Therefore, since brevity is the soul of wit,
And tediousness the limbs and outward flourishes,
I will be brief…
I am not sure if you follow Charlie Munger – partner of Warren Buffett and Vice-Chairman of Berkshire Hathaway. If you don’t start following right now! He is one of those living legends who continues to shine even at the age of 93!
Here are a few Youtube videos of Charlie. Will post more soon…
Excellent talk by Prof. Aswath Damodaran on “The Value of Stories in Business” – Talks at Google
Stock and Flow variables are one of the basic concepts of Economics. Unfortunately, they are not covered in current MBA curriculum (at least based on the courses I attended). But I feel that the concepts are also important beyond the subject of economics and helps in analyzing various commonplace notions/ comparisons people (wrongly) make.
Stock refers to a quantity of a commodity accumulated at a point of time. The quantity of the current production of a commodity which moves from a factory to the market is called flow.
The basis of distinction is measurability at a point of time (which is stock) or over a period of time (which is flow). Note that both stocks and flows are variables. A variable is a measurable quantity which varies (changes).
Consider analogy of a flow of water into a tank, and a small hole at the bottom causing the leak. The following depiction helps in understanding stock and flow concepts.
The water flowing into a tank is a flow variable. The water stored in tank “over a period of time” is a stock variable. And the leak at the bottom of tank can be considered as “depreciation of capital” – the decay!
So, we must remember following points:
- Any flow must have a time component. i.e. per hour, per day, per year etc.
- Stock is NOT defined in terms of time. It is rather a snapshot at a given point in time (cumulative effect till then)
- Flow adds up to a stock, and decay or depletion or depreciation reduces the stock
Let’s apply the concepts of stock and flow to various terms:
- Is GDP a flow variable or a stock variable?
- Is debt a stock or flow variable? How about Capital?
- Is Depreciation a stock variable?
- How about Budget deficit (flow), and Outstanding national debt (stock)
- How about Salary (flow), and savings/ wealth (stock)
- How about Income statement (flow), and Balance sheet (stock)?
In the context of a nation, GDP is a measure of activity per year – and hence a flow variable. So is a company’s Income Statement – economic activity during the year – and hence flow variable. And so is your monthly Salary – a flow variable.
Consequently, Balance sheet of a company (which is a snapshot on a given day) indicates stock variable. The assets and liabilities and retained earnings the company has accumulated over time. Understand how flow (Income statement) and stock (Balance sheet) are related in this case. Some of the earnings from Income statement are retained – and flow to Balance sheet in form of Retained Earnings.
Similarly, you earn some salary and you save some part of the salary – which contributes to your wealth (stock variable). You may or may not be able to save from current salary, in each period – but then you can draw upon your wealth and sustain.
GDP of a nation is a stock variable. The amount of output it produces in each year. What would be the equivalent of Stock then? There is no single answer. One approach is to consider Gross Domestic Debt or Gross National Debt. The idea is to consider ratio of Debt to GDP ratio and interpret it as “number of years to pay off all debt, if all of GDP were to be devoted for debt repayment”. Budget deficit is the “leak” – the shortfall in paying off the debt.
How about Population? Is it a stock variable or flow variable? Well, I hope by now it is clear in your head.
Birth rate is a flow variable. And population is a stock variable.
Just a thought. Can we consider Voltage, Current and Resistance in terms of Stock and Flow?
The relationship between voltage, current, and resistance is described by Ohm’s law. This equation, I = V/R, tells us that the current, I, flowing through a circuit is directly proportional to the voltage, V, and inversely proportional to the resistance, R.
So Voltage is analogous to Stock. The difference in Voltage levels – max at one end and zero at the other – causes current to flow. Thus Current is analogous to Flow. And the resistance, R, causes current to slow down. Not exactly equivalent to a depreciation or depletion, but somewhat similar.
Well, maybe I am pushing the analogy too far, but there are parallels. And they help in understanding concepts.
Now let me comment on the wrong kind of comparisons and how the concepts of stock and flow can help point out the flaws in the comparisons.
We often hear sentences such as “XYZ person in Forbes Richest List is so rich that his wealth is more than GDP or ABC country”. Or, “Mr. X is so rich that he can use his fortune and single-handedly wipe out the country’s Budget Deficit.”
Can you see the flaw? Person’s wealth is a stock variable. And GDP or Budget Deficit are flow variables.
Is it appropriate to compare the two? Maybe yes, maybe not. Depending on what the context is. However, it is important to understand the distinction between the category of things we are comparing.
Let me end this post by extending Stock and Flow concepts to philosophy and religion.
Hindu religion has concepts of पाप (sin), पुण्य (good deed), and पूर्व-संचित. I am sure the other religions would also have something similar. The activities you do and actions you take result in earning पाप or पुण्य in this life. So they are Flow variables 🙂
And your पूर्व-संचित is the things you have accumulated in your past life (or lives). So that is the Stock variable 🙂
Your destiny is shaped by पूर्व-संचित (Stock) as well as by पाप or पुण्य in this life (Flow). You cannot do much about the Stock. However, you can certainly do a lot about the Flow!
I hope you’ll understand the concepts of Stock and Flow much better if you take this perspective! 🙂