Fundamentals of business economics [First edition August 2016] 9781509706310, 9781509706358, 9781509707126, 1509706313, 9781509706327, 1509706321

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Certificate BA1 Fundamentals of Business Economics Our CIMA Course Book offers you:

• Illustrations to follow so that you can see the optimum approach in practice • Quick Quizzes and Topic Summaries to help you integrate and review your learning • All designed to make your student as effective and efficient as possible throughout

Course Book

• A user friendly format for easy navigation • A direct and interactive approach to understanding the technical syllabus content • A range of Activities to develop your application skills and test your understanding as you learn

Fundamentals of Business Economics

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Introduction to the course

Contents Welcome to BA1 Fundamentals of Business Economics Exam Technique Overview

4 10

Syllabus Content 1

Organisations and stakeholders

13

2

Measuring returns to shareholders

29

3

Demand, supply and price

45

4

Price elasticity

65

5

Cost behaviour

83

6

Market failure

101

7

National income

119

8

The trade cycle

139

9

Index numbers

157

10

Government economic policy

175

11

International economics

191

12

International trade

207

13

Functions of the financial system

219

14

Commercial and Central banks

233

15

Financial mathematical techniques

245

16

Impact of interest & exchange rate changes on business performance

269

17

Data and information

281

18

Forecasting

301

Test your learning answers

331

Appendix A: Present Value Tables

341

Bibliography

345

Index

347

3

Welcome to BA1 Fundamentals of Business Economics Description of the paper This subject primarily covers the economic and operating context of business and how the factors of competition, the behaviour of financial markets and government economic policy can influence an organisation. It also deals with the information available to assist management in evaluating and forecasting the behaviour of consumers, markets and the economy in general. The focus of this syllabus is on providing candidates with an understanding of the areas of economic activity relevant to an organisation's decisions and, within this context, the numerical techniques to support such decisions. Syllabus Areas and their weighting Weight

Syllabus topic A. Macroeconomic and Institutional Context of Business

25%

B. Microeconomic and Organisational Context of Business

30% 20%

C. Informational Context of Business D. Financial Context of Business

25% The Objective Test exam

4

Format

Computer Based Assessment

Duration

2 hours

Number of Questions

60

Marking

No partial marking – each question marked correct or incorrect All questions carry the same weighting (ie same marks)

Weighting

As per Syllabus Areas All component learning outcomes will be covered

Question Types

Multiple Choice Multiple Response Number Entry Drag and Drop Hot spot Item Sets

Booking availability

On demand

Results

Immediate

Introduction to the course

Verb Hierarchy

LEVEL

3

LEVEL

2

LEVEL

1

LEARNING OBJECTIVE

VERBS USED

DEFINITION

APPLICATION

Apply

Put to practical use

How you are expected to apply your knowledge

Calculate

Ascertain or reckon mathematically

Demonstrate

Exhibit by practical means

Prepare

Make or get ready for use

Reconcile

Make or prove consistent/compatible

Solve

Find an answer to/prove with certainty

Tabulate

Arrange in a table

LEARNING OBJECTIVE

VERBS USED

DEFINITION

COMPREHENSION

Describe

Communicate the key features of

What you are expected to understand

Distinguish

Highlight the differences between

Explain

Make clear or intelligible/state the meaning or purpose of

Identify

Recognise, establish or select after consideration

Illustrate

Use an example to describe or explain something

LEARNING OBJECTIVE

VERBS USED

DEFINITION

KNOWLEDGE

List

Make a list of

What you are expected to know

State

Express, fully or clearly, the details/facts of

Define

Give the exact meaning of

5

Learning Outcomes A. Macroeconomic and institutional context of business (25%) On completion of their studies, students should be able to: Lead

Component

1. Explain the principal factors that affect the level of a country's national income and the impact of changing economic growth rates and prices on business.

(a) Explain determination of macroeconomic phenomena, including equilibrium national income, growth in national income, price inflation, unemployment, and trade deficits and surpluses

2

(b) Explain the stages of the trade cycle and the consequences of each stage for the policy choices of government

2

(c) Explain the main principles of public finance (i.e. deficit financing, forms of taxation) and macroeconomic policy

2

(d) Describe the impacts on business of potential policy responses of government, to each stage of the trade cycle

2

(e) Calculate indices for price inflation and national income growth using either base or current weights and use indices to deflate a series

3

(a) Explain the concept of the balance of payments and its implications for government policy

2

(b) Identify the main elements of national policy with respect to trade

2

(c) Explain the impacts of exchange rate policies on business

2

(a) Explain the concept of globalisation and the consequences for businesses and national economies

2

(b) Explain the role of major institutions promoting global trade and development

2

(c) Identify the impacts of economic and institutional factors using the PESTEL framework

