Valuation

Or why are vacuum cleaners so expensive? (More on this later.)

Economists like to say that the value of a widget is the price on the market. For instance, when Nomura paid $100 million for a 20 percent stake in Wasserstein-Perella in 1988 it put the value of Wasserstein-Perella at $500 million. At the same time there is also the concept of willingness-to-pay so that if I were willing to pay $5 for a widget but the market clearing price is $2 then my consumer surplus is $3.

I take this as valuation using the market price is not always the best measure of the value of something. For the same reason, if I had to pay the market price for something even though it is not the amount I would like to pay then the valuation via market prices is not the best measure either. For instance, if I were interested in buying a piece of art and I had not bought art before the price I encounter for the first time would be meaningless. I would ridicule the idea of paying $50,000 for a few splotches of paint.

I could of course, investigate the art market and look at returns over time - but then I would be viewing art as an investment not as a pure purchase. Thus, the willingness-to-pay concept, is closer to what I think as valuation. How much do I value it? Yet, willingness-to-pay without actually having paid it is also meaningless. I could just as easily say that I am willing to pay $100 million to preserve biodiversity but the fact that I don't have $100 million makes this statement totally vacuous. This is even more true for the piece of art since it is the first time I am paying for it. And for goods which are unique, valuations are very difficult. I really really want it is as good a valuation as any because it conveys the fact that I am willing to pay a lot for it.

Since valuation is such a big business and such a slippery concept, I suspect that the numbers that consultants trot out at the end of the day are nothing more than educated guesses with wide margins of error. Even though acquirers of companies use these numbers and actually pay for these companies (of course, it's not really their money), these valuations I also suspect are pretty meaningless. Perhaps the acquiring CEO is overcome by the fact that he really really wants it more than anything else and the numbers are used to justify why he wants it.

When we purchased our house, it was listed as $350K. We ended up paying $335K for it. The bank sent some one over to value the house and lo and behold, it was valued at $335K. If we had paid $350K for it, I suspect the valuation would have been $350K. This example is not merely just to expose what a scam real estate valuations are but the entire field of valuation. Valuations are nothing more than a justification for an action that has already been taken. If the number had come in over the price we paid for the house then the bank would have been guilty of losing money on the deal. It should take the money itself, buy the house and sell it for the higher value. If the valuation had come in lower than the purchase price the bank would have been guilt of giving out a bad loan.

Unfortunately, valuations form the basis of every financial transaction and there is no way around this sordid mess. Of course, valuations can differ (and they do change over time - I may not want it as much tomorrow), and would be acquirers can be persuaded to change their minds after looking at the numbers but if he really really wants it then these numbers can also be changed to justify the acquisition.

I come through this thought via a very circuituous route - we are considering remodeling a room and although at the end of the day we are paying the price quoted (after due diligence of obtaining several quotes) it is till above what I am willing to pay. At the end of the day I am looking at it from an investment angle - that it would increase the value of the house although I am not positive it will.

P.S. Why are vacuum cleaners so expensive anyways? It is nothing more than a motor that sucks and they retail for around $200. Is the $200 model really that much better than a $400 model? I paid $300 for one and it was not what I would value the vacuum cleaner.

P.P.S. When I bought the diamond engagement ring I was guaranteed that the valuation would be over what I paid for it (and it was). I suppose this is to make me feel better.

Obama bumper stickers

A little late but these keep popping up - which ones are made up?
Asian Americans for Obama
Women for Obama
Lawyers for Obama
Librarians for Obama

What if I were an Asian American Female Lawyer Librarian and voted for McCain?

Economics as a science

Or rather, what is a science? There has been much ink spilled over whether economics constitutes a science but - what does it mean to be a science? There are natural sciences (mechanical/engineering and natural/geology), biological (e.g. medicine) and social sciences (in which economics claims to be "higher ranked" than sociology). What claims do some or all of these fields have on what it means to be a science?

Is medicine more scientific than economics? Watching "House" one would not think so - diagnostic medicine seems to be more trial and error and method of elimination and less scientific than one would be comfortable with. Yet some would agree that medicine is more scientific than economics. Why? Because at the end of the day someone is cured, a diseased is eradicated, or a cause is found via blood tests and other diagnostic tools. In economics, causality is as elusive as the natural experiment or instrumental variable that can be found - which is to say not very often.

What about engineering? Is predicting loads that a bridge can withstand more scientific than predicting GDP the next quarter? Without a doubt, yes. What about the safety of a bridge 30 or even 100 years from the day it was built? Perhaps it may not be possible to be absolutely positive that the bridge will withstand the stress of loads over this perod but then again, engineering is more of a science because there is less error in making these predictions than in economics (plus the bridge can be over-engineered).

