The economic environment

THE ECONOMIC ENVIRONMENT

                                                                                                                The economy comprises millions of people and thousands of firms as well as the government and local authorities, all taking decisions about prices and wages, what to buy, sell, produce, export, import and many other matters. All these organizations and the decisions they take play a prominent part in shaping the business environment in which firms exist and operate.

The economy is complicated and difficult to control and predict, but it is certainly important to all businesses. You should be aware that there are times when businesses and individuals have plenty of funds to spend and there are times when they have to cut back on their spending. This can have enormous implications for business as a whole.

When the economy is enjoying a boom, firms experience high sales and general prosperity. At such times, unemployment is low and many firms will be investing funds to enable them to produce more. They do this because consumers have plenty of money to spend and firms expect high sales. It naturally follows that the state of the economy is a major factor in the success of firms.

However, during periods when people have less to spend many firms face hard times as their sales fall. Thus, the economic environment alters as the economy moves into a recession. At that time, total spending declines as income falls and unemployment rises. Consumers will purchase cheaper items and cut expenditure on luxury items such as televisions and cars.

Changes in the state of the economy affect all types of business, though the extent to which they are affected varies. In the recession of the early 1990s the high street banks suffered badly. Profits declined and, in some cases, losses were incurred. This was because fewer people borrowed money from banks, thus denying them the opportunity to earn interest on loans, and a rising proportion of those who did borrow defaulted on repayment. These so-called "bad debts" cut profit margins substantially. Various forecasters reckoned that the National Westminster Bank's losses in the case of Robert Maxwell's collapsing business empire amounted to over £100 million.

No individual firm has the ability to control this aspect of its environment. Rather, it is the outcome of the actions of all the groups who make up society as well as being influenced by the actions of foreigners with whom the nation has dealings.

MEASURING ECONOMIC ACTIVITY

                                                                                                            There are a large number of statistics produced regularly on the operation of the world's major economies. The UK's economy is no exception in this respect. You will probably have noticed that often the headlines in newspapers or important items on television news programmes relate to economic data and the implications for individuals and businesses. A prime example of this occurs when interest rates are increased: the media responds by highlighting the adverse effects on businesses with debts and householders with mortgages.

Data is provided on a wide range of aspects of the economy's operation. Statistics are available to show.

*  the level of unemployment

*   the level of inflation

*   a country's trade balance with the rest of the world

*   production volumes in key industries and the economy as a whole

*   the level of wages

*   raw material prices, and so forth.

The main statistics illustrating the economy's behaviour relate to the level of activity in the economy. That is, they tell us whether the economy is working at full capacity using all or nearly all, available resources of labour, machinery and other factors of production or whether these resources are being under-utilized.

The unemployment figures for the economy give an indicator of the level of activity. As the economy moves towards a recession and a lower level of prosperity it is likely that unemployment figures will rise. An alternative measure of the level of activity is national income statistics, which show the value of a nation's output during a year. Economists use the term Gross National Product to describe this data. Changes in the level or trends of such key data have great significance for businesses, as we shall see later.

There are numerous sources of data on the economy of which we can make use. The government publishes much through the Treasury, Department of Trade and Industry, the Bank of England and the Department of Employment. The Central Statistical Office, which was established during the Second World War, publishes about half of the government's economic data.

Much of this is contained in its annual publication, "The Annual Abstract of Statistics". It also publishes the equally valuable "Social Trends" annually. Additionally, private organizations, such as the banks, building societies and universities, publish figures on various aspects of the economy's performance. Economic statistics are presented in many forms, the most common being graphs and tables. Although these statistics can be valuable in assisting managers, they should be treated with some caution when predicting the future trend of the economy and thus helping the business to take effective decisions.

 

ECONOMIC ISSUES

Three economic issues

Economics is the study of how people choose to allocate scarce resources to satisfy their unlimited wants. The main problem in economics is the question of allocating scarce resources between competing uses. In this section three economic issues are discussed to show how society allocates its scarce resources between competing uses. In this connection the question what, how and for whom to produce is of great significance.