2

2. Explain the factors affecting the trade of a country with the rest of the World and its impact on business.

3. Explain the influences on economic development of countries and the effects of globalisation on business.

6

Level

Introduction to the course

B. Microeconomic and Organisational Context of Business (30%) On completion of their studies, students should be able to: Lead

Component

1. Distinguish between the economic goals of various stakeholders and organisations.

(a) Distinguish between the goals of profit seeking organisations, not-for-profit organisations and governmental organisations

2

(b) Explain shareholder wealth, the variables affecting shareholder wealth, and its application in management decision making

2

(c) Distinguish between the potential objectives of management, shareholders, and other stakeholders and the effects of these on the behaviour of the firm

2

(a) Identify the equilibrium price in product or factor markets

2

(b) Calculate the price elasticity of demand and the price elasticity of supply

3

(c) Explain the determinants of the price elasticities of demand and supply

2

(d) Calculate the effects of price elasticity of demand on a firm's total revenue curve

3

(a) Identify the influence of costs on the size and structure of the organisation

2

(b) Explain the sources of market failures and the policies available to deal with them

2

2. Demonstrate the determination of prices by market forces and the impact of price changes on revenue from sales.

3. Explain the influence of economic and social considerations on the structure of the organisation and the regulation of markets.

Level

7

C. Informational Context of Business (20%) On completion of their studies, students should be able to: Lead

Component

1. Apply techniques to communicate business data as information to business stakeholders.

(a) Explain the difference between data and information and the characteristics of good information

2

(b) Identify relevant data from graphs, charts and diagrams

2

(a) Describe the principal business applications of big data and analytics

3

(b) Demonstrate the relationship between data variables

3

(c) Demonstrate trends and patterns using an appropriate technique

3

(d) Prepare a trend equation using either graphical means or regression analysis

3

(e) Identify the limitations of forecasting models

2

2. Demonstrate the uses of big data and analytics for understanding the business context.

Level

D. The financial context of business (25%) On completion of their studies, students should be able to: Lead

Component

1. Explain the functions of the main financial markets and institutions in facilitating commerce and development.

(a) Explain the role of various financial assets, markets and institutions in assisting organisations to manage their liquidity position and to provide an economic return to providers of liquidity

2

(b) Explain the role of commercial banks in the process of credit creation and in determining the structure of interest rates and the roles of the 'central bank' in ensuring liquidity

2

(c) Explain the role of the foreign exchange market in facilitating trade and in setting exchange rates

2

8

Level

Introduction to the course

Lead

Component

2. Apply financial mathematical techniques in a business decisionmaking context.

(a) Calculate future values of an investment using both simple and compound interest

3

(b) Calculate the present value of a future cash sum, an annuity and a perpetuity

3

(a) Describe the impact of interest rate changes on market demand and the costs of finance

2

(b) Calculate the impact of exchange rate changes on export and import prices and the value of the assets and liabilities of the business

3

(c) Explain the role of hedging and derivative contracts in managing the impact of changes in interest and exchange rates

2

3. Demonstrate the impact of changes in interest and exchange rates on controlling and measuring business performance.

Level

9

Exam Technique Overview 1

The Best Approach to the CBA You're not likely to have a great deal of 'spare time' during the CBA itself so you must make sure you don't waste a single minute. You should: 1.

Work through the whole exam, answering any questions you think you can answer correctly in a reasonably short time. If you find on occasion that you are not very confident with your answer, click the 'Flag for Review' button before moving on.

2.

Click 'Next' for any that have long scenarios or are very complex and return to these later.

3.

th When you reach the 60 question, use the Review Screen to return to any questions you skipped past or any you flagged for review

Here's how the tools in the exam will help you to do this in a controlled and efficient way: The 'Next' button What does it do? This will move you on to the next question whether or not you have completed the one you are on. When should I use it? Use this to move through the exam on your first pass through if you encounter a question that you suspect is going to take you a long time to answer. The Review Screen (see below) will help you to return to these questions later in the exam. The 'Flag for Review' button What does it do? This button will turn the icon yellow and when you reach the end of the exam questions you will be told that you have flagged specific questions for review. If the exam time runs out before you have reviewed any flagged questions then they will be submitted as they are. When should I use it? Use this when you've answered a question but you're not completely comfortable with your answer. If there is time left at the end then you can quickly come back via the Review Screen (see below) but if time runs out at least it will submit your current answer. Do not use the Flag for Review button too often or you will end up with too long a list to review at the end. Important Note – scientific studies have shown that you are usually best to stick with your first instincts(!) The Review Screen What does it do? This screen appears after you click 'Next' on the 60 question. It shows you any Incomplete Questions and any you have Flagged for Review. It allows you to jump back to specific questions OR work through all your Incomplete Questions OR work through all your Flagged for Review Questions. th

