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chapter one

1 Economics for
business
Learning outcomes
By the end of this chapter you should understand:

ECONOMIC THEORY
Economics is the study of how society resolves the problem of scarcity

The concept of opportunity cost

The difference between microeconomics and macroeconomics

The difference between market and planned economies

BUSINESS APPLICATION
How firms operate within microeconomic and macroeconomic
environments

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Chapter map

Section 1.1 Economics examines the problems that arise when indi-
WHAT IS
viduals and firms have consumption desires that are
constrained by access to resources. This problem is often ECONOMICS?
reffered to as infinite wants and finite resources. This first
section highlights this central economic problem.
The production possibility frontier is a conceptual
approach employed by economists to highlight a number PRODUCTION
of economic issues, including infinite wants, finite POSSIBILITY
resources, opportunity costs, macro- and micro- FRONTIER
economics, and planned versus market economies. This
part of the discussion provides an examination of the
production possibility frontier and is an important
building block in economic thinking.
Economics can be split between micro- and macroeco-
MICRO- AND
nomics. Microeconomics examines the economic
decision-making of individuals and firms. MACROECONOMICS?
Macroeconomics examines the entire economy and
concerns itself with issues such as economic output,
taxation, government spending, interest rates and
exchange rates. The discussion will use the production
possibility frontier to highlight some of the differences
between macro- and microeconomics.

Section 1.2 This section provides an introduction to the rest of the WHY STUDY
book, highlighting how firms operate within micro- and ECONOMICS FOR
macroeconomic environments. The discussion indicates BUSINESS?
how each chapter provides a building block in the overall
understanding of the firm and its economic environ-
ments.

Appendix The economic approach has a number of features asso- THE ECONOMIST’S
Section 1.3 ciated with it. This section will provide a brief overview APPROACH
but, in summary, economics can be associated with: a
language and terminology, use of abstract models,
diagrams, and positive and normative debates.

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4 Introduction

Economics at a glance
The issue
What is economics and how does economics relate to business?

The understanding
Economics seeks to understand the functioning of market places. An area of the
subject known as microeconomics examines consumers, firms and workers with
markets, seeking to understand why prices change for particular products, what
influences the costs of firms and in particular what will influence a firm’s level of
profitability. Macroeconomics examines the whole economy as one very large
market. Macroeconomics seeks to address how the government might manage the
entire economy to deliver stable economic growth. Through the development of the
production possibility frontier and an initial discussion of markets the basic
economic concepts will be introduced to you.

The usefulness
Firms operate within an economic environment. The revenue they receive from
selling a product is determined within a market. Furthermore, the cost that the firm
has to pay for its labour, raw materials and equipment are also priced within
separate markets. Microeconomics address the various influences at the market
level that will impact upon a firm’s revenues and costs. Macroeconomics address
the issues at an economy level which will similarly effect a firm’s revenues and
costs. Understanding, reacting to, and possibly even controlling micro- and macro-
economic influences on the firm are crucial business skills.

1.1 What is economics?

Think about everything you would like to have or consume. Table 1.1 contains a list
of material items as examples, but it could equally contain items such as a healthy
life and peace in the world.
Table 1.1 Wish list
Big house Luxury restaurant meals
Luxury car Designer clothes
Top of the range mobile phone Membership of a fitness club
Holiday in an exotic location A case (or two) of fine wine
Designer shoes Plasma TV
Swiss watch Xbox console
Digital camcorder Tickets to the Monaco Grand Prix

Now list the resources that might contribute to paying for these desirable items;
Table 1.2 shows ours.
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Economics for business 5

Table 1.2 Resources list

Salary Royalties from book
Consulting fees Generous friends

You will be quick to note that the wish list is significantly longer than the
resources list and there will be a significant gap between the expense required by the
wish list and the likely yield of the resources list.
So we have a problem: we have a wish list that is very long and a resources list
that is very short. What will we spend our resources on and what will we decide to
leave in the shops? This problem is economics, which recognizes the difference
Infinite wants are between infinite wants and finite resources.
the limitless We as individuals would all like to consume more of everything; bigger houses,
desires to consume
goods and services. bigger cars. But we only have finite resources with which to meet all our wants.
Finite resources are Firms also have infinite wants. They would like to be operating in more countries,
the limited amount selling larger product ranges. But firms are limited by their access to shareholders’
of resources that
enable the funds and good labour. Governments too have infinite wants, providing more health-
production and care and better education, but are limited by their access to tax receipts.
purchase of goods
and services.

