Hot Stocks, Freakonomics, and Crime
(1) Response to Question 1
Scenario: Your hairdresser constantly advised you to invest in hot stocks. Recently, she is telling you to invest in media companies.
There are several reasons why you should invest in media company stocks. First, because media company stocks are generally associated with systematic risks (offer high returns to investment and of course high associated risks), the market will compensate assets with systematic risks but not specific risks (risks associated common only to one type of asset) (Cruz, 1996). In short, if one invests in assets associated with systematic risks, then the market can potentially increase its returns. If one invests in assets associated with specific risks (for example, in bank trusts), then the potential return to investment is very low.
Second, the relative price stability of media company stocks may offer a “safety ground” for any financial disaster. For example, if the price of media company stocks ranges from $4 to $6, then an expected downfall in returns will not be in the same percentage change (Cruz, 1996). In short, either the returns to the stocks will remain the same or increase significantly.
Lastly, because media company stocks always earns above the initial price of stocks, then the return again increases per indicated period. This can be due perhaps to the relatively popularity of media companies. That is, media companies are often viewed as necessary tools for increasing the stock price of other stocks (due perhaps to the utility derived from advertisements). Translated into real terms, there is potentially an increasing demand for media company stocks. In short, a further increase in “potential return to investment” is possible.
Investing in media company stocks may be desirable when the economy is in “good shape.” Supposing the economy is in recession (or even depression), there is no reason to invest in media company stocks. There are three reasons for such. First, it is safer for an individual to invest in assets associated with specific risks. This allows generally reduces the associated risks to an investment. For example, the individual may invest in a stock that offers 20% return, say, in June but 0% in July, and to another stock which offers 0% return, say, in June but 20% in July. In sum, the individual earns 10% if he/she invested in two different stocks (with specific risks). This is called “stock price indexing.”
Second, the price of media company stocks often fluctuates significantly during time of economic uncertainty. In short, the possible returns to investment may vary significantly. The individual either receives a high return to investment or a high loss. In short, during economic uncertainty, risks and returns become highly correlated.
Last, during economic crisis, most companies reduce their overall costs. Payments received by media companies from those companies generally decreases. The implication: the stock price of media companies falls. The return to investment of this type of stock decreases. In short, the individual in this type of stock faces a low returns to investment and potentially high risks.
(2) Response to Question 2
Question: What is your assessment of the economic approach to crime as stipulated in “Freakonomics” by Levitt-Dubner?
Levitt-Dubner (2005) introduced a new type of economics that in essence a significant departure from classical economics. Their main arguments are as follows:
1) There is a need to relax the definitions of crime. In short, the legal definition of crime must be narrowed in order to reduce crime incidence. For example, to reduce crime, the government must legalize abortion. Instead of labeling “abortionists” as criminals (or accessories to crime), they may be labeled as “legitimate workers.” The implication to the economy: Investment confidence increases due to potentially low crime rates;
2) Because the legal-political definition of crime is changed, there is also a need to structurally change the moral and ethical codes of the society. According to the author, this is a difficult task. Changing the moral and structural orientation of the society involves a total overhaul of individual perception of ethics and morality. For the sake of economic prosperity, this change must occur;
3) Because some ethical and moral standards conflict with the primary goals of economic development, there is a need to redefine them. As stated earlier, the real problem lies on the definition not on the actual “incidence.” In short, moral and ethical standards, according to the author, are always the antithesis of the doctrines of economic prosperity.
Levitt-Dubner’s definition of crime itself is problematic. The authors argued that crime is a violation of moral and ethical codes and not necessary non-economical. For the authors, crime is not just a transgression of existing ethical and moral standards, it is by itself, an economic means. This is an absurd definition. Crime is an act of deviance. It may be social, political, and economic in nature. As such, the effect can be economic, social, or political. To limit the effects of crime on economic events is purely whimsical in nature. A particular crime may have multiple effects. For example, supposing legalizing a particular crime stimulates an economy, it is possible for such legalization to have significant effects on other sectors of the society. It may have a significant effect on the political infrastructure of the society or even the existing social arrangements. In short, the author neglected some of the non-economic effects in redefining the nature of crime.
Cruz, Paulo. 1996. Banking and Investment. Manila: Manila Publishing House.
Levitt, Steven and Stephen Dubner. 2005. Freakonomics: A Rogue Economist Explores the Hidden Side of Everything. New York: William Morrow.