When should I use it? As soon as you've completed your first run through the th exam and reached the 60 question. The very first thing to do is to work through 10

Introduction to the course

all your Incomplete Questions as they will all be marked as incorrect if you don't submit an answer for these in the remaining time. Importantly, this will also help to pick up any questions you thought you'd completed but didn't answer properly (eg you only picked two answer options in a multi-response question that required three answers to be selected). After you've submitted answers for all your Incomplete Questions you should use the Review Screen to work through all the questions you Flagged for Review. 2

The different Objective Test Question Types Passing your CBA is all about demonstrating your understanding of the technical syllabus content. You will find this easier to do if you are comfortable with the different types of Objective Test Questions that you will encounter in the CBA, especially if you have a practised approach to each one. You will find yourself continuously practising these styles of questions throughout your Objective Test programme. This way you will check and reinforce your technical knowledge at the same time as becoming more and more comfortable with your approach to each style of question. Multiple choice Standard multiple choice items provide four options. 1 option is correct and the other 3 are incorrect. Incorrect options will be plausible, so you should expect to have to use detailed, syllabus-specific knowledge to identify the correct answer rather than relying on common sense. Multiple response A multiple response item is the same as a multiple choice question, except more than one response is required. You will be told how many options you need to select. Number entry Number entry (or 'fill in the blank') questions require you to type a short numerical response. You should carefully follow the instructions in the question in terms of how to type your answer – eg the correct number of decimal places Drag and drop Drag and drop questions require you to drag a 'token' onto a pre-defined area. These tokens can be images or text. This type of question is effective at testing the order of events, labelling a diagram or linking events to outcomes. Hot spot These questions require you to identify an area or location on an image by clicking on it. This is commonly used to identify a specific point on a graph or diagram. Item set 2-4 questions all relating to the same short scenario. Each question will be 'standalone', such that your ability to answer subsequent questions in the set does not rely on getting the first one correct. 11

Key to icons

12

Key term

A key definition which is important to be aware of for the assessment

Formula to learn

A formula you will need to learn as it will not be provided in the assessment

Formula provided

A formula which is provided within the assessment and generally available as a popup on screen

Activity

An example which allows you to apply your knowledge to the technique covered in the Course Book. The solution is provided at the end of the chapter

Illustration

A worked example which can be used to review and see how an assessment question could be answered

Assessment focus point

A high priority point for the assessment

Organisations and stakeholders Learning outcomes Having studied this chapter you will be able to: 

distinguish between the goals of profit-seeking organisations, not-for-profit organisations and governmental organisations



distinguish between the potential objectives of management, shareholders and other stakeholders and the effects of these on the behaviour of the firm

Chapter context The main theme of this chapter is that the behaviour of any organisation will depend on its objectives, which in turn depend on the type of organisation that it is. An organisation will also have to recognise and manage any conflicts between the needs of different stakeholder groups.

Syllabus context This chapter is part of syllabus Section B which looks at the 'microeconomic and organisational context of business'. This syllabus area has a weighting of 30% and is covered by Chapters 1-6.

13

Chapter overview Principal/agent problem

Forms of organisations

Manager does not own company may not have same goals as owner eg

Private

Public

Not-forprofit

Profit seeking

Separation of ownership and control

 Satisficing  Maximise sales  Favour their own interests

Not for profit organisations Solutions Types

Financial constraints

 Public and private

 Not paid for by users

 Corporate governance  Link pay with performance

Goals of organisations and their stakeholders

Problems

Stakeholders

Types  Internal  Connected  External

14

Approaches

Corporate governance

Not for profit

Prioritise with Mendelow's matrix

Wide range of stakeholders

Can

Influence

 Appease dominant group  Satisfy as many as possible

 Objectives and goals  Strategies

 One person dominates  Directors not involved in management  Lack of control

How companies are run

Solutions  Separate chairman and chief executive  Independent directors  Independent setting of pay  Non-executive directors

1: Organisations and stakeholders

1 Organisations An organisation has a purpose that goes beyond the personal goals of individuals. It will involve established hierarchies and methods of working that are designed to make sure that goals are achieved. Organisation An organisation is a social arrangement for the controlled performance of collective goals. (NAO Value for money, 2016)

1.1 Public and private sector organisations Organisations

Public sector

Private sector

The public sector consists of the parts of the economy that provide central or local government services and are under the control of government organisations. The private sector consists of the parts of the economy that are not controlled by the government. Sometimes the public and private sector collaborate, this is sometimes referred to as a public-private partnership (PPP) or as a private-finance initiative (PFI).

