Unit i notes

Economic Environment
Introduction: - Various environmental factors such as economic environment, socio-cultural
environment, political, technological, demographic and international, affect the business and
its working. Out of these factors economic environment is the most important factor.

Meaning of Economic Environment: -

Those Economic factors which have their affect on the working of the business is known
as economic environment. It includes system, policies and nature of an economy, trade
cycles, economic resources, level of income, distribution of income and wealth etc. Economic
environment is very dynamic and complex in nature. It does not remain the same. It keeps on
changing from time to time with the changes in an economy like change in Govt. policies,
political situations.

Elements of Economic Environment:-

It has mainly five main components: -
1. Economic Conditions
2. Economic System
3. Economic Policies
4. International Economic Environment
5. Economic Legislations

1. 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.
Business cycle is another economic condition that is very important for a business unit.
Business Cycle has 5 different stages viz. (i) Prosperity, (ii) Boom, (iii) Decline, (iv) Depression,
(v) Recovery.

Following are mainly included in Economic Conditions of a country:-
I. Stages of Business Cycle
II. National Income, Per Capita Income and Distribution of Income
III. Rate of Capital Formation
IV. Demand and Supply Trends
V. Inflation Rate in the Economy
VI. Industrial Growth Rate, Exports Growth Rate
VII. Interest Rate prevailing in the Economy
VIII. Trends in Industrial Sickness
IX. Efficiency of Public and Private Sectors

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X. Growth of Primary and Secondary Capital Markets
XI. Size of Market

2. 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 conditions of a nation can be of any one of the following type:-

1. 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. Examples of Capitalistic
Economy: - England, Japan, America etc.
2. 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 first country to adopt this concept was Soviet Russia. The two main forms of
Socialism are: -
(a) 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.
(b) Totalitarian Socialism:- This form is also known as Communism. Under this, people
are obliged to work under the directions of Government.
3. 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.

3. Economic Policies: -

Government frames economic policies. Economic Policies affects the different business
units in different ways. It may or may not have favorable 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:-
1. Monetary Policy:- The policy formulated by the central bank of a country to control
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the supply and the cost of money (rate of interest), in order to attain some specified
objectives is known as Monetary Policy.

2. Fiscal Policy:- It may be termed as budgetary policy. It is related with the income and
expenditure of a country. Fiscal Policy works as an instrument in economic and social
growth 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.

3. Foreign Trade Policy: - It also affects the different business units differently. E.g. if
restrictive import policy has been adopted by the government then it will prevent the
domestic business units from foreign competition and if the liberal import policy has
been adopted by the government then it will affect the domestic products in other way.

4. Foreign Investment Policy:- The policy related to the investment by the foreigners in
a country is known as Foreign Investment Policy. If the government has adopted 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.

5. 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 principals and guidelines under the industrial policy of the country.

4. Global/International Economic Environment: - The role of international economic
environment is increasing day by day. 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 United Nations etc.

5. Economic Legislations: - Besides the above policies, Governments of different countries
frame various legislations which regulates and control the business.

Basic problems of Scarcity and Choice
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The purpose of economic activity

Road space throughout the world is becoming increasingly scarce as the demand for motor
transport increases each year – what do you think are some of the best solutions to reducing
the problem of congestion on our roads?

It is often said that the central purpose of economic activity is the production of goods and
services to satisfy consumer‘s needs and wants i.e. to meet people‘s need for consumption
both as a means of survival but also to meet their ever-growing demand for an improved
lifestyle or standard of living.

The basic economic problem is about scarcity and choice since there are only a limited
amount of resources available to produce the unlimited amount of goods and services we
desire.

All societies face the problem of having to decide:

What goods and services to produce: Does the economy uses its resources to
operate more hospitals or hotels? Do we make iPod Nanos or produce more coffee?
Does the National Health Service provide free IVF treatment for thousands of
childless couples? Or, do we choose instead to allocate millions of pounds each year
to providing beta-interferon to sufferers of multiple sclerosis?
How best to produce goods and services: What is the best use of our scarce
resources of land labour and capital? Should school playing fields be sold off to
provide more land for affordable housing? Or are we contributing to the problem of
obesity by selling off these playing fields?
Who is to receive goods and services: What is the best method of distributing
products to ensure the highest level of wants and needs are met? Who will get
expensive hospital treatment - and who not? Should there be a minimum wage? If so,
at what level should it be set?

