Chapter 6

6.1:

Here, we’ll look at the different economic objectives a government might have
and how their absence/negligence will affect the economy as well as
businesses.

 Maintain low inflation: inflation is the increase in average prices of goods and

services over time. (Note that, inflation, in the real world, always exists. It is natural
for prices to increase as the years go by. In the case there is a fall in the price level,
it is called a deflation) Maintaining a low inflation will help the economy to develop
and grow better.
Effects of high inflation:
 As cost of living will have risen and peoples’ real incomes (the value of
income) will have fallen (when prices increase and incomes haven’t, the income
will buy lesser goods and services- the purchasing power will fall).
 Prices of domestic goods will rise as opposed to foreign goods in the
market. The country’s exports will become less competitive in the international
market. Domestic workers may lose their jobs if their products and firms don’t
do well.
 When prices rise, demand will fall and all costs will rise (as wages,
material costs, overheads will all rise)- causing profits to fall. Thus, they will be
unwilling to expand and produce more in the future.
 The living standards (quality of life) in the country may fall when costs
of living rise.
 Low unemployment: unemployment exists when people who are willing and
able to work cannot find a job. A low unemployment means high output, incomes,
living standards etc.
Effects of high unemployment:
 Unemployed people do not produce anything and so, the total
output/GDP in the country will fall. This will in turn, lead to a fall in economic
growth.
 Unemployed people receive no incomes, thus income inequality can rise
in the economy and living standards will fall. It also means that businesses will
face low demand due to low incomes.
 The government pays out unemployment benefits to the unemployed and
this will rise during high unemployment and government will not enough
money left over to spend on other services like education and health.
 Economic growth: economic growth occurs when a country’s Gross Domestic
Product (GDP) increase i.e. more goods and services are produced than in the
previous year. This will increase the country’s incomes and achieve greater living
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standards.
Effects of reducing GDP (recession):
 As output falls, fewer workers will be needed by firms, so
unemployment will rise
 As goods and services that can be consumed by the people falls, the
standard of living in the economy will also fall
 Balance of Payments: this records the difference between a
country’s exports (goods and services sold from the country to another)
and imports (goods and services bought in by the country from another country).
The exports and imports needs to equal each other, thus balanced.
Effect of a disequilibrium in the balance of payments:
 If the imports of a country exceed its exports, it will cause depreciation
in the exchange rate– the value of the country’s currency will fall against other
foreign currencies (this will be explained in detail here).
 If the exports exceed the imports it indicates that the country is selling
more goods than it is consuming- the country itself doesn’t benefit from any
high output consumption.
 Income equality: the difference/gap between the incomes of rich and poor
people should narrow down for income equality to improve. Improved income
equality will ensure better living standards and help the economy to grow faster
become more developed.
Effects of poor income equality:
 Inequal distribution of goods and services- the poor cannot buy as many
goods as the rich- poor living standards will arise.
 An economy will not always go through an economic growth; there is usually
a cycle, as shown below.

Growth– when GDP is rising,

unemployment is falling and there are higher living standards in the country.
Businesses will look to expand and produce more and will earn high profits.
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Boom– when GDP is at its highest and there is too much spending, causing
inflation to rapidly rise. Business costs will rise and firms will become worried
about how they are going to stay profitable in the near future.
Recession– when GDP starts to fall due of high prices, as demand and
spending falls. Firms will cut back production to stay profitable and
unemployment may rise as a result.
Slump– when GDP is so low that prices start to fall (deflation) and
unemployment will reach very high levels. Many businesses will close down
as they cannot survive the very low demand level. The economy will suffer.
(When the government takes measures to increase demand and spending in
the economy to take it from a slump to growth, it is called as the ‘recovery’
period). The cycle repeats.

Government can influence the economic conditions in a country by taking a

variety of policies.

