Chapter 2

Business Cycles and Reasons for Business Fluctuations

Business cycle: rise and fall of economic activity relative to its long-term growth trend.
Macroeconomics: study of economy as a whole – National income, unemployment, inflation.
Microeconomics: studies consumers, producers, and suppliers operating in a narrowly defined market.

Gross Domestic Product (GDP): most common measure of economic activity or output of an economy
- Total market value of all final goods and services produced within the borders of a nation

Nominal GDP: measures the value of all final goods and services in current prices. No inflation
adjustment.

Real GDP: measures the value of all final goods and services in current prices. Adjusted for inflation by
using a price index.

Price index (GDP Deflator): used to calculate real GDP.

Real GDP = Nominal GDP x 100

GDP Deflator

Business cycles
Expansionary phase: rising economic activity (Real GDP) and growth.
Peak: high point of economic activity.
Contractionary phase: falling economic activity and growth and follows a peak.
Trough: low point of economic activity.
Recovery phase (expansionary phase): follows a trough and economic activity begins to increase

Recession: economy experiences negative real economic growth.

- Two consecutive quarters of falling national output.
- Resources are underutilized and unemployment is high

Depression: a very severe recession.

Leading indicators (Before)

- New unemployment claims
- Building permits for residences
- Average length of the workweek
- Money supply
- Prices of selected stocks
- Orders for goods
- Price changes of materials
- Index of consumer expectations

Becker – 2008 Edition Chapter 2 Page 1 of 13

Lagging indicators (After)
- Prime rate charged by banks
- Duration of unemployment
- Bank loans outstanding

Coincident indicators (During/Contemporaneously)

- Industrial production
- Manufacturing and trade sales

Aggregate Demand (AD) Curve: the maximum quantity of all goods and services the households, firms,
and the government are willing and able to purchase at any given price level.

Aggregate Supply (AS) Curve:

- The maximum quantity of all goods and services producers are willing and able to produce at
any given price level
- Short run aggregate supply (SRAS)
o Curve is upward sloping. As the price rises, firms are willing to produce more goods
- Long run aggregate supply (LRAS)
o Curve is vertical corresponding to the potential level of output in the economy

AD, AS, and Economic Fluctuations:

1. Reduction in Demand: Shift left AD
GDP
P

2. Increase in Demand: Shift right AD GDP P
3. Reduction of Supply: Shift left SRAS
GDP
P
4. Increase in Supply: Shift right SRAS GDP P

Factors that shift AD

1. Increase in wealth: W spend AD GDP P
2. Decrease in wealth: W
spend
AD
GDP
P

3. Increase in real interest rates: I borrow
spend
AD
GDP
P

4. Decrease in real interest rates: I
borrow spend AD GDP P
5. Confident economic outlook:  spend AD GDP P
6. Uncertain economic outlook:
spend
AD
GDP
P

7. Appreciated domestic currency:  exports
imports AD
GDP
P

o Goods will become expensive for foreigners, foreign goods become cheap for US.
8. Depreciated domestic currency:
exports imports
AD GDP P
9. Increase in government spending:  AD GDP P
10. Decrease in government spending:
AD
GDP
P

Becker – 2008 Edition Chapter 2 Page 2 of 13

 11. Increase in taxes:  spend
AD
GDP
P

12. Decrease in taxes:
spend AD GDP P

*Federal government controls the economy:

1. Increase or decrease in government spending
2. Increase or decrease in consumer taxes

Multiplier effect: $1 increase in government spending results in greater than $1 increase in real GDP.
- Results from the marginal propensity to consume

Multiplier = 1 x Change in spending

(1-MPC)
(1-MPC) = MPS

Factors that shift SRAS

1. Increase in input price:  SRAS
GDP
P
2. Decrease in input price:
SRAS GDP P

3. Supplies are plentiful:  SRAS GDP P

4. Supplies are curtailed:
SRAS
GDP
P

Economic Measures and Reasons for Changes in the Economy

 Real GDP
 Unemployment rate
 Inflation rate
 Interest rate

GDP includes the economic output of these four sectors:

- Household (consumers)
- Businesses
- Federal, state, and local governments
- The foreign sector

How to calculate the GDP?

