Chapter 1 No key terminology highlighted. Summary of Main Points - Problem solving requires two steps: First, figure out why mistakes are being made; and then figure out how to make them stop. - The rational-actor paradigm assumes that people act rationally, optimally, and self- interestedly. To change behavior, you have to change incentives. - Good incentives are created by rewarding good performance. - A well-designed organization is one in which employee incentives are aligned with organizational goals. By this we mean that employees have enough information to make good decisions, and the incentive to do so. - You can analyze any problem by asking three questions: (1) Who is making the bad decision? (2) Does the decision maker have enough information to make a good decision and (3) the incentive to do so? - Answers to these questions will suggest solutions centered on (1) letting someone else make the decision, someone with better information or incentives; (2) giving the decision maker more information; or (3) changing the decision maker’s incentives. Chapter 2 Wealth - created when assets move from lower to higher valued uses Value for goods or services - measured as the amount of money an individual is willing to pay Seller surplus - difference between the agreed on price and the seller’s value Buyer surplus - the buyer’s value minus the price Governments - play a critical role in the wealth-creating process by enforcing property rights and contracts—legal mechanisms that facilitate voluntary transactions Efficient economy - economy where all assets are employed in their highest-valued uses 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 Art of business - consists of identifying assets in low valued uses and devising ways to profitably move them to higher valued ones Taxes - government collection out of the total surplus created by a transaction; intended effect is to raise revenue for government Subsidies - opposite of a tax; destroy wealth by moving assets from higher to lower valued uses Price control - a regulation that allows trade only at certain prices Price ceilings - outlaw trade at prices above the ceiling Price floors - outlaw trade at prices below the floor Summary of Main Points - Voluntary transactions create wealth by moving assets from lower- to higher-valued uses. - Anything that impedes the movement of as- sets to higher-valued uses, like taxes, subsidies, or price controls, destroys wealth. Such inefficiency implies a money-making opportunity. - The art of business consists of finding assets in low-valued uses and devising ways to profitably move them to highervalued ones. - A company can be thought of as a series of transactions. A well-designed organization rewards employees who identify and con- summate profitable transactions or who stop unprofitable ones. Chapter 3 Fixed costs - costs that do not vary with the amount of output Variable costs - costs that change as output changes Accounting costs - Costs paid to its suppliers, general operating expenses, depreciation expenses and interest payments Interest - the cost that creditors charge for use of their capital Opportunity cost - forgone opportunity to earn profit from the other Sunk cost fallacy - means that you consider costs and benefits that do not vary with the consequences of your decision Hidden cost fallacy - occurs when you ignore relevant costs-those costs that do vary with the consequences of your decision Summary of Main Points - Costs are associated with decisions. - The opportunity cost of an alternative is the profit you give up to pursue it. - Consider all costs and benefits that vary with the consequences of a decision and only costs and benefits that vary with the consequences of a decision. These are the relevant costs and benefits of a decision. - Fixed costs do not vary with the amount of output. Variable costs change as output changes. Decisions that change output change only variable costs. - Accounting profit does not necessarily correspond to economic profit. - The fixed-cost fallacy or sunk-cost fallacy means that you consider irrelevant costs. A common fixed-cost fallacy is to let overhead or depreciation costs influence short-run decisions. - The hidden-cost fallacy occurs when you ignore relevant costs. A common hidden-cost fallacy is to ignore the opportunity cost of capital when making investment or shutdown decisions. - If you begin with by looking at the costs, you will always get confused; if you begin with the decision you are considering, you will never get confused. Chapter 4 Marginal costs - the extra cost required to make and sell one additional unit of output Marginal analysis - If the benefits of taking another step are greater than the costs, then take another step, otherwise, step backwards Marginal revenue - the additional revenue gained from selling one more unit Summary of Main Points - Do not confuse average and marginal costs. - Average cost (AC) is total cost (fixed and variable) divided by total units produced. - Average cost is irrelevant to an extent decision. - Marginal cost (MC) is the additional cost incurred by producing and selling one more unit. - Marginal revenue (MR) is the additional revenue gained from selling one more unit. - The relevant costs and benefits of an extent decision are marginal costs and marginal revenue. If the marginal revenue of an activity is larger than the marginal cost, then do more of it. Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount (maximizing profit). - An incentive compensation scheme that increases marginal revenue or reduces marginal cost will increase effort. Fixed fees have no effects on effort. - A good incentive compensation scheme links pay to performance measures that reflect effort. Chapter 5 NPV rule - If the net present value of discounted cash flow is larger than zero, then the project earns more than the cost of capital. Breakeven quantity - the quantity that will lead to zero profit Breakeven price - the average avoidable cost per unit Economics - often called the “dismal science,” partly because of its dark view of human nature Summary of Main Point - All investment decisions involve a trade-off between current sacrifice and future gain. Before investing, you need to know is whether the future gains are bigger than the current sacrifice. Discounting is a tool that allows you to figure this out. - Companies, like individuals, have different discount rates, determined by their cost of capital. They invest only in projects that earn a return higher than the cost of capital. - The NPV rule states that if the present value of the net cash flows of a project is larger than zero, the project earns economic profit (i.e., the investment earns more than the cost of capital). - Although NPV is the correct way to analyze investments, not all companies use it. Instead, they use breakeven analysis because it is easier and more intuitive. - Breakeven quantity is equal to fixed cost divided by the contribution margin. If you expect to sell more than the breakeven quantity, then your investment will be profitable. - Avoidable costs can be recovered by shutting down. If the benefits of shutting down (you recover your avoidable costs) are larger than the costs (you forgo revenue), then shut down. The breakeven price is average avoidable cost. - If you incur sunk costs, you are vulnerable to post-investment hold-up. Anticipate hold-up and choose contracts or organizational forms that give each party both the incentive to make sunk-cost investments and to trade after these investments are made.
