Free Lunches, Portfolio Allocation, and Equity Premia: Part 1
TANSTAAFL. There Ain’t No Such Thing as a Free Lunch. Someone pays, somehow. The standard textbook example is pilots who refill their plane at a gas station that offers them a “free” steak dinner while charging five cents a gallon more than another station at the same airport. The pilot and co-pilot get $50 dinners for free, the gas station gets an “extra” $150 for the gas sold, and everyone is happy.
I believe this story is better at explaining the Money Multiplier effect than cui bono-ing the transaction. The restaurant might not exist without the cross-subsidy. The pilots spend their “spare” cash on other things. The owners of the gas station and restaurant have a more positive cash flow than they would have otherwise and therefore pay better and/or invest more. That’s a much more relatable story than “the pilots just cost each passenger on their 300-person plane an extra 50 cents per ticket.”
When economists talk about the impossibility of a free lunch, they’re generally starting from “even without transaction costs, there are Search Costs (i.e., addition effort required).” The cheaper gas station costs you in driving distance and longer lines. (This does not apply to airplanes.)
The Exception to Prove the Rule?
But there is one area where, apparently, the Lunch is Free. Rajnish Mehra and the late Ned Prescott published The Equity Premium: A Puzzle in 1985, discovering a possible “free lunch”–a risk-adjusted excess return provided by the Equity Capital Markets over U.S. Treasuries. (Treasuries are risk-free by definition, if you assume the Government uses its ability to tax to pay its debt.) To quote the first line of the Abstract:
Restrictions that a class of general equilibrium models place upon the average returns of equity and Treasury bills are found to be strongly violated by the U.S. data in the 1889-1978 period
What a nice present. One should never look a gift horse in the mouth, since you may find a Trojan there.
Next post: just a quick glance…for Lucas’s sake, if nothing else.
No such thing as a free lunch
In physics, it’s the 2ns Law of Thermodynamics. There’s no getting around it.
Dobbs
yes about the universe and all that. i’m not so sure about the 2nd law. No getting around it apparently, but does that bear directly on the free lunch problem? certainly the gas was free..in the sense that the labor costs of extracting it (less if you can manage effective slave wages) is less than the labor costs of building a pyramid without it.
looks to me like someone’s getting something free anyway.
but it does point me to my two favorite subjects. first is the cost of fighting global warming: certainly less than the cost of not fighting it. but that is then and this is now, so we know what people will do.
second is the cost of paying for social security…which is the same as the cost of all your lunches after you can no longer work. and it is the same whether you pay for it, your kids pay for it, the government pays for it or the rich pay for it.
having what you think is the kids paying for it is simply the most efficient way to get you to pay for it. having the government pay for it is simply a way for you to fool yourself into thinking you don’t pay for it. your taxes will go up, and you won’t even own your future lunch. if government giveth, government can taketh away. and if you can force the rich to pay for it, the rich will own it and will take it away one bite at a time, but meanwhile your prices will go up and your wages go down.
okay..say the kids pay for it; if you save your money under the mattress you withdraw your money from the economy. that is the same as losing it (for a time0. you get nothing from it. the economy gets nothing from it.
then years later when you can’t work and take your money out from under the mattress…you buy things with it and the kids cannot have the things you buy…chicken does not store in the refrigerator as well as money under the mattress. the cost of your lunch to the economy (the still working young) is exactly the same as if they were paying for it…or are paying for their own future lunch by storing their money under a safer mattress (called FICA). now that looks to me more like the First Law than the Second.
Of course all these things can be argued the other way around, depending on your appetite for fooling yourself…or fooling others.
those arguments about the cost of driving around town looking for cheaper gas are not quite specious… i know people who do it… but they have a kind of “i just made this up” feel to them. a lack of precise prices..economy wide… makes the argument either problematic arithmetic-wise, or tautological economy wise*. maybe a little like the “technical adjustment of cost of living adjustment” that assures us substituting chiken for steak proves the cost of living has not gone up.
you won’t know what I am talking about unless you have paid attention to these things for a longish period of time. [i.e. see the Boskin Report].
*tautological: in the case of the pilots’ lunch, they are fooling themselves thinking it is free. but in the case of the economy at large, we of course make trade off;s between what we buy and what we then can’t buy. but it is not certain that we are fooling ourselves or that Sombody isn’t getting a free lunch out of the deal. if you look at the big white spaces on the supply and demand curves, you will see that at every price level there are people who would have paid more and people who would have accepted less, so everyone’s getting a bargain except those few right at the “price” line.
or take the case of the poor parents who buy an encyclopedia. they defintiely do without something to afford it. but the kids don’t get smarter, the salesman gets ulcers, and the publisher gets a free lunch selling aproduct that is about as useful as a Rolex… or a BMW.
No process is entirely efficient. There is always lost energy.
But sometimes this seems irrelevant. Hydroelectric power. Geothermal power. Solar power. To name a few. TANSTAAFL is a metaphor really. But physicists really stand by the 2nd law of thermo as inviolable. Economics is the physics of the social sciences.
Is Economics the “Physics of Social Sciences”?
With ‘superconductivity’, there seem to be instances of ‘no lost energy’.
Is Economics the “Physics of Social Sciences”?
Oh, God no, Economics is the Religion of people who believe in Money. But it likes to play the Physics of Social Science on Television, having recruited a lot of otherwise unemployed physics majors to supply the numbers. But in the Physics of physics, the numbers have to mean something.
Has the First Law been repealed?
There are actually four laws of thermodynamics. (Starting with the ‘zeroth’.) None have been, or ever will be repealed. They are baked into the deepest principles of physics.
Thermo was a one semester mandatory senior year course from the physics department at RPI. The point seemed to be ‘you are not leaving here without this course under your belt,’ I had one friend who failed the final exam and was required to keep taking it (the exam) until he passed it. He managed to do so.