Chapter 2 The One Lesson of Business Managerial

Chapter 2 The One Lesson of Business Managerial Economics: A Problem Solving Approach (2 nd Edition) Luke M. Froeb, luke. froeb@owen. vanderbilt. edu Brian T. Mc. Cann, brain. mccann@owen. vanderbilt. edu 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 lower- to 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 well-designed organization rewards employees who identify and consummate profitable transactions or who stop unprofitable ones.

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 low supply, buying and selling organs is illegal. • Why? 3

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. 4

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 5

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 e. Bay create wealth? • Discussion: Which individual has created the most wealth during your lifetime? • Discussion: How do you create wealth? 6

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. 7

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. ” 8

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. 9

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 10

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. 11

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? 12

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 highervalued uses • Analogy to taxes, subsidies, price controls on internal transactions 13

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? 14

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 15 overseas

• Extra Discussion: Darwinian Evolution of Organizations Pressure to evolve from two sources • Product market competition • Financial market: threat of takeover • Discussion: extinct forms, Phycor 16

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? 17