Making choices

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Because of scarcity, choices have to be made on a daily basis by all consumers, firms and
governments. For a moment, just have a think about the hundreds of millions of decisions
that are made by people in your own country every single day.

Take for example the choices that people make in the city of London about how to get to
work. Over six million people travel into London each day, they have to make choices about
when to travel, whether to use the bus, the tube, to walk or cycle – or indeed whether to work
from home. Millions of decisions are being taken, many of them are habitual (we choose the
same path each time) – but somehow on most days, people get to work on time and they get
home too! This is a remarkable achievement, and for it to happen, our economy must provide
the resources and the options for it to happen.

Trade-offs when making choices

Making a choice made normally involves a trade-off - in simple terms, choosing more of one
thing means giving up something else in exchange. Because wants are unlimited but
resources are finite, choice is an unavoidable issue in economics. For example:

1. Housing: Choices about whether to rent or buy a home – a huge decision to make and
one full of uncertainty given the recent volatility in the British housing market! There
are costs and benefits to renting a property or choosing to buy a home with a
mortgage. Both decisions involve a degree of risk.

2. Working: Choosing between full-time or part-time work, or to take a course in
higher education lasting three years – how have these choices and commitments been
affected by the introduction of university tuition fees?

3. Transport and travel: The choice between using Euro-Tunnel, a speedy low-cost
ferry or an airline when travelling to Western Europe. Your choices about which
modes of transport to use to get to and from work or school each day.

Opportunity Cost

There is a well known saying in economics that “there is no such thing as a free lunch!”
Even if we are not asked to pay a price for consuming a good or a service, scarce resources
are used up in the production of it and there must be an opportunity cost involved.

Opportunity cost measures the cost of any choice in terms of the next best alternative
foregone. Many examples exist for individuals, firms and the government.

Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a
week is the lost wages foregone. If you are being paid £6 per hour to work at the local
supermarket, if you choose to take a day off from work you might lose £48 from having
sacrificed eight hours of paid work.

Government spending priorities: The opportunity cost of the government spending nearly
£10 billion on investment in National Health Service might be that £10 billion less is

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available for spending on education or the transport network.

Investing today for consumption tomorrow: The opportunity cost of an economy investing
resources in new capital goods is the current production of consumer goods given up. We
may have to accept lower living standards now, to accumulate increased capital equipment so
that long run living standards can improve.

Making use of scarce farming land: The opportunity cost of using arable farmland to
produce wheat is that the land cannot be used in that production period to harvest potatoes.

Sectors of production in the economy

Primary sector: This involves extraction of natural resources e.g. agriculture,
forestry, fishing, quarrying, and mining

Secondary sector: This involves the production of goods in the economy, i.e.
transforming materials produced by the primary sector e.g. manufacturing and the
construction industry

Tertiary sector: the tertiary sector provided services such as banking, finance,
insurance, retail, education and travel and tourism
Quaternary sector: The quaternary sector is involved with information processing
e.g. education, research and development

Scarcity

Unlimited Wants

• Human beings, in order to survive need a lot of things. Some of these things are very
important for our existence. For example, food, clothing, water, shelter and air. These
things can be classified as Needs. Apart from this there are things which are needed by us
but they are not important for our survival and we can live without them also. For
example, going on an expensive holiday, owning a 57 inches Plasma TV. These are
known as Wants. This list is never ending and is continuously increasing.

Limited Resources

• On the other hand, we have limited resources to produce these goods and services we
want. There are not enough car factories to provide cars to everybody on earth.
Everything on this planet has some limits except for our Wants.
When unlimited wants meet limited resources, it is known as Scarcity.

Alternative Uses

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• All the resources we have on this planet can be utilised in a number of way. They have
alternative uses. For example, a piece of land can be used for making a factory, or doing
farming or constructing a school and so on. Therefore, we have to choose what is best for
us. If we talk from an economist point of view it means ‗making the optimum use of
resource available‘.

