Economic environment unit1

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Module 11: The Economic Environment

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LEARNING OBJECTIVES
• By the end of this module, you should be able to:
• Explain the economic environment
• Understand basic economic concepts
• Explain the difference between micro and macro
economics
• Understand the different economic situations and
their causes
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Introduction to Basic Economic Theory and Concepts
The Banking Economic Systems
Pricing and Price Mechanism
Inflation
The Government and Economy
Types of Business Organizations
MODULE COVERAGE
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International Trade and Regional Groupings

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Components of economic environment
When we talk of the economic environment, we refer to:
1. Economic conditions
2. Economic system
3. Economic policies
4. International economic environment
5. Economic legislations
Economic Conditions
• Economic policies of a business unit are largely affected by the economic
conditions of an economy. Any improvement in the economic conditions such as
standard of living, purchasing power of public, demand and supply, distribution of
income etc. largely affects the size of the market.
Another economic condition that is very important for a business unit is the
business cycle.
• The economic cycle has 5 different stages; prosperity, boom, decline, depression
and recovery.
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The following are the main aspects Economic Conditions of a country:-
1. Stage of an economic cycle
2. National Income, Per Capita Income and Distribution of Income
3. Rate of Capital Formation
4. Demand and Supply trends
5. Inflation rate in the economy
6. Economic Growth Rate, Exports Growth Rate
7. Interest rate prevailing in the economy
8. Efficiency of public and private Sectors
9. Size of Market
Economic Systems:
• An Economic System of a nation or a country may be defined as a framework of
rules, goals and incentives that controls economic relations among people in a
society. It also helps in providing framework for answering the basic economic
questions.
• Different countries of a world have different economic systems and the prevailing
economic system in a country affect the business units to a large extent. Economic
systems of a nation can be of any one of the following type:
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i) Capitalism- The economic system in which business units or factors of production
are privately owned and governed is called capitalism. The profit earning is the
sole aim of the business units. Government of that country does not interfere in
the economic activities of the country. It is also known as free market economy. All
the decisions relating to the economic activities are privately taken
ii) Socialism - Under socialism economic system, all the economic activities of the
country are controlled and regulated by the Government in the interest of the
public. The two main forms of Socialism are:
- Democratic Socialism - All the economic activities are controlled and regulated by the
government but the people have the freedom of choice of occupation and
consumption.
- Totalitarian Socialism - This form is also known as Communism. Under this, people
are obliged to work under the directions of Government.
iii) Mixed Economy - The economic system in which both public and private sectors co-
exist is known as mixed economy. Some factors of production are privately owned
and some are owned by Government. There exists freedom of choice of
occupation and consumption. Both private and public sectors play key roles in the
development of the country.
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Economic Policies
Government frames economic policies; economic policies affect the different business
units in different ways. It may or may not have favourable effect on a business unit.
The Government may grant subsidies to one business or decrease the rates of
excise or custom duty or the government may increase the rates of custom duty
and excise duty, tax rates for another business. All the business enterprises frame
their policies keeping in view the prevailing economic policies. Important
economic policies of a country are as follows:-
• Monetary Policy - This is the policy formulated by the central bank of a country to
control the supply and the cost of money (interest rate), in order to attain some
specified objectives.
• Fiscal Policy - This may be termed as budgetary policy. It is related with the income
and expenditure of a country. It is framed by the government of a country and it
deals with taxation, government expenditure, borrowings, deficit financing and
management of public debts in an economy.
• Foreign Trade Policy- This also affects the different businesses differently. When
restrictive import policy is adopted by the government, it intends to protect the
domestic businesses from foreign competition. When the liberal import policy has
been adopted by the government then it will affect the domestic products in other
way.
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• Foreign Investment Policy- The policy related to the investment by the foreigners
in a country is known as foreign investment policy. When the government adopts
liberal investment policy then it will lead to more inflow of foreign capital in the
country which ultimately results in more industrialization and growth in the
country.
• Industrial Policy - Industrial policy of a country promotes and regulates the
industrialization in the country. It is framed by government. The government from
time to time issues principles and guidelines under the industrial policy of the
country.
Global/International Economic Environment:-
If any business enterprise is involved in foreign trade, then it is influenced by not only
its own country economic environment but also the economic environment of the
country from/to which it is importing or exporting goods. There are various rules
and guidelines for these trades which are issued by many organizations like World
Bank, WTO, and the United Nations.
Economic Legislation
Besides the above policies, Governments of different countries frame various
legislations which regulates and control the business.
