The economic environment for business

Question 1

The principal objectives of macroeconomic policy will be to achieve the
following:

Answer 1

 full employment of resources
 price stability (low inflation)
 economic growth
 balance of payments equilibrium
 an appropriate distribution of income and wealth.

Question 1

Macroeconomic policy is

Answer 1

the management of the economy by
government in such a way as to influence the performance and behaviour
of the economy as a whole

Question 2

The objectives of macroeconomic policy

Answer 2

The full employment of resources applies in particular to the labour
force. The aim is both full and stable employment.
Price stability means little or no inflation putting upward pressure on
prices.
Economic growth is measured by changes in national income from one
year to the next and is important for improving living standards.
The balance of payments relates to the ratio of imports to exports. A
payment surplus would mean the value of exports exceeds that of
imports. A payment deficit would occur where imports exceed exports.
What is considered an appropriate distribution of income and wealth
will depend upon the prevailing political view at the time

Question 3

Potential for conflict

Answer 3

Both economic theory and the experience of managing the economy
suggest that the simultaneous achievement of all macroeconomic
objectives may be extremely difficult. Two examples of possible conflict
may be cited here.
There may be conflict between full employment and price stability. It is
suggested that inflation and employment are inversely related. The
achievement of full employment may therefore lead to excessive
inflation through an excess level of aggregate demand in the economy.
Rapid economic growth may, in the short-term at least, have damaging
consequences for the balance of payments since rapidly rising incomes
may lead to a rising level of imports.
Government reputation and business confidence will both be damaged
if the government is seen to be pursuing policy targets that are widely
regarded as incompatible.
Policy objectives may conflict and hence governments have to consider
trade-offs between objectives. The identification of targets for policy
should reflect this

Question 4

Aggregate Demand (AD) is

Answer 4

the total demand for goods and services in
the economy

Question 5

Exchange rates

Answer 5

Macroeconomic policy may involve changes in exchange rates. This
may have the effect of raising the domestic price of imported goods.
Most businesses use some imported goods in the production process;
hence this leads to a rise in production costs

Question 6

Taxation

Answer 6

Fiscal policy involves the use of taxation: changes in tax rates or the
structure of taxation will affect businesses, e.g. a change in the
employers’ national insurance contribution (NIC) will have a direct
effect on labour costs for all businesses. Changes in indirect taxes (e.g.
a rise in sales tax or excise duties) will either have to be absorbed or
the business will have to attempt to pass on the tax to its customers

Question 7

Interest rates

Answer 7

Monetary policy involves changes in interest rates. These changes will
directly affect firms in two ways:
 Costs of servicing debts will change, especially for highly-geared
firms.
 The viability of investment will be affected since all models of
investment appraisal include the rate of interest as one, if not the
main, variable

Question 8

Monetary policy is concerned with influencing the overall monetary
conditions in the economy in particular:

Answer 8

 the volume of money in circulation – the money supply
 the price of money – interest rates.

Question 9

The choice of targets

Answer 9

A fundamental problem of monetary policy concerns the choice of
variable to operate on. The ultimate objective of monetary policy is to
influence some important variable in the economy – the level of
demand, the rate of inflation, the exchange rate for the currency, etc.
However, monetary policy has to do this by targeting some
intermediate variable which, it is believed, influences, in some
predictable way, the ultimate object of the policy

Question 10

Monetary policy - The broad choice here is between targeting the stock of money or the
rate of interest:

Answer 10

 The volume of money in circulation. The stock of money in the
economy (the ‘money supply’) is believed to have important
effects on the volume of expenditure in the economy. This in turn
may influence the level of output in the economy or the level of
prices.
 The price of money. The price of money is the rate of interest. If
governments wish to influence the amount of money held in the
economy or the demand for credit, they may attempt to influence
the level of interest rates

Question 11

Interest rate smoothing

Answer 11

Interest rate smoothing is the policy of some central banks to move
official interest rates in a sequence of relatively small steps in the same
direction, rather than waiting until making a single larger change

Question 12

Interest smoothing - This is usually for the following reasons:

Answer 12

 economic (e.g. to avoid instability and the need for reversals in
policy) and
 political (e.g. higher rates are broken to the electorate gently)

Question 13

Inflation may be:

Answer 13

 demand-pull inflation – excess demand
 cost-push inflation – high production costs

Question 14

The cost of finance.

