Chapter 9

Economic influences on business

activity
Intro

 Read Iceland’s Economy making some progress on pg 98

 Managers must understand the likely impacts of govt economic objectives on

their business ­they must plan accordingly to protect the business from
negative impacts & to take advantage of opportunities that may arise due to
govt policy changes.
Govt economic objectives

Macro­economic objectives are set for the whole economy.

These include:
1. Economic growth
2. Low rate of inflation
3. Low levels of unemployment
4. Avoidance of a deficit in the Balance of Payments
5. Exchange rate stability
6. Reduction of inequalities in wealth & income
But there can be a conflict in these
objectives
These objectives often conflict with one another, e.g. to curb inflation, govt may
raise introduce policies to reduce spending ­this will lead to lower demand and
inflation may drop but unemployment may rise as a result.
N.B.
• Start a file of articles on economic events & data, & how businesses are
responding to these changes.
• Update this regularly, including your own notes from TV or radio broadcasts.
• Make sure your file is current before exams!
1. Economic growth

• Economic growth is an increase in a country's productive potential.

It is measured by Gross Domestic Product (GDP).
• GDP is the total value of goods & services produced in a country in a year, & is
measured in monetary terms.
• Real GDP is adjusted for inflation, as inflation (an increase in the general level
of prices) will raise the value of GDP but does not reflect economic growth.
Read pg 99 with examples of economic growth
The importance of economic growth to a
country
1. Increase in GDP means more goods & services are produced and standards of living
increase.
2. Increase in GDP often means employment increases and consumer income and
standards of living increase
3. Increased employment leads to increase in consumer incomes which leads to an
increase in demand (depending on income elasticity of demand for given products -
more later)
4. tax revenue for govt increases and so govt spending goes up on desirable public sector
initiatives (education, healthcare etc).
5. As unemployment drops govt spending on unemployment benefits will fall and more
resources put to public sector spending or taxes may be reduced.
6. Absolute poverty can be reduced or eliminated if growth is sufficiently significant &
the benefits are spread widely enough.
Disadvantages of rapid economic growth

1. Increases in pollution;
2. job losses due to technological change
3. Inflation can be driven by excess consumer spending ­see "boom" period of the
Business / Trade cycle.
The factors that lead to economic
growth
1. Technological change & expansion of industrial capacity due to business
investment & innovation in products & industries. This is highly desirable as it
essentially represents growth due to increased efficiency, and carries no
demand­pull inflationary pressure. Govts therefore encourage business
investment. Business investment is expenditure by business on capital
equipment, new technology, R&D.
2. An increase in available resources ­increased working population or discovery
of new resources (e.g. oil & gas).
3. Increased productivity of available resources ­increase in skills through
training, or greater willingness of workers to work with new technology.
The rate of economic growth leads to
the Trade or Business Cycle
 Economic growth does not occur continuously. There are some years where
GDP falls. This is reflected in the Trade Cycle, which is comprised of 4 stages:
The stages of the Trade or Business Cycle

i.) Boom
ii.) Recession / Downturn
iii.) Slump
iv.) Recovery & Growth
1. Characteristics of the boom stage

• Too much spending

• Prices start to rise fast
• Shortage of skilled workers ­wage increases
• Business costs rise
• Products lose international price competitiveness
• Future for business is uncertain
• Govt often raises interest rates to curb spending
ii.) characteristics of the Downturn / Recession

• Downturn signals a slowing of real GDP growth

• Recession is a period of 6 months or more of declining GDP
• Too little spending due to higher interest rates ­decreasing demand
• Unemployment rises
• Some firms register losses & some close
iii.) characteristics of the Slump stage

 Prolonged recession ­GDP falls substantially

 Asset prices including property, fall
 Very high unemployment
 Standards of living very low
 Government corrective intervention is needed
 Prices fall as little demand
 Many businesses don't survive
iv.) characteristics of the Recovery & Growth stage

• GDP rising due to reducing inflation or govt corrective measures

• unemployment starts to fall; living standards start improving
• favourable for business as demand increases
The impacts of recession

 • As with all external factors, economic changes can bring opportunities as

well as threats.
• Different businesses will be impacted differently.
• Managers must be able to adapt to changes & make the necessary strategic
decisions to take advantage of the positives whilst also protecting the
business from the threats.
Threats Opportunities

• Increased unemployment leads to reduced demand for

normal & income ­elastic goods • Asset prices drop

• Reduced govt tax revenue & hence reduced govt spending • Demand for inferior goods may increase

• Fear of retrenchment may improve worker efficiency

• Downsizing may make firms leaner & fitter ­more

efficient
The impacts of recession or growth on
different types of businesses
• See Table 9.1 pg 101 N.B
• It is of greatest importance that you can analyse the likely impacts of each
stage in the business cycle on a given business, and can conduct a comparative
analysis of impacts on different businesses.
• Furthermore, you must be able to suggest appropriate strategies for given
businesses to cope with a given stage in the cycle.
Do the Case Study Activity 9.1 pg 102
And now on to the second macro-
economic objective of governments….