Opportunity Cost

• Though we have alternative uses, we have to select the best way to use these resources.
When we choose best alternative, the next best alternative which is left out is known as
the Opportunity cost of making a choice. In other words, the benefits we lost and could
have achieved from the next best alternative.

Examples of Opportunity Cost

• A person who invests $10,000 in a stock denies themselves the interest they could have
earned by leaving the $10,000 dollars in a bank account instead. The opportunity cost of
the decision to invest in stock is the value of the interest.
If a city decides to build a hospital on vacant land it owns, the opportunity cost is the
value of the benefits forgone of the next best thing which might have been done with the
land and construction funds instead. In building the hospital, the city has forgone the
opportunity to build a sports centre on that land, or a parking lot.

Economic Problem

• The problem then becomes how to determine what is to be produced and how the factors
of production (such as capital and labour) are to be allocated. Economics revolves around
methods and possibilities of solving the economic problem.

Allocation of resources
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Definition

Analysis of how scarce resources ('factors of production') are distributed among
producers, and how scarce goods and services are apportioned among consumers. This analysis
takes into consideration the accounting cost, economic cost, opportunity cost, and other costs of
resources and goods and services. Allocation of resources is a central theme in economics (which
is essentially a study of how resources are allocated) and is associated with economic efficiency
and maximization of utility.

Business Growth

Why a Business would consider Growing

 A larger business may be able to make more profit.

 Higher pay for the managers if they are able to increase the size of the business.

 It can be easier for a larger business to continue as the risk for it is a lot less (limited
Liability)

 Economies of scale, these will be discussed in greater detail below.

 Not all businesses would want to grow, for example, a sole trader may be happy working
on his or her own.

Profits or growth

 Owners can face a dilemma in deciding whether to expand. Expansion is risky. There's
always the chance that any expansion plans can fail and result in losses rather than profit.
Owners are then worse off than before the growth of the business.

 The risk of expansion means that some owners are reluctant to chance funds. They opt
instead to stay small and earn a relatively risk-free profit.

Benefits of growth

 As a business grows it gains two major advantages over its smaller rivals.

 Large firms have more influence over market price.

 They're big enough to be price setters. (monopoly)

 Economies of Scale

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Methods of Expansion

 Internal growth: the business grows by hiring more staff and equipment to increase its
output.

 External growth: where a business merges with or takes over another organisation.
Combining two firms increases the scale of operation.

 Franchising: where a business leases its idea to franchisees. This allows new branches to
open across the country and internationally.

Measurement of size of Business
The measures commonly used to determine the size of business firms are discussed below

1. Net Worth: The net worth of a company is the aggregate of its paid up capital and free
reserves. But it is very difficult to calculate the net worth of a firm because of the obvious
difficulty of obtaining the accurate date. However, if accurate data are available, net worth can
be used to determine the rate of growth of the firm and the compare the size of different forms at
a particular moment of time. This criteria does not work in practice because of different stages of
growth of the firms and different methods of financing employed by them, The paid up capital of
company may be less but its size may be higher as compared to other similar enterprises because
of accommodation from commercial banks and financial institutions.

2. Total Assets: Size of different firms can be compared by taking the value of their total assets.
For instance, in America, the Fortune Magazine ranks every year the top 500 corporations of the
world on the basis of their total assets an in India, the economic Times uses this criterion for its
study for the corporate Giants of India. Total assets also provide a defective measure of size
because of a number of factors. Firstly, there is generally a wide difference between the book
value and the market value of the assets. Secondly, depreciation policy varies from firm to firm.
Thirdly, the size of the assets per unit of product varies from industry to industry. Fourthly, the
firms stated during inflationary periods will appear to be bigger in size as compared to the older
firms.

3. Number of Workers Employed: According to this standard, the higher the number of
workers employed, the larger is the scale of operations and vice-versa. But this standard can be
used to compare the size of those units which are using the same degree to mechanization. Firms
using capital intensive techniques have a small number of workers even though their scale of
operations is large.

