Theme 1: Introduction to Business Economics PDF

Theme 1: Introduction to Business Economics Ultimately, economics is the study of choice. Because choices range over every imaginable aspect of human experience, so does economics. Economists have investigated the nature of family life, the arts, education, crime, sports, job creation—the list is vi...

Theme 1: Introduction to Business Economics Ultimately, economics is the study of choice. Because choices range over every imaginable aspect of human experience, so does economics. Economists have investigated the nature of family life, the arts, education, crime, sports, job creation—the list is virtually endless because so much of our lives involves making choices. How do individuals make choices: Would you like better grades? More time to relax? More time for watching movies? Getting better grades probably requires more time studying, and perhaps less relaxation and entertainment. Not only must we make choices as individuals, but we must also make choices as a society. Do we want a cleaner environment? Faster economic growth? Both may be desirable, but efforts to clean up the environment may conflict with faster economic growth. Society must make choices. Economics is a social science that examines how people choose among the alternatives available to them. It is social because it involves people and their behavior. It is a science because it uses, as much as possible, a scientific approach in its investigation of choices. Scarcity, Choice, and Cost All choices mean that one alternative is selected over another. Selecting among alternatives involves three ideas central to economics: scarcity, choice, and opportunity cost. Scarcity: Our resources are limited. At any one time, we have only so much land, so many factories, so much oil, so many people. But our wants, our desires for the things that we can produce with those resources, are unlimited. We would always like more and better housing, more and better education— more and better of practically everything. If our resources were also unlimited, we could say yes to each of our wants—and there would be no economics. Because our resources are limited, we cannot say yes to everything. To say yes to one thing requires that we say no to another. Whether we like it or not, we must make choices. Consider a parcel of land. The parcel presents us with several alternative uses. We could build a house on it. We could put a gas station on it. We could create a small park on it. We could leave the land undeveloped in order to be able to decide later as to how it should be used. The choices we confront as a result of scarcity raise three sets of issues. Every economy must answer the following questions: a) What should be produced? Using the economy’s scarce resources to produce one thing requires giving up another. Producing better education, for example, may require cutting back on other services, such as health care. A decision to preserve a wilderness area requires giving up other uses of the land. Every society must decide what it will produce with its scarce resources. b) How should goods and services be produced? There are all sorts of choices to be made in determining how goods and services should be produced. Should a firm employ a few skilled or a lot of unskilled workers? Should it produce in its own country, or should it use foreign plants? Should manufacturing firms use new or recycled raw materials to make their products? c) For whom should goods and services be produced? If a good or service is produced, a decision must be made about who will get it. A decision to have one person or group receive a good or service usually means it will not be available to someone else. For example, representatives of the poorest nations on earth often complain that energy consumption per person in the United States is 17 times greater than energy consumption per person in the world’s 62 poorest countries. Critics argue that the world’s energy should be more evenly allocated. Should it? That is a “for whom” question. Every economy must determine what should be produced, how it should be produced, and for whom it should be produced. We shall return to these questions again and again. Opportunity Cost: It is within the context of scarcity that economists define what is perhaps the most important concept in all economics, the concept of opportunity cost. Opportunity cost is the value of the best alternative forgone in making any choice. If you choose to spend $20 on a potted plant, you have simultaneously chosen to give up the benefits of spending the $20 on pizzas or a paperback book or a night at the movies. The concepts of scarcity, choice, and opportunity cost are at the heart of economics. A good is scarce if the choice of one alternative requires that another be given up. The existence of alternative uses forces us to make choices. The opportunity cost of any choice is the value of the best alternative forgone in making it. The Economic Way of Thinking Economists study choices that scarcity requires us to make. This fact is not what distinguishes economics from other social sciences; all social scientists are interested in choices. An anthropologist might study the choices of ancient peoples; a political scientist might study the choices of legislatures; a psychologist might study how people choose a mate; a sociologist might study the factors that have led to a rise in single-parent households. Economists study such questions as well. What is it about the study of choices by economists that makes economics different from these other social sciences? Three features distinguish the economic approach to choice from the approaches taken in other social sciences: 1. Economists give special emphasis to the role of opportunity costs in their analysis of choices. 