FISCAL POLICY
Using taxes and government spending to influence the demand conditions in
the economy.
 GOVERNMENT SPENDING
Governments can change their spending on education, health, defence, law and
order, transport and communications infrastructure etc. to influence demand. Higher
spending on these services can boost demand in the economy as jobs and GDP
increase. Reducing government spending will reduce demand.
 TAXES
 Direct Taxes are paid directly from incomes. There are different types
of direct taxes.
 Income tax: paid from an individual’s income. Disposable income
is the income left after deducting income tax from it. When income tax rise,
there is little disposable income to spend on goods and services, firms will
face lower demand and sales and will cut production, increasing
unemployment. Lower income taxes will encourage more spending and thus
higher production.
 Corporation Tax: tax paid on a company’s profits. When the
corporation tax rate is increased, businesses will have lower profits left over
to put back into the business and will thus find it hard to expand and
produce more. It will also cause shareholders/owners to receive lower
dividends/returns for their investments. This will discourage people from
investing in businesses and economic growth could slow down. Reducing
corporation tax will encourage more production and investment.
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 Indirect Taxes are added to the prices of goods and services and it is

paid while purchasing the good or service. Some examples are:
 GST/VAT: these are included in the price of goods and services.
Increasing these indirect taxes will increase the prices of goods and services
and reduce demand and in turn profits. Reducing these taxes will increase
demand.
 Import tariffs and quotas: an import tariff is a tax on imported
goods and services; an import quota is the physical limit to the quantity of a
product that can be imported into a country. Increasing tariffs will reduce
demand for foreign products and imposing quotas will mean there are lesser
foreign goods in the market to be sold and so demand is reduced.

MONETARY POLICY
Using interest rates (as well as money supply and the exchange rate) to
influence the demand conditions in the economy.
The interest rate is the cost of borrowing money. When a person borrows
money from a bank, he has to pay an interest (monthly or annually) calculated
on the amount he borrowed. Interest can also be earned by depositing money
in the bank.
A higher interest rate will thus discourage borrowing (as more interest will
have to be paid to the bank) and encourage saving (people will get more
interest from saving) – thus, investing and spending will fall respectively-
demand in the economy will fall. A lower interest rate will increase demand.
From a business’ point of view, a higher interest rate means more interest has
to be paid on existing loans, reducing profits; as well as suffer low demand
levels. They may have to delay expansion plans that involve borrowing from
the bank. A lower interest rate will be more favourable to a business.

SUPPLY-SIDE POLICIES
Both the fiscal and monetary policies directly affect demand, but the policies
that influence supply are very different. It can include:
 Privatisation: selling government organizations to private individuals- this will
increase efficiency and productivity that increase supply as well encourage
competitors to enter and further increase supply.
 Improve training and education: governments can spend more on schools,
colleges and training centres so that people in the economy can become better
skilled and knowledgeable, helping increasing productivity.
 Increased competition: by acting against monopolies (firms that restrict
competitors to enter that industry/having full dominance in the market- refer xxx for
more details) and reducing government rules and regulations (often termed
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‘deregulation’), the competitive environment can be improved and thus become

more productive.
 

*EXAM TIP: Remember that economic conditions and policies are all
interconnected; one change will lead to an effect which will lead to another
effect and so on, like a chain reaction in many different ways. In your exams,
you should take care to explain those effects that are relevant and appropriate
to the business or economy in the question*
How might businesses react to policy changes? It will depend varying on how
much impact the policy change will have on the particular
business/industry/economy. Here are a few examples:

 6.2:

Social responsibility is when a business decision benefits stakeholders other

than shareholders i.e. workers, community, suppliers, banks etc.
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This is very important when coming to environmental issues. Businesses can

pollute the air by releasing smoke and poisonous gases, pollute water bodies
around it by releasing waste and chemicals into them, damage the natural
beauty of a place and so on.
WHY BUSINESSES WANT TO BE WHY BUSINESSES DO NOT WANT TO
ENVIRONMENT- FRIENDLY BE ENVIRONMENT-FRIENDLY
Sense of social responsibility that comes It is expensive to reduce and recycle waste
from the fact that their activities are for the business. It means that expensive
contributing to global warming and machinery and skilled labour will be
pollution required by the business – reducing profits.
Using up scarce non-renewable resources Firms will have to increase prices to
(such as rainforest wood and coal) will raise compensate for the expensive environment-
their prices in the future, so businesses friendly methods used in production- higher
won’t use them now prices mean lower demand.
Consumers are becoming socially-aware
and are willing to buy only environment High prices can make firms less competitive
friendly products. in the market and they could lose sales
Governments, environmental organisations,
even the community could take action
against the business if they do serious Businesses claim that it is the government’s
damage to the environment duty to clean up pollution

A business’ decisions and actions can have significant effects on its

stakeholders. These effects are termed ‘externalities’. Externalities can be
categorized into six groups given below and we’ll take examples from a
scenario where a business builds a new production factory.

