Ketchup Economics Explained

Last week I wrote about a controversial field of gastronomic economics: ketchup economics. OK, you caught me. This field of economics does not exist. Perhaps it should. How then, was I able to quote Larry Summers discussing the findings and controversies in this field at such length in a reputable journal (link here for those with JSTOR access, citation here or here)? Larry was using ketchup economics as a metaphor to understand financial economics.

Broadly speaking, there are two main fields of finance. One, asset pricing is concerned with what it sounds like. How much should a stock, bond, or option be worth given the (uncertain) payouts it promises (dividends, coupon payments, etc.) that it promises in the future? The other, corporate finance, is concerned with how firms' investments are chosen and financed. Should the firm finance itself with equity (e.g., issuing stock in an IPO or SEO), debt (e.g., bank loan or bonds), or some combination?

Larry Summer's view is that these fields are not asking the most interesting questions. For asset pricing, how much should the overall stock market be worth? For corporate finance, what kind of investments should a firm make? Instead, both asset pricing and corporate finance spent a lot of time answering the financial analog of the Summers' ketchup finding that "two quart bottles of ketchup invariably sell for twice as much as one quart bottles of ketchup." In fact, two Nobel prizes (one in asset pricing, one in corporate finance) have been given out for answering questions along these lines. The Black-Scholes option pricing formula shows that the price of an option can be calculated in terms of the price (and other attributes, chiefly volatility) of a stock and a bond (e.g., the interest rate), just as the value of a large bottle of ketchup can be calculated in terms of the price of two smaller bottles of ketchup. The Modigliani-Miller theorem shows that the total value of a company (the sum of the value of a firm's stocks and bonds) is independent of their proportions, just as the price of a certain amount of ketchup will be independent of whether it is sold in two small bottles or one large one.

I'm happy to report that there has been some progress in finance in countering these concerns in the 20 years since Summers first raised them. For example, consumption-based asset pricing shows how the overall level and movement of stock prices can be linked to people's consumption. Instead of just valuing assets relative to one another, we can think about the overall level of asset prices and also connect these levels to the value these assets provide in people's lives.