2. Economists assume that individuals make choices that seek to maximize the value of some objective, and that they define their objectives in terms of their own self-interest. 3. Individuals maximize by deciding whether to do a little more or a little less of something. Economists argue that individuals pay attention to the consequences of small changes in the levels of the activities they pursue. Opportunity Costs are Important! If doing one thing requires giving up another, then the expected benefits of the alternatives we face will affect the ones we choose. Economists argue that an understanding of opportunity cost is crucial to the examination of choices. As the set of available alternatives changes, we expect that the choices individuals make will change. A rainy day could change the opportunity cost of reading a good book; we might expect more reading to get done in bad than in good weather. A high income can make it very costly to take a day off; we might expect highly paid individuals to work more hours than those who are not paid as well. If individuals are maximizing their level of satisfaction and firms are maximizing profits, then a change in the set of alternatives they face may affect their choices in a predictable way. Individuals Maximize in Pursuing Self-Interest! What motivates people as they make choices? Economists assume that individuals make choices that they expect will create the maximum value of some objective, given the constraints they face. Furthermore, economists assume that people’s objectives will be those that serve their own self-interest. Economists assume, for example, that the owners of business firms seek to maximize profit. Given the assumed goal of profit maximization, economists can predict how firms in an industry will respond to changes in the markets in which they operate. As labor costs in the United States rise, for example, economists are not surprised to see firms moving some of their manufacturing operations overseas. Similarly, economists assume that maximizing behavior is at work when they examine the behavior of consumers. In studying consumers, economists assume that individual consumers make choices aimed at maximizing their level of satisfaction. In assuming that people pursue their self-interest, economists are not assuming people are selfish. People clearly gain satisfaction by helping others, as suggested by the large charitable contributions people make. Pursuing one’s own self-interest means pursuing the things that give one satisfaction. It need not imply greed or selfishness. Basic Economics Concepts There are three main actors in an economy: Businesses, Households, and the Government. Businesses and households pay taxes to the government, and in return, businesses may receive subsidies whilst households receive benefits such as state pensions, unemployment benefits, utilities, etc. Households provide factors of production, such as labour, to businesses and in return are paid wages etc. They use this money to buy goods and services from businesses. Economics is, therefore, the study of how the resources land, labour, capital and enterprise are used or allocated by a country to meet its demands for goods, services and ideas, now and in the future. The resources are employed by businesses or firms and are also known as inputs to the production process, or factors of production. Business Outputs Businesses, also known as producers, manufacture goods and services. Goods are classified by economists under two main headings, consumer goods and producer goods. Examples of consumer goods include cars, chocolate bars, Levis, compact discs, a video or disk of the latest movie, and personal computers if used at home for personal or leisure use. The people who buy them are consumers, or customers and they live in households. In contrast, producer goods, as their name suggests, are used to produce other goods. Examples of producer goods include robots used on assembly lines to manufacture cars, personal computers used in offices for work purposes, cement mixers on building sites, jet engines for airliners and prefabricated factories which can be easily assembled. Many businesses are, therefore, the customers of other businesses which buy their output. Some goods are also used in the act of consumption – food, drink or disposable products such as toilet paper or nappies for example – but other goods, known as consumer durables, clearly are not. It would be horribly expensive, for example, if we had to buy a new television set every time, we turned it off at night. Services Services consist of the provision of non-physical items. The list is endless and includes using a cash dispenser at your local bank (although the cash dispenser is a producer good), attending a home game of your local football team, listening to a live band, working out at your local gym, staying in a hotel, watching a video of the latest movie (as opposed to the video as a physical object), making a plane journey, and so on. In each case, consumers are using or consuming a particular service which gives it a distinctive character compared with a good. A service is used up in the act of consumption although it may live on in our memory such as the fond remembrance of a foreign holiday. Businesses also provide