Chapter 9

External economic influences on business behavior

 The ability to spot and exploit a gap in a fast growing economy can lead to high profits.
 Understanding the governments economic objectives is important to managers who
plan to protect their organization from negative policy changes and to position their
business to take advantage of positive policy changes.

Economic objectives of the government

 Economic growth-the annual percentage increase in a country’s total level of output

 Low price inflation-the rate at which the consumer prices on average increase each year
 Low rate of unemployment
 A long term balance of payments between the value of goods and services bought from
other countries and the value of the goods and services the country sells to other
countries
 Exchange rate stability- the government will try to prevent swings in the external value
of the currency in terms of the price compared with other countries
 Wealth and income transfers to reduce inequality- some governments but not all
attempt to reduce the inequalities of personal income and wealth usually by using the
tax system.
Why economic growth is desirable?

 higher real GDP increases average living standards if the population increases at a
slower rate.
 Higher levels of output often lead to increased employment, which will increase
consumer incomes.
 More resources can be devoted to desirable public sector projects such as health and
education, without reducing resources in other sectors.
 Absolute poverty can be reduced or even eliminated if growth is substantial enough and
the benefits are sufficiently widely spread.
 Businesses should experience rising demand for their products although this will depend
on income elasticity of demand for their products.
 Higher GDP makes more resources as the government gains from taxes

Factors that lead to economic growth

  Increases the input resulting from technological changes and expansion of industrial
capacity: governments encourage this form of non-inflationary economic growth by
encouraging business investment and innovation in new industries and products
 Increases in economic resources, such as higher working population of discovery of
new resources of oil and gas: a country can increase its total output when more
economic resources are available.
 Increases in productivity: if existing resources can produce a higher level of output this
year than last year than total output will increase.

The business cycle – the regular swings in economic activity measured by real GDP
that occur in most economies varying from boom conditions to recession when total
national output decline
1. Boom a period of very fast economic growth with rising incomes and profits
however a boom often sows a seed of its own destruction
2. Downtown or recession the effect of falling demand and higher interest rates
starts to bite.
3. Slump real GDP falls substantially and house asset prices fall.
4. Recovery and growth all downturns eventually lead to a recovery when real GDP
starts to increase again.

Inflation and deflation- changes in the value of money

Inflation- an increase in the average price levels of goods and services it results in the fall of
value of money
Deflation- a fall in the average price level of goods and services

Cause of inflation Gov and central bank policy Impact of gov policy and strategy
Cost Push  High exchange rate policy this can be  High exchange rate will make exports less
helped by higher interest rates set competition. Businesses can commit to focusing on
by the bank domestic market
 Discourage high wage settlements  High interest rates can discourage business
may use public sector workers as an borrowing
example  Consumer credit may be discourages reducing
demand

Demand pull  Policies designed to reduce  Higher taxes can reduce demand especially on
aggregate demand such higher tax luxury goods
rates and lower government  Lower gov spending could hit certain industries
spending very much
 Central bank may raise interest rates
What causes unemployment ?
Cyclical unemployment- unemployment resulting from low demand for goods and services in
the economy during a period of slow economic growth
Structural unemployment-unemployment caused by the decline in important industries
leading to significant job losses in one sector of the industry
Costs of unemployment
Unemployment is a waste of human resources. The costs of this are significant:

 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 substantial and is paid for out
of general taxation.
 High unemployment may lead to social problems, such as crime, which is a cost to society.
 Unemployment reduces demand for goods and services by reducing the incomes of those
looking for work.
 There will be loss of income and lower living standards.
 The longer the period of unemployment, the more difficult it is to find work, as skills become
increasingly

If a country’s economy has a large and persistent deficit on its balance of payments, then serious
economic problems could result, such as:

 a fall or depreciation in the value of its currency’s exchange rate

 a decline in the country’s reserves of foreign currency
 an unwillingness of foreign investors to put money into the economy.

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 deficit 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.

The business importance of these problems is likely to be most serious if:

 the exchange rate depreciation (or frequent fluctuations in the exchange rate) make importing
and exporting too risky (see below on exchange rates)
 the government takes corrective actions by, for example, limiting foreign exchange
transactions and putting substantial controls on imports, such as tariffs and quotas. This policy,
used currently by Zimbabwe, might have short-term benefits by reducing imports of
competitors’ products. However, serious consequences could also result. The policy could lead
 to retaliation by other countries that will then reduce export demand. Also, import controls are
serious for firms that depend on imported supplies.

