foundations of american enteprise topics

Economics as a Way of Thinking

Economics is often described as a way of thinking because it focuses on how individuals, businesses, and governments make choices with limited resources. Economists analyze decision-making, resource allocation, incentives, and trade-offs. The goal is to understand how people make decisions and how those decisions interact with others in society.

2. Diane Coyle's "Incontrovertible Principles"

Diane Coyle, a prominent economist, emphasized certain core economic principles that are considered foundational across economic theories:

• Scarcity: Resources are limited, so we must make choices.

• Trade-offs: Every choice involves giving up something to get something else.

• Incentives: People respond to incentives, whether they are economic, social, or psychological.

• Costs and Benefits: Decisions are made based on weighing the costs and benefits of alternatives.

• Interdependence: Economic actions and outcomes are often interconnected globally, making economics a system of interdependent decisions.

3. Capitalism and the Factors (or Means) of Production

Capitalism is an economic system based on private ownership of the means of production and their operation for profit. The factors of production (also known as the means of production) are the resources used to produce goods and services:

• Land: Natural resources like land, water, and raw materials.

• Labor: The human effort used in production.

• Capital: Physical tools, machines, factories, and infrastructure.

• Entrepreneurship: The innovation and risk-taking that drive economic activity and growth.

4. Microeconomics vs Macroeconomics

• Microeconomics: Focuses on the individual parts of the economy, such as households, firms, and specific markets. It looks at supply and demand, pricing, and how individual agents make decisions.

• Macroeconomics: Deals with the economy as a whole, focusing on aggregate indicators like GDP, unemployment rates, inflation, and national income.

5. Markets and the Context Required for Them to Function Well

• Markets are systems where buyers and sellers interact to exchange goods, services, or information.

• For markets to function effectively, certain conditions must be met:

  • Competition: A large number of buyers and sellers ensures no single entity controls prices.

  • Information: All participants should have access to relevant information.

  • Property Rights: Clearly defined and enforceable property rights allow ownership and control.

  • Low Transaction Costs: The cost of making a transaction should be minimal.

6. The Supply and Demand Model

The Supply and Demand model is a fundamental concept in economics that explains how prices and quantities are determined in a market:

• Supply: The amount of a good or service that producers are willing to sell at various prices.

• Demand: The amount of a good or service that consumers are willing to buy at various prices.

• The equilibrium price is where supply and demand meet. When prices are too high, demand falls, and when prices are too low, supply falls.

• The model assumes that, all else being equal, price increases lead to a decrease in demand and an increase in supply, and price decreases lead to an increase in demand and a decrease in supply.

7. Heilbroner's Fundamental Economic Problem

Robert Heilbroner, an economist, pointed out that the fundamental economic problem is how to manage scarce resources to meet the unlimited wants of individuals and society. This leads to the study of how resources are allocated and how economies organize production and distribution.

8. Behavioral Economics

Behavioral economics combines psychology and economics to explore why people often make decisions that are not in their best interest. Traditional economics assumes that people are rational decision-makers, but behavioral economics shows that people can be influenced by biases, emotions, social influences, and cognitive limitations. Key concepts include:

• Bounded Rationality: People make decisions with limited information and cognitive resources.

• Loss Aversion: People feel the pain of losses more intensely than the pleasure of gains.

• Framing Effect: People's decisions are influenced by how information is presented.

9. Variable Cost vs Fixed Cost

• Fixed Costs: These are costs that do not change with the level of output. Examples include rent, salaries of permanent staff, and insurance.

• Variable Costs: These costs change directly with the level of production or output. Examples include raw materials, labor (if it varies with output), and utility costs related to production levels.

• Total Costs: The sum of fixed and variable costs.

• Average Cost: The total cost divided by the number of units produced.

• Marginal Cost: The additional cost of producing one more unit of output

1. The Components of America's Financial System

The financial system in the U.S. is made up of several key components that facilitate the flow of money and investment throughout the economy:

• Financial Markets: Markets where financial securities (stocks, bonds, etc.) are bought and sold, such as the stock market (NYSE, NASDAQ) and bond markets.

• Financial Institutions: Entities that facilitate the exchange of funds, such as commercial banks, investment banks, credit unions, insurance companies, and pension funds.

• Financial Instruments: The actual securities and contracts that are traded, such as stocks, bonds, derivatives, and currencies.