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Common Terminology in Economics
Economics is a social science because it deals with human behavior in society. It deals
with:
• The creation of wealth from scarce resources;
• The production and distribution of goods and services for consumption;
• The behavior, interaction and well-being of the groups involved in the above
activities;
Scarcity
• There exist only a finite amount of resources—human and non-human. Nature
does not freely provide as much of everything as people want. Therefore resources
are scarce according to economists and must be used optimally
Resources
• Resources or factors of production are inputs used in the production of goods and
services. They traditionally include land (original fertility and mineral deposits,
topography, climate, water, and vegetation), labor (contributions of humans who
work (thinking and doing)) and Capital (all manufactured resources including
buildings, equipment, machines, and improvements to land).
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Positive Economics
This is about the way the economy actually works; it is purely descriptive statements
or scientific predictions about economic phenomena (e.g. if A happened then B
will result)
Normative economics
This makes prescription about the way the economy should work; it gives opinion. It is
therefore value judgments about economic policies; it relates to whether things
are good or bad. What ought to be.
Microeconomics
This is the branch of economics that analyzes the market in terms individual
consumers and firms in an attempt to understand the behavior of decision-
making process of firms and households. It is concerned with the interaction
between individual buyers and sellers and the factors that influence the choices
made by buyers and sellers. In particular, microeconomics focuses on patterns of
supply and demand and the determination of price and output in free markets.
Microeconomics is therefore the study of the economic behavior of households and
firms and how prices of goods and services are determined. In microeconomics,
principal concepts include supply and demand, marginalism, rational choice
theory, opportunity cost, budget constraints, utility, and the theory of the firm.
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Supply
In economics, this refers to
the availing of goods and
services for sale or exchange
in the market. It is usually
expressed in terms of quantity
relative to price.
Demand
This refers to the need or
want for a particular good or
service, backed by ability to
pay (effective demand). Like
supply, it is also expressed in
terms of quantities in relation
to supply.
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Market Equilibrium
• The supply and demand model describes how prices vary as a result of a balance
between product availability and demand. The graph depicts an increase (that is,
right-shift) in demand from D1 to D2 along with the consequent increase in price
and quantity required to reach a new equilibrium point on the supply curve (S).
• Prices and quantities have been described as the most directly observable
attributes of goods produced and exchanged in a market economy.
• For a given market of a commodity, demand is the relation of the quantity that all
buyers would be prepared to purchase at each unit price of the good. Demand is
often represented by a table or a graph showing price and quantity demanded (as
in the figure above).
• Demand theory describes individual consumers as rationally choosing the most
preferred quantity of each good, given income, prices, tastes, etc. A term for this is
'constrained utility maximization' (with income and wealth as the constraints on
demand). Here, utility refers to the hypothesized relation of each individual
consumer for ranking different commodity bundles as more or less preferred.
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The law of demand states that, in general, price and quantity demanded in a given
market are inversely related. That is, the higher the price of a product, the less of it
people would be prepared to buy of it (other things unchanged). As the price of a
commodity falls, consumers move toward it from relatively more expensive goods
(the substitution effect). In addition,
Purchasing power from the price decline increases ability to buy (the income effect).
Other factors can change demand; for example an increase in income will shift the
demand curve for a normal good outward relative to the origin, as in the figure.
• Supply is the relation between the price of a good and the quantity available for
sale at that price. It may be represented as a table or graph relating price and
quantity supplied.
• Producers, for example business firms, are hypothesized to be profit-maximizers,
meaning that they attempt to produce and supply the amount of goods that will
bring them the highest profit.
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• Market equilibrium occurs where quantity
supplied equals quantity demanded, the
intersection of the supply and demand curves in
the figure on the left.
• At a price below equilibrium, there is a shortage
of quantity supplied compared to quantity
demanded. This is posited to bid the price up. At
a price above equilibrium, there is a surplus of
quantity supplied compared to quantity
demanded. This pushes the price down.
• The model of supply and demand predicts that
for given supply and demand curves, price and
quantity will stabilize at the price that makes
quantity supplied equal to quantity demanded.
• Similarly, demand-and-supply theory predicts a
new price- quantity combination from a shift in
demand (as to the figure), or in supply.
Market Equilibrium
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On the supply side of the market, some factors of production are described as
(relatively) variable in the short run, which affects the cost of changing output
levels. Their usage rates can be changed easily, such as electrical power, raw-
material inputs, and over-time and temp work.
Other inputs are relatively fixed, such as plant and equipment and key personnel. In
the long run, all inputs may be adjusted by management. These distinctions
translate to differences in the elasticity (responsiveness) of the supply curve in the
short and long runs and corresponding differences in the price-quantity change
from a shift on the supply or demand side of the market.
