L-3 Economic Challenges

ECONOMIC CHALLENGES FACING GLOBAL AND DOMESTIC BUSINESS

Businesses, not-for-profit organizations, and governments with well-thought-out plans can succeed even in the worst of times. Organizations that are flexible enough to change course when necessary – like those that are willing to search for alternative energy sources to reduce their dependence on oil – are likely to survive as well. When we examine the exchanges that companies and societies make as a whole, we are focusing on the economic systems operating in different nations. These systems reflect the combination of policies and choices a nation makes to allocate resources among its citizens. Countries vary in the ways they allocate scarce resources.

Economics is a social science that analyses the choices made by people and governments in allocating scarce resources. There are two types of economics, microeconomics, which is the study of small economic units like individual consumers, families, and businesses. Macroeconomics is the study of a nation’s overall economic issues such as the allocation of resources and government policies. We talked earlier about the increasing interdependence of nations and their economies. Reflecting that interdependence, macroeconomics examines not just the economic policies of individual nations but the ways in which those individual policies affect the overall world economy.

Microeconomics: The Forces of demand and supply

At the heart of every business transaction is an exchange between a buyer and a seller. The exchange process involves both demand and supply. Demand refers to the willingness and ability of buyers to purchase goods at different prices. Typically, for a new product, the price falls away over time causing increase in demand. This is called the demand curve. The demand curve can shift to the right or to the left. Shifts to the right are caused by various factors such as an increase in number of buyers, an increase in incomes or an increase in price of substitute goods. Correspondingly, demand curve shifts to the left if number of buyers decrease, if incomes fall or if prices of complementary goods increase.

Factor:                                                 Right shift:                  Left Shift:

Customer preferences                         increase                       decrease

Number of buyers                               increase                       decrease

Buyers’ incomes                                  increase                       decrease

Prices of substitute goods                   increase                       decrease

Prices of complementary goods          decrease                      increase

Future expectations more                    optimistic                    pessimistic                  

On the other side of demand is supply. Supply is the willingness and ability of sellers to provide goods and services for sale at different prices. The supply curve graphically shows the relationship between different prices and quantities that sellers will offer for sale, regardless of demand. Movement along the supply curve is the opposite of movement along the demand curve. The supply curve shows how much of a good is for sale at increasing prices. Typically, at higher prices, you have higher amounts of the good for sale.

Factors of production (natural resources, capital, human resources, entrepreneurship) play a key role in the supply of goods and services, a change in the cost of any of these inputs can shift the entire supply curve to the left or to the right. For example, if the cost of natural resource increase, the supply of goods at a given price should decrease, shifting the supply curve to the left.

The point at which the demand curve meets with the supply curve is called the equilibrium price. This is the market price at which you can buy a good.

The supply curve shifts occur as follows:

Factor:                                                 Right shift:                  Left Shift:

Costs of inputs                                    decrease                      increase

Costs of technologies                          decrease                      increase

Taxes                                                   decrease                      increase

Number of suppliers                            increases                      decreases

Macroeconomics: issues for the entire economy

Each country faces decisions about how to best use the four basic factors of production. Each nation has political, social and policies that determine its unique economic system. However, in general, there are three main types of economic systems; private enterprise systems (capitalism), planned economies, and mixed economies (which are a combination).

Capitalism (market economy):

Most industrialized nations operate in a capitalistic economy. A private enterprise economy rewards businesses for meeting the needs and demands of consumers. Governments refrain from directly interfering in the economy and instead competition regulates the economy.

In a private enterprise system, in a given industry, there are four levels of competition; Pure competition, Monopolistic competition, Oligopoly, and Monopoly.

Pure competition is a market structure where large numbers of buyers and sellers exchange homogenous products. Prices are set by market as forces of supply and demand interact. Agriculture is probably the best example of pure competition, where buyers see little difference between the goods and services offered by competitors. A commodity market refers to this type of industry situation where price is the only factor.

Monopolistic competition is a market structure where large numbers of buyers and sellers exchange relatively well differentiated (heterogenous) products. Differentiated products are similar but not identical. Competing goods are not perfect substitutes. An example of this type of industry are restaurants and drug stores (pharmacies). Sellers can set quite different prices based on the differentiation level. Entry barriers are not very high.

