Hi. I'm Richard McKenzie.

In case you missed the first lecture, I will be your professor in this video course. This is the first subject of lecture in this video course. My objective in this lecture is very simple - to introduce you to the economic way of thinking. I will do this by posing a series of questions that on their surface, may appear odd. And several might appear to have nothing to do with economics. However, be assured, they are very relevant to the economic way of thinking which is the focs of the lecture. In addressing these questions, I will be using economic principles and concepts, plus And that we have not yet formally developed but we will develop with care in later lectures. For now I want to give you a taste of the economic way of thinking so that you'll see the value of learning the concepts and principles that we will develop again with care in later lecture. My overriding goal, to change the way you see the world. I truly want you to think differently at the end of this lecture, but especially at the end of the course. My lectures will be, not be politically correct. Indeed these lectures will be a politically correct free zone which is to say I will follow the flow of analysis without regard to the political correctness, or lack thereof, of the conclusions drawn. If I had my way with you, you will not be socially acceptable at many cocktail parties. Mainly because you will not be able to resist the temptation, to point out the flaws and the arguments that people around you often times, will make. Now on to the questions. When I start my first, lecture in the fall, of each academic year, I often times have many students in class who are working professionals. I go up, I ask the class, how many in here worked for mismanaged firms? And out of 60 or 70 students, I may have a dozen or, or maybe even twenty students raise their hands. Then I posed a follow up question. How many in here who worked for mismanaged firms, worked for grossly mismanaged firms? Then I will have maybe a half dozen hands go up, I can't help but go up to one of the students and, point to him. If you work for a grossly mismanaged firm why are you here? And the student will stumble and fumble a bit, and, and sometimes will say. Well I'm here to get an education, so that I can find a job with a company that's not so mismanaged. But I'd point out to him.

don't you understand that if you work for a grossly mismanaged firm, there is an economic opportunity sitting right before you. everyday I asked a student and all other students, what is the value of a firm? Again, I get fumbles and mumbles, from the students. The real answer is that the value of a firm today will in some rough approximation equal the stream of profits. that the firm can be expected to make, into the distant future. And if a firm is grossly mismanaged that means that, that profit stream is being depressed. the gross mismanagement can show up as lower revenues then the firm could otherwise make or higher costs than the firms would otherwise have to incur. Both of which can result in a Depression, of the future profit stream. And if that profit stream is depressed, because of the gross mismanagement, that means that the current price of the firm, is going to be depressed. I then pose the student, now do you see the problem I'm trying to get at? trying to understand why you're here when you work for a grossly mismanaged firm? He begins to, to see the, see the point. Because if a firm is grossly mismanaged, that means that the selling price of the firm is going to be depressed. That means that he, or anyone else, can buy the firm. At a low price. And then change the management style, in, in, in all kinds of ways. Improve the management. And in improving the management, the firms or revenue stream can, can go up. And its costs can go down. Its profit stream into the distant future can, can escalate. And with an increase in that profit stream into the future, the value of the firm can go up. So I, in answer, why are you here, I'm really saying to the student, well, if you wo rk for a grossly mismanaged firm, you're sitting on a golden egg. You can buy that firm now, as grossly mismanaged as it is. Buy it at a low price, correct the management policies, and then sell out at a higher price. Well sometimes, students will object. Well, I don't have where with the how to buy my firm. My firm is a big, big firm. Well, that is a problem, you do have to have the capital in, in order to buy, even a low priced mismanaged. firm. But, that shouldn't be all that big a problem, because there are all kinds of people out there, entrepreneurs, who are looking for mismanaged firm, for problem firms. You can take your case to Wall Street, and I am sure, that if you can prove that your

