Economics Notes

Chapter 2 The One Lesson of Business

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?

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Capitalism 101
To identify , you must first understand how wealth is created (and sometimes destroyed). • Definition: Wealth is created when assets are moved from to uses • Definition: Value =
• + .

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• The chief virtue of a capitalist economy is its ability to create wealth • create wealth. , between individuals or firms,

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Example: Robinson Crusoe economy
• A house is for sale:
• The buyer values the house at $130,000 – • The seller values the house at $120,000 – . .

• 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 = • Seller surplus =
• Total surplus = = 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?

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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 .

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• 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 .

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Does government create wealth?
• Discussion: What’s the government’s role is wealth creation?

• Discussion: Why are some countries so poor?
• No , no

• 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 .
• 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 . • Which assets end up in lower-valued uses?

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Destroy Wealth:
• Example: flood insurance – encourages people to build in areas that they otherwise wouldn’t • Which assets end up in lower-valued uses?

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Destroy Wealth:
• Example: rent control ( ) 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.

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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 ( ) • To selling finished goods & services ( )

• 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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