2. Low target rate of inflation

What is inflation?

• Inflation is the increase in the average level of prices of goods & services.
• It results in the fall in the value of money.
• The opposite is known as deflation.

 See the example of inflation in the UK

How do they Measure inflation?

 • A 'basket' of items that commonly appear in a household budget are tracked

in terms of prices. This forms the Retail Price Index, a common measure of
inflation.
 • Each item is weighted relative to its' importance.
 • Weighted price changes are averaged & given an index number which is
relative to a base index period (year selected for comparative purposes.
 • Retail price inflation can then be seen relative to the base period index.
 • The Consumer Price Index may be used ­in this, mortgage interest & other
housing costs are excluded from the RPI ­these factors are then known as
'underlying inflation'.
Causes of inflation

 There are a few causes of inflation

 1. Cost-Push
 2. Demand-Pull
 3. Imported inflation
1. Cost-­push inflation

 Firms raises prices due to increased costs of production.

 Costs of production may increase due to:
 ­Lower exchange rate increases the costs of imported components.
­World demand for materials raises the price (e.g. oil)
 Higher wage costs due to workers' demands either after or ahead of expected
inflation which would reduce their real incomes & standards of living.
2. Demand-­pull inflation

 As consumers demand more (e.g. in a boom), producers & retailers increase

prices to raise profit margins; also to avoid stock selling out too fast which
leads to shortages.
The impact of inflation on business strategy

 There are both benfits and disadvantage of inflation to businesses

1. Benefits to business of inflation (if at
a low level, below 5%)
• Real value of debts falls ­good news for highly geared businesses.
• Rising prices sees an increase in asset value, which makes the balance sheet
appear stronger.
• Cost increases can more easily be passed on to consumers if the general level
of prices is increasing.
• Profit margins on stock bought in advance increase.
Thus during periods of low inflation, businesses may:
1. ­Increase prices to raise profit margins
2. Borrow to buy assets ­the real value of repayments reduces whilst the asset's
value increases, strengthening the firm's financial position.
2. Disadvantages to business of high
inflation (5 ­6%)
 • Employees's Real Incomes fall ­wage increases may be demanded &
industrial disputes may occur.
• Consumers become more price sensitive, seeking bargains rather than brand
names.
• Consumers may stockpile & reduce spending on non­essential items.
• Cash flow problems may arise due to higher C.O.P ­this is worsened if credit
terms are offered to customers.
• Govt may respond to increasing inflation by increasing interest rates ­this
raises interest repayments ­a major concern to highly geared businesses as
although the real value of the debt is declining, finding the additional cash
may be problematic, particularly if credit terms are offered to customers.
• International competitiveness is lost if inflation is higher than in trading
partners' economies.
The extent of the impact of inflation
depends on…..
 ­the rate of inflation
­forecasts for the future in terms of further price rises ­likely govt
intervention & its' impact on the business.
Likely business strategy during periods of rapid
inflation

 Reduce investment expenditure.

 Reduce borrowing so as repayments are at a manageable level.
 Reduce prices to maintain market share.
 Reduce labour costs by downsizing.
 Reduce credit periods offered to customers.
Likely government policy to deal with
inflation & impact on business strategy.
Inflation cause Govt policy response Impact on business Business' strategic response

• Raise interest rates to • Exports less competitive • Focus on domestic market

• Cost­push
strengthen currency • Borrowing is more costly • Cancel investment projects

• Discourage wage increases

• Private sector businesses
­
• Cost­push • little tend
public sector workers set as
to not be swayed by this
example

• Discourage consumer
• Cost­push • little • as above
credit terms
Likely government policy to deal with
inflation & impact on business strategy.

