Economic Analysis for Business

Economic Analysis for Business Definitions

Economics - looks easy but is hard • Economics often looks easy because everyone already thinks they understand what’s going on in an economy without even having to study. Not true at all. • The language of economics is entirely made up of words that have ordinary meanings in everyday life. But these words, when they cross over into economics, suddenly take on very specific meanings that can cause someone to lose the thread during an economic discussion.

Can you answer this? Which producers using what inputs are involved in the production of a loaf of bread. That is, who has to do what to allow you to buy a loaf of bread? Explain how these productive activities are co-ordinated. That is, how does the economic system ensure that there are just enough bakers and bakeries along with just enough wheat so that enough bread is available. And beyond that, how does the economic system get the bread to the place where you are able to buy it?

Definitions provided • Provide a series of definitions of the specialised words used in the text. • Economic terms sound like ordinary language. • Having at least a preliminary grasp of these words and their more technical meaning will also in itself provide a grounding in the nature of the economic theory you will meet in the rest of the book.

Entrepreneur • Entrepreneurs in a market economy are a self-selected group who earn their living by running business firms. • No government appoints them. No government chooses them. • They are people who rise up the hierarchy of large businesses or often simply start their own in small businesses and run them. • Entrepreneurs are actual people who makes the decisions that set the entire process in motion. • A market economy cannot operate without entrepreneurs making decisions to do things because it is these decisions that determine the direction an economy will travel.

Market economy A market economy is one in which most of the production decisions are made by entrepreneurs running their own business firms. It is called a “market economy” because virtually everything is bought using the money one has earned in producing these other goods and services. There is no pre-determined set of goods and services that will be produced and no already worked out way describing how what is produced should be produced. A market economy is, instead, a free flowing set of arrangements in which everyone makes decisions for themselves about what to produce and for whom to work.

Microeconomics • Microeconomics is the part of economic theory that deals with individual decision making. • It looks into consumer behaviour, production decisions, price setting, resource allocation and the theory of the firm. • It asks why particular decisions are made and tries to explain how the entire economy knits together looking from the perspective of the individuals who make the economy up.

Values • Economic theory presupposes that the world is populated by people who are rational, self-interested and moral. • The assumption made is that individuals in trying to feed, clothe and house themselves will think about the best way to achieve their ends (i.e. they are rational), that their focus will be on themselves, their families, their friends and their communities (i.e. they are self-interested), and they will act according to their own traditions and personal values (i.e. they will behave in a moral way). • The market economy is not driven by greed and dishonest practice. The market economy provides an organisational structure that combines the maximum possible personal freedom with an ability to achieve the highest possible standard of living.

Value • The desirability of various goods and services in economics is subjective, personal. But value is not entirely a first person concept. • Value is determined by what other people will offer in exchange for some good or service and is usually given as a sum of money where that money could have been used to buy other things. • Value in economics is a discussion of economic goods, those goods and services that are produced for sale to others. • Value is determined according to the sum of money one is prepared to pay. If an object costs twice as much as another, it is twice as valuable. • Relative value in terms of price is what value ultimately means in economic discussion.

Value added • No concept may be more important than value added. • Every good or service sold on the market has value, and this obviously includes goods and services used as inputs in producing something else. • When something is produced, there has been a combination of labour time, raw material inputs, capital depreciation, along with whatever else was required to bring the product to completion. • Each of these inputs had value. The final product also has value. • Value added occurs only if the value of the output of what is produced is greater than the value of the inputs that were used in its production. • Economies will only grow if in aggregate the value of products produced has been greater than the value of the products that were used up.

Macroeconomics • Macroeconomics is the study of economic aggregates. • Macroeconomics looks at the various totals which are seen to somehow inter-react with each other. • Macro examines consumer and investment behaviour, the effect of government spending or international trade on an economy. • Macro takes the entire economy as its unit for study.

Keynesian economics • At the centre of macroeconomic theory going back to the publication by John Maynard Keynes General Theory of Employment, Interest and Money in 1936. • The core belief is that buying of things creates economic growth irrespective of whether what has been produced is value adding in and of itself. • The assumption is that no matter what the money is spent on, it will get the productive ball rolling by encouraging higher levels of production and employment. • Irrespective of whether a stimulus has been itself value adding, those who spend the money received will create value by encouraging the production of goods and services they seek for themselves.

