The Economic Environment Of Business And Finance Flashcards
What is a market?
Where potential buyers and sellers come together for the purpose of exchange
What is the market mechanism?
The interaction of supply and demand for a particular item
Demand definition
The quantity consumers are willing and able to buy at a given price
Usual demand curve
Quantity demanded goes up as price goes down
Determinants of demand
- Price of the good itself
- Price of other goods
- Substitutes (e.g. different brands)
- Complements (e.g. shirts and ties)
- National income effect on demand for normal/inferior goods
- Fashion
- Population size
- Credit terms
Causes of a shift of a demand curve to the right
- Increase in household income
- Increase in price of substitutes
- Decrease in price of compliments
- Good becoming more fashionable
- Expectation good will increase in price
Price elasticity of demand equation
PED = change in demand/change in price
Convention to ignore sign as usually negative
Inelastic PED =
PED < 1
Elastic PED =
PED > 1
Perfectly inelastic PED =
PED = 0
Perfectly elastic PED =
PED = infinity
Unitary elasticity PED
PED = 1
Factors affecting PED
- Availability and closeness of substitutes (generally increases elasticity)
- Time (generally demand is les elastic in short term)
- Competitors pricing (copying price cut = same demand = inelastic. Not copying = fall in demand = elastic)
(Can create ‘price stickiness’) - Nature of the product (generally demand for luxuries is more elastic, necessities less elastic, habit-forming products are inelastic)
- Proportion of income accounted for by a good. (Large = elastic)
Significance of price elasticity
Prediction: Allows managers to predict effect of price changes on demand and revenue
What will happen when increasing the price of inelastic products?
Total revenue will increase even though fewer units are sold
What will happen when increasing the price of elastic products?
Revenue will decrease if fewer units sold
Price must be due to increase revenue
Similarities of Giffen and Veblen goods
Upward sloping demand curves
Positive price elasticity of demand
Giffen goods
Price increase causes people to buy more
E.g. bread
Veblen goods
Bought for ostentation
So higher price makes them more exclusive and desirable
Income elasticity of demand looks at
The degree demand is affected by changes in household income
Income elasticity of demand formula
YED = (%ΔDemand)/(%ΔHousehold income)
YED > 0 for
Normal goods
YED > 0 for
Inferior goods
YED > 1 for
Luxury goods
Cross elasticity of demand looks at
Degree demand affected by changes in price of other products
Cross elasticity of demand formula
XED =
(%ΔDemand for product A)
/(%ΔPrice of product B)
XED > 0 for
Substitutes
XED < 0 for
Complementary goods
XED = 0 for
Unrelated goods
Supply of a good definition
Quantity suppliers (and would be suppliers) are willing and able to supply at a given price
Supply curves show
Supply v price
Usually what happens in most supply curves
Quantity supplied usually extends as price increases:
Existing suppliers produce more
New suppliers switch to making the product
Price elasticity of supply looks at
Degree to which supply is affected by changes in the price
Price elasticity of supply formula
PES = (%ΔSupply)/(%ΔPrice)
(Usually positive as supply curve is upward sloping)
Perfectly inelastic supply
Supply remains constant at all prices
E.g. antiques
Perfectly elastic supply
Supply infinite at a particular price
Below this the supply drops instantly to zero
Determinants of supply
- Price of good itself
- Price of other goods
- Price of joint products
- Costs
- Changes in technology
- Other (weather, harvests)
Supply effect of changes in price of joint products
Price rise in one will make production of both more attractive
Factors influencing elasticity of supply
- Market period
- Short run
- Long run
Market period influencing elasticity of supply
Inelastic, as changes in supply limited to availability of inventory
Short run factors influencing elasticity of supply
Can change production plans but still limited by capacity (e.g. due to fixed plant and machinery)
Long run factors influencing elasticity of supply
Can expand capacity
New firms can enter industry - more elastic
Equilibrium price
Price where supply and demand is equal
What happens if price is too high in market?
- Supply exceeds demand, leading to surplus
- Short term goods returns to manufacturers, reduced orders, products binned
- Supplier will lower prices to attract more demand
If price is too low in market
- Demand will exceed supply causing shortage
- Short term empty shelves, queues, increased orders at high 2nd hand values
- Supplier will increase prices to reduce shortage
Why would gov define max prices?
Ensure essential goods are affordable
Limit inflation as part of a ‘prices and incomes’ policy
Result of max prices?
