Playing with house money

September 9, 2010 by
Filed under: Economics 

A post by my buddy American Manifesto about ObamaCare has worked me to sputtering rage before my trip to the gym, and I feel the need to respond.

I don’t want to get into the ObamaCare thing.  Whether you think it is a Good Thing, or a Bad Thing is, strictly speaking, not really germane to my point.  What I want to do is talk a little bit about business, and why it is that government mandates always raise prices.

As regular readers know, I recently completed an MBA.  Simply put, I have a masters degree in taking piles of money, and converting them into larger piles of money.  That is all a business, any business, does.  They go about it in many different ways, with different strategies (or “business models”) but at the end of the day, that is all they do.  Take money pile A, and make it into larger money pile B.

Now, consistent with the goal of making their money pile bigger, they have two sub goals:

  1. Make the pile as big as possible, as quickly as possible, with as little friction as possible.
  2. Minimize the possibility that the pile will not get as big as they expected, or heaven forbid, even get smaller.

These truths are universal, whether you are talking about a behemoth like Microsoft or GM, or your local mom-and-pop business.  We call the first sub-goal “profit” or “return”.  We call the second “risk”.  Every business wants to maximize return and minimize risk.  And as they decide on their strategy for making their money pile bigger, or business model, they form it around their expectations of return, and their tolerance for risk.

To use examples to illustrate the point, at one extreme a business could take all their assets and put them into low yield Treasury bonds.  Historically, these bonds are considered perfectly safe in that they guarantee a set rate of return with no possibility of default*.  Very low risk, very low return.  At the other extreme, we might invest our assets in a roll of the Roulette wheel, betting all on black.  A possibility that we will instantly double our money, but an equally even possibility that we will loose it all.  Very high return, very high risk.

Which is the better strategy?  There is math behind this, but accept for the sake of argument that the answer is it doesn’t matter.  An investor doesn’t care about risk versus reward as long as they are getting the right return for the risk that they are taking.  In other words, our hypothetical investor doesn’t care about the roulette wheel, as long as his upside is 100% return.  (And considering the number of people who flock to Vegas regularly, there is observational evidence that this is true.)

OK, what happens if the casino owners decide that instead of returning 100%  on black, they will only return a profit of 75%.  The risk/reward calculation has changed.  Our investor isn’t being compensated for his risk.  So, he picks up his chips and goes to another table, or calls his broker and buys some T-bills.

Back to our business.  Our business owner is making decisions that are no different from that of our gambler in Vegas.  He has to decide how to make his money pile bigger, while avoiding the possibility that it will get smaller.  In order to do this, he formulates a plan:  “I’ll take $1,000 out of the bank and use it to build a churro stand at the street fair.  After all my expenses, I can make 1000 churros, sell them for $2.00 each and make a cool $1,000!”  The potential upside of $1,000 is enough to get our investor out of bed early in the morning on Saturday, and to accept the fact that he may not sell 1000 Churros.  He may only sell 500 and will be eating Churros for dinner for the next few weeks.

What happens when the street fair commission decides to impose a $.50 cent per churro tax at the fair?  Our businessman has a problem.  He can eat the tax, and only accept that he can only make $500 selling churros at the street fair.  But that presents him with a problem.  It’s a real pain in the ass getting up at the crack of dawn.  And he HATES eating the leftover churros.  It’s not worth his time and effort any more if he is going to make a lousy $500.  The reward isn’t worth the risk.  So, he has two choices.  He can raise his price to $2.50, thus bringing his risk and reward back into balance.  Or he can say “screw it” and either exit the marketplace or invest his $1,000 somewhere else that will give him the proper return.

One more wrinkle, and then we will get to insurance.  Suppose instead of selling the churros himself, our hero decides to just give some money to someone else to do it?  He could invest his $1,000 in his neighbor’s churro stand, for example.  His neighbor says he will split the profits with him.  A $1,000 investment now gets him $500 return, and without all the fuss and bother of having to get up early and eat left over churros.  Pretty sweet.  But oh noes, the commission comes up with their churro tax!

Now the neighbor has a problem.  He can go back to his investor and say “Sorry, dude, I can only get you a $250 return on your money.”  But then the investor will probably pull his funding and invest his other neighbor’s deep-fried Oreo stand instead, where his $1,000 still gets him the expected $500 return.  He can eat the tax himself, returning the full $500 to his investor.  But this leaves no profit for him.  Or he can pass along the cost to the consumer, keeping his investor happy, and keeping himself properly compensated for his own risk and effort.

This is precisely what happens in the real world.  When government mandates, or taxes, or regulatory items come down from on high, it alters the risk/reward calculation that businesses go through.  A business is faced with the same basic choices:

  1. Accept a lower profit potential.  Without a corresponding change in risk, investors will transfer their capital to businesses offer better returns.  Put simply, if you have a choice of two investments, A and B that are identical in every way, and both return 10%, where do you put your money?  Now what happens when A’s return drops to 5% and B still returns 10%, where do you put your money?  This is a key point. Businesses do not have this option in the real world.
  2. Raise prices to maintain profits at the level necessary to bring things back into balance.  This is the only choice that a business can make and remain a going concern.  This is why we say there is no such thing as a tax on a corporation.  Taxes on corporations are born by either the customers of the corporation, or the investors of the corporation.

Which, finally, brings us back to health insurance.  ObamaCare mandates that certain things must be covered.  Put another way, they must accept that the cost of providing insurance has gone up; services that they didn’t use to have to pay for are now covered.  The insurance businesses can either raise prices or go out of business.  Those are the only two options.  And at the end of they day, that is what a lot of folks who advocate for more mandates and more government intervention forget.  Businesses always have the option of closing up shop.

*(I say historically…the discussion of whether or not this will be true going forward is best kept for another time.)

Tags:

Comments

5 Comments on Playing with house money

  1. Dod on Thu, 9th Sep 2010 10:39 am

    2. Oh dear. Sorry to do that to your blood pressure.

    Great points. Don’t forget the third group that pays “business taxes” – the employees.

    I should probably mention at this point that I am essentially training to take your pile of money and make it my pile of money. Thanks for making your pile bigger first. :-)

  2. George on Thu, 9th Sep 2010 6:44 pm

    3. I can’t recommend that. We’ve got all the guns! Oh wait…you do, too. Damn!

  3. Dod on Thu, 9th Sep 2010 9:17 pm

    4. All your money are belong to us.

  4. On risk : Newbie Shooter on Fri, 10th Sep 2010 10:18 am

    5. [...] because he does a much better job than I, in a nutshell, he makes a similar point to the one that I did yesterday:  government regulation slows down the pace of innovation, and can even stop it all together. [...]

  5. It begins : Newbie Shooter on Wed, 22nd Sep 2010 7:42 am

    6. [...] made rather the same point, about what happens when you make companies sell products that they can’t make money on.  [...]

Tell me what you're thinking...
and oh, if you want a pic to show with your comment, go get a gravatar!