Business Studies

Chapter 9
External Economic In uences on Business Behaviour

Key De nitions

Economic growth : An increase in a country’s productive potential

measured by an increase in its real GDP.

Gross domestic product (GDP) : The total value of goods and services
produced in a country in one year - real GDP has been adjusted for
in ation.

Business cycle : The regular swings in economic activity, measured by

real GDP, that occur in most economies, varying from boom conditions
(high demand and rapid growth) to recession when total national output
declines.

Business investment : Expenditure by businesses on capital

equipment, new technology and research and development.

Recession : A period of six months or more of declining real GDP.

In ation : An increase in the average price level of goods and services

- it results in a fall in the value of money.

De ation : A fall in the average price level of goods and services.

Working population : All those in the population of working age who

are willing and are able to work.

Unemployment : This exists when members of the working population

are willing and able to work, but are unable to nd job.

Cyclical unemployment : Unemployment resulting from low demand

for goods and services in the economy during a period of slow
economic growth or a recession.

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Structural unemployment : Unemployment caused by the decline in
important industries, leading to signi cant job losses in one sector of
industry.

Frictional unemployment : Unemployment resulting from workers

losing or leaving jobs and taking a substantial period of time to nd
alternative employment.

Balance of payments (current account) : This account records the

value of trade in goods and services between one country and the rest
of the world. A de cit means that the value of goods and services
imported exceeds the value of goods and services exported.

Exchange rate : The price of one currency in terms of another.

Exchange rate depreciation : A fall in the external value of a currency

as measured by its exchange rate against other currencies.

Imports : Goods and services purchased from other countries.

Exports : Goods and services sold to consumers and business in other

countries.

Exchange rate appreciation : A rise in the external value of a currency

as measured by its exchange rate against other currencies.

Fiscal policy : Concerned with decisions about government

expenditure, tax rates and government borrowing.

Government budget de cit : The value of government spending

exceeds revenue from taxation.

Government budget surplus : Taxation revenue exceeds the value of

government spending.

Monetary policy : Is concerned with decisions about the rate of

interest and the supply of money in the economy.

Market failure : When markets fall to achieve the most e cient

allocation of resources and there is under- or overpopulation of certain
goods or services.

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 External costs : Costs of an economic activity that are not paid for by
the producer or consumer, but by the rest of society.

Income elasticity of demand : Measures the responsiveness of

demand for a product after a change in consumer incomes.

Economic objectives of governments

Government ‘macro-economic’ objectives include:

• Economic growth

• Low price in ation

• Low rate of unemployment

• A long-term balance of payments

• Exchange rate stability

• Wealth and income transfers to reduce inequalities.

Economic growth-why is it considered desirable

Economic growth is important to a country for several reasons:

• Higher real GDP increases average living standards if the population
increases at a slower rate.

• Higher levels of output lead to increased employment, which will

increase consumer incomes.

• More resources can be devoted to desirable public-sector projects

without reducing resources in other sectors.

• Absolute poverty can be reduced or even eliminated if growth is

substantial enough and the bene ts are su ciently widely spread.

The factors that lead to economic growth

1. Increases in output resulting from technological changes and
expansion of industrial capacity

2. Increases in economic resources, such as a higher working

population or discovery of new resources of oil and gas

3. Increases in productivity. If existing resources can produce a higher

level of output this year than last year, then total output will
increase.

The business cycle

The four key stages are:
1. Boom - A period of very fast economic growth with rising incomes
and pro ts. In ation rises due to very high demand for goods and
services.

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 2. Downturn or recession - The e ect of falling demand and higher
interest rates starts to bite. Real GDP growth slows and may even
start to fall.

3. Slump - A very serious and prolonged downturn can lead to a

slump where real GDP falls substantially and house and asset prices
fall. This is much more likely to occur if the government fails to take
corrective economic action.

4. Recovery and growth - All downturns eventually lead to a recovery

when real GDP starts to increase again.