An oligopoly is a market structure where few sellers compete and high start-up costs form barriers to keep out new competitors. In some oligopolistic industries, such as paper and steel, competitors offer similar products. In others, such as aircraft and automobiles, they sell different models and features. Examples of oligopoly industries are heavy industries such as the steel industry or soft drinks market. The huge investment required to enter an oligopoly market tends to discourage new competitors. The limited number of sellers also enhances the control these firms exercise over price. Competing products in an oligopoly usually sell for very similar prices because substantial price competition would reduce profits for all firms in the industry. So, a price cut by one firm in an oligopoly would be followed by competitors doing likewise.

Cement is a product for which an oligopoly exists. Cemex is one of the largest cement manufacturers in the world and the largest seller of cement in USA and Mexico. In the US, cement is sold in bulk, like a commodity. However, it is sold as a branded product in Mexico. Although large construction companies in the US can force cement manufacturers to lower prices, Mexican construction firms are not strong enough to do likewise, and end up paying higher prices.

The final type of market structure is a monopoly, where a single seller dominates trade in a good or service in which buyers can find no close substitutes. A pure monopoly occurs when a firm possesses unique characteristics so important to competition in its industry that they serve as barriers to prevent entry by would-be competitors. An example of a monopoly is Rawlings Sporting Goods, who has the entire market for baseballs.

Many pharmaceutical firms create short-term monopolies when research breakthroughs permit them to receive patents on new products. A patent allows a firm to set its own price for a product for a certain period and protects its unique qualities from competing firms.

Besides issuing patents and limiting their life, the government prohibits most pure monopolies through antitrust legislation such as the Sherman Act and the Clayton Act. The US government has applied these laws against monopoly behaviour by Microsoft and by disallowing proposed mergers of large companies in some industries. In other cases, the government permits certain monopolies in exchange for regulating their activities. The postal service is an example of a regulated monopoly.

See table 3.4 for a summary of alternative economic systems.

During the 1980s and 1990s, the US government favored a trend away from regulated monopolies towards deregulation. Deregulation of regulated monopolies  is the process of allowing competitors into a monopoly industry.  Examples of industries that have been deregulated include telephone service, cable television, cellular phones and electrical service. In the phone area for example, the idea is to improve customer service and reduce prices by increasing competition. 

Characteristics	Pure competition	Monopolistic competition	Oligopoly	Monopoly
Number of Competitors	Many	Few to many	Few	No direct competition
Ease of entry into industry by new firms	Easy	Somewhat difficult	Difficult	Regulated by government
Similarity of goods offered	Similar	Different	Similar or different	No directly competing products
Control over price	None	Some	Some	Considerable
Examples	Small-scale farmer	Local fitness center	Boeing aircraft	Supplier of baseballs

Planned Economies:

Examples of planned economies are Communism and Socialism. The main creator of Communism was Karl Marx in the 19^th century. He believed that capitalism exploited workers and created unfair working conditions. Marx suggested an economic system in which all property would be shared equally by the people of a community under the direction of a strong central government. Marx believed that elimination of private ownership of property and businesses would ensure the emergence of a classless society that would benefit all. Under Communism, the central government owns the means of production, and the people work for state-owned enterprises. Communism does not allow ownership of private property and businesses. Instead everything is centrally planned and controlled.

A second type of planned economy, socialism, is characterized by government ownership and operation of major industries. Socialists assert that major industries are too important to be left in private hands and that government-owned businesses can serve the public’s interest better than can private firms. Examples include the health-care system or power sector. However, socialism also allows private ownership in industries considered less crucial to social welfare, like retail shops, restaurants, and certain types of manufacturing facilities.

Many formerly communist countries have undergone dramatic changes in recent years, especially in former Soviet Bloc Countries in Eastern Europe. They have restructured their economies by introducing private enterprise systems. By decentralizing economic planning and sweetening incentives for workers, they are slowly moving towards market-driven systems. Economic reforms in former communist countries have not been smooth sailing, with official corruption, crime and bloated bureaucracies as obstacles along the way.

Today, communism exists in just a few countries like China, Cuba and isolated North Korea. China has been moving towards a more market-oriented economy. The national government has given local government and individual plant managers more say in business decisions and has permitted some small private businesses. Households now have more control over agriculture and some western companies like Mcdonalds and coca-cola are making their way into the lives of Chinese people.

Mixed Market Economies:

Private enterprise systems and planned economies adopt basically opposite approaches to operating economies. However, in practice, most countries implement economic systems that display characteristics of both planned and market economies in varying degrees. Government-owned firms operate alongside private enterprises.