Expenditure Approach (G + I + C + E = GDP)

G – Government purchases of goods and services
I – Gross private domestic Investment
C – Personal Consumption expenditures
E – Net Exports (exports – imports)
= GDP

Becker – 2008 Edition Chapter 2 Page 3 of 13

Income Approach (I + P + I + R + A + T + E + D = GDP)
I – Income of proprietors
P – Profits of corporations
I – Interest (net)
R – Rental income
A – Adjustments for net foreign income and miscellaneous items
T – Taxes (indirect business taxes)
E – Employee compensation (wages)
D – Depreciation (also known as capital consumption allowance)
= GDP

Both approaches give the same GDP.

Net domestic product (NDP) = GDP – Depreciation

Gross national product (GNP) = Opposite of GDP.

- Value of final goods and services produced by residents of a country.
- GNP differs from GDP because GNP includes goods and services that are produced overseas by
US firms and excludes goods and services that are produced domestically by foreign firms.

Net national product (NNP) = GNP – Depreciation

National income (NI) = NNP – sales tax

Personal income (PI) = NI +/- various adjustments

Disposable income (DI) = PI – personal taxes

Unemployment Rate
- Total labor force includes all non-institutionalized individuals 16 years of age or older who are
either working or actively looking for work

Unemployment rate = Number of unemployed x 100

Total labor force

Types of unemployment:
• Frictional unemployment: normal unemployment resulting from workers routinely changing
jobs or from workers being temporarily laid off
o Unions, rotations
• Structural unemployment: jobs available in the market do not correspond to the skills of the
work force, and unemployed workers do not live where the jobs are located
• Seasonal unemployment: result of seasonal changes in demand and supply of labor
o Christmas season
• Cyclical unemployment: rises during recession and falls during an expansion

Becker – 2008 Edition Chapter 2 Page 4 of 13

 o Real GDP is below potential level of output = cyclical unemployment is positive
o Real GDP is above potential level of output = cyclical unemployment is negative
o GDP  Unemployment

o GDP
Unemployment 

Natural rate of employment = “normal” rate of unemployment

- Frictional + Structural + Seasonal Unemployment
Full employment = when there is no cyclical unemployment
- Does not mean zero unemployment

Inflation: sustained increase in the general prices of goods and services.

- Prices on average are increasing over time.

Deflation: sustained decrease in the general prices of goods and services.

- Prices on average are decreasing over time.

Consumer price index (CPI): measure of overall cost of a fixed basket of goods and services purchased by
an average household.

∇CPI = Inflation rate = CPI this period – CPI last period x 100
CPI last period

Demand Pull Inflation: AD  GDP  P 

- Increase in govt spending
- Decrease in taxes
- Increase in wealth
- Increase in money supply

Cost Push Inflation: SRAS
GDP
P 

- Increase in oil prices
- Increase in nominal wages

Holding monetary assets  Inflation makes money lose purchasing power

Holding monetary liabilities  Inflation makes payback on fixed loans a good deal

Nominal interest rate: No inflation adjustment = current dollars

Real interest rate= nominal interest rate – inflation rate

The Money Supply

- The stock of all liquid assets available for transactions in the economy at any given point in time

M1: money that is used for purchases of goods and services.

- Coins, currency, checkable deposits, traveler’s checks
- NOT savings accounts or CDs

Becker – 2008 Edition Chapter 2 Page 5 of 13

M2: M1 + liquid assets than can easily be converted into M1.
- Timed certificates, money market accounts, mutual fund accounts, savings accounts
M3: M2 + CDs over $100,000

Monetary Policy

Open Market Operations (OMO): purchase or sale of govt securities in the open market
- Increase in the money supply:  AD GDP P  Fed purchases = Expansionary
- Decrease in the money supply:
AD
GDP
P
 Fed sells = Contractionary
Changing the discount rate: the rate the FED charges the member banks for short-term loans
- Increase discount rate = decrease money supply: DR I Borrow
Spend
AD
GDP
P

- Decrease discount rate = increase money supply: DR
I
Borrow Spend AD GDP P

Changes in the required reserve ratio (RRR):