Inflation cause Govt policy response Impact on business Business' strategic response

• Focus of product mix shifts to

• Increased tax & reduced govt especially on
less luxury items
spending to luxury items & reduce aggregate on high ­value
• Demand­pull demand items if progressive tax introduced • Firms reliant o govt contracts
seek alternative markets,
• Demand decreases,
perhaps foreign public sectors

• Interest rates increase to • Exports less competitive • Focus on domestic market •

• Demand­pull encourage saving & curb
• Borrowing is more costly Cancel investment projects
spending
 So does that mean that Deflation is good?

Def: Reduction in the average price level of products

• Consumers, speculating on further price reductions, reduce spending, reducing
demand, which could lead to recesssion.
• Real cost of debts increases ­this reduces borrowing for business investment &
growth.
• Reduced prices reduces profitability, further discouraging investment
expenditure.
• Stocks lose value thus orders for supplies reduce, reducing demand, fueling
recession.
• Thus, neither deflation nor high inflation are favourable to business.
• Low target levels of inflation are generally agreed as being optimal (UK & EU
target is a 2% CPI increase p/a)
Do Activity 7.2 page 119 in class
3. Low levels of unemployment

 • Unemployment exists when people who are willing & able to work
 (i.e. the working population) cannot find a job. See table 9.3 on pg 106
Causes of unemployment

 1. Cyclical unemployment
 2. Structural unemployment
 3. Frictional unemployment
1. Cyclical unemployment

 • Unemployment resulting from low levels of demand for products,

 during periods of slow growth or recession.
2. Structural unemployment

 • Unemployment resulting from decline of an important industry, leading to

significant job losses in that industry.
 • Structural unemployment can occur even in periods of economic growth.
 • It can be caused by: changes in consumer demand (tastes) possibly due to
changes in
1. income levels.
2. ­technology replacing traditional business & skills e.g. banking; manual labour­
type work.
3. ­shifts to tertiary sector predominance.
3. Frictional unemployment

 • Unemployment resulting workers leaving their jobs & taking a substantial

period of time to find alternative employment.
 • It results from changing labour demands in different businesses which
occurs constantly.
Government policy to deal with the
causes of unemployment

Cause Policies

• Cyclical • Contain inflation to low levels

• maintain stable exchange rates to sustain foreign

demand

• Education & training programmes to update workers'

• Structural
skill

•Set up Job Centres

• Frictional •Reduce unemployment benefits
The costs of unemployment.

 • Wasted human resources & productive capacity of the country.

 • Unemployment benefits drain tax revenue which could be used elsewhere.
 • Societal problems may result e.g. crime
 • Reduced demand
 • Lower living standards
 • Skills become outdated the longer the period of unemployment ­retraining
costs
 Business may benefit however, as they can negotiate lower wage payments or
lower wage increases during inflationary periods.
Is this unethical?
4.Avoidance of a deficit in the Balance
of Payments (current account)
 The Balance of Payments (current account) records the value of trade in
goods and services between one country & the rest of the world.
 • Imports: Goods & services prurchased from other countries
• Exports: Goods & services sold to consumers & businesses in other
countries.
 • A deficit in the balance of payments: = Value of imports exceeds value of
exports.
Problems arising from a B.O.P deficit

1. Falling foreign reserves may require borrowing from abroad.

2. Borrowing attracts interest payments.
3. Exchange rate depreciation can occur ­more of the local currency is required
to pay for other currencies/the same amount of local currency buys less
foreign currency. This, and fluctuating exchange rates, increases risk in
importing & exporting.
4. Foreign investors become less willing to invest in the country.
5. Govt's attempts to correct the problem may make matters worse ­imposition
of tariffs & quotas often occurs ­this hinders those local businesses reliant on
imported components
6. retaliation can occur which can harm exporters.
5. Exchange rates N.B. Popular exam
topic!
 The exchange rate is the price of one country's currency in terms of anothers'
currency.
 Exchange rate depreciation: A fall in the external value of one currency ­its
value in terms of the another currency has dropped.
 Exchange rate appreciation: A rise in the exchange rate of one country ­in
terms of the another currency has increased.
 The 'price' of a currency is determined by supply & demand.
When demand exceeds supply, the price will rise ­the currency will rise and
we call this an appreciation.
Factors affecting supply & demand for a
currency:
Factors that influence demand for a currency:
1. • Foreigners buying domestic goods ­increases demand
2. Foreigners spending money in the country ­increases demand
3. • foreign investment increases demand
Factors that influence the supply of a currency:
4. domestic businesses buying foreign imports ­reduces supply
5. • domestic population travelling abroad ­reduces supply
6. domestic investment abroad ­reduces supply
6. Exchange rate stability

