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CHAPTER 41

Economic Influences

External influences

There are external influences on which businesses do not have control. Namely,

 Government
 Legislations and regulations
 Environmental factors
 Social factors
 Changes in population
 Pressure groups
 Economic climate consumer tastes
 World events

Economic influences

These are the economic activities and situations which have influence on businesses. Namely,

1. Inflation
2. Exchange rate
3. Interest rate
4. Taxation
5. Government expenditure
6. The business cycle

Inflation

Inflation means rise of general price levels

Inflation should be kept under control in a country in order to keep the prices stable
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Inflation is measured by using the consumer price Index which is a common measure of price
changes used in many countries

Inflation affects businesses in several ways

1. Inflation increases cost for businesses:

 It will increase the shoe leather cost which means business has to spend money
on researching the market every time of the prices of competitors in order to
increase their own price.
 It will increase the menu cost because price changes will lead to changes in
brochures, updates in websites etc.
 Workers will demand higher salaries to compensate increasing cost of living and
management has to spend time on negotiations

2. Uncertainty:
 This will make it difficult for businesses to decide prices for future period time.
 It will be difficult to decide whether to survive or invest
 It will delay businesses from entering into long term agreements

3. Borrowing and lending:

 Real value of debts would reduce with inflation which is good for debtors and
bad for lenders
 When the inflation rises the interest rates also would be increased and it
increases the cost of borrowing

4. Consumer reactions
 If the inflation is prolonging customers would try to save more
 When their confidence goes down they will be less willing to borrow and
spending which will reduce demand
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 When there is hyperinflation there can be a large demand at once which will
lead to shortages

5. International competitiveness
 When the inflation of a country increases the price of exported goods will
become expensive in other countries and it will make them exports less
competitive
 Imported goods will be cheaper than local goods and domestic businesses would
lose sales

A business can respond to inflation in various ways

1. Search for cheaper suppliers

2. Increase prices to compensate high cost
3. Increase productivity of workers – average cost will go down
4. Agreements with trade unions with regard to wage levels – wage cost will remain
constant
5. Have better inventory control in order to prevent constant rising of prices
6. Outsourcing or relocation abroad to avoid domestic inflation

Exchange Rate

It is the price of one currency in terms of another.

When goods and services are bought from another country payment are usually made in the
supplier’s currency.

Rise of the value of one currency against another is called as currency appreciation

Fall of one currency against another known as currency depreciation

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The impacts of currency depreciations are

1. Exports will be relatively cheaper for foreigners therefore export demand and revenue
might increase (depends on price elasticity of demand for exports)
2. Imports will become expensive and demand for imports will fall (depends on price
elasticity of demand for imports)

The impacts of currency appreciation are

1. Exports will be expensive for foreigners and demand for exports may fall (depends on
price elasticity of demand for exports)
2. Imports will become cheaper and demand for imports may rise (depends on price
elasticity of demand for imports)

Businesses are affected by exchange rate in different ways

1. Export businesses are benefitted when currency depreciates because their products
would become competitive in the international markets - Export businesses are affected
when currency appreciates because their products would become expensive in the
international markets.
2. Import businesses will suffer by currency depreciation because the cost of purchase will
increase and profit might decline - Import businesses are benefitted by currency
appreciation because the cost of purchase will decrease and profit might increase
3. Manufacturers who use imported raw materials and components may be affected by
depreciation of currency which increase their cost of production - Manufacturers who
use imported raw materials and components may be benefitted by appreciation of
currency which decrease their cost of production
4. Currency depreciation is beneficial for local businesses because imported products are
expensive in the market they would be more competitive -Currency appreciation is a
problem for local businesses because imported products are cheaper in the market they
would be less competitive
5. Above all frequent fluctuations of exchange rate might create uncertainty for businesses
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There are several ways that a business can respond to a change in exchange rate

Currency appreciation

1. Exporters can reduce their prices to be more competitive

2. Exporters can improve the quality of products (non-price competition)
3. Exporters can increase domestic sales
4. Importers can build up inventories while currency appreciated
5. Importers can lower the prices to capture market share and create customer loyalty
6. Importers can expand their operations
7. Importers of raw materials can reduce their cost of production and prices and capture
the market

Currency depreciation

1. Exporters can raise their prices and increase the profit margins
2. Exporters can use the lower prices to boost sales and capture the market
3. Sustained depreciation would lead to further expansion of export businesses
4. Importers have to maintain lower profit margins to maintain the sales
5. Manufacturers can use local raw materials

Interest Rate

Interest rate is the price of borrowing or saving money.

