Increasing returns and the new world of business

Our understanding of how markets and businesses operate was passed down to us more than a century ago by English economist Alfred Marshall. It is based on the assumption of diminishing returns: products or companies that get ahead in a market eventually run into limitations so that a predictable equilibrium of prices and market shares is reached. The theory was valid for the bulk-processing, smokestack economy of Marshall's day. But in this century, Western economies have gone from processing resources to processing information, from the application of raw energy to the application of ideas. The mechanisms that determine economic behavior have also shifted--from diminishing returns to increasing returns. Increasing returns are the tendency for that which is ahead to get further ahead and for that which is losing advantage to lose further advantage. If a product gets ahead, increasing returns can magnify the advantage, and the product can go on to lock in the market. Mechanisms of increasing returns exist alongside those of diminishing returns in all industries. But, in general, diminishing returns hold sway in the traditional, resource-processing industries. Increasing returns reign in the newer, knowledge-based industries. Modern economies have split into two interrelated worlds of business corresponding to the two types of returns. The two worlds have different economics. They differ in behavior, style, and culture. They call for different management techniques, strategies, and codes of government regulation. The author illuminates those differences by explaining how increasing returns operate in high tech and in service industries. He also offers advice to managers in knowledge-based markets.     

Doctors on the move

We surveyed your colleagues to find out how they're responding to health-care turmoil. Our comprehensive findings show them selling, merging, relocating, or joining up.     

Finance, Politics, and the Accounting for Stock Options

The politics of option accounting crosses party lines, reflecting both the interests of the affected constituencies and the desire for power over standard setting. House Bill HR-3574, which mandates an assumption of zero stock price volatility, runs counter to the recently passed Financial Accounting Standards Board (FASB) rule requiring fair-value expensing of stock options. For any option issued at or out of the money, where strike prices are normally set, expense recognition is zero under this bill's mandated assumption.
Besides excessive use of stock options, the lack of a "final peace" in the option accounting war appears to have encouraged another questionable corporate practice. This article examines a sample of "six-and-one restructurings," exchanges of options in which expensing of re-priced (deep out-of-the-money) options can be avoided if employees wait at least six months and one day before receiving new options. The authors found that market-adjusted stock prices tend to decrease during the six-month period before the strike price is reset. This result provides one more reason why companies should be required to use fair-value option pricing models to expense options.     

Locally Greater Vulnerability to Background Risk

Willingness to take on risk is influenced by the presence of fair and unfair background risks for decision makers who are risk vulnerable as defined by Gollier and Pratt [1996], for these decision makers are more risk averse when they possess such an uninsurable background risk. We present an alternative derivation of the index of local vulnerability based on Diamond and Stiglitz [1974] compensated increases in risk, such that risk aversion increases with the introduction of any small fair background risk if and only if the index of local vulnerability is positive. We establish that the increase in risk aversion is greater for those who are more vulnerable as measured by the index of local vulnerability.     

Relative accuracy and predictive ability of direct valuation methods, price to aggregate earnings method and a hybrid approach

In this paper, we assess the relative performance of the direct valuation method and industry multiplier models using 41 435 firm‐quarter Value Line observations over an 11 year (1990–2000) period. Results from both pricing‐error and return‐prediction analyses indicate that direct valuation yields lower percentage pricing errors and greater return prediction ability than the forward price to aggregated forecasted earnings multiplier model. However, a simple hybrid combination of these two methods leads to more accurate intrinsic value estimates, compared to either method used in isolation. It would appear that fundamental analysis could benefit from using one approach as a check on the other.