- Increase in RRR = decrease money supply: RRR Spend
AD
GDP
P

- Decrease in RRR = increase in money supply: RRR
Spend AD GDP P

Market Influences on Business Strategies

Steps in strategic management (strategic positioning):

1) Define the firm’s vision and mission statements
2) Set the goals of the firm (cost leadership and/or differentiation)
3) Define the objectives of the firm
a. Financial objectives: profits, cash flow, eliminate debt
b. Non-financial objectives: improve product quality & customer satisfaction
4) Decide what to measure and take a baseline measurement
a. Financial measures: financial statements
b. Internal business processes: Quality control measures
c. Customer measures: survey customer satisfaction levels
d. Advance learning and innovation: measure employees
5) Strategic analysis (SWOT)
a. Internal: strength and weakness
b. External: opportunities and threats
6) Create the strategic plan
a. Steps to achieve the objectives and stay within the firm’s vision and mission statement
7) Implement the strategic plan at all levels. Top to bottom levels:
a. Corporate level
b. Business level
c. Functioning level
d. Operating level
8) Evaluate and revise the plan as necessary

Laws of demand and supply

Change in quantity demand: a change in the amount of a good demanded from a change in price

Becker – 2008 Edition Chapter 2 Page 6 of 13

Change in demand: a change in the amount of good demanded from a change in something other than
price

Quantity demanded is inversely related to price for two reasons:

- Substitution effect  Coke vs. Pepsi P D

- Income effect  P
D

Factors that shift demand curves (factors other than price)

 W – changes in Wealth
 R – changes in the price of Related goods (substitutes and complements)
 I – changes in consumer Income
 T – changes in consumer Tastes or preferences for a product
 E – changes in consumer Expectations
 N – changes in the Number of buyers serviced by the market

Change in quantity supplied: a change in the amount producers are willing and able to produce resulting
solely from a change in price.
Change in supply: a change in the amount of a good supplied resulting from a change in something other
than the price of a good.

Factors that shift supply curve:

 E – changes in price Expectations of the supplying form
 C – changes in production Costs (price of inputs)
 O – changes in the price or demand for Other goods
 S – changes in Subsidies  or taxes
= S
 T – changes in production Technology = S

If price is set above the equilibrium (price floor), it will create a surplus, quantity supplied exceeds
quantity demanded.

If price is set below the equilibrium (price ceiling), it will create a shortage, quantity demanded exceeds
quantity supplied.

Change in Demand Change in Supply Effect on Equilibrium Effect on Equilibrium

Price PD PS Quantity QD QS
Increase D Increase S Indeterminate P P
Increase Q Q
Increase D Decrease S
Increase P P Indeterminate Q Q

Decrease D
Decrease S
Indeterminate P
P Decrease Q
Q

Decrease D
Increase S Decrease P
P
Indeterminate Q
Q

Elasticity: measure of how sensitive the demand for, or supply of, a product changes to changes in price

Becker – 2008 Edition Chapter 2 Page 7 of 13

Price elasticity measured in 2 ways:
• Point method: measures price elasticity at a particular point of the demand curve

Price elasticity = % change in quantity demanded = ∇QD

% change in price ∇P
• Midpoint method: measures price elasticity of demand between any two points on a demand
curve

Price elasticity = (Q2 - Q1) ÷ (Q2+Q1)

(P2-P1) ÷ (P2+P1)

Price Inelastic < 1.0

- Price change will not cause a demand change

Price Elastic > 1.0

- Price change will cause a demand change

Unit Elasticity = 1

What makes a product elastic?

- More the substitutes more elasticity
- Longer the time period the more elasticity

Cross elasticity = the % change in the quantity demanded (or supplied) of one good caused by the price
change of another good

Cross elasticity = % change in number of units of X demanded (or supplied) ÷ % change in price of Y

If the coefficient is positive, then the two goods are substitutes

If the coefficient is negative, then the commodities are complements

Explicit cost: are documented out-of-expenses (wages, materials and utilities)

Implicit cost: opportunity costs, the profits that are lost from following one business strategy vs. another

Accounting costs: measure the explicit costs of operating a business

Economic costs: accounting (explicit) costs plus opportunity (implicit) costs

Accounting profits: Total revenue – total accounting costs

Economic profits: Total revenue – total economic costs (include opportunity costs)