Activity 1: Idea generation Required Why do we need organisations? Solution

15

1.2 Not-for-profit organisations Organisations Public sector Not-for-profit organisations

Private sector

Not-for-profit organisations

Profit seeking organisations

1.2.1 Public sector and value for money Public sector organisations include public service providers (eg schools, hospitals), state-owned industries, government departments and quangos. Quangos are quas-autonomous non-governmental organisations funded by, but not directly controlled by, the government eg government regulatory bodies. Public sector organisations are likely to have primarily 'not-for-profit' objectives. 'Value for money' is a commonly used framework for not-for-profit objectives: Value for money 

Economy: purchase of inputs of appropriate quality at minimum cost



Efficiency: maximising output from given inputs, or minimising inputs for a given output



Effectiveness – achieving an organisation's objective(s)

The primary objective(s) is likely to be effectiveness; this will often be nonfinancial eg crime clear-up rates for a police force. Economy and efficiency are secondary objectives and will often be financial (eg operating within budget is a possible efficiency measure) although they may also be non-financial (eg arrests per police officer is a possible non-financial efficiency measure for a police force).

16

1: Organisations and stakeholders

Activity 2: Idea generation Required Suggest possible value-for-money objectives for a not-for-profit school. Solution Economy Efficiency Effectiveness

1.2.2 Private sector not-for-profit organisations Not-for-profit organisations exist in the private sector too, for example: (a)

Charities

(b)

Professional bodies (eg CIMA)

(c)

Mutual organisations (eg trade unions) provide services for members using member subscriptions

(d)

Co-operatives are similar to mutual organisations but generally deal in tangible goods and services. Profits are an aim of some co-operatives but they are not normally its primary aim eg a co-operative retailer is owned by its members and primarily aims to deliver good value to its customers.

1.2.3 Financial constraints in not-for-profit organisations The primary objective of not-for-profit organisations is not to generate income. In fact services will often be free for users, meaning demand for services will be high. Not-for-profit organisations will therefore often operate within challenging financial constraints. Although they will be judged on the services that they provide, they must also stay within their budgets.

17

1.3 Profit-seeking organisations Organisations Public sector

Private sector

Not-for-profit organisations

Profit-seeking organisations

The main objective of many private sector organisations is to maximise the wealth of their owners (this is discussed in the next chapter). There are different types of profit-seeking organisations eg (a)

(b)

Unincorporated – the law does not recognise a difference between the business and its owners. (i)

Sole trader – one person in business

(ii)

Partnership – a collection of people working together, sharing the profits and liabilities of a business venture.

Incorporated – Business is legally separate to its owners. (i) (ii)

Private limited company – shares may not be offered to the public Public limited company – shares may be offered to the public.

All of these organisations typically seek to survive, to grow and to make a return for their owners. In this course we are mainly concerned with profit-seeking organisations.

2 Stakeholders Profit-seeking organisations typically exist to maximise their owners' wealth. However, there will be other parties with an interest in an organisation. These are called stakeholders. Stakeholders Stakeholders are people or groups with an interest in an organisation's strategy and activities. Each type of stakeholder will have their own objectives. There are three broad types of stakeholders: internal, connected, external (ICE):

18

1: Organisations and stakeholders

Connected eg Shareholders

Customers

Suppliers

Financiers

Organisation

Internal eg management employees

Community

Government

Pressure groups

External Figure 1.1: Stakeholders Different stakeholders will influence the organisation in different ways. (a)

Some will support management (eg local authority granting planning permission)

(b)

Some will oppose management (eg workers demanding pay rises)

(c)

Some will participate with management (eg shareholders voting on proposals)

19

2.1 Mendelow's matrix Mendelow classified stakeholders on a matrix whose axes are the level of power (or influence) the stakeholder can exert and the degree of interest the stakeholder has in the organisation's activities. These factors will help define the type of relationship the organisation should seek with its stakeholders. Level of interest Low

Low

High

A

B

C

D

Power/influence High

Figure 1.2: Mendelow's matrix (a)

Minimal effort is expended on Segment A. An example might be a contractor's labour force.

(b)

Stakeholders in Segment B do not have great ability to influence strategy, but their views can be important in influencing more powerful stakeholders, perhaps by lobbying. They should therefore be kept informed. Community representatives might fall into Segment B.

(c)

Stakeholders in Segment C must be treated with care. While often passive, they are capable of moving to Segment D. They should, therefore, be kept satisfied. Large institutional shareholders might fall into Segment C.

(d)

Key players are found in Segment D: any strategy the organisation wants to adopt must be acceptable to them, at least. An example would be a major customer. Key stakeholders may participate in decision making.

2.2 Stakeholders and not–for–profit organisations In profit-seeking organisations, the owners will be important stakeholders. In not-forprofit organisations, other stakeholders will be more important.

