Economic Analysis for Business

Economic Analysis for Business Chapter 15 Cyclical Activity and Governments

Nature of the cycle • each phase of cycle brought about by circumstances prevailing during the preceding phase • seeds of the subsequent recession sown during upturn • factors that will lead to revival come into play as the economy moves into recession RMIT University

Entrepreneurial actions • centre of the response to existing circumstance are entrepreneurial decisions • owners and managers of every business intensely interested in: • the state of economy • level of demand for the products they sell • cost of buying the inputs they use • mindful of the actions of competitors • aware that the unexpected happens all the time • potential for innovation RMIT University

Government actions • four government actions that affect activity: • they tax • they spend • they regulate/legislate • they make adjustments to the market for credit RMIT University

Government actions cause recession • most apparent from the history of economies is that actions taken by governments will frequently do great harm to the economies being managed • unless one brings in the role of government and its effects on production and employment, understanding the causes of the cycle will remain incomplete RMIT University

Governments are more destabilising than markets • governments are possibly the single most important cause of recession • government actions, rather than the operation of the market by itself, are far more likely to cause instability, recession and unemployment RMIT University

Causes of the great depression • high interest rates in 1928 and 1929 • largest tariff increase in US history 1930 • deliberate policy to maintain real wages • public spending and deficit financing • massive new government regulations • bank failures and money supply contraction RMIT University

Governments and the business cycle • no discussion of the cycle complete unless it is understood governments themselves now a major contributor to economic instability • governments may have themselves become the major cause • supposed counter-cyclical activities of government along with government regulation may be the most significant reason for recessions in the modern world RMIT University

How economic theory is usually taught • market mechanism is often taught largely as a basis for explaining what can go wrong • market mechanism seldom explained as what it is: the sole means to achieve prosperity and a continuing improvement in living standards for an entire population. • even where the role of the entrepreneurial-driven market is taught, it is a minor issue RMIT University

Microeconomics • emphasis on supply and demand but little about the price system • little if any discussion of individual decentralised decision making • omit almost entirely role of the entrepreneur • no sense of economic decisions an integral part of everyone’s life • the rest of a typical text will discuss how things are apt to go wrong RMIT University

Perfect competition • ideal micro model described as “perfect” competition • each individual firm is tiny relative to the entire level of sales but is nevertheless endowed with perfect knowledge about the future • the firm in a “perfectly competitive” model faces a perfectly elastic demand curve at the price determined by the overall market supply and demand for the product RMIT University

Imperfect competition • every other market type understood as representing some form of “imperfect” competition – described with those words • told that only with perfect competition is the economy operating efficiently • since not the case, inefficiency must abound • no indication that only through “imperfect” market that innovation and novelty occur RMIT University

Monopoly • worst of all market structure possibilities as described in a modern text is monopoly • monopolists restrict output and raise prices • immense efforts therefore required to prevent and deal with monopoly or to expand and extend competition RMIT University

Externalities • a legitimate issue but one which can only be understood within the context of the role of markets • externality is a cost imposed on third parties not associated with the purchase and sale of the particular product • typical example is some form of pollution • seldom taught is how the market itself deals with such externalities but is usually taught as a reason for government action RMIT University

Macro and economic management • economies as now taught have these characteristics: • continually teetering on the brink of recession, inflation or high unemployment • economies cannot possibly be left to themselves – require constant maintenance and correction • economy left to own devices will spin out of control • no mechanism for self adjustment RMIT University

Self-adjusting economies foreign notion • macroeconomics as now taught is the direct descendant of Keynes • few any longer taught economies have major properties for self-adjustment and are able to recuperate on their own without major government involvement • that the cycle is cyclical and can be counted on to provide most of the momentum towards recovery is unknown and untaught • a self-adjusting economy is a notion foreign to the way economics now presented RMIT University

Economic theory and the market • next to nothing taught about the market process – only supply and demand • instead evidence provided showing the market left on its own will create major problems not solve them • no one taught that the market economy is one of the most beneficial social institutions ever developed by human societies RMIT University

Not taught • will never be told: • an economy in which entrepreneurial decision making is the basis for economic activity cannot be improved upon • a heavy handed government response aimed at reversing the down phase of the cycle is possibly unnecessary • a government stimulus unless very carefully structured to be value adding may be positively harmful RMIT University

Markets need regulation • the market does need regulation • but the kinds of regulation a market needs is regulation that allows market processes to work • not needed are government actions that take the place of the market • governments cannot replace the outcome of entrepreneurial actions by businesses trying to find a market RMIT University

The world we live in • our world is a world of scarcity, shortages and radical uncertainties about the future • in such a world to believe there is any set of arrangements outside the market that will lead to personal prosperity is to be left in complete ignorance about how higher living standards can be created RMIT University

Politics and the market • the market economy is the only set of economic arrangements consistent with personal freedom and individual liberty • political benefits of market economy may be greatest benefit such arrangements bestow • none of this is generally taught • of these matters most students typically know next to nothing at all RMIT University

The constant involvement of governments • typical approach to economic theory underscore belief an economy must have government involvement at virtually every turn • government involvement to rectify and adjust the outcomes that the market would itself produce • the message whether overt or tacit is that governments are a constant necessity to correct major failings of an entrepreneurial managed economy • governments must become a constant presence, time and again changing and adjusting the circumstances to head off instability or rectify social injustice RMIT University

Economics as a discipline • texts at the introductory level designed as user’s manuals for government action • explain why such measures are needed and then provide remedies for such problems • texts almost exclusively deal with what may go wrong not why they go right • means to cure economic problems main intent of the text RMIT University

Nineteenth century policy • nineteenth century governments were largely hands off – rules generally straightforward: • limits on protectionist measures to impede trade • maintenance of the gold standard and fixed exchange rates to inhibit inflationary increases in money supply • balanced budgets • low taxation • small government • little attempt at income redistribution • limited levels of welfare expenditure • few government-run businesses RMIT University

Twentieth (and now 21st) century policies • different probably brought on by the two world wars • government activity became more and more entrenched • Russian Revolution made central planning appear to be the wave of the future RMIT University

Keynesian economics • Keynesian economics was, in effect, a watered down version of central planning but mixed with private ownership • had become clear long before World War II that governments were taking on more and more of the role of economic managers • did not require Keynes to write the General Theory for governments to feel themselves adequate to the task of direct economic management • Keynesian economics provided framework

Cycles and governments • quite possible that classical theory of the cycle superseded by actions of governments • in order to maintain economic stability and foster growth governments have become responsible for most of the instability that now regularly occurs • have become the single major obstacle to growth in our economies today

How Governments Affect GDP and Employment • Monetary policy – interest rates • Taxation – affecting both rates and structure • Government spending • Regulation • Exchange rates • Tariffs • Welfare • Wages and industrial relations

Classical policies • counter-cyclical policy based on classical principles is focused on harnessing entrepreneurial activities and market forces to achieve strong rates of growth • there are things that can be done, most of which are related to ensuring business costs are brought down as quickly as possible while after tax revenues are increased

Possible approaches during recessions • lower taxes particularly on business • containment of wages growth • a more market oriented perspective on regulation and business incentives • containment of unproductive forms of public spending • increases in public sector infrastructure programs that genuinely create value • a commitment to the maintenance of balanced budgets • interest rate reductions during the lowest point of the trough

Actions that should not be taken • large increases in unproductive forms of public spending • increased trade protection • increased government direction of economic activity RMIT University

Economic Analysis for Business