One example of mixed economy is France, where banking, aviation and steel industries amongst others are nationalized, but where other industries are private. In many countries privatization of government-owned industries has taken place, such as the United Kingdom in the nineties. Governments may privatize state-owned enterprises to raise funds and to improve economies, believing that private corporations can manage and operate the businesses more cheaply and efficiently than government units can.

See Table 3.4

System Features	Capitalism	Communism	Socialism	Mixed Economy
Ownership of enterprises	Private	Government	Government and Private	Both private and public
Management of enterprises	Owners or their representatives	Centrally planned and managed	Public enterprises government managed	Private sector like capitalism
Rights to profits	Entrepreneurs and investors entitled	No profits allowed	Only private sector	Both private and public sector
Rights of employees	Right to choose occupation and join unions	Restricted in return for employment	Choice allowed but government influential	Choice of jobs and union membership allowed
Worker incentives	Considerable incentives like profit-sharing	Some incentives	In private sector	In private sector, some limited incentives in public sector

EVALUATING ECONOMIC PERFORMANCE

An ideal economic system should provide a stable business environment and sustained growth.  Growth leads to expanded job opportunities, improved wages and a rising standard of living.

In reality, a nation’s economy tends to flow through various stages of a business cycle: prosperity, recession, depression and recovery. However, nowadays, recession is expected to give way to economic recovery without a depression taking place.

In a growth phase, unemployment falls, strong consumer confidence about future leads to higher purchases, and businesses expand to take advantage of market opportunities.

During a recession – a cyclical economic contraction that last for six months or more – consumers frequently postpone major purchases and only buy only basic functional products carrying low prices. Businesses mirror these changes in the marketplace by slowing production, postponing expansion plans, reducing inventories and laying off workers (especially contract and part-time workers). During past recessions, people facing layoffs and depletion of household savings have sold cars, jewelry, and stocks to make ends meet.

A depression occurs when economic slowdown continues over an extended period of time but economists believe society can now prevent future depressions through effective economic policies.

In the recovery stage of the business cycle, the economy emerges from recession and consumer spending picks up steam. Even though businesses often continue to rely on part-time and other temporary workers during the early stages of a recovery, unemployment begins to decline, as business activity accelerates and firms seek additional workers to meet growing production demands. Consumers start purchasing more discretionary items on things like vacations and electronic goods.

Productivity and GDP:

Productivity is the relationship between the goods and services produced in a nation each year and the inputs needed to produce them. As productivity rises, so does economic growth and the wealth of citizens. In a recession productivity may decline.

As we covered earlier, the productivity of a nation is measured by its gross domestic product (GDP), the sum of all goods and services produced within a nation’s boundaries each year. The per-capita GDP is calculated by dividing total GDP by the country population. A shrinking GDP indicates a recession, while an increasing GDP indicates growth. Data on US GDP can be found at the web site of the Bureau of Economic Analysis (BEA).

Price Level changes:

Another important indicator of an economy’s stability is the general level of prices. Inflation occurs when prices rise caused by a combination of excess consumer demand and increases in the costs of the factors of production such as human resources and raw materials. There are two types of inflation; demand-pull inflation which is caused by excess consumer demand and cost-push inflation, caused by rises in costs of factors of production. Inflation devalues money by reducing the buying power of money.

In rare situations, countries experience hyperinflation – an economic situation characterized by soaring prices. For example, in Ukraine following the collapse of the Soviet Union, prices of goods like food, clothes, and housing rose 50 times in one year.

However, inflation can be good news to those whose income is rising or those with debts at a fixed rate of interest. A homeowner during inflationary times is paying off a fixed-rate mortgage with money that is worth less and less each year.

In a low-inflation environment, businesses can make long-range plans without the constant worry of sudden inflationary shocks. Low interest rates encourage firms to invest in research and development and capital improvements, both of which are likely to produce productivity gains.

Deflation:

A phenomenon called ‘deflation’ occurs when prices fall instead of rising – it’s the opposite of inflation. Deflation has taken place in Japan in recent years. In USA the great depression was the last time when prices fell. The weak economy triggered a deflationary spiral in which companies cut jobs and slashed prices as the economy continued to slow. The result was an ever-weakening economy, staggering rates of unemployment (a 25% unemployment rate at one point) and lower prices. Even shoppers with jobs and purchasing ability postponed purchases to wait for lower prices later.