Factors of production
Economists start their analysis by focusing on the entire economy and noting that
there are a variety of wants from individuals, firms and governments, and only a
Factors of limited amount of resources, or factors of production, which economists group into
production are four categories: land, labour, capital and enterprise.
resources needed
to make goods and Land is where raw materials come from: oil, gas, base metals and other
services: land, minerals. Labour is the ability of individuals to work. Capital is production
labour, capital and
enterprise.
machinery, computers, office space or retail shops. Enterprise is the final factor of
production that brings land, labour and capital together and organizes them into
units that can produce products in the pursuit of profit.
In spotting new market opportunities entrepreneurs are risk-takers, committing
resources to commercial projects, which may flourish or equally perish.

Box 1.1 Bag of wind, or a great idea?

British entrepreneur opens inflatable church

ABC News Online, 14 May 2003

The world’s first inflatable church has opened its Gothic arches to worshippers, to
reveal a blow-up organ, a poly-vinyl pulpit, an air-filled altar and fake stained glass
windows. The church is the brainchild of British entrepreneur Michael Gill, who says
it could breathe new life into Christianity by letting preachers take their message
right into their communities.
Mr Gill says he has already had expressions of interest from more than 20
countries and he also says he has been asked to design inflatable mosques and
synagogues.
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6 Introduction

Box 1.1 provides an extreme example, but proven entrepreneurs might include Richard
Branson of Virgin, Anita Roddick of the Body Shop and in fact any individual who
successfully sets up in business, whether it be as a car mechanic, a business consultant
or a hairdresser. They all organize resources in the pursuit of profit.
When viewing the entire globe, the amount of land, labour, capital and
The production enterprise is limited or, as economists say, ‘finite’.1 Economists use the production
possibility frontier possibility frontier to illustrate the consequences of finite resources for the production
shows the
maximum amount of goods and services.
of products that The production possibility frontier is an important illustrative tool because it
can be produced by
an economy with a can be used to highlight important economic concepts. These are:
given amount of
resources. 1 Finite resources
2 Opportunity costs
3 Macro- and microeconomics
4 Planned, market and mixed economies
We will discuss each in turn.

Finite resources
Figure 1.1 shows the production possibility frontier for an imaginary economy that
produces only two goods, pizza and beer; and highlights the constraint created by

Figure 1.1 Production possibility frontier

The production possibility frontier shows the maximum amounts of beer and pizza that can be
produced with a fixed amount of resources. At Y 1000 litres of beer and 1000 pizzas can be produced.
At Y1 more beer can be produced but some pizza production has to be sacrificed, while at Y2 beer can
be sacrificed in order to produce more pizzas. Z cannot be achieved with current resource levels and
X represents unemployment with production of beer and pizzas below the optimal levels attainable
on the frontier, such as Y, Y1 and Y2

Beer
Z
A Y1

1000 litres Y
of beer

500 litres X
of beer Y2

500 1000 B Pizza

pizzas pizzas

1 This is true at least at one point in time. In the future capital could be expanded by firms investing in additional capital.
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Economics for business 7

access to only a finite amount of resources. With a fixed amount of resources an

infinite amount of beer, or pizzas, cannot be produced. If all resources were allo-
cated to the production of beer, then we would be at point A on the diagram, with
a maximum amount of beer being produced and no pizzas. But if all resources were
allocated to pizzas, then we would be at point B, with a maximum amount of pizzas
being produced and no beer. The curve between points A and B indicates all the
maximum combinations of beer and pizza that can be produced. The frontier shows
what it is possible to produce with a limited amount of resources.
Operating on the frontier is optimal, all finite resources are employed.
Operating at a point such as Z is currently impossible. The economy does not have
the resources to produce at Z. Operating at X is inefficient, because some resources
must be unemployed. More output could be produced by employing all factors of
production and moving towards the frontier.

Opportunity costs
Opportunity costs If pizza production is reduced in order to make more beer, then the opportunity cost
are the benefits is the benefits that could have been received from the pizzas that have not been made.
forgone from the
next best Opportunity costs give the production possibility frontier a negative slope; simply
alternative. more pizzas must mean less beer. Reading this book now has an opportunity cost. You
could be watching TV. Recalling that the economic problem is one of infinite wants
and finite resources, optimally you will try to make your opportunity cost as low as
possible. With your limited resources you will try to maximize your gains from
consumption. This way you are sacrificing the least amount of benefit.

Example

Maximizing gains
If the benefit of reading this book to you can be estimated at £1 per hour and the
benefit of watching TV can be estimated at £0.50 per hour, then the opportunity cost
of reading this book, rather than watching TV is £0.50, the benefit you have given up.
In contrast, if you watched TV, then the opportunity cost would be £1, the benefit
foregone from not reading this book. Given the ratio of these benefits, you can
minimize your opportunity cost by reading this book. If we add in an additional option
to reflect the true student lifestyle, a night out with your friends might be worth £5
per hour to you. Staying in and reading this book would then represent an oppor-
tunity cost of £5 per hour, while going out and not reading the book would only
represent an opportunity cost of £1 per hour, the benefits forgone by not reading this
book. In terms of opportunity cost it is cheaper to go out with your friends rather than
stay in and read this book. If you fail this module, at least you can understand why.