The use of interest rate to help control the economy is called monetary policy (policy using
changes in the interest rates and money supply to manage the economy)

Effects of interest rate on cost

Changes in the interest rates are likely to affect the overhead cost of the business.

Higher the interest rates the higher would be the interest costs
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However, the many loans obtained by businesses are fixed interest loan which means once
obtained the banks cannot change the interest rate. The change of interest rate affects only the
new loans obtained.

Effects of interest rates on investments

There are several effects on investments

1. The cost of loans would increase if the interest rates increase. Therefore, many
businesses cancel or delay their investment projects because of the lack of profitability.
2. When interest are increased businesses would be interested saving more in financial
assets rather than making investments
3. When the interest rate increases businesses would try to pay back the existing loans
quickly rather than obtaining new loans.
4. The rise of interest rate is likely reducing the demand in the economy which will affect
the profitability of businesses / investments.

Effects of interest rates on demand

1. Domestic consumption: rise in interest rate will increase the cost of loans and this will
reduce the purchases of consumer durables by customers on credit. People who have
mortgages with variable interest rate will have to pay more interest and it would reduce
their disposable income and others will postpone mortgages.
2. Domestic investment: it will go down due to high cost of borrowing
3. Stock: businesses will keep fewer stocks when interest rate rises. It is because they need
more money to pay interests and there would be less demand from consumers due to
high interest rate.
4. Export and import: rise of interest rate will lead to appreciation of currency. It is
because more foreign investments come into the country due to high interest payment.
Appreciation is more beneficial for imports rather than exports.
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Responding to the changes in interest rate

Higher interest rates

1. Reduce the amount borrow by cutting back on loans and overdrafts

2. Postpone or cancel marginal investments projects
3. Modify growth targets and release resource, if high interest rates are sustained for a
longer period of time. E.g. making the workers redundant
4. Saving more money in financial assets such as fixed deposits

Lower interest rates

1. Increase investments since returns on investments are high and cost of borrowing is
lower
e.g. Investment on R and D, launching new products, takeover other businesses etc.,
2. Consumer demand would increase and more production have to be done
3. Can increase price if demand rise so fast and it will increase revenue and profits

Taxation

They are the charges made by government on the activities, earnings and income of business
and individuals.

Together with government expenditure it is a part of government fiscal policy.

Fiscal policy means using the changes of taxation and government expenditure to control the
economic activity

There are various types of taxes

1. Direct taxes (taxes on income)

 Income tax: paid on personal income
 National insurance contribution: paid by businesses on employee earning
 Corporation tax: paid by businesses on profits
 Capital gains tax: paid on profit when selling assets
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 Inheritance tax: paid on money transferred to another individual

2. Indirect taxes (Taxes on expenditure which can be passed onto a third party)
 Value added tax (vat): paid on goods and services
 Excise duties: paid on each unit purchase such as petrol or liquor
 Custom duties: paid on imports
 Council tax: paid by residents to the local councils for common services
 Business rates: paid by businesses to the councils for common services

There are various effects on businesses of changes in taxation

1. Consumer spending: taxes reduce the disposable income of consumers and it will
reduce the consumer spending on products
2. Prices: indirect taxes such as Vat and custom duties will increase the price of the
products
3. Business cost, revenue and profits: tax is a cost to the business which leads to higher
prices. High prices reduce the demand and revenue. If the business absorbs the
taxation, then profit margins will go down.
4. Business spending and investments: increase cost and reduced profits means there
would be less retained profits available for investments
5. Shares: increase of capital gain taxes might discourage selling and buying shares
6. Importing and exporting: taxes on imports increase the price of the product and reduce
customer purchasing power. However, it would make local competitors more
competitive in the market against imported products
7. Business operations and employees: increase national insurance contribution will make
the employees better-off but it will discourage firms recruiting workers due to high cost
of labour
8. Tax avoidance and evasion: increase taxes might push businesses to avoid taxation. E.g.
not employing workers. Other businesses would try to evade it unlawful manner.
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9. Other effects: there can be other effects such as protection of environment. E.g. Carbon
tax, landfill tax etc.