20

1: Organisations and stakeholders

Activity 3: Idea generation Required Identify three key stakeholder groups for a charity, and what problems might occur if each stakeholder group is dissatisfied. Solution

3 Agency issues In most organisational types that we have outlined there is a separation between the provider of finance (known as the principal) and the management of the organisation (provided by the agents).

3.1 The principal/agent problem Principal-agent problem This occurs where managers (the agents) are managing an organisation to meet their own needs, not the needs of the owner/provider of finance (the principal).

3.2 Management goals other than profit maximisation Although profit-seeking organisations typically exist to maximise the wealth they generate for their shareholders (by maximising profit) alternative management goals can include: (a)

Satisficing – managers will work just hard enough to achieve the minimum level of profit that shareholders will be satisfied with.

(b)

Sales maximisation – Managers believe that running a large company brings better benefits and more prestige (an example of empire-building). This is not always consistent with profit maximisation.

3.3 Principal/agent problem in the public sector The principal/agent problem also exists in the public sector: (a)

Public workers may use government money to pay for high salaries or lavish offices.

21

(b)

The administrators of a charity may focus activities on a part of the charity's work that they are personally interested in.

This type of organisational slack is sometimes referred to as x-inefficiency. Large organisations, especially if public sector, often exhibit x-inefficiency because managers are not maximising the entity's performance but instead are concentrating on achieving their own agenda eg empire building, minimising their workload etc.

Activity 4: Exam standard In which two of the following organisations is the principal/agent problem most likely to be a significant problem? A B C D

A A A A

sole trader partnership quango public limited company

3.4 Resolving the principal/agent problem The principal/agent problem can be addressed by monitoring the actions of management (corporate governance) or by the use of incentive schemes. Corporate governance The systems by which companies are directed and controlled. (CIMA Official Terminology) Here are some of the main requirements for effective corporate governance: Composition of board of directors

Key committees



Separate the roles of CEO & Chairman – to reduce the power of the CEO

Remuneration committee



Minimum 50% independent non-executive directors (NEDs) - to monitor the actions of the executive directors



Pay & incentives of executive directors set by NEDs

Audit committee 

To ensure sound risk management and internal control, staffed by NEDs only

Nomination committee 

Choice of new directors made by NEDs

Commonly used incentive schemes include: (a)

22

Performance related pay – either against profit or a strategic performance measure.

1: Organisations and stakeholders

If incentive schemes are based on profit they can encourage short-term thinking which can in fact damage long-term shareholder wealth. (b)

Share options – options to buy shares in the future (eg three years' time) at today's share price. This should encourage management to take actions to increase the share price (this is discussed in the next chapter). This will benefit the owners of the business. However, if the share prices are low (eg due to economic recession) then this may not be a strong incentive.

Activity 5: Exam standard The following statements have been made about corporate governance. (1)

Sound systems of corporate governance involve the establishment of risk management and internal control procedures for the organisation.

(2)

Good corporate governance requires the organisation to always act in an ethically acceptable manner even if that is contrary to the law.

(3)

Non-executive directors should not be paid for their services to an organisation in order to keep them independent.

Which of these statements is/are correct? A B C D

(1) and (3) only (1), (2) and (3) (1) only (3) only

23

Chapter summary  The economy consists of the private sector and public sector.  Public sector organisations do not seek profits. Private sector organisations may be profit-seeking or not-for-profit.  Not-for-profit organisations aim to achieve 'value for money': economy, efficiency and effectiveness. Because their services are often free they often face severe financial constraints.  Stakeholders can be divided into internal, connected and external groups. The organisation's response to different stakeholder groups can be analysed according to their power (or influence) and their interest.  Stakeholders can influence an organisation through their power to support, oppose or be consulted on its objectives. Organisations must have strategies to deal with these stakeholders.  A separation of ownership from control occurs where the employment of professional managers means the firm is controlled by the managers rather than the owners. This means the firm may be run in the interests of the management instead of in the interests of the owners.  The main ways to resolve the principal/agent problem are improved scrutiny of agents, checks and balances on their power (corporate governance), and appropriate incentives.

24

1: Organisations and stakeholders

Keywords •

Organisation: An organisation is a social arrangement for the controlled performance of collective goals.

•

Value for money – Economy: purchase of inputs of appropriate quality at minimum cost –

Efficiency: maximising output from given inputs, or minimising inputs for a given output

–

Effectiveness: achieving an organisation's objective(s)

•

Stakeholders: Stakeholders are people or groups with an interest in an organisation's strategy and activities.

•

Principal-agent problem: This occurs where managers (the agents) are managing an organisation to meet their own needs, not the needs of the owner/provider of finance (the principal).

•

Corporate governance: The systems by which companies are directed and controlled.

