tag:blogger.com,1999:blog-8133337349608142588.post3316170799443535591..comments2020-06-04T22:44:43.082-07:00Comments on Fresh Economic Thinking: Why is return-seeking optimal?Cameron Murrayhttp://www.blogger.com/profile/08737859133901303110noreply@blogger.comBlogger2125tag:blogger.com,1999:blog-8133337349608142588.post-81674495429790562292014-01-27T20:17:46.154-08:002014-01-27T20:17:46.154-08:00"And, BTW, I'm not trolling. OK, maybe a ..."And, BTW, I'm not trolling. OK, maybe a little. "<br /><br />You do have a reputation. <br /><br />"But I think these are legitimate comments that you could get from any mainstream economist."<br /><br />You'd be surprised at the often conflicting comments from the mainstream. We've had everything from "We know this already its standard theory", to "It's complete rubbish". So it's getting hard to really take anyone seriously. <br /><br />To address your general point. <br />p104 of D&P (We are in discussions with Pindyck at the moment about the connection between return-seeking and value maximisation. We hope it turns out to be fruitful). <br /><br />"The point (which I tried to get across previously) is that in your model, different choices of "q" correspond to mutually exclusive projects (if I choose scale q1, I cannot choose scale q2), with incomparable cash-flows."<br /><br />Yes, different "q"s are mutually exclusive projects. I'm not sure how it can be otherwise (I choose both q1 and q2?)<br /><br />The story I have in mind is this. Imagine that every dollar you spend as a firm comes from a different investor. You keep expanding output, increasing costs by adding investors (who share profits in proportion to their contribution). You do this only if the overall rate of return on the total costs is increasing. Once you hit that maximum rate of return, adding additional investors to cover greater costs reduces both profits and returns, and hence the value of a share, for existing investors. <br /><br />For a numerical example, if 10 investors pay $1 each to earn a 20% return, or $2 profits in a period, they should not expand output by adding an 11th investor to cover the extra dollar in costs if it generates less that $2.20 in profits, or a 20% return on costs. Say this 11th investor increases profit by $0.10, overall firm profits per period are up, but profit per investor is now $0.19 instead of $0.20. <br /><br />Is that clear?<br /><br />I will look at the papers you cite. <br />Cameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-28381857793817417082014-01-27T11:26:53.739-08:002014-01-27T11:26:53.739-08:00"Dixit and Pindyck showed [...] that the valu..."Dixit and Pindyck showed [...] that the value-maximising strategy of the firm is to jointly maximise 1) their current profit, and 2) the rate of change in firm value. As time reaches its infinitesimal limit the flow off current profits is zero and firms simply maximise the rate of change of firm value over time."<br /><br />Could you perhaps provide more precise reference (which part of Dixit-Pindyck book)? Because I don't think that's how continuous-time optimization works - if firm's objective is to maximize its value, Hamilton-Jacobi-Bellman equation will include both terms with value function and instantaneous profit flow.<br /><br />"When a firm is assessing a new investment of any kind, they will commit to it when the maximum rate of return exceeds their hurdle rate."<br /><br />Indeed. That however doesn't imply that, conditional on project being started, they choose return-maximizing scale. You seem to have in mind a situation where the firm has a list of projects, ranks them by IRR and approves each whose rate of return passes the hurdle rate (so in some sense, it maximizes return). The point (which I tried to get across previously) is that in your model, different choices of "q" correspond to mutually exclusive projects (if I choose scale q1, I cannot choose scale q2), with incomparable cash-flows. In such case, every corporate finance textbook tells you that looking just at IRR is problematic, and NPV is more suitable criterion. <br /><br />"Traditional economic analysis has no agreed method for dealing with the process of capital investment - either capital is fixed, or it has already perfectly adjusted to the ‘long run’."<br /><br />Depends on the meaning of "agreed", but no - of course people have studied dynamic of investment at length. Look up e.g. Abel & Eberly (1994) AER paper for a general model of firm's investment choice, or Caballero chapter in Handbook of Macroeconomics for more general survey.<br /><br />And, BTW, I'm not trolling. OK, maybe a little. But I think these are legitimate comments that you could get from any mainstream economist.ivansmlhttps://www.blogger.com/profile/00955626621561436702noreply@blogger.com