services to other businesses, and, in that sense, the latter are consumers of the former’s products. For example, cleaning agencies employ staff to clean offices in the evening or early morning when the work force are not there. Resources Land – This includes not just what its name suggests but also what is found on it and in it – forests and the timber obtained from them, minerals such as crude oil, natural gas and diamonds, and even the fish in the sea. The cost to be paid by employing land, defined in its widest sense, in the production process, is known as rent. Labour – This is that part of the population who work. Approximately half the UK’s population are too young or too old to work, ill and so unable to work, unemployed, or not wishing to work for various reasons such as being a homemaker, to use the American term. Those who work receive wages. Capital – This word is used for machinery, factories, computers, office blocks and information technology. Capital loses its value over time as buildings suffer wear and tear, and so need maintenance, whilst computers become technologically obsolete. So, businesses have to set money aside to replace capital as it wears out or becomes technologically obsolete; this is known as depreciation. The term capital is also used to mean money; accountants talk of liquid capital to distinguish money from machinery. This money may be used to finance a new office block or a new factory. Alternatively, it may be used to purchase shares in existing companies. Interest is the return earned from making capital available to a business. Finally, working capital is the term used to describe stocks of components and raw materials waiting to be converted into finished goods, and the finished goods themselves, held in warehouses, for example, waiting to be delivered to retailers for sale. Enterprise – or entrepreneurship, is the resource provided by the entrepreneur. It is the expertise he/she provides to combine the other resources most efficiently to produce the output of goods or services. It requires managerial, financial, inter-personal and strategic abilities if the business is to succeed. Famous examples of entrepreneurs are Richard Branson, chairman of the Virgin Group, Anita Roddick of Body Shop, Rupert Murdoch, chairman of the News Corporation which owns publishing and broadcasting businesses around the world, and Bill Gates who co-founded Microsoft. Microeconomics and Macroeconomics Micro means small, so microeconomics looks at an individual business and how it behaves – a business such as British Telecom, or the chain of HMV record stores or a small and medium sized enterprise (SME) – the name given to a business which employs less than 500 people. It also looks at individual industries – the car industry or the television industry – and how businesses within them behave, although these industries can be European Union-wide or global. The focus of microeconomics is on issues such as: the demand by consumers for goods and services; the supply of such goods and services by businesses; the determination of prices by the interaction of demand and supply in a market; the costs which firms incur in producing and the implications for the level of production and the pricing of their output; and how businesses behave in an industry, depending on how it is structured, especially the number of firms in it. Let us look for example at the US plane manufacturers Boeing and McDonnell Douglas which merged in 1997. This created serious implications for the European plane manufacturing consortium Airbus in terms of its ability to compete effectively against such a large corporation, since the new US company and Airbus account for most of the world’s civil aircraft production. This was aggravated by McDonnell Douglas receiving large amounts of money in defense contracts from the US Department of Defense, money which could be used to cross-subsidize its civilian plane manufacture. Both the US government and the European Commission investigated these implications, drawing in part on economic theory which explains the behavior of firms including how they might misuse their economic muscle. The EU only agreed to the merger when safeguards for Airbus had been clearly established. Macroeconomics Macro means large and macroeconomics analyses the economy as a whole, both nationally and internationally. This includes the exploration of key variables or concepts such as inflation, unemployment, economic growth, trade flows, rates of exchange and the balance of payments, and their impact on each other and on the economy as a whole. It also examines the role of government, and its policies to influence these variables and, hence, the performance of the economy as a whole. These policies include fiscal policy, which relates to government taxation and expenditure, and monetary policy, which is concerned with influencing the economy through varying interest rates. Both of these types of policy seek to manage the level of demand for goods and services in the economy. Also used by governments are supply side policies which, as the name suggests, seek to influence how the economy supplies its goods and services – for example by improving education and training provision to enable the workforce to acquire more skills and thus be more flexible in its work patterns; or by reducing the power of trade unions to obstruct more flexible working and reducing the power of businesses to restrict competition or keep their prices high. Supply side policies were the center of much debate between the