25

Activity answers Activity 1: Idea generation The existence of organisations should enable more to be achieved than if individuals were working on their own, for many reasons, for example: 

Allowing skills and knowledge to be shared



Allowing people to specialise



Pooling and co-ordinating resources



Creating a system of controls to allow performance to be objectively assessed and managed.

Activity 2: Idea generation Example of VFM objectives for a school •

Economy – cost per member of staff, premises cost/square metre

•

Efficiency – teaching days per teacher, teacher/pupil ratios, operating within budget

•

Effectiveness – pass rates, absenteeism.

Activity 3: Idea generation Charity Funding

Services Employees/ Volunteers

Donors

26

End users

–

Contribute cash

–

Accept low/no wages as believe in value of work

–

Charity exists to serve them

–

Will cease to pay if dissatisfied with charity

–

Will leave if dissatisfied

–

If dissatisfied will complain  bad publicity  loss of funding

1: Organisations and stakeholders

Activity 4: Exam standard Answer – C and D A sole trader and a partner are likely to have direct control of the management of the key areas of the business. A quango (quasi-autonomous non-governmental organisation) is financed by the government but is not managed by the government so agency issues could be a significant problem (eg empire-building). A public limited company is financed by shareholders but is not normally managed by shareholders so, again, agency issues could be a significant problem.

Activity 5: Exam standard Answer: C Sound corporate governance does not include breaking the law and non-executive directors can expect to be paid for their services but not in such a way that impairs their independence (eg in shares or share options).

27

Test your learning 1

What does the term 'stakeholders' mean?

2

Which one of the following is not a stakeholder for a mutual organisation? A B C D

3

Which of the following denotes a stakeholder that should be Kept Informed in Mendelow's matrix? A B C D

4

5

Customers Staff Shareholders Directors

High power/low interest High interest/low power Low interest/low power High power/high interest

Which of the following is not a mechanism to improve corporate governance? A

Issue directors with long-term employment contracts to improve their loyalty

B

Separate the roles of Chairman and Chief Executive to avoid the board being dominated by an individual

C

Provide incentives to directors that are based on the value they create for shareholders

D

Employ non-executive directors to provide an independent viewpoint at board meetings

A director of a business division who does not own shares in the business can be termed: A B C D

A principal An agent A non-executive director None of the above

6

What does the term 'unincorporated' mean?

7

Which one of the following describes an organisation that is jointly owned by a state-owned organisation and a profit-seeking organisation? A B C D

28

Quango Mutual Public/private partnership (PPP) Co-operative

Measuring returns to shareholders Learning outcomes Having studied this chapter you will be able to: 

explain shareholder wealth, the variables affecting shareholder wealth and its application in management decision making.

Chapter context The main theme of this chapter is how to evaluate the performance of a profit-seeking organisation, and assess its ability to create wealth for its owners (ie shareholders).

Syllabus context This chapter is part of syllabus Section B which looks at the 'microeconomic and organisational context of business'. This syllabus area has a weighting of 30% and is covered by Chapters 1-6.

29

Chapter overview EPS

ROCE Short term

Profit before finance costs and tax Total assets less current liabilities

Profit after tax and preference dividend Issued equity shares (number)

Measuring returns to shareholders

Value of business

Long term

Value of shares

Discount free cash flows to equity

 Discount free cash flows to firm Required rate

Risk free rate Affected by  Time value of money  Inflation

30

Systematic risk  Risk associated with market sector

Unsystematic risk  Risk associated with company

2: Measuring returns to shareholders

1 Short-term measures of return A profit-seeking company can use ratio analysis to give a snapshot of its shortterm financial performance.

1.1 Return on capital employed (ROCE) Simply measuring profit does not give a good measure of how well a firm is performing because it doesn't consider the amount of long-term finance (capital) that has been invested in the firm. Illustration 1 If a company earns a profit of $10,000 this would be a good performance if $50,000 had been invested in the company (10,000 / 50,000  100 = 20% return) but not if $1 million had been invested (10,000 / 1 million  100 = 1% return). 1.1.1 Measuring capital employed Capital is the total amount of long-term finance committed by investors eg 

Long-term debt finance: eg a long-term loan



Preference shares: these are shares that pay a fixed dividend



Ordinary shares (equity finance): ordinary shareholders are the owners of the company; these shares do not pay a fixed dividend. The dividend they pay can vary from year to year.