Is recession always bad?

An economic recession has serious consequences for most businesses
and the whole economy. As output is falling, fewer workers will be
needed. Unemployment will increase and as incomes fall, so demand
for goods and services declines further.

Opportunities that well-managed rms may be able to take

advantage of:
• Capital assets

• Demand for ‘inferior goods’ could actually increase.

• The risk of retrenchment and job losses may encourage improved

relations between employers and employees.

• Hard decisions may need to be taken regarding closures of factories

and o ces.

Type of producer:
Producers of luxury goods and services

Period of economic growth:

• Increase the range of goods and service

• Raise prices to increase pro t margins

• Promote exclusivity and style

• Increase output

Period of recession
• May not reduce prices for fear of damaging long-term image

• Credit terms to improve a ordability

• O er promotions

• Widen product range with lower-priced models

Type of producer:
Producers of normal goods and services
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 Period of economic growth:
• Add extra value to product

• Brand image may attract exclusive tag

• Do nothing

Period of recession:
• Lower prices

• Promotions

• Do nothing

Type of producer:
Producers of inferior goods and services

Period of economic growth:

• Attempt to move product upmarket

• Add extra value to the product

• Extend the product range to include more exclusive or better-

designed products

Period of recession:
• Promote good value and low prices

• Free consumer tests

• Increase range of distribution outlets

In ation and de ation-changes in the value of money

What causes in ation?

• Cost-push

• Demand-pull

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Cost-push causes of in ation

Businesses are faced with higher costs of production which could
result from:
• A lower exchange rate pushing up prices of imported materials

• World demand for materials raising their prices

• Higher wage demands from workers. In order to maintain their living

standards, workers will expect wage rises.

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 Demand-pull causes of in ation
When consumer demand in the economy is rising, usually during an
economic boom, producers and retailers will realise that existing stocks
can be sold at higher prices.

The impact of in ation on business strategy

If the rate is low, bene ts of in ation for businesses:
• Cost increases can be passed on to consumers more easily if there is
a general increase in prices.

• The real value of debts owed by companies will fall.

• Rising prices are also likely to a ect assets held by rms so value of
xed assets could rise

• Since inventories are bought in advance and then sold later, there is
an increased pro t margin from the e ect of in ation

Drawbacks of high rates on in ation on businesses:

• Employees will become much more concerned about the real value of
their incomes.

• Consumers are likely to become much more price sensitive and look
for bargains rather than big brand names

• Rapid in ation will often lead to higher rates of interest.

• Cash- ow problems may occur for all businesses as they struggle to

nd more money to pay higher costs of materials and other costs.

Business strategy during a period of rapid in ation might focus on:

• Cutting back on investment spending

• Cutting pro t margins to limit their own price rises to stay as

competitive as possible

• Reducing borrowing to levels at which the interest payments are

manageable

• Reducing time period for customers to pay

• Reducing labour costs.

Does this mean that de ation is bene cial?

Why businesses would not actually bene t from de ation:

• Consumers would delay making important purchases, hoping that
prices would fall further.

• As prices fall, the future pro tability of new projects appears doubtful.

• Holdings of stocks of materials and nished goods will be falling in

value.

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What factors cause unemployment?

Cyclical unemployment
This cause of unemployment is therefore associated with the business
cycle. Recession stage leads to fall in demand therefore businesses
need fewer employees as fewer products will be produced.

Structural unemployment
This cause of unemployment can exist even when the economy is
growing rapidly. This type of unemployment results in certain types of
workers being unable to nd work. This occurs from structural changes
in the economy.

Causes of structural changes in the economy :

• Changes in consumer tastes or spending patterns.

• Workers in some industries may nd the demand for their service is

declining

• Deindustrialisation in heavy manufacturing industries

• Improvements in technology in many industries.

Frictional unemployment
Most workers who lose their jobs are able to move quickly into new
ones, but others may take longer to nd suitable employment. While
they are looking for work, it is said that they are ‘frictionally’
unemployed.

