Financial Mathematics Text

Tuesday, March 26, 2013

Adam Smith on Equilibrium

The neoclassical conception of "equilibrium" is actually somewhat different than Adam Smith's characterization. In spite of that, neoclassical reasoning often (implicitly) assumes that their equilibrium  has the same implications as Adam Smith's. I would like to briefly describe Adam Smith's notion of equilibrium and would suggest that his notion is far more useful than the neoclassical market clearing equilibrium.

In  An Inquiry into the Nature and Cause of the Wealth of Nations (or simply Wealth of Nations),  Smith described two kinds of prices for commodities. This is all laid out in Chapter VII of Book I. Smith described the Natural Price and the Market Price of commodities. I will begin by looking at the latter as it's the closest concept to the current neoclassical understanding of equilibrium.

Friday, March 22, 2013

Competitive Advantage Types

Economic models often posit the existence of "perfect competition". But in the real world, companies are often able to establish a solid competitive advantage over other companies. This enables them to either be able to charge a higher price than competitors without significantly harming or sales, or it allows them to have lower costs thereby earning them higher profits by charging the same price (or a lower price to compete out competition).

In markets that exhibit "perfect competition", these advantages should be short lived. But in reality, many persist over long periods of time.

The key metrics to look at here are return on capital and cost of capital.  In perfectly competitive markets the two are equal. But sometimes a company can earn a higher return on capital than their cost. If this persists for a long time, it's an indication of a competitive advantage.

In Valuation: Measuring and Managing the Value of Companies, the authors (Koller, Goedhart and Wessels) list a large number of types of competitive advantages. I will reproduce the list here.

Sunday, March 17, 2013

On the Subject Matter of Philosophy

Most disciplines have a very specific, known (and in some cases quite narrow) subject matter. The subject matter of the discipline specifies a domain over which research might take place. For biology, for example, the Greek origins of the term suggest the domain of study is life. Psychology is the study of the mind.

While it's not always the case we can define clear-cut boundaries, there are definite subject matters which we can point and say "that's a question that the psychologists should investigate".

This raises the question of what counts as the genuine subject matter of philosophy. In a broad sense, the term philosophy means "love of wisdom". It seems to encompass all that might be learned or discovered. For example, in its early stages, physics was often referred to as "natural philosophy".

While I am very much sympathetic to this idea, in practice, philosophers have tried to separate their discipline from other disciplines. So what is it that makes philosophy a unique discipline?

Sunday, March 10, 2013

The Dollar is an Excellent Store of Value

To start off, I don't believe the title of this blog, at least not in the usual sense of how the dollar is defined. I would like to suggest, however, that the dollar has been, historically speaking, a good store of value. Whether or not it will do be so in the future is anyone's guess.

If you've ever had the "privilege"  of reading an economics textbook, it will give you a functional definition of money - money is defined in terms its functions. For example, according to the wikipedia article on money, money serves the following four functions:
  1. Medium of Exchange
  2. Unit of Account
  3. Store of Value
  4. Standard of Deferred Payment
The article notes that many economics texts do not list "standard of deferred payment", instead, treating it as parts of the other functions.

As far as the dollar is concerned, it's frequently acknowledged to satisfy 1, 2 an 4 but not 3.  I can use dollars to make all sorts of purchases (medium of exchange), all of the goods and services and debts are denominated in dollars (unit of account) and all of my debts can be dispelled by the use of dollars as a result of legal tender laws (standard of deferred payment).

But regarding store of value, the dollar has not served so well. As I illustrated in Figure 2 from my blog on Currency and Price Stability (reproduced here), the dollar has lost a significant amount of purchasing power over the years.