Answer 14

Any restrictions on the stock of money, or
restrictions on credit, will raise the cost of borrowing, making fewer
investment projects worthwhile and discouraging expansion by
companies. Also, any increase in the level of general interest rates will
increase shareholders’ required rates of return so unless companies
can increase their return, share prices will fall as interest rates rise.
Thus, in times of ‘tight’ money and high interest rates, organisations are
less likely to borrow money and will probably contract rather than
expand operations

Question 15

Demand-pull inflation might occur when

Answer 15

excess aggregate monetary
demand in the economy and hence demand for particular goods and
services enable companies to raise prices and expand profit margins

Question 16

Cost-push inflation will occur when

Answer 16

there are increases in production
costs independent of the state of demand, e.g. rising raw material costs
or rising labour costs. The initial effect is to reduce profit margins and
the extent to which these can be restored depends on the ability of
companies to pass on cost increases as price increases for customers

Question 17

Fiscal policy is the

Answer 17

manipulation of the government budget in order to
influence the level of aggregate demand and therefore the level of activity
in the economy. It covers:
 government spending
 taxation
 government borrowing

Question 18

public expenditure =

Answer 18

taxes raised + government borrowing
(+ sundry other income)

Question 19

taxation may have undesirable economic
consequences. Those most frequently cited are as follows:

Answer 19

 Personal disincentives to work and effort: this may be related
mainly to the form of taxation, e.g. progressive income tax (earn
more, pay more), rather than the overall level of taxation.
 Discouragement to business, especially the disincentive to invest
and engage in research and development (R&D), which results
from high business taxation.
 Disincentive to foreign investment: multinational firms may be
dissuaded from investing in economies with high tax regimes.
 A reduction in tax revenue may occur if taxpayers are dissuaded
from undertaking extra income-generating work and are
encouraged to seek tax-avoidance schemes

Question 20

Government borrowing

Answer 20

Broadly the government can undertake two types of borrowing:
It can borrow directly or indirectly from the public by issuing relatively
illiquid debt. This includes National Savings certificates, premium
bonds, and long-term government bonds. This is referred to as ‘funding’
the debt.

Question 21

A governmenrt can borrow from the banking system by

Answer 21

issuing relatively liquid debt
such as Treasury bills. This is referred to as ‘unfunded’ debt.

Question 22

A government can borrow by issuing

Answer 22

Long-term government bonds (gilts) are issued for long-term financing
requirements, whereas Treasury bills are issued to fund short-term
cash flow requirements

Question 23

Crowding out

Answer 23

It is suggested that fiscal policy can lead to ‘financial crowding out’,
whereby government borrowing leads to a fall in private investment.
This occurs because increased borrowing leads to higher interest rates by creating a greater demand for money and loanable funds and hence
a higher ‘price’.
The private sector, which is sensitive to interest rates, will then reduce
investment due to a lower rate of return. This is the investment that is
crowded out. The weakening of fixed investment and other interest-
sensitive expenditure counteracts the economy boosting benefits of
government spending. More importantly, a fall in fixed investment by
business can hurt long-term economic growth.
Doubts exist over the likely size of any crowding out effect of
government borrowing on other borrowers but a very large PSNCR may
well lead to a fall in private investment.
However, when the economy is depressed, and there is not much new
private sector investment, government spending programmes could
help to give a boost to the economy

Question 24

Incentives

Answer 24

It is likely that all taxes have some effect. Indeed, the structure of taxes
is designed to influence particular economic activities: in particular,
taxes on spending are used to alter the pattern of consumption. Here
are two examples.
 High excise duties on alcohol and tobacco products reflect social
and health policy priorities.
 Policies to use excise duties to raise the real price of petrol over
time are designed to discourage the use of private cars because
of the environmental effects.
Thus, taxes as instruments of fiscal policy can fulfil a variety of useful
functions.
However, there has been a growing concern among some economists
that taxes have undesirable side effects on the economy, notably on
incentives. As we have seen, it is argued that high taxes, especially
when they are steeply progressive, act as a disincentive to work.
Moreover, some taxes have more specific effects. For example,
employer national insurance (NI) payments raise the cost of labour and
probably reduce employment

Question 25

Competition policy

Answer 25

(A monopoly is where a firm has a sufficient share of the market to
enable it to restrict output and raise prices.)
The absence of competition results in disadvantages to the economy
as a whole