Private Costs: costs paid for by the business for an activity.

Examples: costs of building the factory , hiring extra employees, purchasing
new machinery, running a production unit etc.
Private Benefits: gains for the business resulting from an activity.
Example: the extra money made from the sale of the produced goods etc.
External Costs: costs paid for by the rest of the society (other than the
business) as a result of the business’ activity.
Examples: machinery noise, air pollution that leads to health problems among
near residents, loss of land (it could have been a farm land before) etc.
External Benefits: gains enjoyed by the rest of the society as a result of a
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business activity.
Example: new jobs created for residents, government will get more tax from
the business, other firms may move into the area to support the firm-helping
develop the region, new roads might be built that can be enjoyed by residents
etc.
Social Costs = Private Costs + External Costs
Social Benefits = Private Benefits + External Benefits
Governments use the cost-benefit-analysis (CBA) to decide whether to
proceed with a scheme or not and businesses have also adopted it. In CBA,
the government weighs up all the social costs and benefits that will arise if the
scheme is put into effect and give them all monetary values (this is not easy-
what is the value of losing natural beauty?). They will only allow the scheme to
proceed if the social benefits exceed the social costs, if the costs exceed the
benefits, it is not allowed to proceed.

Sustainable development is development that does not put at risk the living
standards of future generations. It means trying to achieve economic growth in
a way that does not harm future generations. Few examples of a sustainable
development are:
 using renewable energy- so that resources are conserved for the future
 recycle waste
 use fewer resources
 develop new environment-friendly products and processes- reduce health and
climatic problems for future generations

Pressure groups are organisations/groups of people who change business (and

government) decisions. If a business is seen to behave in a socially
irresponsible way, they can conduct consumer boycotts (encourage
consumers to stop buying their products) and take other actions. They are
often very powerful because they have public support and media coverage
and are well-financed and equipped by the public. If a pressure group is
powerful it can result in a bad reputation for the business that can affect it in
future endeavors, so the business will give in to the pressure groups’
demands. Example: Greenpeace
The government can also pass laws that can restrict business decisions such as
not permitting factories to locate in places of natural beauty.
There can also be penalties set in place that will penalize firms that
excessively pollute. Pollution permits are licenses to pollute up to a certain
limit. These are very expensive to acquire, so firms will try to avoid buying the
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pollution permit and will have to reduce pollution levels to do so. Firms that
pollute less can sell their pollution permits to more polluting firms to earn
money. Taxes can also be levied on polluting goods and services.

Ethical decisions are based on a moral code. It means ‘doing the right thing’.
Businesses could be faced with decisions regarding, for example,
employment of children, taking or offering bribes, associate with
people/organisations with a bad reputation etc. In these cases, even if they
are legal, they need to take a decision that they feel is right.
Taking ethical/’right’ decisions can make the business’ products popular
among customers, encourage the government to favour them in any future
disputes/demands and avoid pressure group threats. However, these can end
up being expensive as the business will lose out on using cheaper unethical
opportunities.

 6.3:

Globalization is a term used to describe the increases in worldwide trade and

movement of people and capital between countries. The same goods and
services are sold across the globe; workers are finding it easier to find work by
going abroad for work; money is sent from and to countries everywhere.
Some reasons how globalization has occurred are:

 Increasing number of free trade agreements– these are agreements between

countries that allows them to import and export goods and services with no tariffs or
quotas.
 Improved and cheaper transport (water, land, air) and communications
(internet) infrastructure
 Developing and emerging countries such as China and India are becoming
rapidly industrialized and so can export large volumes of goods and services. This
has caused an increase in the output and opportunities in international trade,
allowing for globalisation
Advantages of globalisation

 Allows businesses to start selling in new foreign markets, increasing sales and

profits
 Can open factories and production units in other countries, possibly at a
cheaper rate (cheaper materials and labour can be available in other countries)
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 Import products from other countries and sell it to customers in the domestic
market- this could be more profitable and producing and selling the good
themselves
 Import materials and components for production from foreign countries at a
cheaper rate.
Disadvantages of globalisation

