An almost-intentionally ambiguous term used a lot in economics is ‘Value’. Another is seen as the opposite of value, ‘Cost’, but I’ll get to that on Wednesday. One way that value could be defined is, via Behavioral Economics, the amount of utility than an object gives you. If you find an old book that cost you five bucks twenty years ago in your attic, you might sell it on Amazon for five dollars. If you find the same old book and it turns out to be written by a distinguished but minimally-publicized author (read: his books are popular and rare), you might sell it at auction for $10,000. If the author was your dear grandfather, whom you fondly remember, it might not be worth it to sell it at any price. The point of this exercise is that value is as connected to external context as it is to implicit worth of the object. Some things are hard to put a price on for this reason…
But let’s ignore ALL OF THAT for now.
Economics wouldn’t exist if objective, agreed-upon values for at least some things didn’t exist. In fact, economies wouldn’t exist in their current states if people couldn’t at least agree that a green piece of paper with special ink and markings on it and a picture of some dead guys face was $1 (that concept is called ‘fiat currency’, but I’ll save that for another post). But, here’s where things get a little tricky, Back-to-the-Future style (spoiler alert, it’s kinda time-travel-ish). $1 today is not the same as $1 tomorrow. Right now, $1 is worth $1, and by the time tomorrow arrives, $1 will be worth $1 again. But today, you can’t count tomorrow’s dollar the same as today’s (unless you work for Enron). It has to do with an accounting concept called ‘Net Present Value’.
It boils down to how likely you are to actually obtain tomorrow’s $1. If your unreliable friend promises to give you $1 tomorrow if you lend him $1 today, this deal isn’t a good idea (no matter how many times he asks, UNLESS getting him to shut up will make you $1 of utility happier – careful though, you’ll only encourage him). Potentially, even if he offers to give you $5 WHOLE AMERICAN DOLLARS tomorrow, if you think there is less than a 20% (1/5th) chance he’ll pay you back, it STILL isn’t a good idea.
- Basic Math Time (liberal arts majors, feel free to ignore)
- $1 Today = 1.
- $1 Tomorrow = 20% * 1 = 0.2
- 1 > 0.2 (a.k.a. just hold on to your dollar)
’20%’ is the ‘Discount Factor’. ’0.2′ is the ‘Expected Return’. This is where ambiguity manages to work its way into an otherwise perfectly math-based definition. People disagree on the appropriate discount factor for various things. For example, a common discount factor on loans to startup companies is 50% (which, relative to other common investments, is ENORMOUS). This means that for banks to take on the risk of lending to a startup, the startup has to promise to pay back the loan double.
But if your startup can’t get an investment THAT way, you can try selling the rare and valuable book your dear grandpappy wrote. Just don’t sell it to your friend.