 Do Activity 9.3 together in class

 Learn the definitions on pg 108
Impact of exchange rate appreciation on
domestic firms
Those that benefit:
• All firms benefit in the sense that lower import prices means lower inflation.
• Importers of raw materials & components ­
• Importers & retailers of foreign manufactured goods ­
Those that lose:
• Exporters of goods & services ­
• Local businesses that have foreign competitors in the local market ­
Impact of exchange rate depreciation on
domestic firms
Those that benefit:
 Exporters ­
 Domestic firms with foreign competitors in the local market ­
Those that lose:
• Importers of raw materials & components ­
• Importers & retailers of foreign manufactured goods ­
In summary….

 Thus in summary, importers of components, & of manufactured goods for

retail benefit from………… and lose when ………………occurs;
 Exporters & local businesses with foreign competition benefit from……………..
and lose when……………………. occurs.
What factors other than price will determine the
success of a business?

 These are known as Non-­price factors contributing to international

competitiveness
 • Factors other than price contribute to consumers' buying decisions ­a slight
change in price due to exchange rate fluctuations may in fact not have a
significant effect on international demand.
Non-price factors

1. ­product design & innovation

2. quality & reliability

­
3. effective promotion including wide distribution ­after­sales service

4. investment in technology & staff training.

(Consider cars)

 Read page 124 left

So govt go after their economic obj by following
different
Macro­economic policies
 • Policies designed to impact the whole economy.
• The key influence of these policies is on aggregate demand, and thence,
through GDP to the level of employment.

 Types of policies
1. Fiscal policy
2. Monetary policy
3. Exchange rate policy
4. Supply-Side Policies
1. Fiscal policy

• Refers to decisions made with regard to government expenditure, government borrowing &
taxation.
• Govt expenditure can contribute to up to 40% of GDP. It is funded through tax revenue ­
from income tax, corporation tax, VAT & excise duties (import tariffs).
• Govt's planned expenditure & taxation policies are set out for the coming year in the annual
budget.
• Tax revenue > govt expenditure = budget surplus
• Tax revenue < govt expenditure = budget deficit
• In many cases, minor changes are made that impact only certain sectors of the economy ­
these are not deemed macro­economic changes. However in certain circumstances, the
Finance Minister or Chancellor of the Exchequer in UK, will make changes that will have a
macro­economic effect..
Read pages 124 & 125
a.) Expansionary Fiscal Policy

 See fig 9.5 and read Scenario 1 on pg 111

Contractionary fiscal policy

 See Fig 9.6 and read Scenario 2

 Contractionary Fiscal Policy reduces the need for govt borrowing, whereas
expasionary policy is likely to increase the need for borrowing.
Take note!!

 It takes time for the effects of Fiscal Policy changes to take effect, thus govt's
are nowadays reducing use of Fiscal Policy, increasingly aiming for a balanced
budget, and rather using Monetary Policy as a means to change aggregate
demand to achieve macro­economic objectives.
2. Monetary policy

Refers to decisions regarding the interest rate and the supply of money.
• To bring inflation down to target levels, the central bank (Bank of England in
UK, European Central Bank in Eurozone, Federal
Reserve in USA, Reserve Bank in Zim) will increase interest rates.
• If inflation is below set target (usually 2%), i.r's will be decreased.
• Remember the link between i.r's & exchange rates as a result
of speculator switching.
NB You must be able to evaluate the impact of interest rate changes on a given
business ­remember that the greater impact will be felt by highly geared firms or
those that sell on credit.
Summary of Fiscal & Monetary Policy

 See table 9.6 on pg 113

3. Exchange rate policy

 Govts must decide whether the exchange rate should be fixed, and even join
a common currency, or whether it should be allowed to float.
 Read page 128 left
Advantages of a floating exchange rate
(reasons NOT to join a common currency)
 Own central bank is likely to set i.r's in best interest of own country
 • Independence in Fiscal Policy decision ­making
 • Exchange rate is naturally determined ­central bank can use other measures
to achieve economic objectives.
 • Avoids costs of conversion to dual pricing & changeover of note & bills
disadvantages of a floating exchange rate
(reasons to join a common currency)
 E.r. fluctuations leads to difficulties in costing of imported components; reduced foreign
demand;
 varying foreign asset value ­all these discourage international trade & investment due to
the increased risk.
 Multi­currency usage leads to lack of price comparison transparency.
 Costs of international trade are increased due to: bank commission on currency
conversion, multiple price list generation & updates are needed.
 c­ urrency contracts and hedging can be undertaken to reduce risk of currency instability;
however, charges must be paid to specialist institutions.
 Businesses may choose to relocate to countries within the common zone in order to
reduce risks ­
 Foreign direct investment (FDI) may be lost to common currency’s member countries due
to reduced risk
4. Supply­- side policies: Govt policy, economic
efficiency & business competitiveness

