Managerial Economics
Topic 2:
The One Lesson of Business
At the end of the lesson, the student will be able to:
A. Identify money-making opportunities and creation of wealth
B. Describe the role of the government in the wealth creation process
C. Discuss how economics is useful in business.
Topic 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. This inefficiency
implies a money-making opportunity.
✓ 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.
The goal of this topic is to show you how to exploit inefficiency as an
opportunity to make money. But learning how to turn inefficiency to
opportunity requires as much creativity and imagination as analytic ability.
A. Money-Making Opportunities and Creation of Wealth
Capitalism & Wealth
Wealth is created when assets are moved from lower to higher-valued
uses.
An individual value for a good or a service is measured as the amount of
money one is willing to pay for it. To VALUE a good means that one wants it
and can pay for it.
The buyer’s value for an item is how much he will pay for it, his “top dollar”.
Likewise, the seller won’t accept less than his value, “cost” or “bottom line”.
Voluntary transactions create wealth.
The chief virtue of a capitalist economy is its ability to create wealth.
A capitalist is someone who hopes to profit by investing money or
financing business ventures is a capitalist. A nation's economy is described as
capitalist if it's based on private ownership and profit.
Example:
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
Examples of assets moving to higher valued uses:
1. Factory owners purchase labor from workers, borrow capital from investors,
and sell manufactured products to consumers. In essence factory owners are
intermediaries who move labor and capital from lower-valued to higher uses,
determined determined by consumer’s willingness to pay for the labor and
capital embodied in manufactured products.
2. Rover.com is an online service to match dog owners to dog walkers, pet
sitters, and overnight boarders. Since its founding in 2011, Rover has
become the largest marketplace for pet-sitting services, with over 65,000
registered sitters.
3. When consumers purchase insurance, they pay an insurance company to
assume risk for them. In this context, you can think or risk as a bad, the
opposite of a good, moving from a consumer who wants to get rid of it to an
insurance company willing to assume it for a fee.
Do mergers create wealth?
The movement of assets to a higher-valued use is the wealth- creating
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.
A merger is an agreement that unites two existing companies into one new
company. ergers and acquisitions are commonly done to expand a company's
reach, expand into new segments, or gain market share. All of these are done
to increase shareholder value.
B. The Role of the Government in the Wealth Creation Process
⚫
What’s the government’s role is wealth creation?
Enforcing property rights, contracts, to facilitate wealth creating
transactions
⚫
Why are some countries so poor?
No property rights, no rule of law
Government play a critical role in the wealth creating process by enforcing
property rights and contracts - legal mechanisms that facilitate voluntary
transactions. By making sure buyers and sellers can keep the gains from
trade, our legal system makes trade more likely, which contributes to a
country;s enormous wealth-creating ability.
Many poor countries survive largely on the wealth created in the so called
underground or black market economy, where transactions are hidden from
the government.
Secure property rights are also associated with measures of
environmental quality and human well-being. In nations where property rights
are well protected, more people have access to safe drinking water and
sewage treatment and they live about 20 years longer. If you give people
ownership to their property, they have an incentive to take care of it, invest in it
and keep it clean.
C. How Economics is Useful in Business.
Economics can be used by business people to spot money-making
opportunities (assets in lower-valued uses). to see this, we begin with
EFFICIENCY, one of the most useful ideas in economics.
An economy is efficient if all assets are employed in their highest-valued
uses. An economy is efficient if all wealth-creating transactions have been
consummated.
Economists are obsessed with efficiency. They search for assets in lower
valued uses and then suggest public policies to move them to higher
valued-uses. A good policy facilitates the movement of assets to higher
valued uses; and a bad policy prevents assets from moving or worse, moves
assets to lower valued uses.
Determining whether a policy is good or bad requires analyzing all of its
effects- the unintended as well as the intended effects. Using this idea, Henry
Hazlitt reduced all of economics into a single lesson:
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 of 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.
The one lesson of business: the art of business consists of identifying
assets in low-valued uses and devising ways to profitably move them to higher
valued ones.
Taxes
The one lesson of economics tells us that the intended effect of a tax is to
raise revenue for the government, but unintended consequence of a tax is that
it deters some wealth creating transactions.
Taxes Destroy Wealth:
By deterring wealth-creating transactions – when the tax is larger than
the surplus for a transaction.
Subsidies Destroy Wealth:
Example: flood insurance – encourages people to build in areas that
they otherwise wouldn’t
Price Controls Destroy Wealth:
Example: rent control (price ceiling) in New York City - deters
transactions between owners and renters.
A price control is a regulation that allows trade only at certain price.
Unconsummated Transactions
The one lesson of business tells us that these unconsummated
transactions represent money-making opportunities.
An unconsummated transaction is any client interaction that started with
the client ordering, but then before the transaction closed the process got
derailed. It could be a dropped cart from a website order, or a phone order that
didn't go through, or a sales call that got interrupted.
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.
INEFFICIENCY = OPPORTUNITY
Wealth Creation in Organizations
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.