Monday, July 24, 2017

Making and Taking - Part 2 - Examples

Part 1 showed how to decompose a favorable transaction into a taking part and a making part, using a plot on what we can call a "payoff plane."

But why single out this particular decomposition out of the many possible ways to dissect such a transaction?  Sure, the word "taking" may evoke the intrigue of moral judgment, or an opposite reaction to justify taking, but beyond such emotional reactions is there any rational, objective reason to pay special attention to the taking / making decomposition?  Yes there is.  If your way of understanding material well-being doesn't start the way finance does, by drawing that boundary around the individual or other entity, or if, for instance, you're considering global customs, international law, or ideas that have global influence, then the distinction between making and taking is a crucial one, and here's why.  If a rule or idea influences people to take more, what is the net benefit to our global material well-being?  Zero.  On a global scale, we gain nothing and lose nothing when one entity takes from another.  But a rule or idea or anything that influences people to make more has a positive impact, because every single act of making more material well-being contributes to our global material well-being.

A variety of metrics for comparing alternatives can be derived from the payoff plane, one of which is defined as the benefit to self + the benefit to others.  We can call this metric the "making metric" or synonymously, "value creation."

Let's look at some example situations that illustrate the difference between evaluating according to today's financial conventions and evaluating according to this unconventional making metric.  But before we do that, I'm going to take another crack at the difference between assets and material well-being - which I downplayed in part 1, but I'll insist on making the distinction here, because the two ideas (viz the making metric and material well-being) reinforce each other, and because the distinction will affect the axes of the payoff plane and greatly enhance the illustrative power of the upcoming examples.

On the one hand we have "asset," which is an additive attribute of items that are assigned to an entity through the artificial relationship of ownership.  On the other hand we have "well-being," with synonyms like contentment, health, happiness, and more generally, good condition.  Material well-being is access to goods and services that contribute to good condition.  Unlike the idea of asset, material well-being cannot be exactly divided and accounted for among the whole set of goods and services a person has access to, but that's not to say it can't be understood quantitatively.  If a certain material condition is given as a premise, then the singular contribution of any one good or service either added to or removed from that condition can be evaluated and quantitatively compared to other goods or services.  The financial value of an asset is based on how much it can fetch in trade in a market, whereas the well-being value of a good or service is based on how much the condition of a life is improved.

For clarity, in upcoming graphs where I'm plotting gains in financial assets, I'll label axes in the positive direction with the word "acquisition," and where I'm plotting well-being, I'll use "benefit."

Now we're ready for some example situations.

The first example I'll call "barter."  In this example, two people willingly swap one good for another.  Let's say a shepherd gives a farmer a fleece in exchange for wheat.  It may happen that the market value of the fleece is equal to the market value of the wheat, in which case, from a financial perspective, this trade has zero effect on either party.  In that case, the barter is neutral (no financial change - that is, no change in net worth) to both parties.  In this case, the one-dimensional plot of the financial effect on the shepherd looks just like that for the farmer:

Namely, it shows zero net effect.

But what do we see on the payoff plane when we plot material well-being and use the metric of making?  Now instead of the trade value of assets, we're talking about the effect of goods on the parties' material well-being.  Because the shepherd has more fleeces than he can use, but he doesn't have much wheat to eat, this trade has a positive effect on his material well-being.  And because the farmer has more wheat than she can eat, but she doesn't have enough wool to make the new clothes she needs, this trade also has a positive effect on her material well-being.  The plot (two-dimensional this time) of the effect for the shepherd looks roughly like that for the farmer:

So in the first example, the financial effect (for either party) is zero (neutral), but the creation of value (which is by definition the same for both parties) is positive (beneficial).  Let's look at an example where the contrast between these two perspectives (the perspective of financial assets vs that of material well-being) is even greater.

I'll call the second example "bad loan" after the toxic mortgage loans that led to the housing bubble of 2008 and consequent foreclosures.  Let's consider the effect of one of these loans on a decision-maker - let's say a CEO of a lender whose practice was to sell sub-prime mortgages, pay for favorable securities ratings, and then package and sell the mortgages to investors as low-risk, high yield investments.  Financially, this is a win for the lender, which gives the CEO a bigger bonus, so it's a win for the CEO.

In terms of value creation, this transaction scores the CEO some bonus money, which marginally (because he has no shortage of money to start with) improves his material well-being.  It negatively affects the investor who buys the mortgage, which is later defaulted.  It has an even larger negative effect on the borrower, who loses his house in a foreclosure.

So in the second example, the financial effect for the CEO is positive (beneficial), but the making value is negative (harmful).

The last example I'll call "freecycle" after the internet service that helps people give away unwanted stuff.  In this example, a gardener has removed a walkway of pavers, maybe to make room for a new garden plot.  The gardener has an asset - a stack of pavers - that she gives away to someone else who wants them.  Financially, this is a loss for the gardener.

But because the pavers weren't contributing to the gardener's well-being - in fact, because they took up space, they were diminishing her well-being - and because the new owner had a use for them, this is a gain for both parties in terms of material well-being.

So in the last example, the financial effect for the gardener is negative (harmful), but the value creation is positive (beneficial).

In the next post on this topic, I should talk about the inverses of taking and making, show a more detailed and comprehensive breakdown of the regions of the payoff plane, introduce some other metrics that suggest themselves (besides value creation, which is the making metric), and explain more what this has to do with sustainability.

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