Chapter 2 – The One Lesson of Business Wealth-Creating Transactions

Capitalism 101 Which assets do these transactions move to higher-

valued uses?
To identify money-making opportunities,
you must first understand how wealth is created  Factory Owners
(and sometimes destroyed).  Real Estate Agents
 Investment Bankers
 Keynote: Wealth is created when assets are moved  Corporate Raiders
from lower to higher-valued uses.
 Insurance Salesman
 Definition: Value = willingness to pay
Desire + Income = You want something + you can Do mergers create wealth?
pay for it
Do mergers follow the wealth-creating engine of
 Keynote: Voluntary transactions, between
capitalism? Do they move assets to a higher-valued use?
individuals or firms, create wealth.
- Meaning, people create wealth by pursuing  Our largest and most valuable assets are
self-interest. corporations.
Housing Example Ex: Dell-Alienware merger:
A house is for sale:  In 2006, Dell purchased Alienware, a
manufacturer of high-end gaming computers.
 The buyer values the house at $130,000
- This is the buyer’s top dollar – willingness to pay  Dell left design, marketing, sales, and support in
Alienware’s hands.
 The seller values the house at $120,000
- This is the seller’s bottom line – won’t accept  Dell took over manufacturing though, using its
less expertise to build Alienware’s computers at a
much lower cost.
The buyer and seller must agree to a price that “splits”  However, many mergers and acquisitions do not
surplus between buyer and seller. Here, $128,000. create value.
- If they do, value creation is rarely so clear.
Surplus
 To create value, the assets of the acquired firm
The buyer and seller both benefit from this transaction: must be more valuable to the buyer than to the
seller.
 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.

Does Government Create Wealth?

Discussion: 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
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.”
Property Rights
 Commonly identified as a right to own or
possess something, such as land or an
automobile, and to be able to dispose of it as
one chooses.
 However, this is only one aspect of property
rights that focuses on the exclusive right to
ownership.
 The main legal property rights are the right of
possession, the right of control, the right of
exclusion, the right to derive income, and the
right of disposition.
 There are exceptions to these rights, and
property owners have obligations as well as
rights.
The One Lesson of Economics
Economy – is efficient if all assets are employed in their
highest-valued assets. This is an unattainable, but useful
benchmark.
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.
Businessperson’s solution is to try to make money on
the inefficiency.
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
devising ways to 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.
Destroying Wealth - Anything that stops assets from
moving to higher valued uses is destroying wealth.
1. Taxes Destroy Wealth:
- By deterring wealth-creating transactions –
when the tax is larger than the surplus for a
transaction.
2. Subsidies Destroy Wealth:
- Example: flood insurance encourages people to
build in areas that they otherwise wouldn’t.
3. Price Controls Destroy Wealth:
- Example: rent control (price ceiling) in New York
City deters transactions between owners and
renters.
Profiting from Inefficiency
  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?

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

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.