Chapter 2 The One Lesson of Business Ordering Information: Betty Jung Marketing Specialist, Finance/Economics/Decision Sciences South-Western | Cengage Learning 5191 Natorp Boulevard, Mason, OH 45040 The ISBN for your 2e book alone is:  1439077983   The Bundle ISBN for your 2e book + the printed access card for MBA Primer is: 0538771240 Managerial Economics: A Problem Solving Approach (2nd Edition) Luke M. Froeb, luke.froeb@owen.vanderbilt.edu Brian T. McCann, 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 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.

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

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 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.

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.”

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.

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 Price Controls Destroy Wealth: Example: rent control (price ceiling) in New York City - deters transactions between owners and renters

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?

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 In Class Problem: Ask a student for an example of a price control, tax, or subsidy, and then ask them which assets end up in lower valued uses. Ask someone else if they can figure out a way to make money from the inefficiency? If you get no volunteers, ask someone to analyze the effects of the minimum wage. Do this without supply and demand; instead talk about the transactions that are deterred by the regulation (employers willing to hire at a wage below the minimum wage and those willing to work at below the minimum wage are deterred from transacting). Ask if there is a way to make money by consummating these transactions (outsourcing, start a temp agency, etc.).  

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.

Extra Discussion: Darwinian Evolution of Organizations Pressure to evolve from two sources Product market competition Financial market: threat of takeover Discussion: extinct forms, Phycor Discussion: Give an example of an organizational form or a firm that became extinct because it did not evolve. Answer: PhyCor, Inc. is a medical network management company that operates multi-specialty medical clinics and develops and manages independent practice associations (IPAs), which are networks of independent physicians who contract together to provide medical services to individuals whose health care costs are covered by health maintenance organizations, insurers, employers or other third-party payors of health care services. As of December 31, 1998, PhyCor operated 56 clinics with 3,693 physicians in 27 states. Typically in physician practice manager (PPM) deals, the PPM buys a clinic's operating assets and enters a long-term service deal with doctors. The doctors' group controls medical and physician-hiring decisions, while the PPM manages everything else and becomes the employer of non-doctor staff. Phycor expected to make money by “rolling up” various physician practices to exploit economies of scope and scale in both purchasing and billing. It also intended to leverage its “best practices” management systems over its acquisitions. However, this synergy was not reflected in the company’s stock price. On the logarithmic[1] scale below, you can see that the stock price dropped by over 90% from its high in late 1996. . Quoting from the American Medical News (11/22-29/99), "Like other PPMs, PhyCor's problems have been caused by expected gains in efficiency that never happened and doctor dissatisfaction with PPM management." For Phycor, its main assets are the human capital of the physicians it manages. The physicians make decisions that generate profits for the firm, but if the firm tries tax these profits to pay the shareholders, then the physicians will either work less hard (“shirk”) because they do not earn all of the profit from their labor, leave to join another firm with a lower “tax” rate, or go into business for themselves. In short, this organizational form is unprofitable for the business of providing medical care. [1] With a logarithmic chart, the Y axis is structured in such a way that an equal distance along it represents an equal percentage change.

Managerial Economics - Table of contents 1. Introduction: What this book is about 2. The one lesson of business Benefits, costs and decisions 4. Extent (how much) decisions 5. Investment decisions: Look ahead and reason back 6. Simple pricing 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 The problem of adverse selection 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? Managerial Economics - Table of contents