Applications of Option Theory
Comm 423
Professor: Jing Chen
Date: November 27, 2002
From: Fiona Chan
Option Theory of different forms of Government: Communist and Capitalist
Our world is roughly classified into two types of governments, Communist and
Capitalist.
Examples of Democratic capitalist forms of government are the United
States and the countries of Western Europe. Examples of Communist societies are the
former USSR, China, and North Korea.
This is a call option.
Stock price = GDP, K= the initial investment of the
government.
d GDP
GDP
= r dt + σdz
r = expected growth rate
σ= volatility
According to the relative level of fixed and variable costs, Socialist countries,
like the USSR had in Soviet times, have high fixed costs, and low uncertainty. Their
expected rate of return is high and volatility is low.
Yet, high fixed costs which have
lower variable costs in production need higher output volume to breakeven. (Figure 1)
Capitalist countries like the United States have low fixed cost with high volatility.
Communist Society
In a socialist society, the fixed costs are high, but with low uncertainty. These
countries prosper in stable environments because of their low marginal cost.
However, they have difficulty adjusting when the environment changes quickly. The
Communist societies invested large amounts of money in their industry development.
Communist systems rely on a centrally planned economy, also called a command
economy.
They have high fixed costs because of the heavy investment for the
countries. For example:
At the end of the 1920s Stalin revoked the New Economic
Policy and inaugurated the first of a series of Five-Year Plans, committing the regime
to a program of high paced industrial development and forced collectivization of
agriculture. The result was a radical transformation of Soviet society. The government
built hundreds of factories to produce machine tools, automobiles, agricultural
machinery, motors, aircraft, generators, chemicals, iron and steel, coal, oil, and
armaments.1 During the stable environment between the 1950s and 1970s,
communist economies did achieve some success. Studies of growth trends from the
1950s to the early 1970s showed the centrally planned economies equaling and in
some cases exceeding the growth rates of the capitalist economies. They also attained
high literacy rates, made basic health care available to the population, eliminated
extreme poverty, and avoided unemployment.2
Capitalist Society
Capitalism is an economic system in which private individuals and business firms
carry on the production and exchange of goods and services through a complex
network of prices and markets.
They have low fixed costs because their economies
are based on demand and supply of the market.
number of private-owned companies.
1
The economies consisted of a large
Under this system, a minimum of government
Smith, A. 1993 Russia and the world economy: Problems of integration. London: Routlege. P.20-23
Boswell,T. and Chase-Dunn, C. 2000 The Spiral of Capitalism and Socialism: Toward Global
Democracy. London: Lynn Rienner Publishers. P.85-95
2
supervision is required; if competition is present, economic activity will be
self-regulating.3 The economies of these societies are very flexible.
Changes in the economic environment
During the 1980s and 1990s, the world economy was divided between expansion and
stagnation. In order to foster renewed economic growth and development, firms,
industry, and the state must develop extensive sociopolitical accumulation innovation.
A world economic divide was taking place between high-skilled flexible production,
such as biotechnical, electronic, and information processing, and on the other side,
low-skilled mass production, such as textiles, toys, appliance, and other assembly-line
work. State-socialist societies experienced extremely difficult economic reactions to
the world divide because they had concentrated so heavily on low-skill mass
production in the postwar period.4
For the capitalist societies like the United States, various accumulation innovations
were adopted; the most important factor for successful adaptations has been
“flexibility”. Flexible organizations included decentralized management with much
more cooperative participation from below, higher-skilled and relatively
more-autonomous workers, increased scientific and technical labor, variable-batch
production runs, and rapid adoption of new technology.5
Conclusions
3
Mandel, E. 1973 An introduction to Marxist economy theory. New York: Pathfinder Press p .47-51
Teeple, G. 2000. Globalization and the decline of social reform: Into the twenty-first Century. Aurora:
Garamond press
5
Teeple, G. 2000. Globalization and the decline of social reform: Into the twenty-first Century. Aurora:
Garamond press. p.105
4
Communist Societies prosper in a stable environment because of their low marginal
cost.
However, in a volatile environment they can hardly survive. The capitalist
societies prosper in a volatile environment as low fixed costs make them flexible; they
can adjust the environment quickly. As a result, the capitalist structured societies are
dominated the world.
The communist leaders in the surviving communist countries
like China, have held out against political reform but welcomed economic reform.
Figure 1: Output and return with different level of fixed costs
Rate of return
Low Fixed Cost
High Fixed Cost
Output
Figure 2: Uncertainty and variable cost
1
Variable Cost
High Volatility
Low Volatility
0
5
10
15
Level of fixed Cost
Reference
20
Boswell,T. and Chase-Dunn, C. 2000 The Spiral of Capitalism and Socialism:
Toward Global Democracy. London: Lynn Rienner Publishers.
Mandel, E. 1973. An introduction to Marxist economy theory. New York: Pathfinder
Press
Smith, A. 1993 Russia and the world economy: Problems of integration. London:
Routlege.
Teeple, G. 2000. Globalization and the decline of social reform: Into the twenty-first
Century. Aurora: Garamond press
Hull, J.C. 2000. Options, Futures, and Other Derivatives. New Jersey: Prentice Hall