Measuring price level changes:

In the US, the federal bureau of labour statistics (BLS), a government agency, tracks monthly changes in price levels through the Consumer Price Index (CPI), which is a basket of common goods and services. The following areas are covered; Apparel, Housing, Transportation, Recreation, Medical Care, Education and Communication, Food and Beverages and other services and goods (tobacco and haircuts). Each month, BLS representatives visit thousands of stores, service establishments, rental units, and doctors’ offices all over the US to price the multitude of items in the CPI market basket. They compile the data to create the CPI. However, the CPI changes may overstate spending because it does not take switching (from expensive to cheaper goods) into account by consumers.

The CPI does not directly measure the changes in costs to businesses. The producer price index (PPI) is another economic indicator used to track prices. There are three types, the PPI for finished goods, the PPI for intermediate goods that will undergo further processing and the PPI for crude goods which measure the prices sellers obtained for raw materials.

Employment Levels:

The unemployment rate in an economy is an indicator of its economic health. It is defined as the percentage of total workforce who are actively seeking work but are currently unemployed.

Unemployment can be grouped into four categories; frictional, seasonal, cyclical and structural.  Frictional refers to people temporarily not working but are looking for jobs such as new graduates. Seasonal refers to those working in a seasonal industry such as tourism. Cyclical unemployment includes people not working due to economic slowdown such as executives laid off due to corporate downsizing. Structural unemployment is referring to those workers whose jobs have been replaced by technology and skills no longer needed or those retraining for a new job.

MANAGING THE ECONOMY’S PERFORMANCE

The government has two main methods of managing the economy, to fight unemployment, increase spending and reduce the severity of recessions. The government can use either monetary policy or fiscal policy to fight unemployment, increase business and consumer spending, and reduce the length and severity of economic recessions.

Monetary Policy:

This refers to government action to increase or decrease the money supply, changing banking requirements and altering the interest rates in the economy. An expansionary monetary policy increases the money supply in an effort to reduce the cost of borrowing, which encourages businesses to make new investments, in turn stimulating employment and economic growth.

By contrast, a restrictive monetary policy reduces the money supply to curb rising prices, over-expansion and slows economic growth. In the US, the Federal Reserve (the fed) is responsible for implementing the monetary policy. It has a chairman and a board of governors. All national banks must be members of this system, and keep some percentage of their checking and savings funds on deposit at the Fed.

The Fed can use a number of tools to regulate the economy. By changing the required percentage of checking and savings accounts that banks must deposit with the Fed, the Fed can expand or shrink funds available to lend. The Fed also lends money to member banks, which in turn make loans at higher interest rates to business and individual borrowers. By changing the interest rates charged to commercial banks, the Fed affects the interest rates charged to borrowers, and consequently, their willingness to borrow.

Fiscal Policy:

Fiscal policy is the second method of influencing the economic activities through taxation levels and spending levels. Increased taxes may restrict economic activities, this reduces the amount of money people have to spend, and so the inflation is reduced, and the economy slows down. By lowering taxes and increasing government spending, this influences by increasing the spending, reducing unemployment and encourage economic expansion.

Each year, the president proposes a budget for the federal government, a plan for funding and spending in the year, and presents it to congress for approval. The principal sources of funds are taxes, fees and borrowings. Individual taxes comprise 53% of the total tax revenue, Social-insurance taxes 35% (social security, medicare etc), Corporate income taxes 8% and miscellaneous sources 4%.

Looking at a breakdown of spending, at the parts of the budget; Social Security is 22%, National Defense is 17% and Medicare is 11%, Medicaid 7%, and Net interest on national debt 9%.

When the government spends more than it raises through taxes, a budget deficit is created. The shortfall is made up from borrowings, thus increasing the national debt. The current US national debt is $6.5 trillion. If the government takes in more money than it spends, there is a budget surplus. A balanced budget is when total revenues raised by taxes equals the total spending for the year.

GLOBAL ECONOMIC CHALLENGES FOR 21^ST CENTURY

There are five main challenges (see table 3.5):

1. International terrorism

·         Modify banking laws to cut funds for terrorist groups

2. Shift to a global information economy

·         Software industry in India grows at 50% per year

·         Internet users in Asia to more than double in 5 years

3. Aging of the world population

·         By 2025 number of 65plus will double, putting increased budgetary pressures on government

4. Improving quality and customer service
5. Enhancing the competitiveness of every country’s workforce

·         Move toward leaner organizations

·         Companies must train workers