Thinking about Marginal Effects: A Key Concept
One of our most intelligent investors, Paul, may also be the best informed. A successful entrepreneur, he is semi-retired and able to devote significant time to market research. He reads extensively from various market newsletters, blogs, and investment pundits.
Paul often asks questions about pundits who point out some problem in the market and then suggest an effect. In crafting our answer to this very astute investor, we realized a key factor in evaluating various predictions: Thinking about marginal effects. This approach usually distinguishes between pundits who use economic analysis and those who do not.
The non-economic pundit sees the development of some market threat (or opportunity–it could and has worked both ways), reasons out the likely direction of the effect, and makes a prediction. The prediction often is in near-binary fashion. Things used to be good. Now they will be bad. Quantitative analysis is stated in absolute terms.
The economist approaches the problem differently. There is a recognition that effects are scaled and related to the behavior in relevant markets. There is a disciplined effort to make quantitative estimates.
It is always easier to see abstract situations with some concrete examples. Consider the following:
- There are X million homes for sale. The normal annual run rate of sales is Y. It will take X/Y years to work off the inventory.
- The marginal analysis quickly shows the error. If the prices of the homes for sale dropped dramatically, buyers would emerge, including those buying for a speculative rebound. Supply and demand is not fixed, but rather a function of price.
- The market will clear as homebuilders drop prices, existing homeowners lower prices or drop out of the market, and new buyers emerge at the lower price.
- How much will prices fall? No one knows. It is not a static situation at the old run rate.
- Mortgage requirements tighten. Everyone knows that qualifications were too loose — sub-prime, Alt-A – so the putative demand for housing has been reduced. In a "back of the envelope" calculation, the pundit concludes that these buyers are eliminated.
- The marginal analysis again shows the error. Buyers are not eliminated. They can still qualify, but they need more documentation and may qualify only for a smaller mortgage. The demand curve has shifted. How much does it shift? No one knows, but it is not an absolute amount where all such buyers are completely disqualified.
- The unemployment rate is low and the labor force is shrinking. This either means that government data are wrong, or wages should be spiraling out of control.
- The marginal analysis shows the problem with this analysis. The labor force is dynamic, responding to incentives and opportunities. Young people choose work, school, travel, or the military. Older people choose to retire, work part-time, or consult. Potential immigrants choose to seek opportunity or stay in their home countries. What will happen to the labor force and the unemployment rate? No one knows for sure. The market will clear when opportunities attract potential workers from other choices. (More detailed comment here.)
Economic effects are not binary. Since so many pundits portray consequences in this way, there is an easy opportunity for the knowledgeable investor. The contrarian view is to reject punditry that forecasts the maximum possible impact. As the situation plays out, the extent of the effect will become clear. A good prediction is that it will be significantly smaller than the worst-case projections of a binary approach.
We have taken only three current examples, but such issues are commonplace. This is a time when economic issues are extremely important to the fundamentals of future earnings and market valuation. A little knowledge and insight can go a long way.