firm is grossly mismanaged, you will have a lot of people, willing to listen to you. Why? Because you will be telling them that there is a profitable opportunity in buying their firm. And as a result, you can get a syndicate of investors to go along with you to buy out, buy out the firm, correct the management of problems, and then sell out At a capital gain of later in later in time. The point here, from all of this is that bad management gets capitalized into the market. They are firm. And woe be to the manager who allows his firm or her firm to be grossly mismanaged. Because there are all kinds of people out there who are looking for mismanaged firms precisely because mismanagement translates into a profitable opportunity. . Well let me pose another question. who should we feel sorry for, in the event of, of floods. The people who lived in the flood plains, and are flooded, when a flood comes? Or the people who live on the hillsides, and are not flooded in the event of floods. To illustrate the problem, I'm going to my overhead camera, and I'm going to assume that there is a valley. There's a valley and this is my crude artwork, I have to say, there's a valley. there's, there are hillsides. And then there's, a bottom to the valley. And there is a, a river flowing through the, through the valley. You can imagine that p eople can, in fact, build in what might be construed, as the flood plain. That is, the area that will be plotted, every now and then, when there are heavy, heavy rains or snow run-off. If a person builds a house here, that person can expect to be flooded. If the person builds a house up on, on the hillside, that person can, can expect to escape the flood damage. Well who should we feel sorry for if there is a,a flood that causes these people to be flooded out. Well the normal presumption is that you feel sorry for the people who build in this flood plain, because they are damaged by the flood. They lose their furniture and they may have to rebuild their houses. But, you've gotta think about this carefully, because suppose, that the value of this property, call it A, is $100,000. Sells for $100,000. If in fact property B worked itself for the same amount a $100,000 which property would you, would you want? Especially knowing that this house here is in the flood plain. Well let's suppose that when a flood comes this property owner, the property owners in the

flood plain can expect to $20,000 of worth of damage. Well if that's the case, would you expect these two houses, a and b, to sell for the same price? And the answer is no, because if they did sell for the same price, everybody would want to buy, the house on the hillside for $100,000. Because that house is gonna cost $100,000, and the house in the flood plain is gonna cost $100,000 plus the expected flood damage, or $120,000. Which means that the demand for the houses on the hillside will cause the price of the houses on the hillside to go up, and the price of the houses in the flood plain to go down. Now, this may be that the house here goes to $105,000, and the price here goes to $95,000. would you expect the price to persist, the price differential to persist? No. The reason is, that there's a price differential of about $10,000. There is a flood damage of $20,000, so you should expect the price of a house to, here to continue upward. Indeed it may go up to something like $110,000, while the price of the property in the flood plain declines to $90,000. The result is That the price differential is about $20,000, which is equal to the damage in the event of a flood. Now this means that if you have a flood, and the flood causes damage of only $10,000. Then you have to worry who has. You have to ask who has been damaged the most. Well the person in the flood plain payed $90,000 for his or her house. Add the $10,000 the persons total cost is $100,000. But the person who buys a house. Up on the hillside, incurs a cost of $100 and $10,000. So there's a differential here of about $10,000. One could say, well the person on the hillside is damaged more. Than the person who is flooded out. Indeed many people can buy houses in floodplains simply because property values there are cheaper and they figure that they can be better off by buying a cheaper property and losing their furniture and carpet, and, and, and maybe even pet every now and then. now if indeed the property loss is not $10,000, but say $30,000 you might feel sorry for the people on. In the flood plane. but notice in, in news reports of floods, you can always count on reporters and, and taking a camera crew out, and, and interviewing the people who have been flooded. And of course, they're miserable, and, And, it's, it's hard not for our hearts to go out, for them. But those people may have actually, not incurred as much economic,

