Economic Analysis for Business

1. Economic Analysis for Business Chapter 2 The Economics of the Free Market

2. What studying economics is for To understand how communities become prosperous To understand how an economic environment can be created in which the individual members that make up the community can themselves become prosperous To understand how economic theory can provide guidance to decision makers to help them construct appropriate economic institutions to create the sought after prosperity.

3. The purpose of this course To be able to follow policy discussions. To provide familiarity with the underlying concepts and theory without being overwhelmed with the detail. To know how those in decision making roles think and the kinds of analysis they apply. To provide a proper grounding on how economies work to be able to understand economic events as they unfold.

4. Definition of economics Economics, as Adam Smith in the first great work in the subject stated in his very title, is An Inquiry into The Nature and the Causes of the Wealth of Nations (1776) Economics is the study of what it takes to provide material wellbeing individually and nationally

5. Economics as the study of ends and means The most common definition of economics: “The science which studies human behaviour as a relationship between ends and scarce means that have alternative uses”.

6. Rule of law Economies will never be productive if the legal system does not protect the incomes and the property of those who produce a nation’s wealth. Only where the civil authority is used to protect the incomes and profits earned through productive activity will that productive activity occur. Only in countries where those who run the nation’s police are resolute in protecting from thievery and plunder those who run the nation’s businesses will prosperity occur. Self restraint of government in allowing businesses to succeed is one of the most basic requirements for an economic success.

7. Honesty and character An exchange economy only works where those who engage in production and trade are personally honest in their dealings with others. One cannot push this to any extreme. Dishonesty exists everywhere. With so much wealth at stake, the commercial world will inevitably attract dishonest people. But where dishonest practices become the norm, no economy can expect to succeed.

8. Property rights Prosperity can only occur where private ownership is recognised and the full weight of the legal system is designed to maintain security. If the owners of property must continuously be on the lookout for thieves and governments, the basis for wealth creation, a very patient and long-term process, will seldom be achieved. It is the poor more than anyone else who benefit from strong protections for property rights.

9. Private ownership • Everything that commercially exists, with some trifling exceptions, has an owner. • You can depend on the owners of property to take better care of that property than anyone else. • People take care of the things they own better than they take care of things they do not own

10. Macroeconomics Macroeconomics looks at the entire economy as one large productive unit. The role of macroeconomic theory is to explain how all the parts fit together and in fitting together how the entire mechanism leads to: • increased or diminished employment, • a higher or lower price level, • faster or slower rates of growth and • a balanced or unbalanced level of international trade • the creation of money and finance • the adjustment of rates of interest

11. Policy Economics looks at the actions that should be taken to achieve the traditional aims of policy: • low rates of unemployment • high rates of economic growth • low rates of inflation, and • stability on the balance of payments. All of these issues are related to the material wellbeing of communities.

12. Microeconomics Microeconomics is the part of economic theory that looks at the actions taken by individual producers and buyers. It looks at who does what and the motivations behind the economic decisions made by individuals either as consumers or producers. Deals with decisions individuals make, as buyers and producers, that causes particular goods and services to be produced and end up in the hands of the particular people. Microeconomics is concerned with: • the economic coordination between various producers who buy inputs from each other • and the further coordination between producers and those who finally buy the consumer goods and services at the end of the process.

13. Market mechanism • At the heart of national economic coordination is something called the “market mechanism”. • This “market mechanism” coordinates the commercial, productive, economic actions of total strangers. • At the core of the market mechanism is what is known as the price system.

14. Price system The market mechanism should be seen as a continuous process in which every good and service competes with every other good and service to find buyers, The prices of every item offered to the market are under on-going and relentless pressure to fit into the entire framework of purchase and sale. Prices are constantly changing, shifting relative to each other to reflect the costs of production on the one hand and the willingness of buyers to pay the price on the other.

15. Supply and demand The basic unit of analysis for the market mechanism are the forces of supply and demand. Supply and demand explains how an individual price for an individual product ends up being set once producers have made decisions to produce and sell the product.

16. Process of supply and demand • The process starts from the decisions by sellers to supply something – a good or a service – for sale to others. • There are then buyers who, once the various goods or services are offered up for sale, will buy more at lower prices and less at higher prices. • And finally, supply and demand analysis points out that somewhere there exists a price at which the amount that the sellers wish to sell and the amount that buyers want to buy will be the same.

17. Equilibrium Equilibrium is an important concept in economics which describes a situation where all the forces acting on some outcome are in balance and can be expected to remain unchanged In other words – equilibrium cannot and does not happen ever Economies are always in the midst of change with the past only a rough guide at best to the future

18. The importance of change • even if there were no innovation nothing could be expected to stay as it is • with innovation and surprise the most evident aspect of every economy, the only certainty is that what happens to exist will be transformed over the course of time

19. Entrepreneurial actions • the most important agent of change are entrepreneurs who seek out new products, new services and new means of production • nothing stands still under the relentless efforts of those who own and run businesses to discover and develop products which have never previously existed • equilibrium as defined is impossible when entrepreneurial change is so pervasive

20. Decision making

21. Decision making at the margin At the core of economic analysis is the assumption that individuals making their own decisions about their own economic circumstances will lead to the best outcomes for themselves. Each person is therefore seen as weighing up all of the alternatives they have before them and making a decision based on their own judgement of what is best. Producers must also decide for themselves what it is they will offer up for sale in order to earn the incomes they will spend.