What about natural science e.g. physics? For instance, we observe an apple falling and attribute this to an unseen force called gravity. In the same way we observe stock markets rising and falling and attribute this to an unseen force called "animal spirits" or "fundamentals". Yet, why is gravity more credible a force than animal spirits or fundaments? Perhaps because gravity is predictable. We can posit an equation which will predict the consequence without exception. (QED not withstanding.)

So what makes a science:
1. Causality
2. Predictability
3. Equations

Health care demand

Via Mankiw, the above chart is used to make the following claim:

The accompanying chart shows why we have a health care cost problem. Patients have little direct connection in paying for their care. Their role has fallen significantly. Meanwhile, the government's involvement has grown, as has that of the insurance industry.

Because so many Americans rely on an insurance policy or a government program to pay their health care bills, the internal governors that temper the rest of their purchases are turned off. When a visit to the doctor's office or a diagnostic test costs them a mere $10 or $20 co-payment out of pocket — or there is no charge at all — cost has little impact on their decision to see a doctor.

"By not knowing the full costs associated with health care, consumers demand more and 'overuse' it," Kenneth E. Thorpe explained a few years back in Health Affairs.

Americans would be more judicious in seeking health care — they would self-ration — if the right incentives were in place. An effective way to cut overuse and bring down costs would be to encourage through public policy the use of health savings accounts. If consumers used HSAs to pay the full amount for medical care at the point of service rather than letting employer-funded insurance or a government program pay the bills, the demand would fall.

There several issues that come to mind here:

1) If it were not profitable for the insurance companies to offer fixed co-payments then they would not do so. If we believe in the market then we should let insurance companies set the benefits: copayments and deductibles.

2) It is also true that perhaps the insurance companies are succumbing to political pressure to provide cheap medical care. If this were true then we would see insurance companies going out of business or withdrawing from the health insurance market over time. This is not happening (yet).

3) The reason why insurance companies offer these low copayments is to actually encourage the user to use health services. Why? Because if they do not and consumers postpone seeing the doctor the eventual cost of health may be larger than if they had seeked medical help early. There is no hard evidence of this (for now) except that since insurance companies are offering the low copayments then this is one rationale for them doing so.

4) For the same reason, HSAs will not work if instead of using the savings for routine medical care (e.g. checkups) consumers simply use it to avoid taxes and postpone health investments.

5) Economists may argue that insurance is just that - insurance. It should be used for something as predictable as annual physicals or dental care. These expenses ought to come out of the consumers pockets. This savings motive will also raise the personal saving rate of the economy as a whole. However, it is also true that some people tend to underestimate risks just as there are some who overestimate risks. The former group will postpone getting regular care until it becomes too late in which case the costs to the insurer may be high. On the other hand (as usual) there are those who go to the doctor for every possible scratch or itch.

How should we as a society balance these two forces? For those who believe in the market, we would let the market decide? Some insurers may opt to cover routine care and some may not. Eventualy, the weakest insurer will be weeded out. But this method may continue to increase health care costs overall.

If HSAs were mandated (would they?) and deducted the way Social Security contributions are held in a government entity and routine medical care was also mandated (so that a proportion of the savings are "confiscated" if not used for routine care - use it or lose it) then there may be some hope of containing health care costs via HSAs.

On a personal note I have noticed the following:

1) There were at least 2 occasions that had we not had insurance we would not have gone to the doctor for our kids. Once when there was an eye complaint and another was when there was a fever and in both occasions I would simply have waited. There was no harm to waiting (ex post since the doctor confirmed nothing serious) but it could have been possible that there was something serious.

2) However, even with insurance my last physical was about 4 years ago.

Back to the Chesapeake

We decided to reprise last year's stay at the Hyatt Chesapeake - arrived the day before Christmas Eve and left on Christmas Day. Was pleasantly surprised to get a room that had been refurbished. New carpets and wood floors at the entrance to the room were very nice. As always the food at Water's Edge Grill was good. This year we went to the Blue Point Provision Company at the marina which also had pretty good food. Service was spotty - they got our drink order wrong once and charged us for it. But it all evened out since they forgot to charge us for one kid's breakfast.

Was surprised to find more people arriving on Christmas Eve and Christmas Day. I guess folks aren't as traditional as I thought they would be. Even though it was busier than the last time we were here it wasn't as bad as it could have been when were here years ago during Spring Break and the summer.

Digging out from the snow storm of 2009

We're finally all dug out from the great storm. We managed to get out yesterday for some doctor and dental appointments. Most of Saturday and Sunday was spent shovelling to try to stay ahead of the storm. Reminder to self: Never shovel the sidewalk until the ploughs have gone through. Note to neighbors: Shovelling the sidewalk is only useful if everyone does it.