 Economic inefficiency: output is produced at a higher cost than
necessary. For example, there may be no incentive to reduce
costs by improving the technology used.
 Monopolies may be able to engage in price discrimination:
charging different prices to different customers for the same
goods or services, e.g. peak and off-peak pricing. This may act
against the interests of customers.
 Disincentive to innovate: the absence of competition may reduce
the incentive to develop new products or new production
processes.
 Pricing practices: monopolies may adopt pricing practices to make
it uneconomic for new firms to enter the industry, thus reducing
competition in the long run

Question 26

These potential problems of companies with monopoly power must be
considered in the light of some possible advantages that may be
associated with such firms:

Answer 26

 Large firms may secure economies of scale: it is possible that
there are significant economies of scale, reducing production
costs, but that these require large firms and hence the number of
firms in an industry is restricted. In this case, the benefits of
economies of scale may offset the inefficiencies involved.
 The special case of natural monopolies: this is the case where the
economies of scale in the provision of some basic infrastructure
are so great that only one producer is feasible. This may be the
case of the public utilities in energy and water.
 Research and development: it may be that monopoly profits are
both the reward and the source of finance, which then enable
technological and organisational innovation. Thus, some
disadvantages have to be accepted in order to ensure a dynamic
and innovative business sector

Question 27

Economic theory concludes that,

Answer 27

all other things being equal, economic
welfare is maximised when markets are competitive

Question 28

Fair competition: public provision and regulation

Answer 28

The response to the problems associated with monopoly power can
take a variety of forms. The first of these is public provision. This is
where an economic activity is nationalised. The advantages of this are
as follows:
 unfair pricing practices and/or excessive prices can be eliminated
 cost advantages of economies of scale can be reaped.
Traditionally, public utilities have presented the most convincing case
for nationalisation because they are natural monopolies. However,
nationalised industries may have disadvantages, notably a greater
potential for cost-inefficiency

The alternative response to the dangers of monopoly is regulation

Question 29

Self-regulation is common in many professions where the profession
itself

Answer 29

establishes codes of conduct and rules of behaviour (e.g. the Law
Society, the British Medical Association)

Question 30

public or legal regulation

Answer 30

An example
in the UK is the establishment of regulatory bodies for the privatised
utilities such as OFTEL and OFGAS. These were established in
recognition of the monopoly power of the privatised utilities and have a
degree of power over both prices and services in these industries

Question 31

Fair competition: the control of monopoly
Formal competition policy has typically centred upon two broad issues

Answer 31

 monopolies and mergers
 restrictive practices

The concern for monopolies is with firms which have a degree of
monopoly power (defined as having more than 25% of the market) or
with mergers which may produce a new company with more than 25%
of market share. The underlying presumption is that monopolies are
likely to be inefficient and may act against the interests of customers

Question 32

Monopoly - The concern over restrictive practices is

Answer 32

with trading practices of firms
that may be deemed to be uncompetitive and act against the interests
of consumers.

Question 33

Monopoly - Legislation typically prohibits:

Answer 33

(a) anti-competitive agreements (such as price-fixing cartels); and
(b) abuse of a dominant position in a market

Question 34

Government assistance

Answer 34

The political and social objectives of a government, as well as its
economic objectives, could be pursued through official aid intervention
such as grants and subsidies. The government provides support to
businesses both financially, in the form of grants, and through access
to networks of expert advice and information.
For example, to:
 boost enterprise
 encourage innovation
 speed urban renewal
 revive flagging industries
 train labour force
 sponsor important research

Question 35

Green policies and sustainability issues

Answer 35

When a firm appraises a project it may, rationally, only include those
costs it will itself incur. However, for the good of society, external costs
(such as damage to wildlife) need to be taken into account.
This has led to:
 green legislation
 punitive taxation on damaging practices
which force companies to consider the negative impacts of potential
projects

Question 36

Sustainability

Answer 36

‘meeting the needs of the present without compromising
the ability of future generations to meet their own needs’. Having appropriate environmental policies in place forms a large part of
meeting sustainability targets. Moves to encourage recycling of
business’ products and aims to become net zero carbon producers will
tie into sustainability goals.

Question 37

Corporate governance

Answer 37

Corporate governance is defined as ‘the system by which companies are
directed and controlled’ and covers issues such as ethics, risk
management and stakeholder protection