Structure of production • The structure of production refers to how the economy as a whole fits together. • Every output has its inputs, and each of those inputs have inputs of their own. • Classical economic theory looks at the atomic structure of the economy, at each of the individual productive components separately. • Classical theory thought of the structure as the crucial issue. It was whether the structure of supply could rapidly conform to the structure of demand that was the matter of first importance in understanding how well an economy worked. • The classical theory of recession was based on explaining why the structure of supply and the structure of demand were no longer in harmony. • Policy during recessions was therefore directed towards restoring this balance by hastening, as best a government could, the readjustment of the economy.

Economic growth • An economy can only be said to be growing if value added across all productive activities is positive. That is, only if the value of output in total is greater than the value of all of the resources taken together that were used up during production. • One of the greatest fallacies is that it is the using up of resources that creates growth, which is the concept behind Keynesian economic theory. • It is not using resources that is value adding but only when the output from the use of those resources actually does add additional value • Only when there is more value at the end than existed at the beginning can it be said that value adding activity has occurred and the economy has grown.

Innovation • Innovation is what drives the economy. • These are new products, improved products, improved technologies, more efficient use of labour, improved labour market skills. • Most innovation is not about doing the same things as before in a better way. • Almost all innovation is driven by private sector entrepreneurs without whom almost no innovations would ever reach the market.

Knowledge • What makes the world we are in so extraordinarily productive is that we dwell in what might be called the “knowledge economy”. • It is the commercialisation of scientific knowledge and technological advance that makes the difference in living standards today. • It is not improved efficiency in the narrow sense that matters, but that we have created entirely new products that were inconceivable to earlier generations. • It is our ability to harness such knowledge that is the most important driver of economic change.

Stocks • Not company shares sold in the stock exchange. Nor are stocks just the inventories kept by retailers and manufacturers. • When an economist discusses stocks is discussing the accumulation of past production that remains in the present. • Stocks are the inheritance from the past whether for an individual firm or for the economy as a whole. • Almost the entire productiveness of a national economy is based on the vast accumulation of what has already been produced, the buildings, factories, roads and productive facilities. • And not only these, but the knowledge embodied in individual people, the skills they have, their know-how and abilities.

Flows • Flows are the increments added during some period of time. • Stocks and flows are related terms, with the traditional definition of a flow as the change in the level of stocks. • In thinking about the economy, it is the stock of existing productive assets, including human capabilities, that determines how much additional output, the flow, can be produced in any period of time. • Most measures of economic activity in an economy are flow measures. There are almost no measures of stock. • Our concentration on flow obscures what is more important in terms of how well we live.

Production Possibility Curve • The production possibility curve is the best diagram in economics. The only diagram unlikely to mislead you in understanding what it is intended to explain. • It is very simple, two axes and a semi-circular arc bowed out from the origin. • An economy on the arc is producing as much as it possibly can. It is using all of its productive resources as efficiently as possible. • The diagram reminds you that an economy has limits, that even the largest economy cannot produce everything that would satisfy everyone’s desires, and that a community must have some mechanism for deciding what gets produced and who gets what. • If we want more of something, it can only be achieved by having less of something else. • And if an economy is producing less than it might have, it is either (a) because its resources, especially its labour, is not fully employed, or (b) if its resources are fully employed, they are being used in a wasteful way.

Opportunity cost • In economics, the core idea is that the cost of something is what has to be given up in order to get whatever it is that is received. • Nothing in an economy comes without a cost. Everything requires choices to be made. • Opportunity cost emphasises what has been given up in order to receive whatever one has received. • It is a reminder that what limits how much anyone can receive is not the amount of money but the productiveness of the economy, how much it is able to produce.

Factors of production • The factors of production are the various forms of inputs that are needed if production is to take place. Each comes at a cost. • The traditional factors of production are (1) land, (2) labour and (3) capital to which the role of the (4) entrepreneur is added. • But even that is not enough so added to these four is (5) finance without which most forms of productive activity could never occur. • And there is a sixth which is the (6) knowledge, skills, know-how and abilities possessed by labour as well as the technological sophistication of the capital. It is not more labour and capital that make an economy grow but improvements in what they can do. • And finally, although seldom discussed, (7) time.