Other applications of demand and supply include the distribution of income among
the factors of production, including labour and capital, through factor markets. In a
competitive labour market for example the quantity of labour employed and the
price of labour (the wage rate) depends on the demand for labour (from
employers for production) and supply of labour (from potential workers).
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Production
• Production is the conversion of inputs into outputs. It is an economic process that
uses inputs to create a commodity for exchange or direct use. Production is a flow
and thus a rate of output per period of time.
Cost
• Cost is an amount that has to be paid or given up in order to get something; it is
usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and
utilities consumed, (5) risks incurred, and (6) opportunity forgone in production
and delivery of a good or service.
Efficiency
• A level of performance that describes a process that uses the lowest amount of
inputs to create the greatest amount of outputs. It is an important attribute
because all inputs are scarce and so it makes sense to try to conserve them while
maintaining an acceptable level of output or a general production level.
Opportunity cost
• This is the highest valued alternative that must be sacrificed to attain something or
satisfy a want. Choices must be made between desirable yet mutually exclusive
actions. It has been described as expressing "the basic relationship between
scarcity and choice.
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Economic efficiency
• This describes how well a system generates desired output with a given
set of inputs and available technology. Efficiency is improved if more
output is generated without changing inputs, or in other words, the
amount of "waste" is reduced.
Macroeconomics
• Macroeconomics examines the economy as a whole to explain broad
aggregates and their interactions. Such aggregates include national
income and output, the unemployment rate, price inflation and sub-
aggregates like total consumption and investment spending and their
components.
• It also studies effects of monetary policy and fiscal policy. This considers
the performance of the economy as a whole. It looks at issues such as
economic growth; inflation; changes in employment and unemployment,
trade performance with other countries (i.e. the balance of payments) and
the relative success or failure of government economic policies. It is thus
focused on the movement and trends in the economy as a whole. It also
studies effects of the monetary policy and fiscal policy.
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Economic growth
• Growth economics studies factors that explain economic growth i.e.
the increase in output per capita of a country over a long period of
time. The same factors are used to explain differences in the level
of output per capita between countries, in particular why some
countries grow faster than others, and whether countries converge
at the same rates of growth. Much-studied factors include the rate
of investment, population growth, and technological change.
Economic development
• Economic development refers to the combined effect of growth and
redistribution of wealth in the economy. It adds the qualitative
element to the purely quantitative measures of growth
Inflation
• Inflation is a situation where there is a sustained and abnormal
increase in the general price level.
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Employment and unemployment:
• In macroeconomics, full employment is a condition of the national
economy, where all or nearly all persons willing and able to work at the
prevailing wages and working conditions are able to do so.
• Unemployment is a status in which individuals are without jobs and are
seeking jobs. It is one of the most pressing problems of any economy
especially the underdeveloped ones.
Types of Unemployment
• Cyclical Unemployment: This type of unemployment is consistent with the
trade cycle. When the economy is in its boom phase, there is a reduction
in the unemployment. Conversely, when it passes through the
recessionary phase, unemployment rate rises.
Seasonal unemployment:
• This type of unemployment is most common in hotel, catering or fruit
picking business.
• Frictional unemployment: Frictional unemployment occurs when
individuals are between jobs.
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• Structural unemployment occurs due to a change in the composition of some
industries. Technological progress may make an industry capital intensive from a
purely labor intensive one. The release in labor from such an industry gives rise to
the problem of unemployment.
• Hard core unemployment usually results when a worker is disabled and is not in a
position to work. The worker may also give up his job after a few days due to
dissatisfaction with the wage.
Balance of payments (BOP)
• The balance of payments (BOP), the difference between international receipts and
international payments in an economy, is the measure countries use to monitor all
international monetary transactions at a specific period of time. Usually, the BOP is
calculated every quarter and every calendar year. All trade conducted by both the
private and public sectors are accounted for in the BOP in order to determine how
much money is going in and out of a country.
• The BOP is divided into three main categories: the current account, the capital
account and the financial account. Within these three categories are sub-divisions,
each of which accounts for a different type of international monetary transaction.
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The current account is used to mark the inflow and outflow of goods and services into
a country. Earnings on investments, both public and private, are also put into the
current account.
Within the current account are credits and debits on the trade of merchandise, which
includes goods such as raw materials and manufactured goods that are bought,
sold or given away (possibly in the form of aid). Services refer to receipts from
tourism, transportation (like the levy that must be paid in Egypt when a ship
passes through the Suez Canal), engineering, business service fees (from lawyers
or management consulting, for example), and royalties from patents and
copyrights. When combined, goods and services together make up a country's
balance of trade (BOT).