UK and the rest of the European Union in the mid-1990s. Types of Business Organizations Limited Liability Corporations: The main type of business organization in modern economies is the firm. It is owned by its shareholders who are largely institutional investors such as pension funds, insurance companies and banks. These financial institutions collect money from their depositors and contributors and invest it in company shares and government bonds to increase its value. Other shareholders are households and the number of private individuals holding shares has grown significantly in the last twenty years. Shareholders have limited liability, which means that if the business becomes bankrupt, they will lose some or all of the money they have put into the business by buying its shares. However, their other assets, e.g. home and income, will be safe. Companies are either public limited liability, or private limited liability. A public limited company (Plc) has its shares sold on the stock exchange. In contrast, with a private limited company, the other shareholders have to give their permission if one shareholder wishes to sell some or all of his/her shares. So, a company owned by members of a family might use private limited liability to prevent loss of control of the business by excluding outsiders from becoming shareholders. A public limited company, however, can always be taken over if a buyer is willing to pay a sufficiently high price to the shareholders to gain control of 51 per cent of the shares, giving it a voting majority at the annual general meeting (AGM) of the company, and hence control. A Plc has the advantage of being able to issue new shares to raise more funds to expand, for example by building new factories, developing new products or diversifying into new markets, rather than relying on undistributed (retained) profits, or bank borrowing which are the main options for a private limited company. A business employing 500 employees or fewer is known as a SME, a small and medium sized enterprise. These are distinguished in their own right because they are seen as a major creator of jobs and an engine of economic growth. Hence both the UK government and the EU have sought to provide help to enable them to be established and to flourish. In contrast, large companies have sought for many years to reduce employment as a means to grow, substituting capital for labour – for example, automation of assembly lines. A SME may be a private or a public limited company. Sole Trader: If companies carry the greatest economic weight in terms of size, the largest sector by number is the sole trader. This is the business run by one person, although more than one person might be employed. The building industry has large numbers of sole traders or one-man businesses as they are often known, e.g. plumbers, electricians, carpenters etc. The retail trade is also dominated by sole traders such as butchers and bakers although increasingly these have been replaced in recent years by the supermarket chains which are public limited companies. Although many sole traders argue that there are real benefits in terms of independence, suiting oneself when one works etc., in reality this type of business can be characterized by low financial returns, long working hours and uncertainty. Most importantly it has unlimited liability, i.e. in the event of the business failing the sole trader is liable for the business’s debts to the value of all his/her personal assets – house, car and so forth. Partnership: This is the other main type of business organization. Partnerships are most typically found in the professions such as law, accountancy, and architecture. Some partnerships have limited liability, but many are unlimited. The problems of a partnership arise from decision making through the need to get agreement from all partners for business decisions; the difficulties posed when a partner wishes to retire (he/she has to be bought out); and for some partnerships unlimited liability. These are the least common type of business organization. Industrial Sectors The economy of a country, and hence its businesses, are classified into three main categories: Primary, Secondary, and Tertiary. Primary Sector The primary sector covers such industries as agriculture, forestry, fishing, mining for coal, tin etc. and the extraction of other raw materials such as oil from the North Sea. In other words, it is concerned with the production and extraction of raw materials, which are classified as the resource land. Examples of such businesses are mining, include De Beers (diamonds), English China Clay, Rio Tinto (mining) and Zambia Copper. Other relevant stock market categories include oil & gas and water. This sector has progressively declined in importance over time both in terms of its output as a percentage of Gross Domestic Product (GDP), which is the value of goods and services produced in a country during a time period (usually a year), and as a source of employment. Secondary Sector The secondary sector relates to manufacturing, the provision of energy and the construction industry; so, it processes the output of the primary sector. The manufacturing sector of an economy has traditionally been perceived as the major creator of wealth and jobs, as illustrated by the economic strength of Germany, Japan and increasingly PR China (the Peoples’ Republic of China), all based significantly on manufacturing. If the reader looks at the share price listings in any of the broadsheets, he/she will see a range of headings which