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BUSINESS ENVIRONMENT (BUE 112) CHAPTER 3 ECONOMIC ENVIRONMENT Introduction In chapter 2 we discussed the political and legal environment of the PESTEL which was introduced in chapter 1. In this chapter, we will discuss the economic environment of the business as an external factor as well. Econ...

BUSINESS ENVIRONMENT (BUE 112) CHAPTER 3 ECONOMIC ENVIRONMENT Introduction In chapter 2 we discussed the political and legal environment of the PESTEL which was introduced in chapter 1. In this chapter, we will discuss the economic environment of the business as an external factor as well. Economics Economics is the study of how resources are distributed for the production of goods and services within a social system. There are two categories of economics, and these are: microeconomics and macroeconomics. Microeconomics Microeconomics is the study of economic behaviour of individual aspects of an economy, e.g. people, firms or households. It studies the interrelationships between these aspects in determining patterns of production and distribution of goods and services. The primary aim is to achieve the best return from the factors of production which are shown below. i. Land - The natural resources available for production ii. Labour – The human input onto the production process iii. iii. Capital - Goods used in the supply of other products, e.g. Technology iv. iv. Entrepreneur(ship) - People who take risks and organize the factors of production Macroeconomics Macroeconomics is the study of economic aggregates (grand totals). An example of this would be the overall level of output, prices and employment in the economy. Whilst the two areas may seem to be different, they do overlap and are interdependent in some ways. For example, increased inflation, which refers to a general rise in prices throughout the economy (macroeconomics), can cause the price of raw materials to increase, meaning the price the public pays for the end product increases. Microeconomics takes a “bottom up” approach, looking at areas such as individual consumer choices and how they filter upwards, whilst macroeconomics is a “top down” approach, which looks at the overall economy, how it is managed and how it filters downwards to the consumer. Economic Systems An economic system can be defined as a way in which a nation or state apportions goods and services in its society or geographic area. The concept of resource scarcity Scarcity refers to the excess of human wants over what can be produced. Because of this, various choices have to be made between the available alternatives. Virtually every time we do something, we are making a choice between alternatives. For example, if you choose to stay in, you are choosing not to go out. Likewise, if a country decides to use more of its resources to manufacture goods, there will be less to use on the provision of agricultural goods. From a societal point of view, the existence of economic scarcity poses three serious problems concerning the use of resources: i. What to use the available resources for? That is, what goods and services should be produced (or not produced) with the resources (sometimes described as the‘guns v. butter’ argument)?  ii. How best to use those resources? For example, in what combinations, using what techniques and what methods? iii. How best to distribute the goods and services produced with them? That is, who gets what, how much and on what basis? Basically in economics, there are three economic systems as follows: a. Centrally planned economy b. Free market economy c. Mixed economy a. Centrally planned economy It is an economy where all economic decisions are taken by central authorities. It is also known as a command economy. With central planning, an overall view of the economy can be taken by the government. A nation’s resources can be directed specifically towards a nation’s goals. In a centrally planned economy, most of the key decisions on production are taken by a central planning authority, normally the state and its agencies. Under this arrangement, the state typically: owns and/or controls the main economic resources establishes priorities in the use of those resources sets output targets for businesses which are largely under state ownership and/or control; directs resources in an effort to achieve these predetermined targets seeks to co-ordinate production in such a way as to ensure consistency between output and input demands. Features of centrally planned economy The main features of this economic system include: i. The state decides on what goods and services should be produced in an economy. ii. The government makes decisions on how the goods will be produced. iii. The state controls the prices of goods services Advantages of a planned economy i. There is usually a fairer distribution of goods and services, since it is done by the state. ii. Only desirable and harmless products will be produced in an economy. iii. Prices of goods and services are usually fair and affordable to the masses. iv. There is high production of social goods and services, e.g. school, hospitals etc v. There is no competition between companies in which resources are wasted. vi. Effective long term strategies can be formulated taking into account the needs of the whole society. Disadvantages