Marginal costs (incremental cost): is the change in total cost associated with a change in output quantity
over a period of time

Becker – 2008 Edition Chapter 2 Page 8 of 13

 MC = change in total costs ÷ change in quantity

Economies of scale: are reductions in unit costs resulting from increases size of operations

Diseconomies of scale: size becomes inefficient and they are no longer cost productive

Market Structures and Pricing

1) Perfect competition (most competitive)
2) Monopolistic competition
3) Oligopoly
4) Monopoly (lest competitive)

Perfect competition:
- Very competitive
- A larger number of suppliers and customers
- Little product differentiation (homogenous products)
- No barriers to entry
- Firm is a “price taker” (cannot change the price itself)

Monopolistic competition
- Many firms with differentiated products
- Few barriers to entry
- Ability to exert some influence over the price and market
- Competition to increase brand loyalty

Oligopoly
- Few firms with differentiated products
- Fairly significant barriers to entry
- Ability to fix prices
- Kinked Demand Curve (competitors match price cuts, but ignore price increases)

Monopoly
- Least competitive
- A single firm with a unique product
- Significant barriers to entry
- “Price setters” (the ability of the firm to set output and prices)
- No substitute products

Chart on page B2-53  Must review!

Cartels: a group of firms acting together to coordinate output decisions and control prices as if they
were a single monopoly
Boycotts: organized group of refusals to conduct market transactions with a target group

Becker – 2008 Edition Chapter 2 Page 9 of 13

Factors of production
o Land (natural resources)
o Labor (human capital)
o Capital (non-human physical capital accumulated through past investment)

Minimum wage causes a surplus of workers because a firm can't or don't want to pay works (minimum
wage is set above equilibrium price) = It increases unemployment.

Value-chain analysis  Customer satisfaction

Factors affecting the market competitiveness:

1. Barriers to market entry
2. Market competitiveness
a. Ability of rival firms to respond to change
b. Advertising of rival firms
c. Research and development of rival firms
d. Alliances of rival firms and suppliers
e. Increase in competition
3. Existence of substitute products
4. Bargaining power of the customers
a. Large volume of a firm’s business (high buyer concentration)
b. Availability of information
c. Buyer’s low cost of switching products
d. High number of alternate suppliers
5. Bargaining power of the suppliers
a. Firm is unable to change suppliers
b. Reputation of supplier and demand for its goods

Five basic types of competitive strategies:

 Cost leadership focused on a broad range of buyers
 Cost leadership focused on a narrow range (niche) of buyers
 Differentiation focused on a broad range of buyers
 Differentiation focused on a narrow range (niche) of buyers
 Best cost provider: Combination  reasonable price with differentiation

Cost leadership works well when buyers have large amounts of bargaining power and there is heavy
price competition.

Cost leadership fails when firms focus too much on cutting costs, they may end up overlooking
technological advances.

Differentiation works well when customers are able to see value in a product.

Differentiation fails when firms focus too much on one area may “overdo it” and end up creating a
product whose value does not exceed the higher price.

Becker – 2008 Edition Chapter 2 Page 10 of 13

Merger and acquisition:
- Cost reductions
- Combine research and development activities

Vertical integration:
- Firm buys/controls the value chain on the supply end

Implications of dealing in foreign currencies

3 types of exchange rate risks:

o Transaction risk - single transaction
 Transaction exposure – potential that an organization could suffer economic loss or gain
upon settle of individual transactions as a result of changes in the exchange rates
o Economic risk - government instability, nationalization
 Economic exposure – potential that the present value of an organization’s cash flows
could increase or decrease as a result of changes in the exchange rates
 Impact of currency appreciation: USD  Foreign
Exports
Imports 
 Impact of currency depreciation: USD
Foreign  Exports  Imports

o Translation risk - translation of financial statements
 Conversion of foreign financial statements to US Dollars

Techniques for Transaction Exposure Mitigation

Future hedge: entitles its holder to either purchase or sell a particular number of currency units of an
identified currency for a negotiated price on a stated date. Used for smaller transactions.
- A/P: Domestic currency weakens, more domestic currency will be required to purchase the
foreign currency and pay the payable. An exchange loss will result
o Future hedge contract to buy the foreign currency at a specific price = less risk
- A/R: Domestic currency strengthens, less domestic currency will be purchased from the foreign
currency received. An exchange loss will result
o Future hedge contract to sell the foreign currency at a specific price = less risk

Domestic Currency Foreign Currency

If US Dollar: A/R A/P
Appreciation Loss Gain
Depreciation Gain Loss

Forward hedge: same as future hedge, but much larger amounts.

