1. Chapter 2 The One Lesson of Business
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Managerial Economics: A Problem Solving Approach (2nd Edition)
Luke M. Froeb,
Brian T. McCann,
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.

2. 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.

3. 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?

4. 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.

5. 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

6. 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?

7. 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.

8. 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.”

9. 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.

10. 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

11. 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.

12. 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?

13. 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.).

14. 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?

15. 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.

16. 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.

17. 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