damage in total as people who have, who have bought on higher, ground. Now let's suppose that we do feel sorry for the people, in the flood plain. the result can be that we tax the people on, on the hillside, and if we tax the people on, on the hillside for the purpose of benefiting the people in the, in the floodplain, the result can be that, The demand for houses on the hillside goes down, because they're paying taxes. And that's going to lower the price of the property up on the hillside. The, fact that people, who live in the flood plain, are subsidized, their damages is, is, is reco vered by subsidies that means that there not damaged as much and as a result the property values in the flood plain can go up, which means that the people who buy into the flood plain in the future may indeed be paying. For the price of the property there plus paying a, the value of the expected reinbursements flood damage coverage that they can get in succeeding years. So the people who. You get the plot aid, at the beginning of the plot-aid program, can be better off. But the people buying in to the flood plain, at a later time can in fact be worse off. Now the, point here, is that you've gotta realize, that whenever there's damage, whenever there's harm, those harms The, the damage even benefits can get capitalized into the price of properties. Now, other than southern California And I often ask my, er, students, why does California have so many water crises, and we have barely regularly that is we are running out of water, the reservoirs are not filled and so forth. And their peels will go out for people to curb their waterviews. When I ask my clients why do we have water crises, I, I get a variety of answers, but inevitably some student is going to say, well, it doesn't rain very much in southern California. And I have to admit they're correct. it's in Irvine, California where I live, it's, it's really a natural desert, which means we only get eleven to twelve inches a, a year, that is on average. Now, I tell my students who, who give me the answer that it doesn't rain much that you know that would be a very good answer in a course in you know meteorology. But it's not a very good, good explanation for a class and, and, and economics. And I, I point out to them, surely it doesn't rain very much water in, in Southern California. But I also have to say that it doesn't rain much in the way of Snicker's candy bars in Southern

California. It doesn't rain much in the way of Mercedes Benz in, in, in Southern California. can it be that it's the rain that is the source of the problem? we've never had a Snicker's candy bar c risis in, in southern California and, neither have we had a Mercedes Benz crisis. Unless you're willing to, to argue that when six Mercedes Benz crash at the intersection of Mcarthur and Bison, that's, that's something of a crisis. And I must say, Mercedes Benz, incomparably priced cars are, are, Are common, in this area of the country. Now, why is it that we have water crises, but we don't have Snickers candy bar crises and Mercedes Benz crises? Well, if there's a shortage in, in, in chocolate, in the world for some reason, we can imagine that the. price of chocolate will go up, and the price of Snickers candy bars will go up, and there will be no shortage of Snickers candy bars. The price will rise to, to eliminate the crisis. If there's an increase in demand for Mercedes Benz the price of Mercedes Benz will, will go up. And there will be no crisis, no shortage of Mercedes-Benz. But this leads us to an insight that we often times have of what are crises in Southern California. not because of the lack of rain but mainly because the price of water is checked, it's controlled. It's controlled, by, government authorities, and so, when we have less than the average amount of rainfall each year, the price of water does not rise. And as a result we have a shortage in the market. people will continue to, to water their lawns as if there has been no drop off in the rainfall. And, and by the way, the sprinkler systems out here in southern California go full blast during what are called a water crisis. And the reason is that each individual home owner can reason, well if I sprinkle my yard, I will use more water, but it's not going to matter that much, and as a result I will not avert a water crisis in southern California by cutting back on my sprinkling. And designs if I could back on last sprinkling that just means that there have more water for other people to make use of. the mor, the moral of the lesson of, of that story is, is very simple and that is whenever you see, hear talk of a crisis whether its a water crisis or electricity crisis or whatever beyond the alert. for controlled, prices. Now, here in Southern California, we have a grocery

