external environment - business and the economy
Richard Bowett introduces the link between business and the economy
Introduction
People often talk about ‘the economy’ as in ‘the economy is doing well’, or ‘the economy looks a bit dodgy at the moment’. But what does ‘the economy’ mean?
One answer to this question is to say ‘it means all the economic activities of people, business and government’. But that just re-poses the question as ‘what are economic activities?’ Again, there is a common answer ‘it’s to do with making money’ which has some truth in it, but there’s more to it than that.
The Basic Economic Problem
We use resources (land, labour, capital, enterprise and time) to produce goods and services to satisfy our needs. The problem is that these resources are limited ("finite") and our needs are unlimited ("infinite").
So it is impossible to produce enough to satisfy everyone’s needs. This means choices are necessary. If we can’t have everything, we then need to choose what we do, in fact, have.
There are three basic and important choices a society has to make.
1. What to produce ie which kinds of good and services
2. How to produce it ie which resources and which production methods should be used.
3. Who gets it when it’s been produced.
Solutions to the Problem
There are different ways to solve the basic economic problem. The main two are:-
1. Centrally Planned Economies
This means Communist economies which used committees of ‘experts’ to make the three choice mentioned above, although some use was also made of prices. In theory, this is an attractive option because committees of people can take into account all and any possible social objectives, such as a fair distribution of income. In practice this system has been a disastrous failure.
2. Market Economies
This is the system we use in the UK, and prices are the main tool to make the choices discussed above. What to produce is what is most profitable to businesses to produce, bearing in mind they have to sell it to someone when they’ve made it. How to produce is whatever way is cheapest. Who gets it is whoever can afford it.
All these words (‘profitable’, ‘sell’, ‘cheapest’ and ‘afford’) imply a way of measuring them ie prices. The big problem is with the last one, because the market system decides who gets big incomes and small, but we, as humans, don’t always agree with these outcomes, and we also think some minimum standards should apply to everyone whether they can afford it or not. For this reason, and for some other technical reasons such as externalities, we don’t rely merely on the price system, but we also add government intervention into the market in some places.
How the Price System Works
1. Demand Rationing
Part of the problem is that wants are infinite and there isn’t enough to go round. Putting prices on goods, services and resources rations (limits) demand. This isn’t simply a matter of some people not being able to afford it. But we all have finite budgets (even if very large in some cases) and we have to decide (choose) how to spend our budget in the best way according to our own preferences. So we often say ‘I can afford X, that’s not the problem, but I only get so much satisfaction from X and at the same price I’m better off buying a Y because I get more satisfaction from a Y’.
2. Resource Allocation
Prices in markets change according to whether there are more buyers than sellers (prices rise) or more sellers than buyers (prices fall) or buyers and sellers are in balance (prices stay the same). These changes in price act as signals about relative scarcity of resources.
All resources are scarce ie there aren’t enough of them to go round. But some resources are more scarce than others. A rising price tells us that relative scarcity is rising ie there is less available relative to how much is wanted than before. For example, if the weather gets colder, more fuel will be needed for heating so the amount of fuel stays the same, but the amount of fuel wanted rises, so the amount of fuel available relative to how much is wanted falls ie it becomes more scarce. This means the price rises. This sends important signals to buyers to use less, and to sellers to go out and find some more. Either way, relative scarcity then falls back towards where it was before. On the other hand, a new discovery of iron ore means there is now more iron ore relative to how much is wanted. The resource has become less scarce. So price falls. This sends important signals to buyers to buy more and to sellers to sell less. Either way, relative scarcity then rises back towards where it was before.
3. Production & Profits
When consumers buy something they send a signal that says ‘this is a wanted use of scarce resources’ and when they don’t buy they send a signal that says ‘this is not a wanted use of scarce resources’. Sellers see the results of picking up these signals correctly in their profits. If they produce what consumers want to buy, then they are likely to make profits. So rising profits are a signal of using resources in a way, and producing them in a way, that society (consumers) wants. Falling profits punish sellers for making wrong decisions about this.
4. Efficiency
If businesses aim to push revenues up and costs down, this must mean they are more successfully producing what is wanted, and more successfully using fewer resources to produce it. The reward is higher profits. But they have satisfied more of the infinite wants and used fewer of the scarce resources, so they have more successfully helped to answer the basic economic problem. Doing this more effectively is called ‘efficiency’ by Economists and the same thing is called ‘efficiency’ by Business Students although each is using the word in a slightly different and specialist way.
5. Competition
Competition is a powerful spur to efficiency, because it forces businesses to fight over customers. Without competition, businesses may get lazy ands therefore become inefficient.
6. Failures of the Market
Lack of competition is one way in which the market will not work properly and will not produce what consumers most want whilst at the same time using fewer resources to do it. There are other failures of the market, mostly to do with externalities. When the market doesn’t do its job properly that is usually a good reason for the government to step in and intervene in the market.
Real (or ‘Mixed’) Economies
In the real world, no economy is entirely planned or free market. Even Communist economies used prices in some area. Most so-called ‘free market’ (or ‘capitalist’) economies have a fair degree of government intervention. Even the USA, that paragon of the free market, has a government that controls around 30% of GDP. In the UK the figure is about 40%. In Germany and France the figure rises towards 50%. In such cases it is more realistic to talk of a ‘mixed economy’ that uses a mixture of the free market and government planning to deliver the goods and services that consumers want to satisfy their wishes.
In theory, the free market does everything except where it has problems, such as those attached to externalities. In practice, there are all sorts of reasons (varying from one country to another) about why one set of goods and services is provided by the market or by the government. Health, for example, is mainly provided by the private sector in the US and by the public sector in the UK.
Transition Economies
Over the last 15 years, since the collapse of the old Soviet empire, the economies of previously centrally planned countries, such as Poland and Hungary, have changed from central planning to free market economies. This has been an interesting experiment, and of course has had a lot of problems.
The first problem is political. Any change produces winners and losers, and of course the losers have objected. It has taken time to win them (or most of them) round. Some losers have suffered very large losses. Many old industries survived under the previous system but were totally unable to compete in market economy due to massive inefficiency which had been disguised by the previous absence of market prices. These industries have largely collapsed and so have the jobs that went with them. This meant that large amounts of ‘nominal’ GDP simply disappeared and the first movement of these economies was backwards as the damage of the previous 50 years or so was undone.
Since then these economies have experienced growth although some have been more successful than others. Inflation has also been a problem and it stripped away the savings of many poorer people, especially pensioners. But, overall, the experiment has been a success in terms of improving the living standards of the inhabitants of those countries, and of course their political freedoms have been restored. Some of the countries have done sufficiently well to be considered for EU membership in 2004. That will bring a range of new problems all of its own. Put simply, the businesses of Eastern Europe have much lower costs, especially labour costs. On the other hand, they are often much less efficient and they suffer from a shortage of modern management skills. So it will be interesting to see how these factors will balance out, and what will be the effect of the more established business of the present EU including the UK.
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