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Chapter 2
The One Lesson of Business
Managerial Economics: A Problem Solving Approach (2nd Edition)
Luke M. Froeb, [email protected]
Brian T. McCann, [email protected]
Website, managerialecon.blogspot.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Chapter 2 – Summary of main points
• Voluntary transactions create wealth by moving assets from lowerto higher-valued uses.
• Anything that impedes the movement of assets to higher-valued
uses, like taxes, subsidies, or price controls, destroys wealth.
• Economic analysis is useful to business for identifying assets in
lower-valued uses.
• The art of business consists of identifying assets in low-valued uses
and devising ways to profitably move them to higher-valued ones.
• A company can be thought of as a series of transactions. A welldesigned organization rewards employees who identify and
consummate profitable transactions or who stop unprofitable ones.
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Introductory anecdote
• Two prominent hospitals recently refused
patients for kidney transplants because the
organs were from “directed donations.”
• Demand for organs is high – far exceeding
supply - and many never receive them.
• Despite high demand and low supply, buying
and selling organs is illegal.
• Why?
Capitalism 101
To identify money-making opportunities, you
must first understand how wealth is created
(and sometimes destroyed).
• Definition: Wealth is created when assets are
moved from lower to higher-valued uses
• Definition: Value = willingness to pay
• Desire + income
• The chief virtue of a capitalist economy is its
ability to create wealth
• Voluntary transactions, between individuals or
firms, create wealth.
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Example: Robinson Crusoe economy
• A house is for sale:
• The buyer values the house at $130,000 – top dollar
• The seller values the house at $120,000 – bottom line
• The buyer and seller must agree to a price that “splits”
surplus between buyer and seller. Here, $128,000.
• The buyer and seller both benefit from this transaction:
• Buyer surplus = buyer’s value minus the price, $2,000
• Seller surplus = the price minus the seller’s value, $8,000
• Total surplus = buyer + seller surplus, $10,000 = difference in
values
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Wealth-Creating transactions
• Which assets do these transactions move to higher-valued
uses?
• Factory Owners
• Real Estate Agents
• Investment Bankers
• Corporate Raiders
• Insurance Salesman
• Discussion: How does eBay create wealth?
• Discussion: Which individual has created the most wealth
during your lifetime?
• Discussion: How do you create wealth?
Do mergers create wealth?
• The movement of assets to a higher-valued use is the wealthcreating engine of capitalism.
• Our largest and most valuable assets are corporations
• Dell-Alienware merger:
• In 2006, Dell purchased Alienware, a manufacturer of high-end
gaming computers.
• Dell left design, marketing, sales and support in Alienware’s
hands; manufacturing, however, was taken over by Dell.
• With its manufacturing expertise, Dell was able to build
Alienware’s computers at a much lower cost
• Despite this example, many mergers and acquisitions do not
create value – and if they do, value creation is rarely so clear.
• To create value, the assets of the acquired firm must be more
valuable to the buyer than to the seller.
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Does government create wealth?
• Discussion: What’s the government’s role is
wealth creation?
• Enforcing property rights, contracts, to facilitate
wealth creating transactions
• Discussion: Why are some countries so poor?
• No property rights, no rule of law
• Discussion: Much of the justification for government
intervention comes from the assertion that markets
have failed. One money manager scoffed at this idea.
“The markets are working fine, but they’re giving
people answers that they don’t like, so people cry
market failure.”
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The one lesson of economics
• Definition: an economy is efficient if all wealth-creating
transactions have been consummated.
• This is an unattainable, but useful benchmark
• The One Lesson of Economics: the art of economics
consists in looking not merely at the immediate but at the
longer effects of any act or policy; it consists in tracing
the consequences of that policy not merely for one group
but for all groups.
• Policies should then be judged by whether they move us
towards or away from efficiency.
• The economist’s solution to inefficient outcomes is
to argue for a change in public policy.
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One lesson of economics (cont.)
• Taxes Destroy Wealth:
• By deterring wealth-creating transactions – when the tax is
larger than the surplus for a transaction.
• Which assets end up in lower-valued uses?
• Subsidies Destroy Wealth:
• Example: flood insurance – encourages people to build in areas
that they otherwise wouldn’t
• Which assets end up in lower-valued uses?
• Price Controls Destroy Wealth:
• Example: rent control (price ceiling) in New York City - deters
transactions between owners and renters
• Which assets end up in lower-valued uses?
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The one lesson of business
• Definition: Inefficiency implies the existence of
unconsummated, wealth-creating transactions
• The One Lesson of Business: the art of business
consists of identifying assets in lower valued uses,
and profitably moving them to higher valued uses.
• In other words, make money by identifying
unconsummated wealth-creating transactions and
devise ways to profitably consummate them.
The one lesson of business (cont.)
• Taxes create a profit opportunity
• Discussion: 1983 Sweden tax
• Subsidies create opportunity
• Discussion: health insurance
• Price-controls create opportunity
• Discussion: Regulation Q. & euro dollars
• Discussion: What about ethics?
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Companies create wealth
• Companies are collections of transactions:
• They go from buying raw materials, capital, and labor
(lower value)
• To selling finished goods & services (higher value)
• Why do some companies have difficulty creating
wealth?
• They have trouble moving assets to higher-valued uses
• Analogy to taxes, subsidies, price controls on internal transactions
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Alternate intro anecdote
• Zimbabwe experienced economic contraction of
approximately 30 percent per year from 1999 to 2003
• Unemployment rates have been as high as 80 percent and life
expectancy has fallen over 20 years during the reign of
Robert Mugabe
• Why has economic growth been so low?
Alternate intro anecdote (cont.)
• One main problem occurred in 2000
• Mugabe backed his supporters takeover of commercial farms,
essentially revoking property rights of these farmers
• The state resettled the confiscated lands with subsistence
producers - many with no previous farming experience.
Agricultural production plummeted.
• Farm debacle had economic ripple effects through the banking
and manufacturing sectors
• Declining production deprived the country of ability to earn
foreign currency and buy food overseas
• Widespread famine ensued
• The government's initial attack on private property eventually
led to more direct intervention in the economy and the
destruction of political freedom in Zimbabwe.
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Extra Discussion:
Darwinian Evolution of Organizations
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• Pressure to evolve from two sources
• Product market competition
• Financial market: threat of takeover
• Discussion: extinct forms, Phycor
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1. Introduction: What this book is about
Managerial Economics 2. The one lesson of business
3. Benefits, costs and decisions
Table of contents
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7.Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19.The problem of adverse selection
20.The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?