stores know as Trader Joe's that are expanding throughout, throughout the country. A number of years ago, Trader Joe's introduced a wine called Charles Shaw. And it sold the wine for $1.99 a bottle and, Charles Shawn was, not a great wine, but it was sufficiently great in order to win a wine contest. In indeed, I had my, I had a blind taste test with Charles Sean, Kendall Jackson at my home at the end of the quarter with my students. And 76% of the students chose Charles Shaw Wine over Kendal Jackson which is five times as expensive. the question I posed to you is, what is the impact of Charles Shaw? Well, if you, if you think about it, if you, if you, if Trader Joe brings on Charles Shaw at $1.99 a bottle, which is a, was a, was at the time about one-third of the price of, of table wine you can expect more people to buy more wine. And with more people buying more wine, you can expect more people to engage in, in drinking and, and, and driving. As a result of the introduction of Charles Shaw you probably had more cases of, of drunk driving. And more than just because of Charles Shaw because when Charles Shaw lowered its lower the price of its wine, it forced other producers to lower the price of wine and encourage drinking across, the board. In the late 1980's there was a plane crash in, in Iowa, of a, of a DC-10 and there have been videos of the crash being shown today, repeatedly and the DC-10 tumbles down the Iowa runway in a fiery ball. On that on that plane a mother was carrying a baby, and apparently during the crash, during the tumbling, the baby flew out of the mother's arms and hit the bulk head and the baby died. Congressman Jim Lightfoot got up on the stump and said well, we've got to make sure that no more babies die in plane crashes. We've got to require that parents buy a seat for their infants and the parents must put their infants and toddlers in safety seats. It was a warm-he arted proposal, but the analysis needs to be done on it. What is the impact of requiring families to buy seats for their infants and toddlers, and then to buy safety seats to put them in? Well the easy answer is that it immediately drives up the cost of families flying and as a consequence of that, it's going to cause fewer families to fly. Moreover, many of these families that do not take their trips by airlines will go by car and travel is about 100 times as deadly as air

travel. As a consequence you could find that a requirement that parents buy seats for their infants can actually cause more deaths of Americans on American roads than would have been saved in the air by the safety seat. A colleague of mine and, and I ran the numbers in the late 1980s and we found that, that such a requirement, that is families buying seats for infants and toddlers, toddlers would result in about 150 deaths on American roads. The FAA did a similar study and it found that for every half baby that's saved in the air from the required seat purchase there would be five babies killed on American roads. Now only economists at the FAA can, can tell you how they figured how a half a baby can be saved in the air. Now I would like to go from that line of argument to replying that the 9/11 terrorists have probably killed more Americans since 9/11 than they killed on 9/11. And the 9/11 terrorists have been dead ever sense. How can that be? Well the answer is, is pretty simple or pretty easy from an economic prospective. When the 9/11 terrorists flew the planes into those twin towers they increased the risk cost of flying and there by the total cost of flying. When the TSA responded by checking everyone who travels by air, they increased the lines going through the security check points. They increased the weight cost of flying. As a result, they increased the overall cost to flying and they reduced the number of, of Americans flying. Of course, many of these Americans moved from travel by airways to travel by the highways. Again, highway travel is, is far more deadly than, than airway. travel. Economists at Cornell University have indeed checked the data and found that in12 months after 9/11, 1,250 more Americans were killed on American highways than would have been Killed had we not had 9/11, had we not had the greater risk of supplying and the greater, greater time cost of, of flying. Well, I could go on with any number of other problems like this and I will pose these kinds of problems throughout these lectures. I want to leave you with a, a problem. Suppose you are given two choices. In option A, if you choose option A, you are certain to receive $800 from your choice. You, it's a certainty. If you choose option B. How you have an 85% chance of receiving $1000 and a fifteen percent chance of receiving nothing. That is, $zero. Which do you take? You can't take both.

Again, you have option A which is a certainty. You get eight hundred dollars. If you choose option B you get an eighty five percent chance of getting a thousand dollars and a fifteen percent chance of receiving nothing at all. Which do you take? Now my assignment for you for the next lecture is assume that seventy five percent of the people watching this video. Choose option A. That is a certainty, the $800 payoff. If in fact that is the case, is there money being left on the table? That's the first question, is there money being left on the table? The second question is, if there is money being left on the table, can you devise a means of picking up some of that money on the table. I'll forward to talking with you about this problem in our next lecture and thank you for listening.