Government policy towards the causes of unemployment

Cyclical
• The government attempts to manage the economy so as to avoid
swings in the business cycle.

• This includes the objective of keeping in ation low. If in ation rises,

the government might be forced to use di erent measures, which are
most likely to lead to cyclical unemployment.

• Government may also aim to maintain a competitive rate of exchange

so that overseas demand for goods does not fall.

Structural
• Aim of the government is not prevent the economic changes that lead
to structural unemployment.

• It will provide education and training programs for workers who do

not have required skills.

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 • The UK government’s ‘New Deal’ program had o ered training
courses to all long-term unemployed.

Frictional
• The e ciency of the labour market can be improved and frictional
unemployment can be reduced by the provision of information about
job opportunities.

• Government should reduce unemployment bene ts for those people

who are slow to nd alternative employment.

Costs of unemployment

The costs of unemployment:

• The economy could be producing more goods and services, which
would then be available for consumption.

• The cost of supporting unemployed workers and their families is

important and is paid for out of general taxation.

• High unemployment may lead to social problems.

• Unemployment reduces demand for goods and services.

• There will be loss of income and lower living standards

• The longer period of unemployment, the more di cult it is to nd

work.

Balance of payments (current account)

Economic problems caused by a de cit in a country’s balance of

payments:
• A fall or depreciation in the value of its currency’s exchange rate.

• Decline in country’s reserves of foreign currency

• Unwillingness of foreign investors to put money into the economy

Business importance of these problems is likely to be most serious

if:
• The exchange rate depreciation make importing and exporting too
risky.

• The government takes corrective actions by limiting foreign exchange

transactions and putting controls on imports such as tari s and
quotas.

Exchange rates
As with any price on a free market, exchange rates are determined by
the forces of supply and demand.

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 Demand for the currency:
• Foreign buyers of domestic goods or services

• Foreign tourists spending money in the country

• Foreign investors

Supply of the currency:

• Domestic businesses buying foreign imports

• Domestic population traveling abroad

• Domestic investors abroad

Exchange rate uctuations

When demand for a currency exceeds supply, its value will rise. This is
called exchange rate appreciation because one unit of the currency will
buy more units of other currencies.

Winners and losers from exchange rate appreciation

Winners:
• Importers of foreign raw materials and components, the domestic
currency cost of these imports will be falling.

• Importers of foreign manufactured goods, who are able to import the

products more cheaply in terms of domestic currency.

Losers:
• Exporters of goods and services to foreign markets.

• Businesses that sell goods and services to the domestic market and
have foreign competitors.

Depreciation of the currency

The fall in the value of a currency in terms of other currencies will have
e ects which are the reverse of an appreciation.

Winners:
• Home-based exporters who can reduce prices in overseas markets

• Businesses that sell in the domestic market will experience less price
competition from importers

Losers:
• Manufacturers who depend heavily on imported supplies of materials.

• Retailers that purchase foreign supplies, especially if there are close

domestic substitutes.

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 International competitiveness-non price factors

Consumers consider many non-price factors in making purchasing

decisions too.

Factors other than product prices that can determine the

international success:
• Product design and innovation: An innovation product, will attract
customers.

• Quality of construction and reliability

• E ective promotion and extensive distribution: These two factors
go some way to explain the universal success.

• After sales service: This includes extended guarantee periods.

• Investment in trained sta and modern technology: This should

allow the exibility of production to meet frequent changes in
consumer tastes.

Macro-economic policies
Policies that are designed to impact on the whole economy.

Fiscal policy

The economy is in recession and unemployment is rising-

Expansionary scal policy:
• Recession - raise government spending, lower tax rates - increased
aggregate demand - increase in output and employment.

The economy is booming and is in danger of overheating-

Contractionary scal policy:
• Boom - reduce government spending, raise tax rates - reductions in
aggregate demands - reduce output, employment and in ation.