of the planned economy i. There are limitations on personal freedom and control over resource allocation. ii. Due to the absence of competition, the quality of goods and services is poor. iii. There are inefficiencies in production and distribution of goods and services due to bureaucratic tendencies of the government. iv. Companies are not free to produce goods and services they want and consumers are not free to buy goods according to their choices b. Free market economy It is an economy where the economic decisions and pricing of goods and services are guided solely by the interactions of a country’s businesses and citizens. There is very little central planning or government intervention. This means that under this system, the economy functions automatically. Features of a free market economy A free market economic system has the following characteristics: i. Individuals and private firms control the economy by deciding goods and services that should be produced and how the goods will be produced.  ii. There are no price controls and therefore individuals can charge any price they feel / want. iii. There is private ownership of property. iv. The prices of goods and services are determined by the market forces of demand and supply which are ruling on the market. v. The allocation of goods and services is done by the market forces of demand and supply. Advantages of free market economic system i. High production of goods and services due to the availability of incentives such as profits. ii. There is production and consumption freedom, that is producers are free to produce what they want and consumers buy what they prefer. iii. Efficiency in allocation of resources because such allocations are done by the market forces of demand and supply. iv. Due to the availability of competition, the quality of goods and services is high. Disadvantages of the free market system i. Some vital services cannot be provided by the private enterprise. ii. Some undesirable and harmful products can be produced. iii. There is inequitable (uneven) distribution of goods and services, as demand and supply determine where and when products and services are needed. iv. Only rich people can afford to buy the best products on the market because they might be very expensive. v. There is low production of social services, such as roads, schools etc, because the private sector will aim at maximising their profits. vi. In a free market many resources can be wasted due to high failure rate of new businesses because a lot of money can be spent on setting up the new business.  c. The mixed economy The disadvantages of the free market system listed above indicate the need of government intervention in the workings of the economy. As such, a mixed economy is blended by the state and the private enterprise. A mixed economy is an economy where economic decisions are made partly by the government and partly through the market. Because of the problems with centrally planned economies and free market economies, all real world economies are a mixture of the two systems. In the private sector, individuals decide on what goods and services should be produced, how they should be produced and the allocation of goods and services is done by the forces of demand and supply. In the public sector, the government controls on what goods and services should be produced and how the goods and services should be allocated. Examples of mixed economies are USA, United Kingdom, Malawi, and Japan. In mixed economies, the government influences the following:  relative prices of goods, by taxation or subsidies  relative income, by use of taxation, welfare payments or direct control over wages, profits, etc.  macroeconomic problems of unemployment, inflation, lack of growth, balance of trade deficits, exchange rate fluctuations, level of interest rates and bank lending, and the foreign exchange rate. Government intervention can be used to influence some market failings. However, it is worth noting that governments are not perfect and their actions and interventions can cause both beneficial and adverse reactions. For example, if a government increases levels of personal taxation, levels of disposable income will fall and consequently levels of consumer spending and saving may also decline. If a government increases the levels of taxation for a business, this will lead to lower levels of business confidence, and their ability to invest and create employment opportunities. Advantages of mixed economy i. There is high production of goods and services because there are incentives such as profits, in the private sector than in a planned economy. ii. Prices are usually affordable to the masses because they are set up by the government than in a free market economy where prices are determined by the market forces of demand and supply. iii. Production reflects the wishes of consumers as goods and services being produced are the ones being demanded on the market as compared to a planned economy where the state decides on what should be produced. iv. The system is flexible in the way that it responds to different conditions of demand and supply as compared to a command /planned economy. v. Resources can be allocated more equitably because the government will attempt to produce and distribute products in areas where there