Comparative Advantage Creates Value

Rortybomb has a post up where he argues that the financial sector creates no value. But then strangely he goes ahead and argues that the finacial sector exists because of imperfections in the market.

Now what I esoterically read the MM Theorem as teaching us is that we can say that the financial sector here is only adding value if and only if it is resolve a market imperfection. There is asymmetric information – the factory knows it’s profitability better than the Doctor does, and could rob her. So we hire analysts to keep an eye on the investments. There are coordination problems – the factor might need 1,000 doctors to each give $1,000 before it can make its profit. There are costs associated with having to declare bankruptcy and there are benefits to having debt – you can write it off your taxes. As such, you’ll want to hire some corporate finance people to set up your company correctly.

Taking his logic forward, we would find that no intermediary creates value, of course provided there are no market imperfections. But even in perfect markets there is a need for intermediaries such as retailers, distributors, transactors.

The reason for this is simply that they do create value due to the comparative advantage they bring to the table of doing a particular job better than someone else. Whether it is providing convenience, reducing search costs for customers or simply being a trusted third party to the transaction.

He displays a chart showing how the financial sectors profits are an outsized portion of the overall profits

Financial Sector Share of Profits

Financial Sector Share of Profits

But a simple way of looking at this, is simply that the comparative advantage of the rest of the economy with respect to finance is lesser. Manufacturing gets outsourced to China and Mexico, support services get outsourced to Philippines and India and consequently moving a percentage of the profits in these businesses offshore.

Financial services simply have a structural advantage in the US economy and their share of profits simply reflects that. As structural changes take place and comparative advantage of firms changes, this will also change.

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