Monetary policy
- interest rates increase, people borrow less money, lower disposable
income, spend less money.

- Interest rates decrease, people borrow more money, higher

disposable income, spend more money.

Impacts on businesses of higher interest rates:

1. Increases interest costs and reduces pro ts for business that have
very high debts

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 2. Reduces consumer borrowing and this reduces demand for goods
bought on credit.

3. It tends to lead to an appreciation of the country’s exchange rate.

Table 9.6

Exchange rate policy


in addition to nancial and monetary policies, the government also has
to have a view about the exchange rate of the currency.

Drawbacks of oating rates/bene ts of joining a common

currency:
1. Appreciation and depreciation of a currency against causes industry
many problems:

• Fluctuating prices of imported raw materials and components, making

costing of products di cult.

• Fluctuations in export prices and overseas competitiveness, which

lead to unstable levels of demand.

• Uncertainty over pro ts to be earned from trading abroad or from

investing abroad.

2. When rms are planning to purchase goods from abroad it is di cult

to make costs comparisons because suppliers from di erent countries
will be using di erent currencies.

3. Having di erent exchange rates adds considerably to the costs of

rms trading overseas in three main ways:

• Currencies have to be converted into the domestic currency and this

involves a commission cost to bank.

• Di erent price lists have to be printed and updated for each separate
countries.

4. If the currency continues to oat and if the common currency is not

adopted, much of this foreign investment could be lost to countries with
a common currency.

5. Business strategy may have to adapt to the country remaining

outside the common currency.

Advantages of not joining a common currency:

1. By not joining the common currency, the central bank could keep its
status as the interest-setting authority.

2. Replacing the currency with a common currency will lead to

common tax policies throughout the currency zone, which reduces
the independence of each government to control its own tax rates.

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3. Allowing exchange rates to oat means that the government and
the central bank can allow the exchange rate of the pound to nd its
own level and will not use economic policies.

4. Conversion costs from one currency to the common currency could

be essential in terms of dual pricing and the change of notes.

Government policies and business competitiveness

Low rates of income tax

If workers and managers are forced to pay high rates of tax on any
increase in income, then they could lose motivation to work hard and to
gain promotion.

Low rate of corporation tax

This is a tax on the operating pro ts of limited companies after interest.

High rates of this tax will leave fewer funds for reinvestment in
businesses.

Increasing labour market exibility and labour productivity

Labour is a key economic resource. Most governments want to use
policies that will increase the skills and e ciency of the country’s
workforce.

Polices used by governments to achieve these aims:

• Subsidies for worker training programs and increasing state provision

at colleges for skilled training.

• Increased funding of higher education to allow a higher proportion of

future workers to enter employment.

• Low rates income tax to encourage workers to take the risk of setting
up their own businesses.

• Encouraging immigration of skilled workers who can ll job vacancies.

Further economic issues

Government intervention in industry

Government measures in order to intervene in industry to support
small and large businesses:
• Subsidies to help keep down prices

• Subsidies to stop a loss making business from failing

• Grants to locate to particular regions

• Financial support for consumers to buy products

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Income elasticity of demand

Income elasticity of demand is calculated by the formula:

% change in demand for a product

Income elasticity of demand = —————————————————

% change in consumer incomes

Income elasticity can be described for three classes of goods:

1. Normal Goods: The income elasticity for normal goods is positive
and between 0 and 1. When consumer incomes rise, the demand
for these goods may well also increase but by a smaller proportion.

2. Luxury goods: The income elasticity of luxury goods is positive and

greater than 1. When consumer incomes rise, the demand for these
goods will rise by an even greater proportion.

3. Inferior Goods: The income elasticity for these products is

negative. Demand for these products will decline following an
increase in consumer incomes, but will rise when consumer
incomes are reduced. Examples of these goods: second-hand
goods, own-brand food products, poorer cuts of meat and weekend
breaks in own country.