Macroeconomics is
the study of how Macroeconomics and microeconomics
the entire economy
works. By focusing on points X, Y and Z we can draw your attention to two important
Microeconomics is distinctions in economics, (i) the study of macroeconomics and (ii) the study of
the study of how
individuals make microeconomics.
economic decisions
within an economy.
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8 Introduction

Macroeconomics
Points X and Z represent mainly macroeconomic problems. At point X the economy
is not operating at its optimal level; we said point X was likely to be associated with
unemployment. This occurs during a recession. Part of macroeconomics is in under-
standing what creates a recession and how to remedy a recession. Governments and
the central bank adjust interest rates, taxation and government spending to try to
move the economy from point X towards point Y. Point Z is also a macroeconomic
issue. The economy cannot achieve point Z now, but in the future the economy
could grow and eventually attain point Z. How do we develop policies to move the
economy over the long term to point Z? This question has been the recent focus of
UK macro policy, with Gordon Brown repeating the mantra of ‘sustainable
economic growth’.

Microeconomics
Microeconomics places the focus of analysis on the behaviour of individuals, firms
or consumers. Rather than looking at the economy as a whole, microeconomics
attempts to understand why consumers prefer particular products. How will
changes in income or prices influence consumption patterns? In relation to firms,
microeconomists are interested in the motives for supplying products. Do firms wish
to maximize sales, profits or market share? What factors influence costs and how
can firms manage costs? What determines the level of competition in a market and
how can firms compete against each other?
By focusing on individual consumers, firms and the interaction between the
two, the economist is particularly interested in the functioning of markets. This
particular aspect of economics can be highlighted by examining movements along
the production possibility frontier. Point Y on the frontier has been described as
being efficient. But points Y1 and Y2 are also on the frontier and are therefore
equally efficient. At Y the economy produces a balanced mix of pizza and beer. At
Y1 the economy specializes more in beer and at Y2 the economy specializes more in
pizza production. How will the economy decide between operating at Y, Y1 and
Y2? The answer lies in an understanding of resource allocation mechanisms.

Planned, market and mixed economies

In a planned
Planned economy
economy, the
government
In a planned economy the government plans whether the economy should operate
decides how at point Y or another point. These systems were common in the former Soviet Bloc.
resources are
allocated to the
production of
particular products.
Market economy
In a market In a market economy there are two important groups, consumers that buy products
economy, the
government plays
and firms that sell products. Consumers buy products because they seek the benefits
no role in allocating associated with the consumption of the product. For example, you eat food because
resources. Instead it stops you feeling hungry; and you drive a car because it helps you to travel
markets allocate
resources to the between various locations. Similarly, firms sell products in order to make a profit.
production of In the market place information is exchanged between consumers and firms.
various products. This information relates to the prices consumers are willing to buy products at and
similarly the prices that firms are willing to sell at. For any particular product you
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Economics for business 9

will have a maximum price that you are willing to buy at; the more desirable you
find the product, the greater will be your maximum price. In contrast, firms will
have a minimum price at which they are willing to sell at; the easier or cheaper it is
to make the good, the lower this minimum price can be. If the minimum price that
firms are willing to sell at is less than consumers’ maximum willingness to pay then
the potential for a market in the good exists. Firms can make the product in the clear
expectation of making a profit.
Firms are likely to move their productive resources – land, labour, capital and
enterprise – to the markets that present the greatest opportunities for profit. Given
our discussion above, profits will vary with the willingness to pay by consumers and
the costs incurred by firms. If consumers are willing to pay higher prices, or
production costs fall, then profits will increase. Increasing profits will lead firms to
move resources into the market. In contrast, as consumers reduce their willingness
to buy a product, or if firms’ costs increase, then profits will fall and firms will look
to reallocate their resources into more profitable markets.

Example

Pizza and beer

In our pizza and beer example, let us consider the following: we are at point Y and
suddenly scientists show that beer is very good for your health. Following this
news, we would expect consumers to buy more beer. As beer increases in popu-
larity, beer producers are able to sell for a higher price and make greater profits. In
contrast, pizza producers would begin to lose sales and profits, as consumers
allocate more of their income to beer. Over time pizza-makers would recognize that
consumers have reduced their consumption of pizzas. In response, pizza producers
would begin to close down their operations and move their resources into the
popular beer market. The economy moves from Y to Y1 in Figure 1.1.