4. Quantity of Power and Materials Used: Sometimes, the amount of power used and the raw
materials used serve a good standard to measure the size. However, it is possible that a firm is of
a smaller size as compared to other firms, but is using more power and materials because of
greater inefficiency at various levels.

5. Volume of Output: The quantity of output produced or sold may be used as a yardstick of
comparison between different firms. But this standard is applicable only if the output of different
firms is uniform or homogeneous in nature. But these days, every firm attempts to differentiate
its products from those of other firms. Therefore, volume of output or sales cannot be used as a

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basis of comparison.

6. Value of Output or Sales: Value of output or sales expressed in monetary terms is sometimes
used to measure the size of a firm. Comparison of firms in terms of the value of their output is
simple. But difficulty arises in cases where comparison is to be made over two periods of time.
The price level generally keeps on changing. So the value of the same quantity of output will be
higher during boom period and it will be lower during depression period. However, the value of
output during two periods can be compared by making adjustments according to the index of the
purchasing power of monetary unit.

7. Capacity of Plants: The plant capacity may be used as a basis of comparison when units
produced a wide variety of products and when other standards of measurement cannot be suitable
employed. For example, in case of Jute and Cotton Textile firms, the number of spindles and
looks may be taken to be a measure of size.

All the above discussed standards of measurement are only approximate and have limited
applicability. The measure to be used will differ from one firm to another. It will be influenced
by the type of industry, nature of product, type of equipment and the purpose of measurement.
However, volume of output seems to be a better measure of comparison when output of two or
more firms is similar in product features an quality. And in other cases, value of production may
be taken as the standard of measuring the size of the business unit.

Balance of trade
The balance of trade, or net exports (sometimes symbolized as NX), is the difference between
the monetary value of exports and imports of output in an economy over a certain period. It is the
relationship between a nation's imports and exports.[1][dead link] A positive balance is known as a
trade surplus if it consists of exporting more than is imported; a negative balance is referred to
as a trade deficit or, informally, a trade gap. The balance of trade is sometimes divided into a
goods and a services balance.

The balance of trade forms part of the current account, which includes other transactions such as
income from the international investment position as well as international aid. If the current
account is in surplus, the country's net international asset position increases correspondingly.
Equally, a deficit decreases the net international asset position.

The trade balance is identical to the difference between a country's output and its domestic
demand (the difference between what goods a country produces and how many goods it buys
from abroad; this does not include money re-spent on foreign stock, nor does it factor in the
concept of importing goods to produce for the domestic market).

Measuring the balance of trade can be problematic because of problems with recording and
collecting data. As an illustration of this problem, when official data for all the world's countries
are added up, exports exceed imports by almost 1%; it appears the world is running a positive
balance of trade with itself. This cannot be true, because all transactions involve an equal credit
or debit in the account of each nation. The discrepancy is widely believed to be explained by
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transactions intended to launder money or evade taxes, smuggling and other visibility problems.
However, especially for developed countries, accuracy is likely.

Factors that can affect the balance of trade include:

The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting
economy vis-à-vis those in the importing economy;

The cost and availability of raw materials, intermediate goods and other inputs;

Exchange rate movements;

Multilateral, bilateral and unilateral taxes or restrictions on trade;

Non-tariff barriers such as environmental, health or safety standards;

The availability of adequate foreign exchange with which to pay for imports; and

Prices of goods manufactured at home (influenced by the responsiveness of supply)

In addition, the trade balance is likely to differ across the business cycle. In export-led growth
(such as oil and early industrial goods), the balance of trade will improve during an economic
expansion. However, with domestic demand led growth (as in the United States and Australia)
the trade balance will worsen at the same stage in the business cycle.