Capital • When we talk about capital in economics, we are talking about physical inputs into the production process that have themselves been created by the production process. • Capital is NOT money or finance. • It is improvements in capital in its widest sense that causes economic growth, not just the amount of capital but the technical capabilities as well. • An economy grows, in part, because is has more capital – and “more” is a problem in itself since unlike labour there are no units in which capital can be measured – but also because capital has become more productive through innovation and tech changes.

Capitalist system • It is sometimes said that a market economy is a “capitalist” economy as if capital were the actual difference that mattered. • Every economy requires capital and improvement in the capital stock does lead to improvement in living standards. • It is not the existence of capital or owners of capital that make the difference, but the role of the entrepreneur. • When someone discusses “capitalism” what they really mean is an economy where its direction comes from private sector entrepreneurs. • The owners of capital are often also entrepreneurs, but unless they run businesses, the owners of capital are not the people who make the economy what it is.

Consumption • The final end of all economic activity is to satisfy the needs and wants of the population. • The term that has come into use within economics, to describe the purchase of goods and services by the community, is “consumption”. • In earlier periods in economics, consumption meant using up. • When production took place, resources were said to have been consumed. A new product might have emerged, but the labour time, raw materials, capital equipment or whatever had been devoted to some particular use, had been consumed in other words. • In the text we will use the modern meaning of consumption as the production of the goods bought by consumers.

Investment • Investment is the process of using up resources in the present to enlarge the productive capabilities of the economy in the future. • The word when used in economics must never be confused with investment in the share market or any other kind of financial investment of money to earn more money. • Investment in economics is a form of production. Investment is the use of resources to build an economy’s productive strength. • Consumption and investment are alternative uses of a nation’s resources. In both cases the resource base is drawn down. • With investment, in place of the resources that were used is an economy that is capable of producing even more than it had before.

Saving • Saving in everyone’s mind is about individuals putting money in the bank or keeping a store of money in some financial institution. • Whatever an individual might do, a nation cannot save by putting money in the bank or keeping a store of cash and credit on hand. • National saving, the only kind of saving of interest when discussing the national economy, is the use of a nation’s resources in productive ways. • In an economy, the resources available can be used to produce consumer goods or they can be used to produce investment goods. • A nation saves when it is investing and not when it is consuming.

Price • In a market economy, everything comes at a price which is almost invariably denominated as so many units of the local currency. • The price on such products is decided by the sellers, although in saying that it must be understood that there are an immense number of constraints on sellers that narrow their pricing options. • A seller cannot choose just any price and cannot raise (or lower) prices without consequences. • There may be a best price from the seller’s point of view but it is very hard for the seller to know what that price is. • A price, in a market economy, does more than indicate the number of units that have to be paid to a seller. The price must reflect scarcity on the one hand and the intensity of demand amongst those who wish to purchase the good or service on the other.

Supply and demand • Supply and demand is the way production and sale is described. • For everything bought there has had to have been a seller and a price. • Where many units are sold to many different people, there are usually many sellers and a large number of units sold. • Supply and demand analysis is the way that production and sale is now discussed within economics.

Supply and demand analysis • Supply and demand has become something of a formalised clichéd expression which refers to the standard explanation given by economists for how prices are set and volumes determined for any single product. • In the standard analysis, we are dealing with a single product because the aim is to work out what will determine the price that is paid and the number of units that will be sold. • One might do this with cars and cameras in a very superficial way but since every model of car or camera may have a different price, this standard approach is clearly meant to be taken as metaphorical, not a genuine description of how prices and volumes sold of generic products, like cars and cameras, are worked out in the real world.

Ceteris paribus • In an actual economy everything is going on at one and the same time. • Within economic analysis the approach is to look at the effects of particular circumstances one by one. • Formally, it is said that all other things being equal the effect of some specific particular circumstance on some event has been such and such. • We know that other things were happening at the same time, but if we wish to look at the effect of one particular cause on outcomes, then we say that all other things being equal, the effect of this event will have these consequences. • The Latin phrase for “all other things being equal” is ceteris paribus which is a phrase often used by economists.

Market • There are literally millions of products sold today and for each one there is a separate market, that is, a separate set of circumstances that determines how many units are produced and the prices that are charged for each unit sold. • The market in general is the process by which all goods and services are sold while particular markets refer to the purchase and sale of individual products. • Because supply and demand relate to the purchase and sale of individual products, there has been probably too much focus given to products on their own when in fact everything is sold jointly with other goods and services so that overheads are spread and shared.