Money market hedge: used international money markets to plan to meet future currency requirements.
A money market hedge uses domestic currency to purchase a foreign currency at current spot rates and
invest them in securities times to mature at the same time as related payables.

Becker – 2008 Edition Chapter 2 Page 11 of 13

Transfer pricing:
- Claim profits in country with lowest tax rate

- Temporal method (remeasurement method) - assumes function currency of the sub is that of
parents
- translation gains and losses flow through the income statement
- if we are converting from the 3rd currency to functional, those gains flow through I/S
- Current method (translation method) - functional currency of the sub is different from parent
- translation gains and losses flow through other comprehensive income
- if we are converting from functional to reporting currency, those gains flow through
other comprehensive income

Factors influencing exchange rates

· Relative inflation rates - when country A inflation exceeds country B inflation, country B currency
appreciates as country A residents try to protect their money from eroding
· Relative income levels - when country A's income increases compared to country B, country B
currency appreciates as country A residents buy more of B's goods and services
· Government controls - Tariffs or taxes on country B's goods will decrease the demand for B's
currency, depreciating it compared to A
· Relative interest rates - when country A's interest rates are lower than country B's, country B's
currency appreciates as country A residents seek better returns in country B
There are 3 theories explaining exchange rate risk
· Purchasing Power Parity - the price of identical goods should cost the same in two different countries
when measured in the same currency
- Absolute form - prices will be exact between countries
- Relative form - prices will be approximately equal (accounts for transportation and govt reg)
· International Fischer effect - explains the fluctuation in FX rates through analysis of interest rates.
· Interest Rate Parity - holds that foreign and domestic interest rates will reach equilibrium once
covered interest arbitrage is no longer possible
Types of hedges
· Futures - trade on an exchange, smaller transaction and are denominated in standard amounts
· Forwards - trade over-the-counter, larger transaction and denominated in standard amounts
· Money Market Hedge - uses domestic currency to purchase a foreign currency at spot rates and invest
them in securities times to mature at the same time as the payable is due
B2-79 example of money market hedge
Transfer pricing - transaction between subsidiaries to minimize taxation while still being legal
Other
SCOR Model (Supply Chain Operations Reference)
· Plan – consists of developing ways to balance demand and supply
(planning inventory levels, purchase of raw materials, etc)
· Source – procure the resources required to meet and manage the infrastructure for the sources
(selecting vendors, collecting vendor payments, quality assurance, etc)
· Make – all activities that turn raw materials into finished products
(manufacturing the product, changes in engineering, performing quality assurance tests)
· Deliver – all activities that get the product to the consumers

Becker – 2008 Edition Chapter 2 Page 12 of 13

(managing orders, forecasting, pricing, A/R, shipping)

Situations causing competition to be an even stronger force impacting the profitability of a firm:

• The market is not growing fast.

• There are several equal-sized firms in the market.
• Customers do not have strong brand preferences.
• The costs of exiting the market exceed the costs of continuing to operate.
• Some firms profit from making certain moves to increase market share.
• The various firms in the market use different types of strategic plans.

Integrated enterprise stage of supply chain management

- the firm's management will move away from simple consolidation of its operations to an
internally-integrated supply chain, which all work together towards the main business issue of
the cost of customer service.
Cross-functional teams stage of supply chain management:
- the firm's management will turn its attention to consolidation of the various departments that
make up operations in order to solve the firm's problems, and the focus will be on customer
service.
Extended supply chain stage of supply chain management:
- integration moves external to the firm to involve those outside the firm who are able to work as
a unified team in an attempt to obtain slow, profitable growth.
Supply chain communities stage of supply chain management:
- the extended supply chain forms a single competitive entity with a synchronized supply chain
and a complex system of networks.

Becker – 2008 Edition Chapter 2 Page 13 of 13