Governments, Corporations, and Markets

 Governments, Corporations, and Markets

The government also supports business activity in other, less direct, ways. The regula- tion of capital and commodity markets helps companies obtain investment funds and raw materials at competitive prices. Insurance of bank deposits encourages individuals to save, which provides funds for banks to lend to individuals and businesses. Professional certification of doctors, dentists, lawyers, and pilots provides a tacit assurance of quality. This increases consumer confidence and consumer use of these professional services. A well-developed legal system encourages business activity by penalizing firms that engage in unfair trade practices and assuring that contractual commitments are honored.

Financial crises often lead to new regulations by the government beginning with the Great Depression and the creation of the Securities and Exchange Commission in 1934. Recent history has its own examples of the interplay between financial markets and government regulation. The accounting scandals involving firms like Enron and WorldCom led to the passage of Sarbanes-Oxley (SOX) in 2002, with its tighter reporting standards, strength- ened insider trading rules, and the separation of auditing and consulting services by accounting firms. The “Great Recession” resulted in the Dodd-Frank bill that was signed in 2011. Some of its key provisions included the creation of the Bureau of Consumer Finan- cial Protection and the Financial Stability Oversight Council.

Within the limitations and opportunities provided by this legal framework, corporations compete in markets that operate according to the laws of supply and demand. Corpora- tions sell the goods and services they produce in product markets. Product markets also provide the raw materials and other inputs that firms use in their production process. To create value for their shareholders, corporate managers must pay careful attention to the product markets as they choose the mix of items to produce and decide how best to produce them. Successful managers have a knack for figuring out what consumers want and providing it at an acceptable price. The left-hand side of the financial balance sheet reflects the product market decisions made by managers as they work toward increasing the wealth of shareholders.

Besides product markets, firms also participate in financial markets. A company’s finan- cial market activities appear on the right-hand side of the financial balance sheet under long-term liabilities and equity. Financial markets supply the funds that firms use to purchase productive assets, such as factories, machinery, trucks, computers, and offices. Financial markets also provide a mechanism for valuing a firm’s securities. Investors buy and sell stocks and bonds in these markets. These transactions determine security prices and, thereby, the value investors place on a firm.

Figure 2.1 shows how government, product markets, and financial markets all interact on the financial balance sheet.

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CHAPTER 2Section 2.1 Governments, Corporations, and Markets

Figure 2.1: The financial balance sheet and government

Product Markets

Financial Markets

Taxes paid to government units

Government

Internal and external funds provided to the corporation

Investments made by the corporation

The Financial Balance Sheet

Cash flow from operations

The role of government in the decisions of corporations is complex, impacting both product and financial markets.

One important lesson of modern finance is that corporations are defined in large part by the markets in which they operate. Therefore, in many respects finance is the study of markets. Understanding the markets in which corporations participate is essential to understanding corporations themselves. Corporate assets, such as plant, equipment, and human resources are shown on the left-hand side of the financial balance sheet and reflect the corporation’s activity in product markets. The right-hand side of the financial balance sheet shows how the firm financed those assets; that is, it presents a record of the firm’s activities in the financial markets. The corporation acts as a conduit, linking investment funds from the financial markets to goods and services in the product markets. The cor- poration invests the funds in machinery, factories, raw materials, and skilled personnel, which are organized to produce items that consumers want. See Figure 2.2 for an illustra- tion of this interaction on the financial balance sheet.

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