22. Marginal analysis Being marginal means that the moment of calculation is NOW. All economic decision are taken in the present. Marginal analysis comes into play only when a decision must be made Marginal analysis is about weighing up alternative courses of action to reach a decision on what to do

23. Expected benefits weighed up against expected costs • The past is unalterable and must be taken as given. It is what it is. The present is merely the baggage that has been deposited by what has come before. • From that initial point, any decision brings with it benefits (the reasons in favour of making the decision) and costs (the reasons not to make the decision) • If the expected benefits exceed the expected costs, that is, if the decision is expected to make a net improvement in one’s circumstances, then one goes ahead with the decision. Otherwise not.

24. The entrepreneur The single most important individual so far as economic activity, growth and prosperity are concerned is the entrepreneur. Who is the entrepreneur? Entrepreneurs: • own and run private sector firms • make decisions on what, how, where to produce • are dependent on the success of the businesses they run for their own personal livelihoods • are the agents of innovation and economic growth. Entrepreneurs are a self-selected group of people who have decided to make their living by operating a firm. No one in government chooses who will run our private businesses. It is the embedding of the entrepreneur within the market economy that causes the economy to become as productive as it is.

25. Entrepreneurs the major agents of change Entrepreneurs are the agents of economic change Some entrepreneurs run businesses using techniques and knowledge that are the inheritance of the past But other entrepreneurs – probably the minority – change the world entirely from what it was Think Steve Jobs and Apple or Bill Gates and Microsoft – they left the world a different place

26. Uncertainty and risk At the centre of the mystery of economic events is the existence of radical uncertainty. The entire economy is wrapped in an impenetrable shroud of unknowing. All production and investment are done in anticipation of returns on productive activity that will take place in the future. Business decisions often go wrong because the future did not turn out as expected. This is the kind of uncertainty in which every business must exist.

27. For an economy to work the parts must mesh The question is how do the various parts of the economy mesh in just those ways that will maintain and increase prosperity, keep everyone in jobs, keep prices stable and allow our own economy to trade profitably with others. The emphasis should be put on the word “mesh”. What is needed is an understanding of how the various parts fit together so that each individual element can play a coordinated and cooperative with all of the other elements.

28. Aggregate demand – Keynesian economics The modern approach to understanding the macroeconomy is through an examination of various aggregates. At the very centre of macroeconomics is something called “aggregate demand”, the demand for everything. In most treatments of aggregate demand, it is broken down into a series of sub-components: • consumption (C) • investment (I) • government expenditure (G) • exports (X) • with imports (M) netted out

29. The core equation of Keynesian economics The core equation is that national output (represented by the letter “Y”) is the sum of these individual expenditures: Y = C + I + G + X – M Variations in output can be explained, it is argued, through variations in the level of the individual components of demand Macroeconomic policy therefore revolves around getting the components of demand to rise

30. You are hereby warned • As will be discussed in greater detail, Keynesian economic theory is dangerously misleading • To use Keynesian demand management as the basis for economic policy will create many problems while solving none

31. Production takes place in anticipation of demand The basic unit of understanding is to recognise that that the production of almost all goods and services occurs in anticipation of demand An item bought on any particular day has become available for sale only because of a string of production decisions that go back in time, often well back Economic decisions are made before anyone can tell whether the decision will lead to a profit or loss The motivation is always gain, but the outcome is only sometimes profitable

32. The structure of demand and supply It is the structure of demand not the level of demand that is important in understanding how an economy works. Understanding an economy requires you to understand how all the parts are made to work together Economies grow, employ and continue to prosper so long as the structure of demand, that is, the precise goods and services that others wish to buy, is the same as the structure of supply, the set of goods and services that are put up for sale. Never forgetting, of course, that most of what is produced is produced to become an input into something else

33. The entrepreneur and production At the very centre of production and economic activity is the role of the entrepreneur – no one is more important to the success of an economy Every input and every form of output is subject to the forces of innovation, product development, cost adjustment and redundancy Each and every good or service has the potential to be replaced in the volatile markets of a normal economy

34. The nature of the macroeconomy There is a continuous mutual adjustment taking place between those who buy and those who sell. But remember this: those who produce are both sellers of what they create and buyers of the inputs sold to them by others. Each producer of inputs is typically selling their products to a range of buyers. Amongst those buyers are businesses growing larger, others growing smaller but all may have a different level of demand for the products they buy as each day goes by.

35. Structure of production Each and every one of these businesses must remain alive to the commercial world in which they are engaged. They must be aware of the prices they pay, the prices they charge, the demands of their customers, the actions of their competitors along with having some notion of the state of the economy they are operating in. This interlocking maze of commercial relationships constitutes the structure of production.

36. Economic structure and recession When the structure of demand moves out of alignment with the structure of production economies slow and unemployment goes up. Thinking about economies in terms of their structure makes it possible to understand the nature of economic activity and why it goes wrong

37. The pre-Keynesian theory of the cycle Prior to the revolutionary arrival of Keynesian economics, the swings and roundabouts of economic activity were explained by the many many theories of the cycle that had then existed The contours of the business cycle : • the trough • upturn or recovery • the peak • downturn or recession

38. The pre-Keynesian theory of recession All economic activity based on anticipating demand Recessions are the result of economy wide production errors Factors that can have these effects include unexpected changes in interest rates, a major fall in the availability of credit, a large increase in costs, international instability, bad business decisions or poor decisions by government Although such mistakes may initially affect a relatively small number of businesses, the effects can spread wider as each industry contracts and reduces demand for products of other industries

39. International economic relations Deals with matters such as: • Exports • Imports • Exchange rates • Tariffs Everybody likes to export but is reluctant to import No area of economic misunderstanding is more comprehensive than the value of international trade

40. Free trade and protection Most people are natural protectionists Some understanding of the importance of trade in raising domestic incomes and evening out economic instability provides a minimal requisite for understanding how market processes make individuals better off