Receipts from income-generating assets such as stocks (in the form of dividends) are
also recorded in the current account. The last component of the current account is
unilateral transfers. These are credits that are mostly worker's remittances, which
are salaries sent back into the home country of a national working abroad, as well
as foreign aid that are directly received.
The capital account is where all international capital transfers are recorded. This refers
to the acquisition or disposal of non-financial assets (for example, a physical asset
such as land) and non-produced assets, which are needed for production but have
not been produced, like a mine used for the extraction of diamonds.
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In the financial account, international monetary flows related to investment in
business, real estate, bonds and stocks are documented. Also included are
government-owned assets such as foreign reserves, gold, special drawing rights
(SDRs) held with the International Monetary Fund, private assets held abroad, and
direct foreign investment. Assets owned by foreigners, private and official, are also
recorded in the financial account.
The Balancing Act
The current account should be balanced against the combined-capital and financial
accounts. However, this rarely happens; with fluctuating exchange rates, the
change in the value of money can add to BOP discrepancies. When there is a
deficit in the current account, which is a balance of trade deficit, the difference
can be borrowed or funded by the capital account. If a country has a fixed asset
abroad, this borrowed amount is marked as a capital account outflow. However,
the sale of that fixed asset would be considered a current account inflow (earnings
from investments). The current account deficit would thus be funded.
When a country has a current account deficit that is financed by the capital account,
the country is actually foregoing capital assets for more goods and services. If a
country is borrowing money to fund its current account deficit, this would appear
as an inflow of foreign capital in the BOP.
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Monetary Policy
This refers to actions taken by a central bank, currency board or other regulatory
committee that determines the size and rate of growth of the money supply which
in turn affects interest rates. Monetary policy is maintained through actions such
as increasing the interest rate, or changing the amount of money banks need to
keep in the vault (bank reserves).
• Monetary policy can control the growth of demand through an increase in interest
rates and a contraction in the real money supply. Higher interest rates reduce
aggregate demand in the following ways:
• Discouraging borrowing by both households and companies
• Increasing the rate of saving (the opportunity cost of spending has increased)
• The rise in mortgage interest payments will reduce homeowners' real 'effective'
disposable income and their ability to spend. Increased mortgage costs will also
reduce market demand in the housing market
• Business investment may also fall, as the cost of borrowing funds will increase.
Some planned investment projects will now become unprofitable and, as a result,
aggregate demand will fall
• Higher interest rates could also be used to limit monetary inflation. A rise in real
interest rates should reduce the demand for lending and therefore reduce the
growth of broad money.
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Fiscal policy
• This refers to government actions that
may influence economic activity. It’s the
means by which a government adjusts
its levels of spending in order to
monitor and influence a nation's
economy.
• Governments can influence
macroeconomic productivity levels by
increasing or decreasing tax levels and
public spending. This influence, in turn,
curbs inflation (generally considered to
be healthy when at a level between 2-
3%), increases employment and
maintains a healthy value of money.
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Common Economic Indicators
Gross Domestic Product (GDP)
GDP is the total value of all goods and services produced in the country. This includes
consumer spending, government spending and business inventories. Real GDP is a
variant that takes out the impact of inflation, so that GDP can be compared over
time. Real GDP is the basic measure of business activity.
Consumer Price Index (CPI)
This is a measure of the price of a basket of goods and services. Increase in this index
indicates in inflation and the reverse deflation.
Producer Price Index (PPI)
PPI is a measure of the price of commercial items, such as farm products and
industrial commodities. PPI indicates the cost of producing items and is also an
indicator of inflation.
Trade deficit
This results when a country's imports exceed its exports.
Trade surplus
This results when a country's exports exceed its imports.
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Balance of payments (BOP)
•Is the amount of foreign
currency taken in minus the
amount of domestic currency
paid out.
Unemployment rate
•This indicates the number or
percentage of unemployed
people in a country. Increases
in the unemployment rate
tend to occur when the
economy declines and vice
versa.
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Economic Cycles
Economic cycle refers to the
recurring and fluctuating levels of
economic activity that an
economy experiences over a long
period of time.
The five stages of the economic cycle
are growth (expansion), peak,
recession (contraction), trough
and recovery. At one time, these
cycles were thought to be
extremely regular, with
predictable durations, but today
they are widely believed to be
irregular, varying in frequency,
magnitude and duration.
Economic cycles
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Phases of the Economic Cycle

Economic environment unit1

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