Chapter 2

One Lesson of Business

Capitalism 101

To identify money- Understand how wealth is
making opportunities created (and sometimes
destroyed).
 Wealth is created when assets are moved from lower to higher-valued uses

Lower Valued Higher Valued

Uses Uses
Value = Willingness to pay

Desire + Income= you want something + you can pay for it
 By pursuing self-interest, people create wealth

 Voluntary transactions, between individuals or firms, create wealth

Housing Example:
A house is for sale:
 The buyer values the house at $130,000
This is the buyer’s top dollar – willingness to pay
 The seller values the house at $120,000
This is the seller’s bottom line – won’t accept less
 The buyer and seller must agree to a price that “splits” surplus between buyer and seller. Here,
$128,000.

Surplus
The buyer and seller both benefit from this transaction:
Buyer surplus
◦ buyer’s value minus the price
◦ $130,000 - $128,000 = $2,000 buyer surplus
Seller surplus
◦ the price minus the seller’s value
◦ $128,000 - $120,000 = $8,000 seller surplus
Total surplus
◦ buyer + seller surplus = difference in values
$2,000 + $8,000 = $10,000
$130,000 - $120,000 = $10,000
$10,000 are the gains from trade

Wealth creating transactions
Which assets do these transactions move to higher-valued uses?
Factory Owners
- purchase labor from workers, borrow capital from investors and sell manufactured goods to
consumers.
Labor and capital
Lower-valued uses Higher-valued uses
As determined by consumers'
willingness to pay for the labor and
capital embodied in the
manufactured products
Corporate Raiders
- buy up companies and sell off their component pieces. They earn money only if the value of
the sum of the pieces is higher than the value of the company as a whole.

COMPANY sells off Components 1,2,3,4…..n
Value as a whole < Value of sum of the components
Insurance Salesman
- When consumers purchase insurance, they pay an insurance company to assume risk for
them. In this context, you can think of risk as a ‘‘bad,’’ the opposite of a ‘‘good,’’ moving from
consumers willing to pay to get rid of it to insurance companies willing to assume it for a fee.
risk
customer pays insurance company Assumes the risk for a fee
pays
Do mergers create wealth?

 Many mergers and acquisitions do not create value
 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?
What’s the government’s role is wealth creation?
 Enforcing property rights and contracts legal tools that facilitate wealth creating transactions
 Ensures that buyers and sellers keep gains from trade
Why are some countries so poor?
 No property rights
 No rule of law

The one lesson of business
An economy is efficient if all assets are employed in their highest-valued assets.
 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.
 Must look at the intended and unintended effects of policies to understand their efficiency.
 The economist’s solution to inefficient outcomes is to argue for a change in public policy.
 Business person’s solution is to try to make money on the inefficiency.
Inefficiency implies the existence of unconsummated, wealth-creating transactions
 The art of business consists of identifying assets in lower valued uses and devising ways to
profitably moving them to higher valued uses.
 Make money by identifying unconsummated wealth-creating transactions and devise ways to
profitably consummate them.

Destroying wealth
- Anything that stops assets from moving to higher valued uses is destroying wealth.
Taxes Destroy Wealth:
o By deterring wealth-creating transactions – when the tax is larger than the surplus for a
transaction.
Subsidies Destroy Wealth:
o Flood insurance encourages people to build in areas that they otherwise wouldn’t
Price Controls Destroy Wealth
o Price Control - regulation that allows trade only at a certain prices
o Price Ceiling - outlaw trade at prices above the ceiling
o Price Floor - outlaw trade at prices below the floor

Profiting from inefficiency

Taxes
Subsidies Creates profit

opportunity
Price Controls
Taxes create a profit opportunity

1983 Sweden tax
 Sweden imposed a 1% “turnover” (sales) tax on stock sales on the Sweden Stock Exchange
 Before the tax, large institutional investors pay commisions that averages 0.25%.
 Turnover tax was four times the size of the old trading costs and fell most heavily on these big
institutional investors.
 After tax was imposed, the number of transactions on the Swedish Stock Exchange fell by 40% and
institutional investors started trading shares on London and New York Stock Exchanges and
brokers recognized these opportunity and profited by moving their trades to London and New York
Stock Exchanges.
 Swedish government removed turnover tax on 1990 but the Swedish Stock Exchange never
regained its former vitality.
Subsidies create opportunity
health insurance
 A health insurance company fully subsidizes visits to doctors
 If you got sick, you visit the doctor and the doctor will charge the insurance company a certain
amount for your care.
 Some employers have recognized this started to offer insurance that requires large deductible or
co-payment, which dramatically reduced the cost of insurance. The employers can either keep the
money or use it to raise the workers' wages to attract better workers
Price-controls create opportunity
Taxis which are regulated with fixed price
 Taxis have minimum and fixed fares which function like price ceiling which won't recover the return
trip if your destination is out of town
 poorly maintained
 recklessness in order to increase volume to increase earnings
 Uber is an alternative which exploits these regulatory inefficiencies; flexible pricing and customers'
ratings give Uber drivers incentive
 Uber's success can also be attributed to more efficient driver-passenger matching technology,
larger scale, surge pricing to match the demand and supply

Wealth creation in organizations
Companies = a collection of transactions
They buy raw materials (capital, labor, etc.) and create and sell higher-valued goods and services
Can equate market-level problems (taxes, subsidies and price controls) with organization-level goal
alignment problems
Ex: The overbidding from the oil company = “subsidy” paid to management for acquiring oil reserves
Allows us to use the same analysis

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One Lesson of Business

Lower Valued Higher Valued

Value = Willingness to pay

 By pursuing self-interest, people create wealth

Lower-valued uses Higher-valued uses

Value as a whole < Value of sum of the components

Do mergers create wealth?

Subsidies Creates profit

Taxes create a profit opportunity

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