Comparing command and market economies

Market economies rely on a very quick and efficient communication of information
that occurs through prices. Firms ordinarily set a price that indicates their will-
ingness to sell. Consumers communicate their willingness to buy by purchasing the
product at the given price. The problem of what should be produced and what
should not be produced is solved by the price system.
The command (or planned) economy, in setting production levels for various
goods and services, requires similar market-based information regarding the costs of
production and the consumption requirements of consumers. But how would you
go about setting food, clothing, drink, transport and education output levels for the
UK? You might conduct a questionnaire survey asking consumers to rank the
different products by level of importance. But this has a number of problems. It is
costly, the respondents might not represent the views of all consumers and it might
not be timely with the questionnaire only being carried out every couple of years.
The collection of information required for effective planning is very complicated
and costly within a command economy, especially when compared with the simple
and efficient exchange of information in the market economy through the pricing
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10 Introduction

system. It is of little surprise that in recent years planned economies have become
less popular.

In a mixed Mixed economy

economy the
government and In reality many economies function as a mixture of planned and market economies.
the private sector For example, within the UK the sale of groceries is a purely market solution
jointly solve
economic with private firms deciding what they will offer to consumers within their own
problems. supermarkets. The National Health Service is an example of the government
deciding what healthcare treatments will be offered to the UK population.
Economies differ in the degree to which they are mixed. The US is arguably more of
a free market than the UK with, for example, more services such as healthcare left
to the private sector. At the other extreme, economies such as China and Cuba are
more dependent upon planning, with only a few (but perhaps an increasing number
of) private enterprises.

In summary, economics studies how individuals, firms, governments and economies

deal with the problem of infinite wants and finite resources. Microeconomics
examines the economic issues faced by individuals and firms, while macroeconomics
studies the workings and performance of the entire economy. We will now indicate
why an understanding of economics can provide an essential understanding for
business.

1.2 Why study economics for business?

Business and management draw upon a number of different disciplines including,
but not exclusively, accounting and finance, human resource management, opera-
tions management, marketing, law, statistics and economics. Each discipline has a
particular focus and set of issues that it specializes in understanding.
The economist’s analysis of business begins with a simple assumption: firms are
in business to make profits for their owners. Moreover, firms are in business to
maximize profits, or make the highest amount of profit possible. The assumption
that firms are profit maximizers is clearly a simplification. Firms represent a
collection of workers, managers, shareholders, consumers and individuals perhaps
living within the locality of the firm’s operations. Each of these groups may have
different interest within the firm. For example, shareholders may seek greater profit,
but workers and managers may seek increased wages. These conflicts generate
complexity within the organizational environment of firms. Economists try to
simplify the complex nature of reality. Therefore, rather than attempt an under-
standing of all the complex interrelationships within a firm, economists simply
assume that the firm is in business to maximize profits. Economists are not arguing
that the complex interrelationships between the various interest groups within a
firm are not important. Instead, economists are assuming that without profits, firms
would find it difficult to survive financially. Therefore, while subjects such as human
resource management, organization theory, and corporate social responsibility focus
upon how the firm might manage the conflicting relationships between the
competing interest groups of shareholders, workers and wider society, business
economists have focused upon an understanding of firms’ profits.
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Economics for business 11

Firms, as profit-making organizations, can be viewed as a combination of

revenue-based cash flows going in, and cost-based cash flows going out. Within
this view of firms, economics for business can be simplified to an analysis of the
economic influences that enhance revenues and reduce costs, thereby
increasing firm-level financial performance or, more directly, profit.

In Figure 1.2 the firm is positioned between its revenue and its costs. By placing
the firm in the middle of the diagram it is also recognized that the firm operates
within micro and macroeconomic environments. The micro and macro environ-
ments are covered in detail by the various chapters within this book but, impor-
tantly, and perhaps simplistically, each chapter adds to an understanding of how the
firm can improve its revenue and/or cost position. Broad areas of interest and
importance are now discussed.

Figure 1.2 Economics for business

Microeconomy Macroeconomy
Chapter 2 Consumers in the Chapter 9 Introduction to the
Revenues
market place macroeconomy
Chapter 3 Firms in the Chapter 10 Measuring
market place macroeconomic variables and
Chapter 4 Markets in action policy issues
Chapter 5 Market structure Firm Chapter 11 Domestic
and firm performance government policy
Chapter 6 Strategic rivalry Chapter 12 Supply side
Chapter 7 Growth strategies policies and economic growth

Chapter 8 Governing Costs Chapter 13 Exchange rates

business and the balance of payments
Chapter 14 Globalization

Markets and competition

The particular focus of economics is on the functioning of markets. Markets are
important for firms in a number of ways. First, a market place is where a firm will
sell its product and, therefore, generate revenue. Second, a firm’s inputs – land,
labour, capital and enterprise – are all purchased through markets and, therefore,
markets influence a firm’s level of costs. The level of competition varies across
markets, some are highly competitive, others are not. Throughout life, if you wish
to be a winner, it is easier to achieve success when the competition is weak; and
business is no different. In highly competitive business environments prices will fall,
while in low competitive environments price competition will be less severe. If inter-
ested in enhancing revenues, it is therefore important to understand how to
recognize issues likely to promote competition and influences that will enable
competition to be managed and controlled. It is also important to understand how
a firm can change its mode of operations in order to improve its competitive
advantage. Growth by acquisition of a rival clearly reduces competition, but growth
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12 Introduction

by the purchase of a raw material supplier into the industry also places your rivals
at a disadvantage, because you then own what your rivals need. Good business
people understand how to manage and exploit competitive opportunities.

