Lecture #2: Topic #1The One Lesson of

Businessversus economics

Topic # 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?

3

Capitalism 101To 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.

4

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

5

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?

6

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.

7

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.”

8

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.

9

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

• Which assets end up in lower-valued uses?

• Price Controls Destroy Wealth:

• Example: rent control (price ceiling) in New York City - deters transactions between owners and renters

• Which assets end up in lower-valued uses?

10

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.

11

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?

12

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

13

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?

14

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.

15

Extra Discussion: Darwinian Evolution of Organizations• Pressure to evolve from two sources

• Product market competition• Financial market: threat of takeover

• Discussion: extinct forms, Phycor

16

Lecture #2: Topic #2Benefits, Costs, and

Decisions

Chapter 3 – Summary of main points

• Costs are associated with decisions, not activities.

• The opportunity cost of an alternative is the profit you give up to pursue it.

• In computing costs and benefits, consider all costs and benefits that vary with the consequences of a decision and only those costs and benefits that vary with the consequences of the 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 will change only variable costs.

Chapter 3 – Summary (cont.)• Accounting profit does not necessarily correspond to

real or 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.

• EVA® is a measure of financial performance that makes explicit the hidden cost of capital.

• Rewarding managers for increasing economic profit increases profitability, but evidence suggests that economic performance plans work no better than traditional incentive compensation schemes based on accounting measures.

Introductory anecdote: Armadillo Appliances

• Armadillo Appliances switched steel suppliers because a new manufacturer offered a price $0.01/lb less than the old purchasing price.

• Multiplied by the nine million pounds of steel used annually, AA anticipated $90,000 in savings

• Instead – acquisitions costs increased by $75,000

• Why? What happened?

• Discussion: Diagnose the problem.

• Discussion: Come up with a proposal to fix it.

Armadillo’s freight costs went up

Coil Steel Procurement Original Supplier

$0.50/lb.

Old Supplier $0.50/lb

New Supplier $0.49/lb

Material Cost Savings: $93,000/yr

HOWEVER, Transportation Cost Increase: $170,000/yr

Old Supplier

New Supplier

$77,000 Total Cost Increase

Arma-dillo

Background: Types of costs• Definition: Fixed costs do not vary with the

amount of output.

• Definition: Variable costs change as output changes.

• For Example: A Candy Factory• The cost of the factory is fixed.• Employee pay and cost of ingredients are variable

costs.

Total, Fixed, and Variable Costs

Your turn

• Are these costs fixed or variable?• Payments to your accountants to prepare

your tax returns.• Electricity to run the candy making

machines.• Fees to design the packaging of your candy

bar.• Costs of material for packaging.

Background: Accounting vs. Economic cost

• Typical income statements include explicit costs: • Costs paid to its suppliers for product ingredients • General operating expenses, like salaries to factory managers

and marketing expenses• Depreciation expenses related to investments in buildings and

equipment• Interest payments on borrowed funds

• What’s missing from these statements are implicit costs:• Payments to other capital suppliers (stockholders)• Stockholders expect a certain return on their money (they could

have invested elsewhere)• “Profit” should recognize whether firm is generating a return

beyond shareholders expected return

• Economic profit recognizes these implicit costs; accounting profit recognizes only explicit costs

Example: Cadbury (Bombay)• Beginning in 1978, Cadbury offered managers free

housing in company owned flats to offset the high cost of living.

• In 1991, Cadbury added low-interest housing loans to its benefits package. Managers moved out of the company housing and purchased houses. The empty company flats remained on Cadbury’s balance sheet for 6 years.

• 1997 Cadbury adopted Economic Value Added (EVA)® • A capital charge appeared on division income statements

• Senior managers then decided to sell the unused apartments after seeing the implicit cost of capital.

• Discussion: How did this action increase profitability?

Accounting costs for Cadbury

Opportunity costs & decisions• Definition: the opportunity cost of an action is

what you give up (forgone profit) to pursue it.• Costs imply decision-making rules and vice-versa

• The goal is to make decisions that increase profit

• If the profit of an action is greater than the alternative, pursue it.

• Whenever you get confused by costs, step back and ask “what decision am I trying to make.”

