Economic Analysis for Business

1. Economic Analysis for Business Chapter 4 Governments and the Market

2. Governments • Within an economy there is the overlay above all economic activity made up of the decisions made by government. • Government decisions change the regulations under which businesses work and the taxes that are paid.

3. Government and Value Added • Some of what governments do is value adding, some is not. • Some of what governments do is essential to the smooth running of an economy, some is not. • And importantly, some of what governments do makes the economy run badly with no compensating benefits.

4. Defence, Law and Law Enforcement • There is, firstly, the legal, administrative and enforcement side of what governments do. • These, along with national defence, are the historic roles of government found as far back as history itself.

5. Public Administration • Governments contribute to economic activity by its administration generally. • Governments manage the community’s affairs in ways that improve the social and economic environment. • A community is an intricate social network that requires management.

6. Infrastructure • Governments provide infrastructure. • These are the capital works that are the major connecting rods of economic activity. • Transport, wharves, harbours, roads all provide economic benefits and these have been traditionally, but not necessarily, supplied by governments.

7. Welfare • Governments have also taken on some of the responsibility of providing at least a minimum of welfare for the poor and indigent going back centuries.

8. Government and Taxation • In undertaking all of its tasks, governments have depended on the tax revenues raised. • Whether as tariffs or tolls or taxes in general, the principal source of funds for governments have been the monies collected from the population it governs. • In choosing how and how much to tax, governments, both then and now, have played an important role in encouraging industry and promoting value adding industry.

9. Government Businesses • Governments run businesses • The most common form of government business have been natural monopolies – businesses where the capital requirements are so large that economies of scale ensure there could never be a successful second provider. • There is almost no form of business that governments have not run somewhere at some time.

10. Management of Government Run Businesses • Government owned and operated businesses have not been managed well and frequently run at a loss. • Governments have run profitable enterprises, but usually they are public utilities of the natural monopoly variety. • Governments do not normally have the knowledge to mange businesses successfully • Their agents are public servants whose expertise is seldom related to managing firms. • Market disciplines are often not as developed as they need to be, which often means they draw on taxpayers to make up the losses incurred.

11. Government and the Economic Stimulus • Public spending, especially in times of economic distress, is considered by many as an appropriate counterweight to a downturn in the private sector. • Such theoretical justifications almost totally discount the need for spending to add value. Any spending will supposedly do to start the wheels of exchange turning. • It is the belief that unproductive public spending can cause overall economic growth that is the largest fallacy in the realm of government. • Unproductive spending is unproductive.

12. Production Possibility Curve • The production possibility curve is typically drawn to provide a basic understanding that in any economy there are limits and that choices need to be made. • Although usually presented as a throw away before getting on to the real economics, it instead contains an enormous storehouse of the conceptual ideas needed to understand how economies work

13. An economy can only produce so much • To understand the curve properly, it must be understood that it represents combinations of forms of output that completely exhaust the resource base of the economy. • Given the existing institutional arrangements of an economy, the stock of existing capital, the skill sets and knowledge of the labour force, and the entrepreneurial and managerial skills available only so much can be produced and no more.

14. Every economy has only so much • The constraints on an economy: • the institutional structure which includes all of the laws, rules, regulations, structures, conventions, moral and religious beliefs that determine what is permitted • the quantum of capital in existence that those who own the capital are prepared to use • the efficiency and productivity of the capital base • the size of the labour force • the skills, capabilities, knowledge, attitudes, personal characteristics of the labour force • the availability of natural resources that can be used for productive effort • the abilities of the economy’s entrepreneurs and managers

15. Private A P P´ A´ Government G G´ Production Possibilities Curve Any pair of goods or services can be on the axes as long as they fully absorb the productive capabilities of the economy

16. Opportunity cost • In a fully employed economy at some moment in time, if you want more of one set of goods, you can only do so by having less of some other. • More public sector goods and services can only be had by having fewer private sector goods and services. • The cost, known as the opportunity cost, of more of one good or service is the highest valued goods and services that have to be given up to get what one does end up with.

17. Private X P Government G An economy not reaching its potential Unemployment and/or Inefficiency

18. Points inside the Production Possibility Curve • The meaning of any point inside the production possibility curve is that more could be produced of either one or both given: • the existing institutional structure • entrepreneurial capabilities • managerial skills • capital base • employee numbers • employee skills, abilities and personal characteristics • natural resources

19. Unemployment and underemployment • The most obvious and straightforward reason is due to unemployment and underemployment, usually thought of as relating to labour, but can just as well occur with all other kinds of resources. • Some of the resources that were available were not put to work. • This is the nature of recession – some of the resources of the economy are unable to be employed with labour the most important social problem although owners of capital are also often harmed during recession

20. Inefficiency • An economy can be inside the production possibility curve because of the inefficient use of resources. • This is a reason that is much more important and often much more difficult to deal with than with unemployment. • Resources are wasted when they are not used to produce that combination of goods and services that would have created the highest level of value added even though they could have done so had they been used in a different way.

21. Efficiency and the market • It is one of the most important roles of market competition to drive resource use to their highest valued form of utilisation. • Competition is designed to lower the profits of firms not using the resources they are buying to the maximum advantage. • Market competition pushes firms towards the most efficient form of production. • Because every firm in a competitive economy is driven to be as efficient as possible, it pushes the economy as a whole towards producing as much as it possibly can with the resources that it has on hand.

22. What causes economic growth Economic growth can be caused by any of these factors: • additions to the capital base • improvements in the institutional structure • improvements in entrepreneurial abilities • improvements in management practice • improvements in technology and innovation • additional employment • improvements in the relevant skills base of employees • additions to the resource base

23. Economic growth – more of everything

24. Economies can also contract Economies can also contract for the same kinds of reason but in reverse: • erosion of the capital base • diminished entrepreneurial activity and withdrawal of capital due to uncertain economic conditions • changes in the underlying institutional structure • less efficient management practices • a slowdown in technological improvement and innovation • a contraction in the labour force • a fall off in the availability of relevant skills and abilities • a fall in the resource base

25. Economic contraction

26. Consequences of contraction • The consequences of a contracting economic base can be a rise in unemployment • But it can also be a fall in living standards – with less to share there is less available for each person

27. Misdirected government spending and economic growth • Amongst the most important reasons for diminished rates of economic growth and even for contracting standards of living is the mismanagement of resources by governments • If government directs resources into non value adding areas of activity, the growth rate will be slower than it might otherwise have been and might even contract

28. Ideas based on the Production Possibility Curve It is the concepts that are important, in this case that: • there are always limits on how much can be produced from available resources • in a fully employed economy, to have more of some goods and services it is absolutely necessary to have less of others • not producing at the maximum possible is either due to some resources being unemployed or is due to resources not being used as efficiently as they might have been • economic growth means more goods and services can be produced

29. A note on diagrams • The final reminder about this and other diagrams drawn in economics is that they are just for instruction and not in any way an exact representation of anything at all. • They are drawn to provide an understanding of concepts, not to be seen as a scale model of some underlying actual reality which almost invariably no one ever knows.