Government intervention
Governments can also intervene in markets. Society, or government, does not view
excessive pollution of the environment as desirable. Some pollution may be an
unavoidable consequence of beneficial production. In order to manage pollution the
government can attempt to influence the commercial activities of firms. This usually
involves increased taxes for firms that pollute, and subsidies or grants for firms that
attempt to operate in a more environmentally friendly manner. Therefore, the
government can seek to influence firms’ costs and revenues, boosting them when the
firm operates in the interest of society, and reducing profits when the firm operates
against the public interest. Firms need to be able to understand when their activities
are likely to attract the attention of government, or pressure groups, and what
policies could be imposed upon them.

Globalization
Finally, firms do not operate within singular markets; rather, they function within
massive macroeconomic systems. Traditionally such systems have been the national
economy but, more recently, firms have begun to operate within an increasingly
global environment. Therefore, in order for firms to be successful they need to
understand how macroeconomic events and global change will impact on their
current and future operations.
National economies have a tendency to move from economic booms into
economic recessions. If a firm’s sales, and therefore revenues, are determined by the
state of the macroeconomy, then it is important for the firm to understand why an
economy might move from a position of economic prosperity to economic recession.
Similarly, during a recession firms struggle to sell all of their output. Price discounts
can make products and inputs – such as labour, raw materials and capital equipment
– cheaper, thereby reducing a firm’s costs.
While understanding the state of the macroeconomy is important, it is also
beneficial to have an understanding of how the government might try to manage the
economy. How will changes in taxation affect consumers, firms and the health of
the economy? How will interest rate changes influence inflation and the state of the
economy? These are common governmental policy decisions with important impli-
cations for business.
Moreover, within the global economy matters of international trade, exchange
rates, European Monetary Union and the increasing globalization of business all
impact upon the operations and competitive position of business. Operating interna-
tionally may enable a firm to source cheaper production, or access new market and
revenue streams. But, equally, international firms can access UK markets, leading to
an increase in competition for UK domestic producers. Successful companies will not
only recognize these issues but, more importantly, they will also understand how
these issues relate to themselves and business generally. From this, strategies will be
developed and the firm will attempt to manage its competitive environment.
In order to develop your understanding of these issues, this book is separated
into a number of parts that build on each other. In Part II you will be introduced to
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Economics for business 13

the workings of market places. Part III will develop an understanding of competition
in markets. This will then be followed by an overview of firm governance by share-
holders and government. This will conclude the microeconomic section of the book.
Macroeconomics is split into two obvious parts: macroeconomics in the domestic
economy and macroeconomics in the global economy. At the domestic level you will
be introduced to how the macroeconomy works, the factors leading to the level of
economic activity and the options available to a government trying to control the
economy. At the global level you will be provided with an understanding of inter-
national trade and the workings of exchange rates. This will lead to the important
issue of European Monetary Union. Finally, an assessment of globalization and the
implications for business will be provided.
In order to highlight the relevance of economics to business, each chapter begins
with a business problem. Theory relevant to an understanding of the problem is
then developed. Each chapter closes with two applications of the theory to further
highlight the relevance of the theory to business and management. In this way
economic theory is clearly sandwiched between real-world business issues and prac-
tices, highlighting for you that economics, where appropriate, is a subject to be
applied in the understanding of business problems.

1.3 Appendix: The economist’s approach

Economics as a subject has a number of characteristics associated with it and, to aid
your learning, it is worth pointing them out to you.

Language
The economist makes use of terms and phrases that are particular and peculiar to
economics. For example, from the above discussion economics is the study of why
you cannot have everything. But the economist talks about infinite wants, finite
resources, opportunity costs and production possibility frontiers. Using the
economic terminology will help you. Economists use particular terminology because
it helps them to understand each other when communicating ideas. Succinct terms,
such as opportunity cost, once understood, convey complex ideas quickly to anyone
else who understands the phrase.