Exchange rates
 Exchange rate fluctuations- When demand for a currency exceeds supply, its value will rise. T is
is called an exchange rate appreciation because one unit of the currency will buy more units of
other currencies.
 Appreciation of the currency – The domestic f rms that gain from an appreciation of the
country’s currency are:
 Importers of foreign raw materials and components, for whom the domestic currency cost of
these imports will be falling – this increases their competitiveness.
 Importers of foreign manufactured goods, who are able to import the product more cheaply in
terms of domestic currency – in 2008, it was claimed that European importers of US-produced
cars were profiteering at the expense of consumers. This was because, although the import
price of cars was falling due to the appreciation of the euro against the US dollar, they were not
selling them more cheaply to European consumers. Hence, they were taking advantage of the
appreciation to make much higher profits.
 Lower import prices will help to reduce the rate of information for the whole economy and all f
rms are likely to gain from this more stable position. T e domestic f rms that lose from an
appreciation are:
 Exporters of goods and services to foreign markets – this will include not just manufactured
goods, such as cars, but also own-country holiday resorts will experience a fall in demand from
overseas tourists because of the higher costs of products in terms of the foreign currency. Some
businesses may decide to locate overseas to avoid the high exchange rate.
 Businesses that sell goods and services to the domestic market and have foreign competitors –
as appreciation makes imports cheaper, it will make domestic producers less competitive in
their own market. Consumers will be prepared to switch to imported goods and foreign
holidays because of the cost advantages they have over home-produced products. However,
firms importing raw materials from other countries should be able to lower prices to combat
this.

Depreciation of currency winners and losers

The domestic businesses that gain from a depreciation are:

 Home-based exporters, who can now reduce their prices in overseas markets – this should
increase the value of their exports and lead to an expansion of the business.
 Businesses that sell in the domestic market will experience less price competition from
importers – prices of imported goods and services are likely to rise on the domestic market. The
home-based businesses that are likely to lose from a depreciation are:
 Manufacturers who depend heavily on imported supplies of materials, components or energy
sources – these costs will rise and will reduce competitiveness.
International competitiveness – non-price factors

The following are the factors, other than product prices, that can determine the international success –
or competitiveness – of a business:

 Product design and innovation: An innovative product, such as the latest Apple iPad, will attract
custom, even though it may be sold at premium prices.
 Quality of construction and reliability: For several years, Japanese cars have been declared the
most reliable on the US market and, even though they are not the cheapest models
 Retailers that purchase foreign supplies, especially if there are close domestic substitutes – the
prices of these imports will rise and the retailers may be forced to find domestic suppliers of
similar quality goods.
 Effective promotion and extensive distribution: These two factors go some way to explain the
universal success of McDonald’s restaurants.
 After-sales service: This includes extended guarantee periods.
 Investment in trained staff and modern technology: This should allow flexibility of production to
meet frequent changes in consumer tastes. Higher labour productivity can overcome drawbacks
caused by higher costs of other resources.

Macro-economic policies
These are policies that are designed to impact on the whole economy – or the ‘macro-economy’.
T ey mainly operate by influencing the level of total or aggregate demand in the economy. T is
level of demand then works through to determine the value of output of goods and services
(GDP) and, as a consequence, the level of employment.

Monetary policies
If information is low and is forecast to remain below government targets, then the central bank
may decide to reduce interest rates – especially if economic growth is slowing down and there is
a danger that unemployment might rise. T e European Central Bank did this in 2013. Although
the central bank is concerned about these other targets of economic policy, its primary objective
is the control of information. Using higher interest rates will have an impact on businesses in
three main ways:
1 Increases interest costs and reduces profits for business that have very high debts.
2 Reduces consumer borrowing and this reduces demand for goods bought on credit, e.g.
houses, cars, washing machines.

Claimed drawbacks to floating rates – or the benefits of joining a common currency These include:

 fluctuating prices of imported raw materials and components, making costing of products
difficult
 fluctuations in export prices and overseas competitiveness, which lead to unstable levels of
demand
 uncertainty over profits to be earned from trading abroad or from investing abroad – the value
of overseas assets also varies with currency fluctuations. T ese factors, when combined, may
discourage f rms from engaging in international trade because of the increased risk caused by
 currency movements. A common currency, it is argued, would encourage trade and investment
between the participating countries.
2. When firms are planning to purchase goods from abroad it is difficult to make cost
comparisons because suppliers from different countries will be using different currencies and
these may change from one month to another. This means the cost differences are not clear –
there is no ‘price transparency’ as there would be if all suppliers used the same currency.
3. Having different exchange rates adds considerably to the costs of firms trading overseas in
three main ways:
 currencies have to be converted into the domestic currency and this involves a commission cost
to the bank
 different price lists have to be printed and frequently updated for each separate country
 attempts to take out the risk of dealing in different currencies by using currency contracts and
‘hedging’ can be expensive as charges have to be paid to the specialist institutions involved. 4
The world economy has become increasingly dependent on overseas investment, much of it in
the form of foreign factories and of ices. The danger is that if the currency continues to float
and if the common currency is not adopted, much of this foreign investment could be lost to
countries with a common currency.