Return on capital employed (ROCE) measures a company's current success by relating the amount of profit to the value of the resources employed in generating it. This reflects the efficiency with which the resources have been used. Formula to learn ROCE = Profit before interest and tax % Long-term debt plus equity Profit before interest and tax is sometimes called 'operating profit' Alternatively, capital can be measured in terms of how the long-term finance has been invested ie the assets that have been purchased (net of any short-term liabilities). Assets can include non-current assets (ie long-term) such as land and buildings, or current assets (ie short-term) such as inventory or trade receivables. Formula to learn ROCE = Profit before interest and tax % Total assets – current liabilites The figure for capital employed is normally averaged out between the beginning and the end of the year. However, the ROCE calculation can also be 31

based solely on the value of capital employed at the end of the year, so you will have to read the question to see how to perform the calculation.

Activity 1: Exam standard Strontium Lining Co has the following results.

Operating profit Interest paid (finance costs) Taxation Profits after tax

Non-current assets Current assets

Equity Non-current liabilities Current liabilities

20Y6 $'000 15,000 (2,000) 13,000 (4,000) 9,000

20Y5 $'000 12,000 (2,000) 10,000 (3,000) 7,000

220Y6 $'000 60,000 50,000 110,000

20Y5 $'000 50,000 48,000 98,000

50,000 30,000 30,000 110,000

50,000 25,000 23,000 98,000

Required Calculate ROCE (i)

for both years based on closing capital employed in each year

(ii)

for 20Y6 based on average capital employed

Solution

32

2: Measuring returns to shareholders

1.2 Earnings per share (EPS) EPS shows the maximum dividend that could be paid to the owners of the business (ie the ordinary or equity shareholders) out of that year's profit after all payments have been made to other providers of finance (eg banks and preference shareholders). Formula to learn EPS =

Profit after interest, tax and preference dividend Number of issued equity shares

EPS shows the return earned by the ordinary shareholders only, unlike ROCE which considers the return generated to all the investors including those who have just lent money to the company (eg banks).

Activity 2: Exam standard Zani Co has the following results. Operating profit Interest paid (finance charges) Taxation Profits after tax Dividends payable* Retained earnings Issued share capital (shares of $1)

$'000 100,000 (10,000) 90,000 (26,000) 64,000 (30,000) 34,000 100 million

* Includes preference dividend of $10 million Required Calculate earnings per share (EPS). Solution

1.3 Analysing short-term returns to shareholders Profit-based measures such as ROCE or EPS show short-term financial performance, but they do not show whether the level of returns being achieved is acceptable to the owners of the business (ie ordinary shareholders). 33

1.3.1 Measuring the return expected by shareholders Investors can invest their money in ways that eliminate risk eg in short-term government debt (assuming the government has a good credit rating!), or in a bank account (which may be guaranteed by the government up to a certain limit). The rate of return that is available on risk-free investments will be low, and is often referred to as the risk-free rate. Ordinary shareholders will expect a rate of return above the risk-free rate because of the high risks associated with owning shares. Risks can be classified as: (a)

Systematic risk – the risk associated with a particular market sector eg car industry – if there is a recession then all car manufacturers will be heavily affected because buying a new car is not a necessity.

(b)

Unsystematic risk – the risk associated with a specific company because of factors unique to it eg a product recall by a specific car manufacturer. Shareholders can reduce their exposure to this type of risk by investing in a number of different companies (ie by building an investment portfolio). The rate of return that shareholders expect will increase as the level of risk (especially systematic risk) increases.

Activity 3: Idea generation 10% Return

8% 6%

x

y

Risk

The risk and return of companies A (risk = x, return = 8%) and B are illustrated in the risk-return diagram shown above. Required What factors may explain this data? Solution

34

2: Measuring returns to shareholders

1.3.2 Assessing if return is acceptable The return expected by shareholders is sometimes referred to as the cost of equity. This can be used to assess whether the level of return (ie profit) that has been achieved is acceptable to shareholders. Illustration 2 Zani Co has the following results

$'000 Operating profit

100,000

Finance charges

(10,000) 90,000

Taxation

(26,000)

Profits after tax

64,000

Dividends payable

(including $10m preference dividend)

Retained earnings

(30,000) 34,000

Zani has $100 million of equity capital and $100 million of retained earnings (including the $34 million from the current year as shown above). Zani's shareholders expect a return of 10%. Required Assess whether Zani Co is producing an adequate short-term return to shareholders. Solution Profit after tax = $64 million. This belongs to ordinary shareholders. Zani's shareholders expect a return of 10% on their equity investment of $200 million (share capital + retained earnings) ie 200 x 0.1 = $20 million. Profits after tax are greater than $20 million so Zani is producing an adequate short-term return to its shareholders.

2 Long-run measures of return The usual assumption is that companies are trying to maximise the wealth of their shareholders by making a profit. However, for a company whose shares are traded on a stock market the critical issue for shareholders is the movement in the share price. The value of shares depends on a company's future cash flow potential, not just its current profitability.