encompass the secondary sector including alcoholic beverages, chemicals, construction, electricity, food manufacturers, pharmaceuticals and transport. Tertiary Sector The tertiary sector of the economy relates to the provision of services and is the fastest growing sector in many mature economies. It covers a wide range of activities from hairdressing to the services provided by a top computer software author. Enterprise is another example and is often marketed under the heading of management consultancy, through major accountancy firms. The tertiary sector is the major provider of employment, a considerable amount of which is part time, and the major contributor to GDP. In the stock market listings, businesses providing services are grouped under such headings as banks, insurance, investment trusts, health care, media, retailers, support services, and telecommunications. The growth sector is ‘dot com’ companies. Types of Market Structure Monopoly: Single Seller. This is the most extreme case of concentration of economic power and is known as a monopoly. Typically, monopolies have been state-owned through the fear that they would abuse their power by charging high prices and blocking entrants, to make greater than normal, i.e. monopoly, profits. Former state-owned public utilities such as gas, electricity and water were examples of this and were known as natural monopolies because it would not make economic sense to have more than one supplier (three different companies’ gas pipes all going to the same house would waste resources). Oligopoly: The type of market structure is where the market is dominated by a small number of large firms. High street banks such as Barclays, Halifax, HSBC, Lloyds–TSB, and NatWest are one example of this type of market structure, whilst filling stations such as BP, Esso, Mobil, Shell, and Texaco are another. It is quite possible that some small businesses, e.g. a family run filling station, will also exist in the market; however, they will have little economic influence over such factors as the price of petrol, or the long-term plans of the big companies. The technical name for this type of market is an oligopoly. Its importance to business economics is that whatever any one big business does will have an impact on the others, encouraging them to respond in a similar fashion. They may compete vigorously, or they may collude to stifle competition, exclude newcomers and hence maximize profits. Monopolistic Competition: Large number of small businesses selling differentiated products. They offer broadly the same products but compete by differentiating these through advertising and branding to make consumers perceive them as slightly different. As such, they are local monopolies since they dominate a local area but compete with other similar businesses close by. It is relatively low cost to enter this type of market whilst the expertise needed is also limited; economists call these low entry barriers facing newcomers. Similarly, it is relatively easy to leave the industry, i.e. exit barriers are low. Perfect Competition: Large number of small firms selling homogeneous products. The Business Economic Environment and How Businesses Appraise It? The environment within which businesses operate is constantly changing, which will affect how they perform. This changing environment therefore forces businesses to regularly review their operations and their strategies for achieving their defined objectives. This will mean a business examining a wide range of different issues. Some, but not an exhaustive list, are given here as an illustration. 1. Product portfolio The range of products it produces, called its product portfolio, whether these need to be changed and, if so, to what extent. How well each product or brand is doing – in other words, whereabouts it is in its life cycle. Are sales of some older products slowing down and, if so, can the products be revitalized, or should they be allowed to die? Which new products competitors are bringing to the market and how they compare with this business’s own products. 2. New markets The markets supplied and whether these need changing, e.g. with the implementation of the euro should the business expand into other European Union markets, or should it look to the US more, rather than just supplying to the UK? 3. Investment Is sufficient being spent on research and development (R&D) of new products, compared with competitors? Are sufficient new products (or brands) being brought to the market quickly enough to replace declining ones? Should the business seek to reduce its operating costs by reducing labour and substituting capital? Can it afford a new investment program? 4. New Partners Can the business continue as at present or should it seek to grow by ploughing back retained earnings and/or borrowing from its bank and/or issuing new shares.  