• Central Bank (The Federal Reserve): The institution that manages the nation’s money supply, regulates financial institutions, and implements monetary policy.

• Government and Regulatory Agencies: Organizations that oversee the financial system to ensure stability, transparency, and fair competition, including the Securities and Exchange Commission (SEC), the Federal Reserve, and the Treasury.

2. The Requirements of an Efficient Financial System

For a financial system to be efficient, it must:

• Facilitate the Flow of Funds: It should provide a mechanism for savings to be converted into investments, allowing funds to flow from those who have them to those who need them.

• Provide Liquidity: The system must allow assets to be easily bought or sold without significantly affecting their price.

• Provide Transparency: Financial markets and institutions must be transparent about risks, financial conditions, and investments.

• Risk Management: The system should allow individuals and businesses to manage and diversify risks through a variety of financial products and services.

• Promote Stability: An efficient system should help prevent financial crises and maintain economic stability.

3. Types of Securities and Their Purposes

• Stocks (Equities): Represent ownership in a company and provide investors with a share of the company’s profits (dividends) and potential capital gains. They are used to raise capital for businesses.

• Bonds (Debt Securities): Debt instruments issued by governments or corporations to raise funds. The issuer agrees to pay the bondholder interest (coupon) periodically and repay the principal at maturity. Bonds are a way for entities to borrow money.

• Treasury Bills (T-Bills): Short-term debt securities issued by the U.S. government, often used as a safe investment with low risk.

• Treasury Notes and Bonds: Longer-term debt securities issued by the U.S. government, used to finance national debt.

• Derivatives: Financial contracts whose value is derived from the price of an underlying asset (such as options, futures, and swaps). They are used for hedging or speculation.

• Mutual Funds: Pooled investments that allow investors to invest in a diverse portfolio of stocks, bonds, or other securities.

• Exchange-Traded Funds (ETFs): Similar to mutual funds but traded on stock exchanges, offering liquidity and diversification.

4. The Role of the Federal Reserve and Congress in Monetary Policy

• Federal Reserve (Fed): The central bank of the U.S. plays a critical role in managing monetary policy, which involves controlling the money supply, regulating interest rates, and stabilizing the economy. Its key functions include:

  • Setting Interest Rates: Through the Federal Open Market Committee (FOMC), the Fed sets short-term interest rates, influencing borrowing costs, inflation, and employment.

  • Open Market Operations: The Fed buys and sells government securities to influence the amount of money in circulation.

  • Reserve Requirements: The Fed sets the reserve requirements for commercial banks, which impacts how much money banks can lend.

  • Lender of Last Resort: During times of financial distress, the Fed provides liquidity to banks and financial institutions.

• Congress: While the Fed is independent, Congress plays a role in monetary policy through its control over fiscal policy (taxing and spending) and oversight of the Fed. Congress also has the power to change laws related to banking, taxation, and the national debt, all of which can influence monetary policy.

5. GDP (Gross Domestic Product)

• Definition: GDP is the total value of all final goods and services produced within a country’s borders over a specified period (typically a year or a quarter). It’s used as a measure of the economic activity and health of a country.

• GDP Formula:

  GDP=C+I+G+(X−M)GDP = C + I + G + (X - M)GDP=C+I+G+(X−M)

  Where:

  • C = Consumption (spending by households on goods and services)

  • I = Investment (spending by businesses on capital goods, and household purchases of new housing)

  • G = Government Spending (expenditures by the government on goods and services)

  • X = Exports (goods and services sold to foreign countries)

  • M = Imports (goods and services purchased from foreign countries)

• Uses of GDP:

  • Economic Health Indicator: GDP helps to measure the economic performance of a country and can be used to compare the output of different economies.

  • Policy Guidance: Policymakers use GDP data to guide decisions on fiscal policy (government spending and taxation) and monetary policy (interest rates and money supply).

  • Economic Growth: By comparing GDP growth over time, economists can assess whether the economy is expanding or contracting.

GDP is often used as an indicator of standard of living, though it doesn’t account for distribution of income, environmental sustainability, or non-market activities (e.g., household labor).

1. Double-Entry Bookkeeping

Double-entry bookkeeping is the accounting system used to record financial transactions. Every transaction affects at least two accounts: one account is debited (increased) and another is credited (decreased), ensuring the accounting equation remains balanced. This method helps prevent errors and provides a more accurate financial picture.