 Increasing imports into country from foreign competitors- now that foreign
firms can compete in other countries, it puts up much competition for domestic
firms. If these domestic firms cannot compete with the foreign goods’ cheap
prices and high quality, they may be forced to close down operations.
 Increasing investment by multinationals in home country- this could further add
to competition in the domestic market (although small local firms can become
suppliers to the large multinational firms)
 Employees may leave domestic firms if they don’t pay as well as the
foreign multinationals in the country- businesses will have to increase pay and
conditions to recruit and retain employees.
When looking at an economy’s point of view, globalisation brings consumers
more choice and lower prices and forces domestic firms to be more efficient (in
order to remain competitive). However, competition from foreign producers
can force domestic firms to close down and jobs will be lost.

Protectionism refers to when governments protect domestic firms from foreign

competition using trade barriers such as tariffs and quotas; i.e. the opposite of
free trade.
Import quota is a restriction on the quantity of goods that can be imported into
the country.
Tariffs are taxes on imports.
Imposing these two measures will reduce the number of foreign goods in the
domestic market and make them expensive to buy, respectively. This will reduce
the competitiveness of the foreign goods and make it easy for domestic firms
to produce and sell their goods. However, it reduces free trade and
globalisation.
Free trade supporters say that it is better to allow consumers to buy imported
goods and domestic firms should produce and export goods and services that
they have a competitive advantage in. In this way, living standards across the
globe will improve.
 Multinational businesses are firms with operations (production/service) in
more than one country. Also known as transnational businesses. Examples:
Shell, McDonald’s, Nissan etc.
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Why do firms become multinationals?

 To produce goods with lower costs– cheaper material and labour may be

available in other countries
 To extract raw materials for production, available in a few other countries.
For example: crude oil in the Middle East
 To produce goods nearer to the markets to avoid transport costs.
 To avoid trade barriers on imports. If they produce the goods in foreign
countries, the firms will not have to pay import tariffs or be faced with a quota
restriction
 To expand into different markets and spread their risks
 To remain competitive with rival firms which may also be expanding abroad
Advantages to a country of a multinational setting up in their country:

 More jobs created by multinationals

 Increases GDP of the country
 The technology that the multinational brings in can bring in new ideas and
methods into the country
 As more goods are being produced in the country, the imports will be reduced
and some output can even be exported
 Multinationals will also pay taxes, thereby increasing the government’s tax
revenue
 More product choice for consumers
Disadvantages to a country of a multinational setting up in their country:

 The jobs created are often for unskilled tasks. The more skilled jobs will be
done by workers that come from the firm’s home country. The unskilled workers
may also be exploited with very low wages and unhygienic working conditions.
 Since multinationals benefit from economies of scale, local firms may be
forced out of business, unable to survive the competition
 Multinationals can use up the scarce, non-renewable resources in the country
 Repatriation of profit can occur. The profits earned by the multinational could
be sent back to their home country and the government will not be able to levy tax
on it.
 As multinationals are large, they can influence the government and
economy. They could threaten the government that they will close down and make
workers unemployed if they are not given financial grants and so on.
 
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The exchange rate is the price of one currency in terms of another currency.

For example, €1=$1.2. To buy one euro, you’ll need 1.2 dollars. The demand
and supply of the currencies determine their exchange rate. In the above
example, if the €’s demand was greater than the $’s, or if the supply of €
reduced more than the $, then the €’s price in terms of $ will increase. It could
now be €1= $1.5. Each € now buys more $.
A currency appreciates when its value rises. The example above is an
appreciation of the Euro. A European exporting firm will find an appreciation
disadvantageous as their American consumers will now have to pay more $ to
buy a €1 good (exports become expensive). Their competitiveness has reduced.
A European importing firm will find an appreciation of benefit. They can buy
American products for lesser Euros (imports become cheaper).
A currency depreciates when its value falls. In the example above, the Dollar
depreciated. An American exporting firm will find a depreciation advantageous
as their European consumers will now have to pay less € to buy a $1 good
(exports become cheaper). Their competitiveness has increased. An American
importing firm will find an depreciation disadvantageous. They will have to buy
European products for more dollars (imports become expensive).
In summary, an appreciations is good for importers, bad for exporters; a
depreciation is good for exporters, bad for importers; given that the goods are
price elastic (if the price didn’t matter much to consumers, sales and revenue
would not be affected by price- so no worries for producers)