Abstract models
Models or theories Economists think about the world in terms of models or theories.
are frameworks for Economists recognize that the world is extremely complicated and, therefore,
organizing how we
think about an prefer to make models using simplifying assumptions. The complexity of the real
economic problem. world is stripped out in favour of a simple analysis of the central, or essential, issues.
As an example we will consider how an economist might approach how David
Beckham bends free kicks.
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14 Introduction

Example

Bend it like Beckham

In modelling David Beckham’s ability to bend free kicks, economists would strip out
the complex issues, such as natural talent, good practice and high-pressure cham-
pionship experience, and take the simplifying assumption that David Beckham
behaves like a world-class physicist. David Beckham must behave like a highly
accomplished physicist because he can clearly calculate all the angles and force
needed to bend a free kick and score a goal.
In reality David Beckham probably has no more understanding of physics than
many of us. So, to say that David Beckham behaves like a physicist seems peculiar.
However, the important point is that the theory predicts; it need not explain. The
theory does not explain why David Beckham can bend free kicks and score goals
with such accuracy. But it does predict that David Beckham will score spectacular
goals if he behaves like a world-class physicist. This is because a leading physicist,
indeed any physicist, could use the Newtonian laws of motion to work out the
perfect angle and trajectory for the football to travel in a speculator arc into the
back of the net. But why should economists wish to develop strange abstract
assumptions about reality, leading to theories that predict, as opposed to theories
that can explain?
The answer to this question is that economists try to keep things simple and
extract only the important points for analysis. The world is very complex, so what
we try to do as economists is to simplify things to the important points. David
Beckham is probably a football player because of some natural talent, a good deal
of practice, championship experience and perhaps some poorer opponents. All
these would explain why David Beckham can score great goals. But to keep things
simple we will assume he behaves like a leading physicist. If theoretically true, then
David Beckham will also be an amazing free kick specialist. Therefore, the
predictive approach is a theoretical short cut that enables economists to simplify
the complex nature of reality. So, whenever you come across a theory in this book
that is not a true reflection of reality, do not worry. We are happy in our little fantasy
world where people like David Beckham double up as Einstein.

Normative and positive economics

Positive economics A positive economics question and a normative economics statement will help to
studies objective or
scientific
clarify the differences:
explanations of
how the economy Positive question: What level of production will maximize the firm’s profits?
works.
Normative Normative statement: Firms should maximize profits.
economics offers
recommendations
based on personal The positive question seeks to address a technical point – can economics identify the
value judgements. output level where firms will make the largest profit? The normative statement, in
contrast, seeks to assert the opinion that profit maximization is best – it is making a
value judgement. In the case of the positive question economists can make a response
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Economics for business 15

with theory consisting of a set of accepted rational arguments that provide a technical
answer to the question. But in respect of the normative statement, economists can only
reply with similar or alternative value statements: for example, firms should not
entirely focus on profit maximization; I believe they should also consider the needs of
wider stakeholders such as workers, the environment, suppliers and customers.’
This is an important distinction. Positive economics is the technical and objective
pursuit of economic understanding. As a subject it seeks to provide answers to ques-
tions and propose solutions to problems. Normative economics is different in that it
does not seek to answer questions; rather, it seeks to assert and represent particular
beliefs – which are difficult, if not impossible, to provide positive answers to.

Diagrams
Quickly flick through all the pages of this book. How many diagrams did you see?
Economists like diagrams. For the economist diagrams are an effective way of commu-
nicating complex ideas. In order to develop your understanding of economics you will
need to develop your competence in this area, as it is almost impossible to manage
without them, which is disappointing for any of you who detest them with a passion.
As a brief reminder a diagram, at least as we will be using them, provides a
visual indication of the relationship between two variables. For example, consider a
fridge and an oven. Neither are currently switched on. When we do switch them on
we are interested in seeing how the temperature inside the oven and the fridge
changes the longer each appliance is on. This is not rocket science: the fridge will
A positive get colder and the oven hotter. A maths teacher would say that there is a positive
relationship exists relationship between time and temperature in the cooker.
between two
variables if the In our example of the oven, as time increases – 1 minute, 2 minutes, etc. – the
values for both temperature of the oven also increases. Our two variables, time and temperature,
variables increase
and decrease
increase together.
together. In contrast, the maths teacher would say that there is a negative relationship
A negative between time and temperature in the fridge.
relationship exists In our example of the fridge, as time increases, the temperature of the fridge
between two
variables if the decreases. Figure 1.3 is a diagram showing the positive relationship between time
values for one and temperature within the oven, while Figure 1.4 is a diagram of the negative rela-
variable increase
(decrease) as the
tionship between time and the temperature inside the fridge.
value of the other
variable decreases
(increases).
Figure 1.3 Positive relationship: oven temperature against time

300
Positive
250 relationship:
Celsius
Temperature Celcius

temperature
200 increases the
Temperature,

greater time the

150
oven is switched
100 on.

