should the company choose to disburse the extra profits to shareholders via a dividend). But the flip side of the coin is that owners of a stock also bear the brunt of any losses; profits are certainly not guaranteed, and common stock owners have the last claim on profits. In other words, the stockholder only gets anything after everybody else has been