• The Accounting Equation: Assets=Liabilities+Owner’s Equity\text{Assets} = \text{Liabilities} + \text{Owner’s Equity}Assets=Liabilities+Owner’s Equity

  • Assets: What the business owns.

  • Liabilities: What the business owes.

  • Owner’s Equity: The owner’s interest in the business, which represents the residual value after liabilities are subtracted from assets.

Example: If a company borrows money from a bank, its assets (cash) and liabilities (loan payable) both increase by the same amount. This keeps the books in balance.

2. How and Why Enterprise Insiders and Outsiders Use Financial Statements

Financial statements are essential for both insiders (e.g., managers, employees) and outsiders (e.g., investors, creditors, regulators) for different purposes.

• Insiders (Managers/Owners):

  • Decision-Making: Managers use financial statements to make informed decisions regarding operations, strategy, and planning. They rely on the data to track performance, plan budgets, and assess profitability.

  • Performance Evaluation: Owners and managers can use the income statement and balance sheet to evaluate the company’s financial health, efficiency, and the effectiveness of various strategies.

  • Resource Allocation: Financial statements help identify areas where resources are being used effectively and where cuts or investments are needed.

• Outsiders (Investors, Creditors, Regulators):

  • Investment Decisions: Investors use financial statements to assess whether a company is profitable, solvent, and likely to provide a return on investment. They focus on earnings, cash flows, and financial stability.

  • Creditworthiness: Lenders (e.g., banks) analyze a company's balance sheet and income statement to determine its ability to repay debt.

  • Regulation and Compliance: Regulatory agencies, such as the Securities and Exchange Commission (SEC), use financial statements to ensure companies are complying with legal and tax obligations and to protect investors.

3. The Manager-Owner Problem (or Agent-Owner Problem)

The manager-owner problem refers to the conflict of interest between company managers (agents) and the owners (shareholders) of a business. While managers are hired to make decisions in the best interest of the owners, their personal interests or incentives might not always align with those of the owners. This issue can affect financial reporting and decision-making.

Examples of Misalignment:

• Short-term vs Long-term Goals: Managers may focus on short-term profitability (e.g., cutting costs) to improve their bonuses, while owners may be more concerned with long-term growth.

• Risk-Taking: Managers may be less risk-averse than owners, as they may not face the full consequences of risky decisions, whereas owners bear more financial risk.

Solution: Financial statements help address this problem by providing transparency. By relying on accurate financial reports, owners can better assess how well managers are performing and whether they are acting in the company’s best interest.

4. Financial Statements: Income Statement and Balance Sheet

• Income Statement: The income statement shows the company’s profitability over a specific period. It outlines revenues and expenses, leading to net income (or loss).

  • Key Components:

    • Revenues/Sales: The total amount of money earned from business activities.

    • Cost of Goods Sold (COGS): Direct costs of producing goods or services sold.

    • Operating Expenses: Indirect costs such as salaries, rent, utilities.

    • Net Income: The profit (or loss) after all expenses have been subtracted from revenues.

  Formula:

  Net Income=Revenue−Expenses\text{Net Income} = \text{Revenue} - \text{Expenses}Net Income=Revenue−Expenses

  The income statement helps stakeholders understand the company’s ability to generate profit, manage costs, and its overall financial performance.

• Balance Sheet: The balance sheet provides a snapshot of a company’s financial position at a specific point in time. It shows what the company owns (assets), what it owes (liabilities), and the owner’s equity (the value of the company to the owners).

  • Key Components:

    • Assets: Divided into current (short-term) and non-current (long-term) assets.

    • Liabilities: Divided into current (due within one year) and non-current (due after one year) liabilities.

    • Owner’s Equity: The residual interest in the assets after liabilities are deducted. This is also known as shareholders' equity for corporations.

  Formula:

  Assets=Liabilities+Owner’s Equity\text{Assets} = \text{Liabilities} + \text{Owner's Equity}Assets=Liabilities+Owner’s Equity

  The balance sheet helps investors and creditors evaluate the company’s financial health, liquidity, and solvency.

5. Cash Flow Statement (coming later)

• The cash flow statement tracks the flow of cash in and out of a company during a specific period, categorized into operating, investing, and financing activities. It helps assess a company’s liquidity, solvency, and its ability to generate cash to fund operations and investments.