Claimed 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. If the UK did adopt the euro, then the European Central Bank would
determine the interest rates for the UK. Having one rate of interest across the European Union
may mean that it is too high for some economies but not high enough for others, such as those
experiencing ‘overheating’.
2 Replacing the currency with a common currency will eventually lead to common tax policies
throughout the currency zone, which reduce the independence of each government to control
its own tax rates.
3 Allowing exchange rates to float means that, except in extreme cases, the government and
the central bank can allow the exchange rate of the pound to find its own level and will not use
economic policies to keep it at one level or another. Interest rates can therefore be adjusted to
achieve other economic objectives.
4 Conversion costs from one currency to the common currency could be substantial in terms of
dual pricing and the changeover of notes and tills.

Government policies and business competitiveness

Government policies that aim to increase industrial competitiveness are often referred to as
supply-side policies because they aim to improve the supply effciency of the economy. If
successful, these policies will make a country’s industries more competitive in global markets.
Tree examples of policies that could have this effect are:
1. 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. Also, high rates of income tax will discourage entrepreneurs from setting
 up new businesses as they will consider that the rewards after tax do not justify the
risks involved. So, reducing rates of income tax is a supply-side policy.
2. Low rate of corporation tax T is is a tax on the operating prof ts of limited companies
af er interest. High rates of this tax will leave fewer funds for reinvestment in
businesses and will discourage new investments and new projects. T is lack of
investment will reduce the competitiveness of businesses. Many governments have
steadily reduced the rates of corporation tax in recent years, especially for smaller
companies. In the Republic of Ireland and Poland, for example, it has been reduced to
just 10%.
3. Increasing labour market flexibility and labour productivity Labour is, of course, a key
economic resource. Most governments want to use policies that will increase the skills
and ef ciency of the country’s workforce and encourage workers to demonstrate a
strong incentive to work.

These are some of the policies used by governments to achieve these aims:
 Subsidies for worker training programmes and increasing state provision at
colleges for skills training.
 Increased funding of higher education to allow a higher proportion of future
workers to enter employment with degrees and other high-level
qualifications.
 Low rates of income tax to encourage workers to take the risk of setting up
their own businesses and to encourage work incentives, e.g. gaining
promotion and working harder to earn more money.
 Encouraging immigration of skilled workers who can fill job vacancies and
help to increase total industrial output.
 Restricting welfare benefits to those in genuine need so that healthy and
potentially productive workers are not encouraged to stay at home and ‘live
of the state.

Income elasticity of demand

Virtually all businesses will have greater opportunities for increased sales, profits and expansion during
periods of economic growth. The impact of growth and the rising consumer incomes that accompany it
will not be evenly felt, however. Some businesses will experience substantial increases in the demand
for their goods and services, while others will notice a more limited rise – and, in certain cases, demand
may actually fall for particular product categories. T is varied experience resulting from economic
growth is most clearly analyzed by considering the concept of income elasticity of demand. Elasticity
measures the responsiveness of the demand for a product following a change in a variable.

Income elasticity of demand is calculated by the following formula:

Income elasticity of demand = % change in demand for a product % 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. This
means that, when consumer incomes rise, the demand for these goods may well also increase
 but by a smaller proportion. These tend to be essential or necessity goods, which will be bought
in roughly the same quantities by consumers no matter what their incomes
2. Luxury goods: The income elasticity of luxury goods is positive and greater than
1. This means that, when consumer incomes rise, the demand for these goods will rise by an
even greater proportion. This is because consumers may already be purchasing sufficient
quantities of normal goods. Thus, when their disposable incomes rise, they are able to
spend these increases on more unusual non-necessity items, such as holidays, leisure
activities and consumer durables. Among these will be the expensive but preferred
alternative goods, which cannot be afforded when incomes are low.
2. Inferior goods: The income elasticity for these products is negative. This means that demand
for these products will decline following an increase in consumer incomes, but will rise when
consumer incomes are reduced. Such products tend to have preferred but more expensive
substitutes. Examples of these goods and services could include:
 second-hand goods, such as furniture
 ‘economy’ own-brand food products
 poorer cuts of meat
 weekend breaks in own country rather than long holidays abroad. T us the
producers and retailers of these products may actually gain during a recession and
experience a decline