50

0
0 2 4 6 8 10 12 14 16
Time minutes
Time, minutes
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16 Introduction

Figure 1.4 Negative relationship: fridge temperature against time

25 Negative
relationship:

Celsius
Temperature Celcius
20
temperature
decreases the
Temperature, 15
greater time the
fridge is
10
switched on.
5

0
0 1 2 3 4
Time
Time,hours
hours

We will be doing nothing more complicated than this. We might reasonably

argue that as prices increase consumers will buy less; we therefore expect to see a
negative relationship between the price of a product and the amount of the product
purchased by consumers. Similarly, in the case of a positive relationship we might
argue that consumer expenditure increases as income levels rise. Essentially the
diagrams are a simple visual illustration of the relationship between two variables.
The more you try to understand them and gain confidence in using them, the easier
economics becomes.

Economic data
Economists make use of data to examine relationships between variables. Data can
Time series be categorized into time series data and cross-sectional data.
data are the For example, the price of a cinema ticket recorded for each year between 1990
measurements of
one variable at and 2004 is an example of one variable measured at various points in time. The time
different points in period between each observation is usually fixed. So in the case of cinema tickets,
time.
the variable, price, is measured once every year. However, time series can be
Cross-sectional
data are the
measured in a variety of periods – yearly, monthly, daily, hourly or by the minute.
measurements of The price of shares on the London stock market is measured in all of these formats.
one variable at the The profits of individual companies in the supermarket industry in 2004 would
same point in time
across different be an example of cross-sectional data, with profits of different companies being
individuals. measured at the same point in time.
Rather than measure the profits of individual supermarkets in 2004 we could
also measure individual companies’ profits in 2003, 2002, 2001 and so on. This way
Panel data we are combining cross-sections and time, thus providing us with panel data.
combines cross-
sectional and time
series data.
Using data
In using data economists employ a number of simple mathematical techniques,
including calculations of percentages and the use of index numbers. Both are simple
to understand, but a refresher may help your understanding.
A percentage In order to measure the change in a variable we can use percentages.
measures the We can use Table 1.3 to understand how big a particular percentage change is.
change in a variable
as a fraction of 100.
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Economics for business 17

Table 1.3 Percentage changes

Percentage Size of change
10% 10% = 10/100 = 1/10. The variable has increased by one tenth of its original value
25% 25% = 25/100 = 1/4. The variable has increased by a quarter of its original value
50% 50% = 50/100 = 1/2. The variable has increased by a half of its original value
100% 100% = 100/100 = 1. The variable has increased by the same amount as its original value; it has
doubled in size
200% 200% = 200/100 = 2. The variable has increased by twice its original value; it has tripled in size
500% 500% = 500/100 = 5. The variable has increased by five times its original size.

Since a percentage measures the rate of change in a variable, we need both the
variable’s original and new value.

We calculate the percentage as the absolute change divided by the original number,
then multiplied by 100:
(New value – Original value)
× 100
Original value

For example, the share price of Company A was £2.00 in 2003 and £3.00 in 2004.
The percentage change is therefore:
(£3.00 – £2.00) × 100 = 50%
£2.00

Index numbers
Index numbers are As an example of the use of index numbers take the data series in Table 1.4, which
used to transform a measures the price of a pint of beer.
data series into a
series with a base
value of 100. Table 1.4 Index numbers
Year Price of beer Index
1999 £1.50 100
2000 £1.60 107
2001 £1.80 120
2003 £2.00 133

The price of beer is in pounds sterling. To convert this data series into a unitless
series with a base value of 100, we first need to select the base year. In Table 1.4 we
have selected 1999 as the base year. In order to generate the index we simply take
the price of beer in any year, divide by the base year value and times by 100. So in
1999 we have (£1.50/£1.50) × 100 = 100. In 2000 we have (£1.60/£1.50) × 100 =
107.
A sensible question is to ask why we use index numbers? There are a number
of reasons. The first is to recognize that since we have a base value of 100 it is very
easy to calculate the percentage change in the variable over time. From Table 1.4 we
can readily see that between 1999 and 2003 beer has increased by 33 per cent.
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18 Introduction

The second reason is that index numbers facilitate averaging. Assume we are inter-
ested in how prices across the economy are rising. If an index was created not only
for beer prices but also for car prices, cigarettes and in fact all products that are
commonly sold, then an average of all the indices would enable an assessment of
average price rises in the UK.
The Retail Price Index does exactly this. It is an average of many individual
product price indices. The average is weighted by the importance of the product
within the average household’s consumption. For example, since housing costs
represent a major element of household consumption, the house price index receives
a higher weight in the Retail Price Index than the price index for sweets and confec-
tionary. The FTSE 100 is another example of an index and combines as an average
the prices of all shares in the FTSE 100. The value of the index increases (decreases)
if on average shares in the FTSE 100 increase (decrease).
In summary, index numbers are used to create data series that are unitless. They
have a base year of 100 and can be used to calculate percentage changes from the
base year with ease. By virtue of having a common base year value of 100, index
numbers can also be used to create averages from many different indices, such as
price level indices or stock market indices.