Differentiate among the current account, balance of trade, and balance of payments

BALANCE OF PAYMENTS

―When countries trade, financial transactions among businesses/consumers of
different nations occur, Products and services are exported and imported, monetary
gifts are exchanged, investments are made, cash payments are made and cash
receipts received, and vacation and foreign travel occurs. In short, over a period of
time, there is a constant flow of money into and out of a country. The system of
accounts that records a nation‘s international financial transactions is called its
balance of payments.‖

Main points of the definition:

1. When countries trade there are financial transactions among businesses or
consumers of different nations

2. Money constantly flows into and out of a country
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3. The system of accounts that records a nation‘s international financial
transactions is called its balance of payments (BP)

4. It records all financial transactions between a country‘s firms, and residents,
and the rest of the world usually over a year

5. The BP is maintained on a double-entry bookkeeping system

―The BP is the difference between receipts and payments‖

BP Receipts

• Merchandise export sales.

• Money spent by foreign tourists.

• Transportation.

• Payments of dividends and interest from FDI abroad.

• New foreign investments in the U.S.

BP Payments

• Costs of goods imported.

• Spending by U.S. tourists overseas.

• New overseas investments.

• Cost of foreign military and economic aid.

The BP includes three accounts:

(1) current account—a record of all merchandise exports, imports, and services
plus unilateral transfers of funds;

(2) capital account—a record of direct investment, portfolio investment, and
short-term capital movements to and from countries;

(3) The official reserves account—a record of exports and imports of gold,
increases or decreases in foreign exchange, and increases or decreases in liabilities
to foreign central banks;

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CURRENT ACCOUNT

The current account is important because it includes all international trade and
service accounts, i.e., accounts for the value of all merchandise and services
imported and exported and all receipts and payment from investments. The balance
of trade reflected in the current account is the single most important factor in any
economy.

BALANCE OF TRADE

The relationship between merchandise imports and exports is referred to as the
balance of merchandise trade or trade balance. If a country exports more goods
than it imports, it is said to have a favorable balance of trade; if it imports more
goods than it exports, it is said to have an unfavorable balance of trade. Usually a
country that has a negative balance of trade also has a negative balance of
payments. Both the balance of trade and the balance of payments do not have to be
negative; at times a country may have a favorable balance of trade and a negative
balance of payments or vice versa.

Role and Methods of trade protectionism
Protectionism is implemented to secure the domestic industries from international industries.
Imported goods usually have high quality and are available at cheaper price then domestic goods.
This increased the demand for imported goods and reduces the demand for the domestic goods.
This leads to unemployment as some firms are not able to survive. This also means less revenue
from the taxes for the government and low GDP of the country. To tackle this problem, the
governments take some measures and methods to protect the domestic industries in known as
protectionism.

The methods are:

# Tariff: It means to implement tax on the importing of foreign goods, increasing their costs and
hence decreasing there demand in the market. But it is only effective if the demand is elastic as
in case of inelastic a rise in price will make a small decrease in demand.

# Quota: It means banning or putting a limit to imports. No one is allowed to import more than
the limit specified by the government. This creates scarcity in the market and hence increased the
demand for the domestic products. This method is more better than Tariff as it does not depends
on the demand being elastic or inelastic. In a light trade policy, the government increases the
Tariff but decreases the quotas imposed. Government needs more accurate information on the
consumption of goods and the total stocks available in the country. In this way, the government

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can decide on the right amount of quotas to be imposed. If this information is inaccurate, there
might be surplus or shortage of goods in the country.

# Ban: Also known as Embargoes. This means to completely ban the imports of some goods.
Government can put ban on the goods that are in surplus as the domestic industries can fulfill the
demand of the consumers. Some country's governments also use this to ban the imports of some
harmful goods.

# Subsidies: This is to provide grants or other benefits like tax reduction to local firms so that
there cost of production reduces leading to decrease in the price of the local product against
international product. Hence increasing the demand for the local goods.

# To set certain packaging and quality standards: Some governments set certain packaging
and quality standards for the country so to discourage imports and the high quality and
packaging standards usually increase the cost of production of the product, resulting in decrease
demand for imports.
# Administrative problems: Some countries set complicated, expense and time consuming
procedures to allow imports. Now imports have to use a lot of resources and finance to imports
hence discouraging the imports

# Exchange Control: Types of controls that governments put in place to ban or restrict the
amount of foreign currency or local currency that is allowed to be traded or purchased. Common
exchange controls include banning the use of foreign currency and restricting the amount of
domestic currency that can be exchanged within the country.

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Unit i notes

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