Excess demand
Queues
Rationing
Black markets
Why would gov define min prices?
Protect suppliers (e.g. EU CAP)
Minimum wage agreements
Results of min prices?
Excess supply (butter mountains, farmers paid to not grow crops, unemployment?)
How is the national output of goods and services measured?
GDP
GDP 4 factors considered which generate a return
- Land
- Labour
- Capital
- Entrepreneurship
GDP Land return
Rent
GDP Labour return
Wages
GDP Capital return
Interest
GDP Entrepreneurship return
Profit
GDP is
Amount of expenditure spent on output
Gov influences on national economy
- Producing goods and services
E.g. education, health - Purchasing goods and services
E.g. uniforms, supplies - Investing in capital projects
E.g. new roads, schools - Transferring payments from one area of the economy to another
E.g. taxes to fund unemployment payments
Consumer influence on national economy
Spending their disposable income on goods and services instead of saving it
Amount consumers spend disposable income depends on
Changes in disposable income and marginal propensity to consume (spend v save)
Changes in distribution of wealth
Gov policy (tax and spending)
Major new products development
Interest rates
Price expectations
Savers impact on national economy
Investing what they choose not to spend
Amount saved depends on
Income
Interest rates
Need for long term savings
Businesses impact on national economy
Amount invested in capital goods
Which drive growth of economy
Business/trade cycle
Growth and fall of GDP
The four main phases of the business cycle
- Recession
- Depression
- Recovery
- Boom
Does a recession begin relatively quickly?
Yes
Cutting back adds momentum to the recession
Depression
Aka stagflation
If demand isn’t stimulated a period of full depression will set in
Is recovery fast?
No
Takes time to grow consumer confidence
How does gov try to limit depression?
Boosting demand in economy as a whole
Boom
- Demand may outstrip supply causing inflation
- Businesses tend to be profitable
- Expectations of future very optimistic
Inflation
Increase in general price levels
Decrease in purchasing power of money
Deflation
Generally falling prices
Normally associated with lower growth and recession
What type of prices do most governments aim for?
Stable
Why is high inflation undesirable?
- Fewer people can afford goods
E.g. low/fixed income - Wage inflation
Productivity falls while new rates agreed - Exports fall
As imports appear cheaper (exchange rates usually alter to accommodate this) - Consumers may stockpile
Fearing price increases
Leads to shortages
Leads to further price increases
Types of inflation
- Cost-push
- Demand-pull
Cost push inflation
Price rises due to increase in costs of production
E.g. imported raw materials or wage increases
Demand pull inflation
Price rises from persistent excess of demand over supply
Supply cannot grow any further once ‘full employment’ is reached
2 main causes of demand pull inflation
- Fiscal
- Credit
Fiscal cause of demand pull inflation
Increase in gov spending
Or reduction in taxes
Raises demand in economy
Credit cause of demand pull inflation
Levels of credit extended to customers increases
Expenditure rises
(Inflation likely to be accompanied by customers’ debt burdens)
Gov macroeconomic policies used to grow the economy and control inflation
- Monetary policy
- Quantitative easing
- Fiscal policy
- Supply-side policies
Monetary policy
Interest rates
Exchange rates
Money supply
Effects of rise in interest rates
Price of borrowing in the economy will rise
Impact of interest rate rise on companies
Reduced borrowing and investment in non-current assets
Impact of interest rate rise on households
Increased saving decreased spending
Unwillingness to borrow for house purchase
Outcome of rising interest rates
Reduced aggregate demand in economy
Results of higher sterling exchange rate
- Cost of exports higher
Cost of imports lower - Foreign investors attracted to sterling investments
- Reduction in spending and investment
Economic outcome of higher sterling exchange rate
Reduction in aggregate demand in economy
Quantitative easing
Central bank buying financial assets (e.g. gov and corporate bonds) using money generated electronically
Form of relatively unconventional expansionary monetary policy
Fiscal policy
Government spending:
Taxation
Borrowing
Government spending uses
Stimulate aggregate DEMAND
Influence DISTRIBUTION of wealth
Taxation uses
raise funds
influence the distribution of wealth
suppress economic growth
Government borrowing
Based on fiscal stance
Main source of gov spending
Tax
Three fiscal stances
- Expansionary
- Neutral
- Contradictionary
Expansionary fiscal stance
Gov spending > tax = increased borrowing
Contradictionary fiscal stance
Gov spending < tax = reduced borrowing
Neutral fiscal stance
Gov spending = tax
Supply wide economics