Summary
1 Economics assumes that everybody would like to consume more of everything,
but we only have a limited amount of resources with which to facilitate such
consumption.
2 Economic factor resources are split into four categories: land, labour, capital and
enterprise.
3 The production possibility frontier is used by economists to provide an illustration
of finite resources. The production possibility frontier shows the maximum total
output that can be produced using the limited amount of factor inputs. As more of
one good is produced, less of the remaining good can be produced.
4 Opportunity cost is measured as the benefits forgone from the next best alter-
native.
5 Operating on the frontier represents full employment and is defined as productively
efficient. Operating inside the frontier is inefficient as the output of both goods can
be increased by making an efficient utilization of the underemployed factor
resources. Operating outside the frontier is currently impossible. However, over
time the economy may become more productively efficient, producing more output
for a given level of input; or the economy may gain access to additional factor
inputs, also enabling output to increase.
6 Macroeconomics is an examination of the economy as a whole and, therefore,
considers issues such as the level of economic activity, the level of prices, unem-
ployment, economic growth, and international trade and exchange rates.
7 Microeconomics focuses upon the economic decision-making of individuals and
firms. Microeconomics examines how individual markets function and how firms
compete with one another.
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Economics for business 19

8 Where on the frontier an economy operates, producing more beer than pizza, or vice
versa, depends upon the resource allocation mechanism. In command economies
the government plans how much of each good to produce. In market economies the
interaction of consumers and firms through the pricing system of the market directs
resources away from non-profitable markets and towards profitable markets.
9 Economics has a language and terminology; this aids communication of ideas and
should be mastered.
10 Economics uses abstract models. In reality the world is very complex. In economics
simplifying assumptions are deployed in order to make the world simple. As a
consequence, an explanation of reality is often sacrificed for prediction.
11 Positive economics seeks to address objective questions with theory. Normative
economics seeks to assert value judgements on what is preferable economic
behaviour.
12 Economists place an emphasis on diagrams when explaining ideas and theories. A
positive relationship exists between two variables if both variables increase
together. A negative relationship between two variables exists when as one variable
increases the other variable decreases.
13 Economic data can be time series, cross-sectional or a combination of the two
(panel data). Time series data are the measurements of one variable at various
points in time. Cross-sectional data are the measurements of one variable at the
same point in time, but across a number of firms or individuals.
14 A percentage measures the change in a variable as a fraction of 100. You can
calculate a percentage change as (New value – Original value)/Original value × 100.
15 An index converts a variable into a unitless data series with a base year of 100. This is
achieved by dividing each value by the base year value and then multiplying by 100.
16 Index numbers can be combined to create averages. Common examples are the
retail price index and the FTSE 100. Changes in the individual price indices then lead
to changes in the average indices.

Learning checklist
You should now be able to:
Explain the economic problem of scarcity

Understand the concept of opportunity cost

Explain the difference between microeconomics and macroeconomics

Highlight the differences between market and planned economies

Explain why an understanding of economics is important for business

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20 Introduction

Links to other chapters

All

Developments in this chapter

Infinite wants and finite resources
Production possibility frontier
Opportunity costs
Macro- and microeconomics
Positive and normative economics
Use of economic language and abstract models
Use of diagrams: positive and negative relationships
Use of index numbers and percentages
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Economics for business 21

Questions
1 List goods, or services, that compete for your income. Similarly, list activities that
compete for your time. In deciding what you will spend your income on and how you
will allocate your time, do you minimize your opportunity costs?
2 Which of the following statements relate to macro or microeconomics? (a) During
the last 12 months average car prices have fallen; (b) inflation for the past 12
months has been 3.5%; (c) strong sales in the housing market have prevented the
Bank of England from reducing interest rates.
3 Why does business need to understand the functioning of markets?
4 Why does business need to understand the functioning of the economy?
Questions 5 and 6 relate to material within the appendix
5 Which of the following is positive and which is normative? (a) It is in the long-term
interest of the UK to be a member of the Euro; (b) Will entry into the Euro reduce UK
inflation?
6 Using the data listed below, plot house prices on the Y axis and time on the X axis.
Is there a positive or negative relationship between time and house prices? Convert
the data series on house prices into an index using 2000 as the base year.
Year Average price of a house
1999 £60,000
2000 £75,000
2001 £80,000
2002 £90,000
2003 £110,000
2004 £120,000

Calculate the percentage increase in house prices for the following periods:
1999–00, 2000–01, 2001–02, 2002–03, 2003–04.
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