are inefficiencies than in a free market economy. Economic Factors This refers to fundamental data about an economy or market that influences business performance. The following are some of the economic factors which influences business performance: a. Interest rates b. Unemployment c. Inflation d. Economic cycles  a. Interest rates In simple terms, the interest rate is the price of credit (expressed as a percentage) and is the result of the demand for, and supply of credit. The current and expected interest rates and possible changes in the structure of interest rate (short term and long term rates) are important to the enterprise. High interest rates on overdrawn bank accounts and installments credit may adversely affect the spending patterns of consumers, especially expenditure on durable consumer goods (motor cars, furniture), and investment in machinery, machinery, equipment and stocks of enterprises. The use of loan financing when interest rates are high adversely affects an enterprise’s cash position and even its creditworthiness at a later stage. b. Unemployment Unemployment is the number of people who are currently without a job, but who are actively looking for employment. The unemployment rate is the number of unemployed expressed as a percentage of the labour force. However, there are differing opinions on who should be officially counted as unemployed. For example, some authorities believe that students shouldn’t be counted in the unemployment figures. Therefore, when we say unemployment rate is high, it means that there are many people who are unemployed, as they are within a productive age and are searching for jobs. In most democratic states the goal of ‘full employment’ is no longer part of the political agenda; instead government pronouncements on employment tend to focus on job creation and maintenance and on developing the skills appropriate to future demands. The consensus seems to be that in technologically advanced market-based economies some unemployment is inevitable (unavoidable) and that the basic aim should be to reduce unemployment to a level which is both politically and socially acceptable. c. Inflation Inflation is usually defined as an upward and persistent movement in the general level of prices over a given period of time. It can also be characterised as a fall in the value of money. This means that inflation causes the purchasing power of money to fall continually and may have considerable long-term effects on individual customers as well as businesses. Inflation can be caused by a number factors, but the basic ones are: i. demand-pull inflation - rising of prices of goods or services following a high demand which surpasses supply ii. Cost-push - rising of prices of goods and services following increase of cost of production (e.g. raw materials, labour etc.) Inflation also influences consumer behavior, firms and investors in general. It has an adverse effect on the real income of consumers and therefore on their disposable income and propensity to save. Consumers become more price conscious, buy substitute products which are cheaper and become more quality conscious (demand value for their money) For governments of all political complexions reducing such movements to a minimum is seen as a primary economic objective. Governments aim to keep inflation low and stable. One of the main reasons for this is because it aids the economic decision-making process. For example, businesses will be able to set wage rates and prices and make investment decisions with more confidence about the longer term if inflation is stable. d. Exchange rates An exchange rate is the ratio at which the currency of one country can be exchanged for that of another country. A relatively weak currency (Malawi Kwacha for example) in comparison with other currencies encourages exports and makes imports more expensive. On the whole, governments and businesses involved in international trade tend to prefer exchange rates to remain relatively stable, because of the greater degree of certainty this brings to the trading environment; it also tends to make overseas investors more confident that their funds are likely to hold their value. To this extent, schemes which seek to fix exchange rates within predetermined levels (e.g. the Exchange Rate Mechanism (ERM)), or which encourage the use of a common currency (e.g. the ‘euro’), tend to have the support of the business community, which prefers predictability to uncertainty where trading conditions are concerned.  e. Economic cycles Economic cycles refer to the fluctuating state of an economy from periods of economic expansion and contraction. It is consists of expansions occurring at about the same time in many economic activities, followed by silar general recessions. Economic cycle has four stages as follows: i. Expansion This occurs when an economy is growing and people are spending more money. Their purchases stimulate the production of goods and services, which in turn stimulates employment. The standard of living rises because more people are employed and have money to spend. However, rapid expansion of the economy may result in inflation. Inflation can be harmful if individuals’ incomes do not increase at the same pace as rising prices, reducing their buying power. ii. Peak The peak is reached when the growth