 Govts aim to increase local industries' international competitiveness.

 Certain Fiscal & Monetary policies hinder this, and thus should not be
continuously applied.
 Further, in efforts to raise international competitiveness of business, govts
may make use of the following supply­side policies to aid business' efficiency:
Supply-side policies

1. Low rates of income tax ­to increase worker motivation & provide greater
incentive to new business start­ups
2. Low rates of corporation tax ­especially on smaller businesses ­allows for
greater profit to be reinvested for growth & improved competitiveness.
3. Increased labour market flexibility & labour productivity through:
­subsidies for worker training / govt provided schemes
­increased funding of higher education
­encouraging immigration of skilled workers
­reducing state benefits
­reducing income tax
Further economic issues –market failure

 Markets should work by a mechanism underpinned by supply & demand ­price

& other factors have a direct impact on how resources are allocated.
 See examples page 116
 Market failure occurs when markets fail to achieve the most efficient
allocation of resources & there is under or over­production of certain goods or
services.
 Examples of market failure
Example Details

1. External costs:
• As external costs are not included in the price, true costs are not reflected.
Costs of a particular economic activity that are paid for by society, not the producer
or consumer • If true costs were included, less would b
e.g. pollution demanded & produced; as it is, too much is demanded & produced.

2. Insufficient Labour training Due to a fear of trained staff being 'poached', training • Productive capacity of labour in the economy is reduced, reducing potential
is often under­provided. GDP.

3. Monopoly producers
In aiming for highest possible profits, output may be restricted to raise prices & • Products are thus under­provided in relation to demand.
potential competitors are prevented from entering the market.
How do govts correct Market Failure?
Stakeholder Groups most affected Corrective policy action

1. External Costs
• Consumers ­may have to buy environmentally damaging products • Business may need to reduce externaliti if poor image reduces sales
•Govt ­voter & pressure group activity • Govt fines or limits on pollution levels.
•Workers ­health & job security

2. Inadequate Labour Training

• Trade Associations could hold indusrty­wide training, levying members.
• Consumers ­output may be restricted ­higher prices, reduced customer service
• Govt ­limit on international competitiveness of domestic firms • Govt training colleges paid for from tax
• Shareholders ­reduced potential output reduced potential profit revenue ­

3. Monopoly producers • Consumers may actively seek alternativ

suppliers; internet use can break the hold o ,monopolies
• Consumers ­lack of choice, high prices restricted supply, reduced innovation
• Govt can institute competition policies, investigate monopolies & privatise
• Govt ­inflationary effect, reduced international competitiveness
nationalised monopolies by selling to multiple private buyers
Income Elasticity of Demand

Measures the responsiveness of demand for a product after a change in consumer

incomes.
(More on other Elasticities Ch 16)
Formula:
Income Elasticity of demand = % change in demand for the product
% change in consumer income
Description of Income Elasticities for 3
distinct classes of goods:
1. Normal goods:
• Have a +v YEd of ­between 0 & 1 e.g.
• As Y increases, Demand increases, but less than proportionally to the increase
in Y.
• As Y decreases, Demand will decrease, but less than proportionally to the
decrease in Y.

Examples: basic necessities, pharmaceuticals

2. Luxury goods:

• Have a positive YEd >1 e.g.

• As Y increases, demand increases, more than proportionally to the increase in
Y.
• As Y decreases, demand will decrease, more than proportionally to the
decrease in Y.
• Examples: holidays, consumer durables, leisure activities
3. Inferior goods:

 • Have a ­negative YEd e.g.

• As Y increases, demand decreases.
• As Y decreases, demand will increase.
• Examples: second­hand goods, economy­brands, cheaper cuts of meat, local
holidays rather than holidays abroad.
• Producers of these gain during a recession.
Do act 9.6 and 9.7