Asset valuation

Standard economic theory says that in a competitive market the quantity produced and consumed will be that which sets prices equal to marginal cost. The definition of "cost" here includes the need to provide a return of and to capital employed. The return to capital employed is what accountants would call profit (but not economists).

There are three interesting cases of how asset valuation problems make this theory unworkable.

The first is the problem of assessing something like the asset value of Telstra's network for determining regulated access prices. The difficulty is all in determining what is the appropriate allowance for return of capital. Technically this is achieved by recognising depreciation as a cost - but the challenge is how to work out the depreciation. Once again the economists have a different approach to the traditional accounting mathematical discounting measures. The economic depreciation looks at how much the asset will be used in different time periods - so if it is a new network whose use grows the depreciation is backended while depreciation formulae would usually allow more depreciation upfront.

But the issue becomes far harder if there is a change in ownership of the asset. The Telstra example is that there are some who would argue Telstra's network has mostly been depreciated (the capital has been returned) and so access prices should be set at that new asset value. However, the asset was sold (in three stages) to new owners who didn't pay the depreciated value of the asset but instead valued the asset on the basis of expected future cash flows. (In the economics biz this is called "capitalizing monopoly rents" and was always the problem of privatisation).

The second example comes from banks and interest rate margins. The Australian banks earn their income on the spread between rates they lend and borrow money at, less the cost of operations plus fees. Their problem is not the return of capital but the return to capital. Their shares are traded on the open market and have been increasing in traded value based upon expectations of future dividend streams. But the higher share value increases artificially the "asset base" that the banks need to get a return on. (The solution is to increase the share of not-for-profit banks and get people to stop expecting bank share prices to increase).

The final example is derivatives. The big debate with financial product asset valuation is whether they should be "marked to market" or not. Marking to market avoids firms artificially inflating an asset value but equally it leads to systemic risk if there is asset price inflation.

Ultimately one failure of standard theory is to ascribe to assets only their value in use whereas in real markets potential purchasers consider assets to have potential value in use and potential value from future resale. Bubbles are simply those cases where the rational purchaser ascribes more value to the future resale than to the value of use.

The biggest divergence between orthodox and heterodox economists is the belief of the former that "the market" is not just a platonic ideal but an actual timeless reality, whereas the heterodox believe that all markets are socially constructed.

It is some benefit to the heterodox that asset values, not just markets, are also socially constructed.