At least M got to take the kids out sledding - it would have been awful if they had spent the time at home waiting for moi to finish clearing out the snow. As it was they found the zest to pitch in as well.

Speculations of the future

1. What Battling Spacecraft will look like (HT: MR)
2. Disappearance of currency
All transactions would be made with POS or cell phones, backed by interest-bearing assets, in one form or another. You might think that's unlikely today but it's at least possible in the future. In any case, it's a thought experiment.

In this world there would no longer be a trade-off between currency and interest-bearing assets, as we find in traditional Keynesian models. There would be no substitution out of one and into the other and there would be no swapping of currency for interest-bearing assets.

What would the macroeconomics of this world be like? Would the AD curve slope upwards? Would increases in employment be contractionary? No and no. It would only be slightly different from our current world, a point Kroszner and I made in our book Explorations in the New Monetary Economics. It just doesn't matter that much if you pay for your retail transactions by leaving a five on the counter or by using a credit or debit card backed by interest-bearing assets.

3. Krugman - Stross interview - This was an interesting pairing - perhaps because in his younger days Paul Krugman contemplated about The Theory of Interstellar Trade? Sci-fi author Stross had some interesting insights:

CS: I think things have changed a lot in the last 30 years, but not in the direction that somebody 30 years ago would have expected. The 20th Century, and going back to the 19th Century, the real visible vector of change technologically was transportation speeds. ....

PK: ... What you came out believing if you went to the New York’s World Fair in 1964 was that we were going to have this enormously enhanced mastery of the physical universe. That we were going to have undersea cities and supersonic transports everywhere. And there hasn’t been that kind of dramatic change. ... My favorite test, which shows something about me, is the kitchen. If you walked into a kitchen from the 1950’s it would look a little pokey, but you’d know what to do. It wouldn’t be that difficult. If someone from the 1950’s walked into a kitchen from 1909 they’d be pretty unhappy – they might just be able to manage. If someone from 1909 went to one from 1859, you would actually be hopeless. The big change was really between 1840 and the 1920’s, in terms of what the physical nature of modern life is like. There’s been nothing like that since. So we can do fancy information searches in a way that no one envisioned 30 years ago – as one of my colleagues at the Times, Gail Collins, likes to say all the time where are the flying cars?

CS: Yeah, where is my food pill, where are my jetpacks. .... I think that what has been happening rather than progress continuing and accelerating in a visible direction that everybody’s expected from 1960, we’ve seen immense progress in other directions and the effects are not immediately obvious because they take time to sink in. ... It’s not a great cognitive leap from aeroplanes capable of carrying loads to bombers. It’s a hell of a leap from idea of getting a cheap camera chip and adding it to a mobile phone and coming up with a phenomenon of “Happy Slapping”. I don’t know if everyone knows what Happy Slapping is, it isn’t Slapping, and it isn’t Happy, but its where kids basically find some random stranger beat them up while one of their friends videos it with their camera and then upload it to YouTube. As social phenomenon go, that’s not one you can predict from the input technology. That’s a second order effect. ...

CS: Actually, if I had to make a guess at one of the major things that’s going to affect us in the next 20 years … periodically, I keep hearing about peak oil and the long emergency that’s going to come … and it’s going to be very, very grim … and how our food travels an average of a couple of thousand miles between where its produced and where we consume it. I have a slightly different way of looking at this. We’re going to come to the end of cheap energy not because energy is going to be innately expensive because we’ve used all the oil up, but because we can’t afford to keep pumping more carbon into the air. Now we’ll be able to actually maintain an oil-based economy indefinitely. My betting is on Craig Venter, the guy who founded Celera Genomics tried to bootstrap a private enterprise genome program. His current venture with Shell is to try and crack the problem of producing diesel oil using genetically produced algae. And they’re throwing large amounts of money at this problem. I would reckon in 50, 60 years time Shell will still be selling you oil. It won’t be oil they’ve pumped out of the ground, though, it will be oil they’ve synthesized using atmospheric carbon, so it will be carbon neutral. That’s a whole lot cheaper than switching to a hydrogen economy because you don’t have to scrap all of your plant and tankage, just keep using the same stuff. But going a step further, there’s a huge inefficiency in these hub and spoke models of distribution and shipping stuff long distances. If you can produce stuff locally, and distribute it locally, that gives you a huge advantage. I think one of the things logistics is going to … well, computers are going to give us, is much tauter supply chains between production and consumption.

PK: That’s by the way one of the mysteries … we don’t quite know why there’s so much stuff being shipped long distances, …