of the economy reaches a plateau or maximum rate. It is usually characterized by higher inflation that needs to be corrected. iii. Contraction This is a slowdown of the economy characterized by a decline in spending and during which businesses cut back on production and lay off workers. Economic contraction occurs when spending declines. As already mentioned, businesses cut back on production and lay-off workers and the economy as a whole slows down. Contraction of the economy lead to recession. Recession is the decline in production, employment and income. Recessions are often characterized by rising levels of unemployment. Rising levels of unemployment tend to stifle demand of goods and services, which can have the effect of forcing prices downward, a condition known as deflation. iv. Trough A severe recession can turn into depression. This is a condition of the economy in which unemployment is very high, consumer spending is low, and business output is sharply reduced. The trough is characterized as a low point in the economy from which it can re-enter an expansion phase. Impact of economic phases  When the economy is in expansion phase, businesses generate profits which leads to hiring of more employees, leading to more disposable income and spending. Furthermore, it leads to more profits for businesses, and it continues in a virtuous cycle.  When the economy is in contraction, businesses lose profits which leads to downsizing and lay-off of employees. When employees lose their jobs, there is less disposable income and less consumer spending. This leads to even lower profits for businesses. It continues in a vicious cycle.  An economy should be in a continuous expansion. However, contractions are needed to keep inflation in check and to make sure the economy does not overheat. An economic cycle Peak Expansion Contraction Trough Economic policies An economic policy is a course of action that government take with the intention of influencing or controlling the behavior of the economy. There are two economic policies which are used to influence the economy. These are  a. Monetary policy b. Fiscal policy a. Monetary Policy Monetory policy refers to the macroeconomic activities taken by the nation’s central bank to control money supply and achieve sustainable economic growth. Monetary policy seeks to influence monetary variables such as the money supply or rates of interest in order to regulate the economy. While the supply of money and interest rates (i.e. the cost of borrowing) are interrelated, it is convenient to consider them separately. Interest rates As far as changes in interest rates are concerned, these clearly have implications for business activity, as circular flow analysis demonstrates. Lower interest rates not only encourage firms to invest as the cost of borrowing falls, but also encourage consumption as disposable incomes rise (predominantly through the mortgage effect) and as the cost of loans and overdrafts decreases. Such increased consumption tends to be an added spur to investment, particularly if inflation rates (and, therefore ‘real’ interest rates) are low and this can help to boost the economy in the short term, as well as improving the supply side in the longer term. Raising interest rates tends to have the opposite effect – causing a fall in consumption as mortgages and other prices rise, and deferring investment because of the additional cost of borrowing and the decline in business confidence as consumer spending falls. If interest rates remain persistently high, the encouragement given to savers and the discouragement given to borrowers and spenders may help to generate a recession, characterised by falling output, income, spending and employment and by increasing business failure. Changes in the money stock (especially credit) affect the capacity of individuals and firms to borrow and, therefore, to spend. Increases in money supply are generally related to increases in spending and this tends to be good for business prospects, particularly if interest rates are falling as the money supply rises. Restrictions on monetary growth normally work in the opposite direction, especially if such restrictions help to generate increases in interest rates which feed through to both consumption and investment, both of which will tend to decline.  b. Fiscal policy Involves the use of changes in government spending and taxation to influence the level and composition of aggregate demand in the economy and, given the amounts involved, this clearly has important implications for business. Reductions in taxation and/or increases in government spending will inject additional income into the economy and will, via the multiplier effect, increase the demand for goods and services, with favourable consequences for business. Reductions in government spending and/or increases in taxation will have the opposite effect, depressing business prospects and probably discouraging investment and causing a rise in unemployment. REFERENCES 1. Worthington, I and Britton, C (2014), The Business Environment, 7th Edition, Pearson Education 2. Ferrell, O.C, Geoffrey, H and Ferrell, L (2008), Business, a changing world, 6th Edition, McGraw-Hill 3. Marx, S, Reynders, H.J.J and Van Rooyen, D.C (1993), Business Economics, 1st Edition, J.L. Van Schaik Publishers, Pretoria