Supply • An invisible barrier whose whereabouts is never known by anyone. • In every market during any period of time there is a maximum amount of each product sellers in total would be willing to sell at each price. • Individual sellers may know how much they would individually be willing to sell but in relation to the market no one can know how many units in total all sellers taken together would be willing to sell at each price • Supply curves as drawn by economists are thus a useful fiction providing information that is never known by any market participant. • Supply curves set out in abstract one of the forces that exists in every market that help to determine how many units of each good or service will be produced and what their prices will be.

Demand • Demand is an invisible barrier whose whereabouts is never known to anyone. • In every market during any period of time there is a maximum amount of each product that buyers in aggregate would be willing to buy at each price. • Individual buyers may know how much they would buy but in relation to the market no one can possibly know how many units all buyers together would be willing to buy. • Demand curves, like the supply curves drawn by economists are a useful fiction providing information never known by any market participant. • Demand curves set out in abstract one of the forces that exists in every market that help to determine how many units will be produced and what the prices of the products sold will be.

Price determination • Goods and services are sold in a market economy at a price that is somehow in some way determined by the forces of supply and demand. • Those with a product to sell make decisions about what price they should charge, the most important constraints typically being their own production costs and the prices being charged by others for similar products. • But into these pricing calculations go many other considerations, both long term and short that are matters of judgment. • Supply and demand is the theoretical answer but since no one setting a price has any idea where these curves are there is more of a trial and error approach to pricing than any kind of science.

Equilibrium • Equilibrium in economics is a condition where all of the forces in play are balanced in such a way that whatever the situation happens to be would be expected to continue into the future without change if there was no outside disturbance to cause change to occur. • But here is the reality. Nothing in an economy is ever in equilibrium. • Equilibrium is a condition never met because no economy nor any part of it is ever in a situation where the factors affecting current conditions are stable. • Economies are always shifting. There is no equilibrium. • The best definition of equilibrium is a condition where all expectations are met. This is obviously a condition that could never exist.

Uncertainty • The absence of sure knowledge about the future is the province in which all economic activity takes place. • Think of someone in a foreign land where they have never been before sitting on a train with their back to the engine. All they know about what’s ahead is based on what they see out the window. • No one knows what’s coming next. • Everyone must make their own economic decisions based on their own best estimates of what is ahead and how best to prepare themselves for what is coming. • But no one can really know so the possibility of error is large and therefore so too is the possibility of large scale loss.

Risk • Because there is uncertainty in the nature of things, there are risks in every decision made. • Since economic activity is about making a single throw of the dice and not about repeatable events, it all falls back to uncertainty. • Given how many facets there are to virtually every economic decision, with so many complex elements that can go wrong with major consequences, the traditional distinction between risk and uncertainty is of little practical value. • In the end, every decision comes with risk because the future is uncertain and therefore outcomes will be different from how they were expected to be.

Economic decision making • At the centre of economic decision making is the recognition that all decisions are made in the present before the consequences of those decisions are known. • And because decisions are made before the consequences are known, those decisions may turn out to be wrong. • Had they known then what they know now, they would not have done what they did. But they didn’t know then what they know now so they made the decision and paid the price. • A market economy is designed around a recognition that decision makers need to take responsibility for their mistakes and with that kind of pressure on are: • less likely to make mistakes • more likely to try to repair what has gone wrong and • Very likely to readjust what they are doing to accommodate the situation as it actually turned out to be.

Marginal analysis (traditional) • The word “marginal” in standard economic theory means “extra” or “additional”. • One makes decisions based on infinitesimal adjustments based on a single unit of some particular measurable return. • The marginal benefit from some decision is the extra or additional benefit that is gained from taking usually a single step in a particular direction. • It is seen as the core of economic decision making where it must again be emphasised, the concept deals with the effect of small adjustments.

Marginal analysis (this course) • Marginal analysis is the core of economic decision making but here we are not talking about incremental change in one variable compared with its effect on some other variable. • Decision making is always done in the present – a decision is made NOW at some particular moment in time. • There is what is already known about the past, or at least what someone thinks they know about the past, which is mixed with the conjectures one has made about the future. • A decision is a step into the dark but with any important decision, usually accompanied by a very deliberate weighing up of all possibilities. • Marginal analysis is the process in which possibilities are weighed up and a conclusion reached.

