School of Accountancy Business and Hospitality

Accountancy Department
Academic Year 2021-2022

Lesson 2: The One Lesson of Business

I. The One Lesson of Business

A. Capitalism 101

B. Wealth-Creating transactions

Topic: C. Do mergers create wealth?

D. Does government create wealth?

E. The one lesson of economics

F. Companies create wealth

At the end of this module, you are expected to:

• Assess the economic system of the Philippines and consider how most
Learning Outcomes:
organizations create wealth

• Examine the role of the Government in the creation of Wealth

LEARNING CONTENT

Introduction:

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?

Lesson Proper:
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
o 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:
o The buyer values the house at $130,000 – top dollar
o 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:
o Buyer surplus = buyer’s value minus the price, $2,000
o Seller surplus = the price minus the seller’s value, $8,000
▪ Total surplus = buyer + seller surplus,
$10,000 = difference in values

Revisiting the Market Equilibrium

• The forces of supply and demand determine the prices of goods and services and the
quantities sold.
• Market equilibrium reflects the (most efficient) way markets allocate scarce resources.
• Whether these market allocations are desirable is determined by welfare economics.

Welfare Economics

• Buyers and sellers receive benefits from taking part in the market.
• The equilibrium is a market maximize the total welfare of buyers and sellers.
• Equilibrium in a market results in maximum benefits, and therefore maximum total welfare
for both the consumers and the producers of the product.
• Consumer surplus measures economic welfare from the buyer’s side.
• Producer surplus measures economic welfare from the seller’s side.

Consumer Surplus

• Willingness to pay is the maximum price that a buyer is willing and able to pay for a good.
• It measures how much the buyer values the good or service.
• Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the
buyer actually pays for it.
• The market demand curves depict the various quantities that buyers would be willing and
able to purchase at different prices.
• Consumer surplus, the amount that buyers are willing to pay for a good minus the amount
they actually pay for it, measures the benefit that buyers receive a good as the buyers
themselves perceive it.
Producer Surplus

• Producer surplus is the amount a seller is paid minus the cost of production.
• It measures the benefit to sellers participating in a market.
• Just as consumer surplus is related to the demand curve, producer surplus is closely
related to the supply curve.
• At any quantity, the price given by the supply curve shows the cost of the marginal seller,
the seller who would leave the market first if the price were any lower.

Market Efficiency

• Consumer surplus and producer surplus may be used to address the following questions:
o Is the allocation of resources determined by free markets in any way
desirable?

Economic Well-being and Total Surplus

Consumer surplus = value to buyers – amount paid by buyers

Producer surplus = amount received by sellers – cost to sellers

Total surplus = consumer surplus + producer surplus

Total surplus = value to buyers – cost to sellers

• Market efficiency is achieved when the allocation of resources maximizes total surplus.

Three Insights concerning market outcomes

• Free markets allocate the supply of goods to the buyers who value the most highly.
• Free markets allocate the demand for to the sellers who can produce them at least cost.
• Free markets produce the quantity of goods that maximizes the sum of consumer and
producer surplus.

WEALTH-CREATING TRANSACTIONS

• Which assets do these transactions move to higher-valued uses?

o Factory Owners
o Real Estate Agents
o Investment Bankers
o Insurance Salesman

DO MERGERS CREATE WEALTH?

 • The movement of assets to a higher-valued use is the wealth-creating engine of
capitalism.
o Our largest and most valuable assets are corporations
• Dell-Alienware merger:
o In 2006, Dell purchased Alienware, a manufacturer of high-end
gaming computers.
o Dell left design, marketing, sales and support in Alienware’s hands;
manufacturing, however, was taken over by Dell.
o 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?

o Enforcing property rights, contracts, to facilitate wealth creating
transactions
• Discussion: Why are some countries so poor?
o 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.”

Government policies

• In a free, unregulated market system, market forces establish equilibrium prices and
exchange quantities.
• While equilibrium conditions may be efficient, it may be true that nor everyone is satisfied.
• One of the roles of economists is to use their theories to assist in the development of policies
(economist as a policy maker).