How might businesses respond to changes in taxation?

 Businesses prefer lower taxes because it increases demand, business confidence, profits
and investments
 When taxes are increased demand will fall and businesses would act defensively
 If the corporation taxes are high businesses would try to relocate in a country where
taxes are low
 If taxes on spending are increased business would react by scaling down production
 If direct taxes are increased, it will reduce the disposable income people and demand
and businesses should use better pricing strategies to attract consumers

Government expenditure

It is the amount spent by the government in its provision of public services

E.g. healthcare, education, defense, general public services etc.

The effects of changes in government expenditure on businesses are

1. Increased government expenditure on the economy will increase the disposable income
of consumers, demand and revenue.
2. Too much of spending also will lead higher inflation and interest rates
3. In order to finance the spending government may increase taxes.
4. It will increase the government debts and if the government raise finance from local
banks money available for private businesses will go down (Crowding out effect)
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How might businesses respond to changes in government expenditure?

1. When the government expenditure increase the money will flow into the economy and
disposable income of people will increase. It will increase the aggregate demand and
therefore businesses may increase production.
2. The benefits receive by each business depends on the way government expenditures
are done e.g. expenditure on infrastructure is more beneficial for construction
companies
3. Too much of spending on public sector might reduce the development of the private
sector. Thereby private sector might try to raise prices rather than invest and expand

Business cycle

The business cycle describes the rise and fall in production output of goods and services in an
economy. Business cycles are generally measured using rise and fall in real – inflation-adjusted
– gross domestic product (GDP).
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Stages of business cycle are

1. Boom: this is the peak of the cycle. GDP is growing. Existing firms expands and new
firms are coming in. new jobs are created. Wages and profits are rising. However,
inflation also rising. It also will lead to rising asset price.
2. Downturn: Economy grows but at a slower rate. Demand has begun to fall.
Unemployment starts to rise. Wages and profits goes down, business expansion slow
down.
3. Recession and depression (Slump): GDP starts to fall. There are many economic
hardships. The demand will fall and unemployment will rise. Business confidence will be
low. Asset prices will fall. (less severe version of a depression is recession)
4. Recovery or Upswing: GDP starts to rise again. Business and consumer confidence
rising. Demand would rise. Unemployment falls.

The impacts of business cycle on businesses are

1. Output: during a boom there would be more output, luxurious products would be on
high demand because incomes are high. However, during the recession demand will fall
due to fall in income and more essential products are produced.
2. Profits: when there is a boom profits will rise but during recession businesses cut their
profit margins in order to survive.
3. Business confidence and investments: during boom business confidence is high and
business would invest more in new products, new markets etc. during recessions,
investment will be postponed or stopped and businesses will try to survive.
4. Employment: in boom periods there is high demand for employees and labor cost will
increase due to high wage rates. In recessions there would be high unemployment and
labour would be cheap.
5. Business startups and closure: during booms there would be more business startups
because it is easier to make profits. However, during recessions, it is not possible
because of lack of confidence.
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A business responds to the different phases of business cycle

1. During a boom:
 expand operation
 product development and diversification
 recruit more staff
 borrow more money and invest
 takeovers
 raise prices and earn more profits
2. During downturn:
 look ways to cutting cost
 selling off or closing down marginal divisions
3. During recession or depression:
 scaling back operations
 down size operation
 mothballing
 making some workers redundant
 delay the new ventures and maintain the existing ones
4. During recovery
 Start to take longer view and do more investments