• If you start with costs, you will always get confused

• If you start with a decision, you will never get confused

• Discussion: What was cost of capital• To Bombay division?; to company?

• How do we get GOAL ALIGNMENT?

Relevant costs and benefits

• When making decisions, you should consider all costs and benefits that vary with the consequence of a decision and only costs and benefits that vary with the decision.

• These are the relevant costs and relevant benefits of a decision.

• You can make only two mistakes• You can consider irrelevant costs

• You can ignore relevant ones

Fixed-cost fallacy• Definition: letting irrelevant costs influence a

decision

• Football game example – how does ticket price affect your decision to stay or leave at halftime? Should it?

• Launching a new product – what if overhead deters a profitable product launch

• Discussion: does your company include “overhead” in transfer prices?

• Discussion: outsourcing agitator production

• Diagnose problem using Decisions rights; evaluation metric; compensation scheme, • Try to fix it: how do you better align the incentives of the plant

managers with the profitability goals of the company?

Discussion: Outsourcing

Hidden-cost fallacy

• Definition: ignoring relevant costs when making a decision

• Example: another football game

• Discussion: should you fire an employee?

• The revenue he provides to the company is $2,500 per month

• His wages are $1,900 per month

• His office could be rented out $800 per month

• Discussion: Come up with examples of the hidden-cost fallacy.

Subprime mortgages

• The subprime mortgage crisis of 2008 is a good example of the hidden-cost fallacy.

• Credit-rating agencies failed to recognize the higher costs of loans made by dubious lenders.• Example: Long Beach Financial • Gave loans out to homeowners with bad credit,

asked for no proof of income, deferred interest payments as long as possible.

• Credit ratings didn’t reflect the hidden costs of risky loans, as a result many Wall Street investors purchased packaged risky loans and eventually went bankrupt when the debtors defaulted.

Hidden cost of capital• Recall that accounting profit does not

necessarily correspond to economic profit.

• Discussion: Economic Value Added

• EVA®= net operating profit after taxes minus the cost of capital times the amount of capital utilized

• Makes visible the hidden cost of capital

• The major benefit of EVA is identifying costs. If you cannot measure something, you cannot control it.

• Those who control costs should be responsible for them.

Incentives and EVA®

• Goal alignment: “By taking all capital costs into account, including the cost of equity, EVA shows the dollar amount of wealth a business has created or destroyed in each reporting period. … EVA is profit the way shareholders define it.”

• Discussion: can you make mistakes using EVA?

• Does it help avoid the hidden cost fallacy?

• Does it help avoid the fixed cost fallacy?

Does EVA® work?• Adopting companies of EPP’s (+ four years)

• ROA from 3.5 to 4.7%• operating income/assets from 15.8 to 16.7%

• Indistinguishable from non-adopters• Bonuses increase 39.1% for EVA® firms • But 37.4% for control group

• Interpretations• Selection bias?

• NO, cheaper to use existing plans• Goal alignment, YES.

• EVA® is no better or worse• Rival EPP’s• Bonus plans• Discussion: WHY?

Psychological biases• Not enough information or bad incentives are not the only

causes for business mistakes. Often psychological biases get in the way of rational decision making.

• Definition: the endowment effect means that taking ownership of item causes owner to increase value she places on the item.

• Definition: loss aversion – individuals would pay more to avoid loss than to realize gains.

• Definition: confirmation bias – a tendency to gather information that confirms your prior beliefs, and to ignore information that contradicts them.

• Definition: anchoring bias – relates the effects of how information is presented or “framed”

• Definition: overconfidence bias – the tendency to place too much confidence in the accuracy of your analysis

Alternate intro anecdote• Coca-Cola in the 1980s had very little debt, preferring to raise

equity capital from its stockholders

• Company had a diversified product line, including products like aquaculture and wine. These other businesses generated positive profits, earning a ten percent return on capital invested.

• The company, however, decided to sell off these “under-performing businesses”

• Why?

• At the time, soft drink division was earning 16 percent return on capital

• The “opportunity cost” of investing in aquaculture and wine is the foregone profit that could have been earned by investing in soft drinks

• A dollar invested in aquaculture and wine is a dollar that was not invested in soft drinks

• Divisions sold off and proceeds invested in core soft drink business