CHAPTER 41: ECONOMIC INFLUENCES
I. Economic Influences
Factors beyond the control of businesses.
May constrain a business’s decision & may prevent its growth
& development.
Involves:
1. Rate of Inflation
2. Exchange rates (appreciation & depreciation)
3. Interest rates
4. Taxation
5. Government spending
6. Business cycle
II. Inflation - refers to the rise in the general price level.
A government will want to keep prices stable in the country’s
economy. This means that inflation must be kept under
control.
How does inflation affect businesses? (If there is
high/fluctuating inflation)
1. Increased costs
Due to inflation, prices of raw materials will increase
so the business will have to find an alternative
supplier which offer cheaper raw materials. The time
spent on research, transportation & energy of finding
new supplier will incur costs which is called shoe
leather costs.
Customers have to be informed of the new prices.
Brochures might have to be reprinted & sent out.
Websites might have to be updated. These costs are
called menu costs.
2. Consumer reaction
During inflation, prices will rise so consumers will not
be able to save & they will have less purchasing
power. They will be buying less amount of goods but
have to pay higher price. So, demand will fall. If
demand falls, business will have to produce less. At
first, their revenue will fall due to lower sales. Then if
the business’s cost increases due to more expensive
raw materials & higher demand for wages then their
profit will fall.
3. International competitiveness
CHAPTER 41: ECONOMIC INFLUENCES
Both exports & imports of domestic country may fall
if it is experiencing inflation. e.g., If both Bahrain &
Oman are exporting to Dubai but Oman has inflation.
So, Dubai will buy less from Oman since it will be
expensive so Oman will be less competitive.
III. Exchange rates
A. Depreciation (price of X falls, demand for X rises & price of M
rises, demand for M falls)
1. Export (impact to British exporters)
Here, UK is the domestic country. Suppose a British
car cost £4000 to build & sells for £5000 in the UK to
Europe so UK has to convert it to European currency.
Currency is 1.5-1.1 In 2007, the European price of
this car would be €7500(5000×1.5)
In 2008, the European price of this car would be
€5500(5000×1.1)
The depreciation means that European consumers
now find British cars much cheaper. This should
increase demand for British cars. Thus, sales & profit
for British exporters will rise.
2. Imports (impact on importers of raw materials)
British firms who import raw materials will see an
increase in the cost of buying raw materials. If the
British car company imports engines from Germany to
make the car, then it will have to pay more.
Suppose an engine costs €1000 to import from
Germany.
In 2007, this costs £666(1000˜1.5)
In 2009, with the fall in the value of the pound
(1.5 to 1.1) they will have to spend
£909(1000˜1.1) to buy the same German engine.
Since raw materials will be expensive, this will increase
costs for the business (British importers) so they will
have to charge higher prices. Demand will fall for
finished goods in UK. Hence, British importers will buy
less raw materials from Germany so British importers
will reduce their production. This will lead to lower sales
then profit for British importers.
CHAPTER 41: ECONOMIC INFLUENCES
B. Appreciation (price of X rises, demand for X falls & price of M
falls, demand for M rises).
1. Export
Exchange rate: July 2011 £1=€1.1
Oct 2012 £1=€1.25
UK will sell British car of £6000 & will have to convert to
European currency.
July 2011, the European price of the car would be
€6600(6000×1.1)
Oct 2012, the European price of the car would be
€7500(6000×1.25)
Europeans will find it expensive to purchase UK’s car, so
demand will fall for British exporters since it will be more
expensive. This will lead to lower sales & profit for
British exporters.
2. Import
If UK will have to buy engine which costs €500 from
Germany to make a car.
In July 2011, thus engine will cost £454(500˜1.1)
In Oct 2012, this engine will cost £400(500˜1.25)
Since importing engine will be cheaper, demand for
imported goods will increase. Since they will have lower
costs, they can charge lower prices for finished goods.
So, demand will rise & UK importers will benefit.