Price Controls

• Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
• Result in government-created price ceilings and floors,
• Yet, these policies can generate inequities of their own.

Price Ceilings and Price Floors

Price Ceiling – a legally established maximum price at which a good can be sold.
Two outcomes are possible when the government imposes a price ceiling:

• The price ceiling is not binding if set above the equilibrium price.
• The price ceiling is binding if set below the equilibrium price, leading to a shortage.
• Example: rent controls – are ceilings placed on the rents that landlords may charge their
tenants. The goal of rent control policy is to help the poor by making housing more affordable.

Price Floor – a legally established minimum price at which a good can be sold.

• Whereas a price ceiling places a legal maximum on prices, a price floor places a legal
minimum.
• When the government imposes a price floor, two outcomes are possible:
o The price floor is not binding if set below the equilibrium price.
o The price floor is binding if set above the equilibrium price, leading to a
surplus.
• Effects of a price floor
o A price floor prevents supply and demand from moving toward the
equilibrium price and quantity.
o When the market price hits the floor, it can fall no further, and the market
price equals the floor price.
• Example: minimum wage – minimum wage laws dictate the lowest price possible for labor that
any employer may pay.

THE ONE LESSON OF ECONOMICS

• Definition: an economy is efficient if all wealth-creating transactions have been

consummated.
o 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.
o 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.
• Taxes Destroy Wealth:
o By deterring wealth-creating transactions – when the tax is larger
than the surplus for a transaction.
o Which assets end up in lower-valued uses?
• Government levy taxes to raise revenue for public projects.

Potential impacts of taxes

• Taxes discourage market activity.

• When a good is taxed, the quantity sold is smaller.
 • Buyers and sellers share the tax burden.

Taxes

• Tax incidence is the study of who bears the burden of a tax.

• Taxes result in a change in market equilibrium.
• Buyers pay more and sellers receive less, regardless of whom the tax is levied on.
• Subsidies Destroy Wealth:
o Example: flood insurance – encourages people to build in areas
that they otherwise wouldn’t
o Which assets end up in lower-valued uses?
• Price Controls Destroy Wealth:
o Example: rent control (price ceiling) in New York City - deters
transactions between owners and renters
o Which assets end up in lower-valued uses?
• 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.
• Taxes create a profit opportunity
• Subsidies create opportunity
• Price-controls create opportunity

COMPANIES CREATE WEALTH

• Companies are collections of transactions:

o They go from buying raw materials, capital, and labor (lower value)
o To selling finished goods & services (higher value)
• Why do some companies have difficulty creating wealth?
o They have trouble moving assets to higher-valued uses
▪ Analogy to taxes, subsidies, price
controls on internal transactions

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?
• One main problem occurred in 2000
o Mugabe backed his supporters’ takeover of commercial farms,
essentially revoking property rights of these farmers
 o The state resettled the confiscated lands with subsistence
producers - many with no previous farming experience. Agricultural
production plummeted.
o Farm debacle had economic ripple effects through the banking and
manufacturing sectors
o Declining production deprived the country of ability to earn foreign
currency and buy food overseas
o Widespread famine ensued
o 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.
• Pressure to evolve from two sources
o Product market competition
o Financial market: threat of takeover

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.

END of LESSON

ASSIGNMENT

Read about Benefits, Costs, and Decisions

REFERENCES

Textbooks

Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor (2019) Managerial Economics-5th
Edition. Cengage learning.

Avila-Bato, Malveda and Viray (2016) Microeconomics simplified. Anvil Publishing, Inc.
Colander, D. (2020) Microeconomics- 11th Edition. McGraw-Hill Education.

Arnorld, R. (2019) Microeconomics. Cengage learning.

Blanchard, A. (2019) Microeconomics. Ed-Tech Press.

Mankiw, N.G. (2018) Principles of Microeconomics. Cengage learning.

Gwartney, J.,et.al. (2018) Microeconomics: Private and Public Choice-16th Edition. Cengage
learning.