Marginal revenue • The marginal revenue (MR) is the extra revenue or additional revenue one expects as the result of making a particular decision. • There is all of the other revenues that one might already expect to make. The decision is therefore expected to have some effect on revenues. • The expected effect on revenue is the marginal revenue. It is the effect on revenue that comes from making some decision.

Marginal cost • Nothing in economics comes without cost. When one makes a decision to do something, there are costs involved. • In making some decision, the extra or additional costs that are incurred because of that decision is the marginal cost (MC). It is the negative side of making some decision. • These are the outlays that must be paid that allow the revenues to be eventually earned. • Note that the costs almost inevitably must come before the revenues are earned.

Cost benefit analysis • When decisions are being made on whether or not to undertake some project, a project that might cost millions and take years to complete, the marginal revenue (MR) is compared against the marginal cost (MC). • That is, at the moment the decision is made, the expected additions to revenue are compared with the expected addition to cost. • If the expectation is that there will be a greater addition to revenue than the addition to costs, then the decision to go ahead with the project will be taken. • If, however, the expected addition to costs is greater than the expected addition to revenue, then whatever the project might have been will be rejected.

Profit maximisation • Businesses can only survive if their revenues are greater than their costs. • Since costs must be borne before revenues are earned, decision making must focus on different time horizons, sometimes the immediate present, sometimes the distant future and sometimes somewhere in between. • The actions of a business must be arranged in such a way that bills are paid on time and revenues cover costs so that during some time frame the business has become profitable for its owners. • Profit maximisation cannot be summarised as any particular description of what a business will do. Must be seen as a guiding principle in the management of a business since only if revenues are greater than costs will the firm survive. • Beyond that, so long as costs are being met, the profitability of the firm remains something that will be determined by market outcomes.

MR=MC • You are warned to keep away from the following analysis which argues that profits are maximised where MR=MC. • This is an approach that is exceptionally complex and yet will leave you with almost no understanding of what takes place in business or how decisions are actually made. • This explanation of profit maximisation looks at only a single product but nevertheless describes it as “the theory of the firm”. • It argues that profits are maximised for the sale of this single product when marginal revenue and marginal cost are equal.

Money • Money is the medium of exchange that provides a universal purchasing power. • It is only with varying degrees of difficult that every other form of asset is able to be exchanged. It is exchangeability that makes money crucial. • But money must have another function which is as a store of value. One will only accept money if the purchasing power of the money received remains intact. If the value of the money is unstable, its usefulness diminishes since money is no longer a place where value can be stored. • There is also a third very important role for money which is as a unit of account. People who use a currency are familiar with what it will buy and how difficult or easy a thousand units of the currency are to get.

Relative prices • A price is just a number with almost no meaning in itself. • Prices are related to how difficult it is to get the number of units of currency to pay the price. • But in economics it is relative prices that are of particular importance. • Buyers make judgments on the products they buy and compare how much they have to pay for one product rather than another. • More importantly, it is producers who are able to use relative prices of possible inputs to work out the lowest cost means to produce. • This not only ensures that prices are kept as low but also that production across the economy is driven to its highest efficiency.

Finance • Few firms are able to pay for all of their inputs from revenues already earned. • Virtually all firms depend on finance, which are essentially borrowed savings which come as money in one form or another. • But the actual resources that are used in production must always be kept in mind as the actual reality behind the money borrowed. • It is to secure use of these resources that the money is borrowed.

Credit and debt • Most expenditure in business occurs before revenues are earned. • Business must therefore be built by using the money that has been saved by others to purchase the needed inputs so that production can take place while the cost of inputs, such as the wages paid to labour, is being met. • What is borrowed comes in the form of money, or much more commonly as a credit entry in a financial institution. • The funds borrowed are then used to pay for the resources used during production, which are only available because others have chosen to save.

Interest rates • Interest rates are the price of borrowed money but seen more deeply are the price paid to access national savings available for use in production. • There are two associated concepts that must be kept straight since both are crucial to understand the nature of investment and economic growth: • Money rate • Natural rate

Economic Analysis for Business