Should it be looking for mergers and acquisitions as means to grow? If it is a pharmaceuticals firm, for example, a merger with a rival will enable it to secure a wider portfolio of products and share the very expensive R&D costs. Appraising the Environment If a business does not remain alert to its changing environment, then it will be left behind by other competing businesses which do regularly monitor it. The resultant loss of competitive advantage, in other words its ability to compete effectively with its business rivals, will lead to reduced profits or worse. Businesses need to review a number of areas which might affect their short-term operations (running the business from day to day) and their long-term strategy (where the business intends to be in three years, for instance, and how it will get there). Such an appraisal of its business environment may be undertaken under a number of headings which, together, are known as PESTLE, an acronym for Political, Economic, Social, Technological, Legal and Environmental/Ethical. These are variables or factors which can affect a business. Political Political changes may have a major impact on a business. After a general election, for example, a newly elected party will usually want to introduce a different tax structure or other policies which impact on business. Businesses based in Scotland will watch with some trepidation to see whether the Scottish electorate votes for independence, with some Scottish based businesses talking of moving their head offices to England if such an event occurs. Again, London based businesses will watch the election of an American style mayor for London to see how far he uses the tax gathering powers allocated to the office, whether anything can be done about traffic congestion etc. Economic There are many economic issues which can affect a business environment. For example, the rate of inflation and the level of the exchange rate against other main trading partners, especially the US and the reminder of the EU, can have a major impact on the competitiveness of UK exports and the extent to which foreign imports penetrate the domestic market. Large businesses will undertake their own forecasts; smaller ones will rely on buying in specialist agencies’ forecasts to plan ahead and assess the impact on their pricing strategies and production costs. Similarly, the collapse of Asian export markets in 1997 and 1998, and the world economic slowdown, had implications for British businesses in terms of lost sales opportunities. Social The impact of EU social policy has had a major effect on businesses. Regulations have been introduced forbidding a business from requiring its workforce to work more than forty-eight hours per week, unless they wish to do so. Another regulation requires both parents to be allowed three months leave after the birth or adoption of a child and the right to return to work with no loss of seniority. Both of these impose costs on a business and explain why the previous Conservative government of John Major opposed the UK signing the social charter which introduced these and other regulations. Taking social in a wider sense, the nature of the workforce has changed, with the growth of part time work for women at the expense of full-time jobs for men. Additionally, women are now securing more senior posts in business. As well as simple issues, such as the need for businesses to provide more crèches for the children of women staff, there are much wider issues in terms of the range of products and services businesses seek to sell to women, marketing policies aimed at women, and a whole range of other complex issues which pose businesses very different problems from those say twenty years ago when fewer women worked, and in much lower-level jobs. Technological For the last decade the world has been experiencing a technological revolution so profound as to change the very nature of how we live and work. Obviously, this has enormous implications for businesses. The rapid growth of e-mail and Internet-based voice telecommunications, increasingly supported by computer-based cameras, has real implications in terms of lost revenue for traditional postal services and telephone companies. E-commerce (electronic commerce) is growing rapidly, led by such companies as Amazon. This also has implications for business workforces; they are increasingly likely to work from home, whilst consumers are increasingly likely to shop from home. US analysts have predicted that companies will have to get involved in minute-by-minute price wars as consumers use specialist search engines to compare the prices of similar goods across different outlets and countries. Environmental/Ethical Companies which, by their actions, cause harm to the environment, or their workforce, must understand the impact it will have on their sales and their corporate image when consumers become aware of this, as well as the legal penalties. Good companies will have a health and safety strategy, which betters legal requirements, and will be aware of what their competitors are doing. Intensive farming methods are another example of environmental harm. The use of phospho- organic compounds such as fertilizers and pesticides have not only caused concerns about their impact on the health of the consumers of farm produce; they have also harmed the habitat of birds and mammals once common to the countryside but now in danger of extinction in some cases. The effect of CJD, or mad cow disease, and genetically modified foodstuffs, the so-called Frankenstein foods, is further illustration of environmental issues. Ethical issues are of limited but growing importance to businesses. Senior executives of a company awarding themselves large pay increases, often unwarranted by company performance, has been one example. Companies which exploit child labour in developing nations as some sports shoe manufacturing companies are alleged to have done, and companies which harm rainforests by felling hardwood trees for furniture production, are other examples of how businesses are increasingly being monitored by consumer agencies and pressure groups. Consequently, businesses have to be alert to changing consumer values and ensure that they conform to these.