The oil price shocks

Oil is an important commodity in modem economies. Oil and its derivatives provide fuel for heating, transport, and machinery, and arc basic inputs for the manufacture of industrial petrochemicals and many household products ranging from plastic utensils to polyester clothing. From the beginning of this century until 1973 the use of oil Increased steadily. Over much of this period the price of oil fell in comparison -with the prices of other products. Economic activity was organized on the assumption of cheap and abundant oil.

In 1973  – 74 there was an abrupt change. The main oil-producing nations, mostly located in the Middle East but including also Venezuela and Nigeria, belong to OPEC — the Organisation of Petroleum Exporting Countries. Recognizing that together they produced most of the world's oil, OPEC decided in 1973 to raise the price at which this oil was sold. Although higher prices encourage consumers of oil to try to economize on its use, OPEC countries correctly forecast that cutbacks in the quantity demanded would be small since most other nations were very dependent on oil and had few commodities available as potential substitutes for oil. Thus OPEC countries correctly anticipated that a substantial price increase would lead to only a small reduction in sales. It would be very profitable for OPEC members.

Oil prices are traditionally quoted in US dollars per barrel. Fig. 1 shows the price of oil from 1970 to 1986. Between 1973 and 1974 the price of oil tripled, from $2,90 to $9 per barrel. After a more gradual rise between 1974 and 1978 there was another sharp increase between 1978 and 1980, from $12 to $30 per barrel. The dramatic price increases of 1973  – 79 and 1980  – 82 have become known as the OPEC oil price shocks, not only because they took the rest of the world by surprise but also because of the upheaval they inflicted on the world economy, which had previously been organized on the assumption of cheap oil prices.

People usually respond to prices in this or that way. When the price of some commodity increases, consumers will try to use less of it but producers will want to sell more of it. These responses, guided by prices, are part of the process by which most Western societies determine what, how and for whom to produce.Consider first how the economy produces goods and services. When, as in the 1970s, the price of oil increases six-fold, every firm will try to reduce its use of oil-based products. Chemical firms will develop artificial substitutes for petroleum inputs to their production processes; airlines will look for more fuel-efficient aircraft; electricity will be produced from more coal-fired generators. In general, higher oil prices make the economy produce in a way that uses less oil.

Sions

 

 

 

Oil price ($ per barrel)

Figure 1. The price of oil. 1970  – 86

How does the oil price increase affect what is being produced? Finns and households reduce their use of oil-intensive products, which are now more expensive. Households switch to gas-fired central heating and buy smaller cars. Commuters form car-pools or move closer to the city. High prices not only choke off the demand for oil-related commodities; they also encourage consumers to purchase substitute commodities. Higher demand for these commodities bids up their price and encourages their production. Designers produce smaller cars, architects contemplate solar energy, and research laboratories develop alternatives to petroleum in chemical production. Throughout the economy, what is being produced reflects a shift away from expensive oil-using products towards less oil-intensive substitutes. The for whom question in this example has a clear answer. OPEC revenues from oil sales increased from $35 billion in 1973 to nearly $300 billion in 1980. Much of this increased revenue was spent on goods produced in the industrialized Western nations. In contrast, oil-importing nations had to give up more of their own production in exchange for the oil imports that they required. In terms of goods as a whole, the rise in oil prices raised the buying power of OPEC and reduced the buying power of oil-importing countries such as Germany and Japan. The world economy was producing more for OPEC and less for Germany and Japan. Although it is the most important single answer to the 'for whom' question, the economy is an intricate, interconnected system and a disturbance anywhere ripples throughout the entire economy,

In answering the 'what' and 'how' questions, we have seen that some activities expanded and others contracted following the oil price shocks. Expanding industries may have to pay higher wages to attract the extra labour that they require. For example, in the British economy coal miners were able to use the renewed demand for coal to secure large wage Increases. The opposite effects may have been expected if the 1986 oil price slump had persisted.

The OPEC oil price shocks example illustrates how society allocates scarce resources between competing uses.

A scarce resource is one for which the demand at a zero price would exceed the available supply. We can think of oil as having become more scarce in economic terms when its price rose.