IRR and Externalities. Yeah, I don’t care. Exactly

For many, 2020 has been an on-going challenge to know where to focus and what to ignore. Me too. This is a reflection on some tools I learned as an undergraduate. While I’ve moved away from the technical aspects of the story, it continues to serve me as a framework. You may find it a bit technical but I hope it will be a thoughtful read. Comments and sharing are always welcome.

In this post:

Story: IRR Externalities Yeah I don’t care

As an undergraduate I found my way to the study of business finance. Financial analysis provides all sorts of cool tools that ranged from accounting to economics. My journey has taken me away from analysis of the value of “stuff” to a focus on the systems that drive the relationships between people, organizations, and our environment. Some of those seemingly obscure tools continue to inform my world view.

Two concepts that have stuck with me over the years are the internal rate of return (IRR) and externalities. IRR is a tool for measuring the rate of return a project requires to make the adjusted value of income and expenses equal to zero. The IRR delivers a single number used to compare projects of varying scope, size, and duration. Multiple acceptable projects can be prioritized by sorting from high to low.

Externalities are costs and benefits not directly included in the price of a product or service. Externalities may have a positive or negative impact on a project. When we moved last year, I decided that knowing the purpose of the various light switches in our condo was a negative externality I didn’t need to concern myself with. Since I don’t see, I don’t need to clutter my brain with remembering which switches do what.

Congratulations for reading this far. You may have just said to yourself “Externalities, yeah, I don’t care.” Exactly. What continues to interest me in externalities is not that they fall outside of our circle of concern, but how they got that way. Externalities make sense. If everything is relevant, nothing is relevant. A line needs to be drawn somewhere.

Lessons
learned

A classic example of externalities is the cost of pollution. When environmental costs are included in the price of a product, producers have an incentive to avoid the costs of polluting. This is part of the reason environmental standards are such a political issue. When environmental standards are in place producers include the cost of either paying for or avoiding regulatory consequences in the price of producing a product. In the absence of standards, the cost of polluting is an inconsequential externality.

It is possible to manipulate externalities to alter the calculation of the Internal Rate of Return. When products are made far from consumers the need for environmental standards is obscured. The treachery of this strategy is that the need for environmental standards are not apparent to the buyer. This is also part of the reason industries with poor environmental records are often co-located with disenfranchised groups who can neither afford the things produced in their back yard nor have much of a voice in regulatory decisions.

Another concept from economics is “the assumption of perfect information. ” It presumes decisions are based on full knowledge of all relevant facts. In theory, we know everything about the working conditions and safety standards associated with everything we consume. We also know the motivations of every person we interact with and the long-term implications of every decision we make. The statement “Wow, I sure wish I would have known that” doesn’t exist in this perfect information world.

Applying the lessons

In reality, we rarely have enough information to make fully informed decisions. We pick out a set of things we believe are important and weigh the pro’s and con’s of a limited set of parameters. I don’t really know how the workers at my grocery store are treated or where the garage goes with the oil they drain from our car. I might make different choices if I had different information. Some things to consider:

  • What is an informed decision for you?
  • How much information is enough?
  • What are the hard facts you need to know?
  • What are the subjective considerations to include?
  • How do you weigh subjective vs. objective data?
  • What is your basis for assuming externalities?
  • How do you avoid “analysis paralysis” when seeking “perfect information?”

Definitions/resources:

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For more information:

Dan Lococo, PhD
, Barrier Knocker Downer
Twitter: @danlococo
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Affinity By Design, LLC
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Copyright 2020, Dan Lococo, All rights reserved

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