1. What is a Corporation?

A corporation is a legal entity that is separate from its owners (shareholders) and is designed to carry out business activities. It can own property, enter into contracts, sue, and be sued, much like an individual. The key features of a corporation are:

• Limited Liability: Shareholders’ personal assets are protected; they are only liable for the amount they invest in the corporation.

• Perpetual Existence: A corporation can continue to exist independently of the owners or managers, allowing for long-term stability.

• Transferability of Shares: Shares of the corporation can be bought and sold, making ownership flexible.

Corporations are often structured to maximize efficiency, raise large amounts of capital, and scale quickly.

2. The Three Innovations That Most Influenced the Growth of Large Corporations

Three key innovations were crucial in enabling the rise of large corporations:

• The Limited Liability Corporation: The concept of limited liability allowed individuals to invest in companies without risking personal financial ruin, which encouraged more investment in large corporations.

• The Development of Stock Markets: Stock exchanges and markets enabled corporations to raise capital by issuing shares of stock, giving them access to large pools of money. This made it easier for corporations to expand and diversify.

• The Modern Corporation Structure: The separation of ownership (shareholders) from management (executives) helped corporations scale by allowing professional managers to run the day-to-day operations, while shareholders focused on investment. This separation encouraged efficiency and specialization in large businesses.

3. What is "Permanent Capital", Why Is It Fundamental to the Corporation, and What Innovations and Developments Did It Drive?

• Permanent Capital refers to the funds that a corporation raises through the issuance of stock, which is not repaid like a loan. This capital is essentially "permanent" because it does not need to be returned to investors unless the corporation is liquidated.

• Why It’s Fundamental: Permanent capital allows corporations to fund large-scale operations, investments, and long-term projects without the pressure of paying off the capital. This gives corporations stability and the ability to undertake large, long-term ventures without the fear of bankruptcy or running out of funding.

• Innovations and Developments It Drove:

  • Expansion and Diversification: Permanent capital allowed corporations to scale operations and diversify into multiple industries. Companies could invest in research and development, build new facilities, and enter new markets.

  • The Development of the Modern Financial System: The availability of permanent capital and the structure of stock markets helped establish a broader financial ecosystem, including the growth of financial services, investment funds, and institutional investors.

  • Corporate Governance: Permanent capital led to the development of modern corporate governance structures, with board members overseeing company activities, which separated ownership from management.

4. Why Did Companies Grow Bigger Faster in the US Than in Other Countries?

Several factors contributed to the rapid growth of U.S. companies compared to those in other countries. While this will be discussed in class, some of the key reasons include:

• Liberal Economic Policies: The U.S. had fewer restrictions on business formation and competition, encouraging entrepreneurial activity and corporate expansion.

• Natural Resources: The U.S. had abundant natural resources, which fueled industries like manufacturing, agriculture, and energy, driving corporate growth.

• Technological Innovation: The U.S. was a leader in technological innovation, especially during the Industrial Revolution. Innovations such as the telegraph, railroad, and assembly line contributed to faster business growth.

• The Role of Capitalism: The U.S. capitalist system, with a strong emphasis on private ownership, minimal government intervention, and a thriving stock market, allowed businesses to flourish and grow more quickly than in more regulated economies.

• A Large and Growing Domestic Market: The large and expanding U.S. population created a large consumer market, which encouraged businesses to scale up production and distribution.

5. What Are Externalities and Why Do They Matter?

• Externalities are costs or benefits of economic activities that affect third parties who are not directly involved in the transaction. These effects can be either positive or negative.

  • Negative Externalities: When a company’s activity imposes a cost on others, such as pollution or noise, this is a negative externality. For example, if a factory emits pollution, the surrounding community may suffer from health problems, but the company doesn’t pay for these costs directly.

  • Positive Externalities: When a company’s activity benefits others, such as when a company improves public infrastructure or creates jobs, this is a positive externality. For example, a business investing in employee education could have broader societal benefits, such as a more skilled workforce.

• Why They Matter:

  • Market Failure: Externalities can lead to market failure when businesses do not account for the full costs or benefits of their activities. Negative externalities, in particular, may cause overproduction of harmful goods or services.

  • Regulation and Policy: Governments often intervene to correct externalities through regulations, taxes (e.g., carbon tax for pollution), or subsidies (e.g., tax credits for renewable energy) to encourage socially beneficial behavior or discourage harmful activities.

  • Social Welfare: Addressing externalities can improve overall social welfare by ensuring that businesses internalize the costs or benefits of their actions and operate in ways that benefit society as a whole.