Policies to encourage suppliers to produce more goods at lower prices
Main supply side macroeconomic policies
More involvement of the private sector in the provision of services
Reduction of taxes to increase incentive to supply
Increasing flexibility in the labour market by reducing the power of trade unions
Improving education and training so quality of labour is enhanced
Increasing competition though deregulation and privatisation of utilities
Abolition of exchange controls and allowing free movement of capital
Market structure definition
Description of the number of buyers and sellers in a market for a particular good and their relative bargaining power
Four main types of market structure
- Perfect competition
(Infinite firms in the industry) - Monopolistic competition
- Oligopoly
- Monopoly
(One firm in industry)
Perfect competition structure
Large number of buyers and sellers
None can influence market price alone
(No collusion)
Free entry/exit to market place in long run
Free access to perfect info on all market conditions
Resulting in identical cost structures
Homogenous/identical products
Perfect competition implications
Single market-wide selling price
Suppliers are ‘price takers’
Can sell as much as they like but only as market price
Suppliers only make ‘normal’ profits in long run
(So seen as good for consumers)
Monopoly structure
One supplier
Many buyers
Barriers prevent new entrants
E.g. size/economies of scale
Patents
Public sector protection
Unique talent
Access to unique resources
Monopoly implications
Supply can fix price or quantity
(Other determined by demand curve)
Firms make super-normal profits
(Hence often seen as bad for consumers)
Types of monopoly
{I’m getting a PANG for a monopoly}
- Pure monopoly
Only one supplier - Actual monopoly
One dominant supplier - Natural monopoly
Not due to legal factors
(E.g. monopolies of scale) - Government franchise monopoly
Based on gov policy e.g. NHS
Monopolistic competition structure
Many buyers and sellers
Some differentiation of products
E.g. by branding/advertising
Some customer loyalty
Few barriers to entry
Monopolistic competition implications
Firms have some freedom to set prices
(Face downward-sloping demand curve
So price rises will lose customers)
Lack of barriers to entry ensure only normal profits in the long run
Oligopolies structure
Few large suppliers
Differentiation of products
High degree of mutual dependency
Oligopolies implications
Difficult to predict the actions of competitors
E.g. follow the leader pricing
Rivals copy price cuts but not increases
Price wars
May prefer non-price competition
E.g. advertising
Collusion from cartels
E.g. OPEC
Perfect competition examples
Fruit markets
Stock market?
Monopolistic competition examples
Pubs
Hairdressers
Oligopolies examples
Oil industry
Banking
Washing powder
Market failure definition
Free market fails to produce optimum allocation of resources
4 factors in market failure
- Market imperfections
- Externalities
- Public goods
- Economies of scale
Market imperfections
Markets don’t satisfy assumptions of perfect competition
E.g. monopolists charge higher prices
Powerful customers drive prices too low
Imperfect information poor decisions
Time lags
Public goods
Goods that would not be provided at all without gov intervention
E.g. street lighting, police force, national defence
Public goods properties
Non-excludability
Provision to one person allows rest of society to benefit
Consumption by one doesn’t reduce amount available to others
So market for this type of goods doesn’t exist
Non-excludability
Can benefit from good without having to pay for it (free rider)
Externalities in market failure
Costs or benefits the market mechanism fails to take into account because the market only incorporates private costs and benefits
4 Externalities
- Private cost
- Private benefit
- Social cost
- Social benefit
Private cost
Cost to supplier of producing good
Private benefit
Benefit obtained directly by supplier/buyer
Social cost
Cost to society as a whole of producing good
Social benefit
Benefit obtained by society as a whole
Negative externalities
Social cost > private cost
E.g. pollution
Positive externalities
Social benefit > private benefit
E.g. training staff who then leave
What does perfect competition involve?
Many smaller firms
Can economies of scale result in lower prices for consumers than under perfect competition?
Yes
Types of economies of scale
Internal economies
External economies
Internal economies of scale
Arising from side of firm
Specialisation/division of labour
Indivisibilities in inputs
(More efficient utilisation of capacity)
Financial economies
(E.g. bulk discounts, inventory policy)
External economies of scale
Arising from size of industry
Specialisation in local labour force that reduces training costs
Agglomeration economies
I.e. provision of ancillary backup service industries
