Chapter 7: External economic influences on business activity

The state of a country's economy and government economic policies are two of the most significant
external influences on business activity and decisions. Governments intervene in business in a variety of
ways. Which we are going to explore below.

7.1 Government support for business activity

Governments can also step in to help or subsidize new businesses, small businesses, and existing
businesses.

Government assistance for entrepreneurs

Most governments offer special assistance to entrepreneurs and other small business owners.

Among these measures are:

• Providing loan guarantee schemes, which are government-funded programs that guarantee
repayment of a certain percentage of a bank loan if the new enterprise or small business fails.

• Providing entrepreneurs with information, advice, and training programs through government industry
departments and local colleges.

• Financing the construction of small workshops that are rented out to entrepreneurs and small
businesses at low rates. This assistance is frequently provided in economically depressed areas, such as
cities with high unemployment rates.

• Reducing the amount of paperwork and legal formalities required to start a new business.

• Lowering the corporation tax rate for new and small businesses. This allows them to keep more profits
in the business for future growth.

Government assistance for all businesses

Government can intervene in the economy in ways that will support both small and large businesses,
such as through subsidies or grants to relocate them to areas with high unemployment. It is also
common for governments to provide financial support for consumers to buy products (e.g. houses) that
will increase national output.

Advantages of subsidies Disadvantages of subsidies

• They prevent rising unemployment due to
business failure.
• They keep suppliers in business.
• If a business fails, consumers may switch to
buying imported products, making the balance of
payments worse.
• In order to provide subsidies, the government
must raise taxes or cut other spending programs.
• Subsidies discourage businesses from becoming
more efficient.
• Because consumers buy subsidised goods at
lower prices, they spend less on non-subsidised
goods, distorting the market.

7.2 How governments deal with market failure

According to economists, free markets should operate efficiently to match demand and supply at
equilibrium prices so that resources are allocated as efficiently as possible. One major criticism of this
approach is that it does not consider all costs when setting prices. Some production methods, for
example, may have environmental costs that are not reflected in free market prices. This could result in
inefficient resource allocation. Failure to allocate resources effectively is referred to as market failure.

Examples of market failure and their solutions

Example 1: External costs

Pollution resulting from manufacturing is a good example of an external cost. When a business makes a
product, it must pay for the costs of the land, capital, labour and materials. These are called private
costs. There are other consequences of production, however air pollution, carbon emissions, noise
pollution and the dumping of waste products are all side effects of most manufacturing processes. Then
who pays for the costs of cleaning up after the production of chemicals or plastics? Unless the business
is forced to pay, the costs will be borne by the rest of society mainly through taxation. So in these cases,
the market fails to include the external cost of production in the price of the product. One way to limit
this kind of market failure would be for the government to impose fines on polluting businesses or
impose strict limits on pollution levels.

Example 2: Labour training

There is a real danger that qualified workers could be poached by other businesses that have not paid
for their training. Too many businesses will not provide sufficient training to avoid this, which will reduce
economic growth. In this case there would be under-provision of training, another form of market
failure. One way to limit this kind of market failure would be for the government to pay for more
training courses at colleges, funded from general taxation.

Example 3: Monopoly producers

When a market is dominated by one supplier, a monopoly is said to exist. As a monopolist can prevent
competitors from entering the market, this leads to under provision of products compared with
demand. This is, therefore, a form of market failure. One way to limit this kind of market failure would
be for the government to introduce competition laws.

7.3 How Macroeconomic objectives impact business activity

These macroeconomic objectives include:

• Economic growth. Growth in the economy occurs when the real level of GDP rises as a result of
increases in the physical output of goods and services in an economy. Economic growth means that a
country is becoming richer. It is measured by increases in GDP, which is measured in monetary terms,
and inflation will raise the value of GDP. Economic growth in a country will lead to businesses
experiencing rising demand for their products, be able to increase output and raise prices to increase
their profit margins.

• Low rate of inflation. Inflation is a persistent rise in the average level of prices over time. A low rate of
inflation is good for the economy because it is stable and predictable and helps money keep its value
and makes it easier for businesses to forecast their costs in the years ahead which helps them expand
accordingly. This helps the economy expand at a sustainable rate, creating higher incomes and new jobs.

• Low rate of unemployment of the workforce. Unemployment is the term when a person who is
actively looking for work cannot find a job. Low unemployment will guarantee increased output for
businesses as more people will have jobs and more tax revenue for the government as more people will
have wages insuring they’ll pay taxes but full employment will cause costs of labour to rise which lead
them to pass the costs on to their customers reducing their products affordability.

• A long-term balance of payments between the value of imports and the value of exports.

• Exchange rate stability: an exchange rate is the rate at which one currency will be exchanged for
another currency, it is determined by the forces of demand and supply. Exchange rate stability is the
prevention of uncontrolled changes in the exchange rate system. These changes are appreciation which
when the local currency increases in value in comparison to the foreign currency and depreciation which
is when the local currency reduces in value in comparison to the foreign currency. These 2 notions are
important to business activity in many ways, for example; An appreciation of a country’s currency may
give local businesses more purchasing power of foreign raw materials thus increasing production and
depreciation of a currency may cause local businesses to be investing heavens for foreign investors thus
also increasing production. However, these 2 changes may also cause problems to businesses namely;
low purchasing power of raw materials for local businesses in case of a depreciation and few exports for
local businesses as their currency is more valuable than their trading partners rendering their exports
more expensive.

Several of these objectives may conflict with each other. In trying to achieve one of these targets, the
government could make it less likely that one or more of the others is achieved. For example, if it is
believed that the rate of inflation is too high, then policies might be introduced to reduce spending. This
will lead to lower demand and result in increased unemployment.