Summary:
During depreciation, the one who will benefit will be the exporters of
domestic country.
During appreciation, importers of domestic country will benefit.
IV. Interest rates
is the price of borrowing/ saving money.
If a business/ an individual borrows money, they usually
have to pay interest on the loan. Equally, if they put
their savings into a bank, they expect to receive
interest.
A. Effect of Interest rates on costs
CHAPTER 41: ECONOMIC INFLUENCES
If the business borrows from the bank & there is high interest
rates, cost of borrowing will increase so this will increase costs
for the business.
At the same time, even if the business does not borrow, if other
businesses like suppliers borrow & there is high interest rates.
Then suppliers will charge higher prices for raw materials which
will also increase the costs for the business.
B. Effect of interest rates on Investment
High interest rates mean firms will borrow less since cost of
borrowing is high. Business will invest less so their production will
fall which will lead to lower sales.
Sometimes, even if interest rate is high, firms might still borrow.
Due to high costs, they might increase their price, hence,
demand will fall. So, firms will have to reduce their production.
Thus, their profit will fall.
In general, higher interest rate will lead to fall in investment
because business will borrow less due to higher costs of
borrowing. So production will fall which will lead to lower sales &
profit.
C. Effect of interest rates on Demand
A rise in interest rates will tend to push down AD. Thus, sales of
the business will go down because less is being bought.
A fall in interest rates will tend to increase demand. Hence,
businesses will receive more orders which will lead to higher
sales.
V. Taxation
Taxation refers to the charges made by the government on
the activities, earnings & income of businesses & individuals.
A. Effect on consumers
Direct tax-If there is income tax, consumers will have less
disposable income, so they will only be able to buy less. So,
demand will fall. This will lead to fall of sales for the business.
Indirect tax-due to VAT, prices of goods & services will increase
so consumers will buy less. Thus, demand will fall.
B. Effect on businesses
Direct tax-If business will have to pay corporation tax to the
government, it may demoralize the business especially if the tax
is high since they know that no matter how much profit they
make, it will go to the government. So, business will produce
less. Thus, sales & profit will fall.
Indirect tax-Due to indirect taxes, this might increase costs of
raw materials for the business. Due to higher costs, they will
decrease their production which will lead to lower sales & profit.
CHAPTER 41: ECONOMIC INFLUENCES
VI. Government Spending
Is the amount spent by the government in its provision of
public services.
Pros of Government spending:
If the government invest in a building/ infrastructure it
will lead to job creation & high employment. Since
people will have income, demand will rise which will
lead to higher sales for the business.
If the government invest in a mega project, it will
usually need a lot of businesses to work with. So, this
will increase sales for those businesses.
If the government invest on roads & highways, it will be
more accessible for consumers to go to different
businesses which will lead to higher sales.
Cons of Government spending:
If the government invest in public schools/ hospitals,
then they will charge lower price. So, businesses will
have to lower their price as well otherwise they will
lose their customers. So, their profit will fall.
VII. Business Cycle
Impact of business cycle on businesses:
1. Output
During BOOM, business will increase output to meet
rising demand. So, businesses will have higher profit.
During recession, profit of the businesses will fall since
they will only be producing less due to low demand.
2. Profit
During a BOOM, business profits are likely to rise.
This is because demand is rising & it is easier to raise
prices.
During recession, some businesses will have lower
profits & will even make losses since consumers will
have less income so demand will fall.
3. Business Confidence & Investment
CHAPTER 41: ECONOMIC INFLUENCES
During an economic recovery & boom, business
confidence is high. Business owners are optimistic
about the future & are prepared to take more risks.
During a recession, business confidence is low &
business owners are cautious & anxious about the
future. Thus, they are not likely to take risks & are
more inclined to contract their businesses.
Investment is likely to fall.
4. Employment
During a boom, unemployment falls because
businesses are taking on more workers to cope with
rising demand.
During a recession, businesses lay off workers &
unemployment rises