35

2.1 Discounting future cash flows When valuing a share on the basis of future cash flows we need to recognise that money expected to be received in the future is worth less than money received today. This is because investors prefer to receive money sooner rather than later. So the value of a company's future cash flows will need to be adjusted to reflect this time value of money; this process is called discounting. This is introduced below but is dealt with in more detail in Chapter 15. 2.1.1 Discounting free cash flows to equity Free cash flows to equity The cash flows generated by a business in a particular year after interest and tax and investment spending. Free cash flows to equity are available either to pay as a dividend or to keep within a business – either way this cash is a benefit to ordinary (equity) shareholders. Illustration 3 Normington Co is predicted to generate the following free cash flows to equity.

Year 1 $50 million

Year 2 $55 million

Year 3 $94 million

There are 50 million shares and shareholder's required rate of return is 10%; this is to reflect the time value of money and indicates the rate at which future cash flows are to be discounted. The discounted, or present, value of the cash flows in year 1 can be calculated as $50m / 1.1 = $45.5m. This means that shareholders are indifferent between receiving $45.5m now or $50m in 1 year. On the same basis the cash flows for year 2 and 3 can be valued as:

$55m /1.12

$45.5m

$94m /1.13

$70.6m

Total value = $45.5m + $45.5m + $70.6m = $161.6m Price per share = $161.6m / 50m = $3.23

36

2: Measuring returns to shareholders

2.1.2 Discounting free cash flows to the firm Free cash flows to the firm The cash flows generated by a business in a particular year after tax and investment spending (but before interest). Free cash flows to the firm are available to pay to all investors, whether shareholders or providers of debt finance. Illustration 4 Normington Co (above) has a $20m three-year loan costing 10%. Repayments on this loan are $2m in year 1, $2m in year 2 and $22m (capital plus interest) in year 3. Normington is predicted to make the following free cash flows to the firm.

Year 1 $52 million

Year 2 $57 million

Year 3 $116 million

There are 50 million shares and the overall cost of capital is 10%. The discounted value of the cash flows in year 1 can be calculated as $52m / 1.1 = $47.3m. On the same basis the cash flows for year 2 and 3 can be valued as:

$57m /1.12

$47.1m

$116m /1.13

$87.2m

Total value = $47.3m + $47.1m + $87.2m = $181.6m This is the value of the cash flows to all investors (debt or equity); the value of debt therefore needs to be subtracted to obtain the value of equity. Value of equity = $181.6m - $20m = $161.6m Price per share = $161.6m / 50m = $3.23 (as before) 2.1.3 Discounting free cash flows to perpetuity If you are asked to calculate the present value of a constant cash flow that is expected for the foreseeable future, this is called a perpetuity. Formula to learn Present value to perpetuity =

Cash flow Cost of capital

37

Activity 4: Exam standard Gerrard Co is predicted to generate free cash flows of $50m per year for the foreseeable future. These cash flows are before finance costs. Gerrard Co's cost of equity is 8%; this is the same as its overall cost of capital. There are 100m ordinary shares in issue. Gerrard has $50m of debt finance costing 8% pa. Required Calculate Gerrard Co's share price using: (i) (ii)

the free cash flows to equity the free cash flows to the firm

Solution

2.1.4 Increasing shareholder wealth The value of the company's shares directly influences shareholder wealth. Although future cash flows will partly depend on the state of the economy, management also have the ability over the long run to affect these cash flows and therefore to increase the share price. Over the long run it is the ability of the management team to increase the share price that will be of most importance to shareholders.

38

2: Measuring returns to shareholders

Activity 5: Idea generation Required What types of actions can management take to increase the share price? Solution

39

Chapter summary  Investors invest in companies by buying their shares. The companies are expected to maximise the wealth of their shareholders by generating profit from trading operations. Investors will only provide funds if they believe that the prospective returns from investing in a company are adequate.  Shareholders need objective measures of company performance if they are to make sensible investment decisions. Short-term measures include ROCE and EPS.  Before deciding whether to buy, hold or sell shares in a firm the investor will consider whether the returns from the firm are adequate to compensate them for the risks of investing in the firm. The minimum rate of return that is acceptable to shareholders is called the required rate.  An increase in forecast dividends or free cash flows will lead to an increase in current market price, as will a reduction in the cost of equity.

40

2: Measuring returns to shareholders

Keywords 

Free cash flows to equity: The cash flows generated by a business in a particular year after interest and tax and investment spending.



Free cash flows to the firm: The cash flows generated by a business in a particular year after tax and investment spending (but before interest).

41

Activity answers Activity 1: Exam standard (i) Profit before finance costs and tax Long - term debt plus equity

20Y6 15,000 30,000  50,000

20Y5 12,000 25,000  50,000

15,000 80,000

12,000 75,000

18.75%

16%

Alternatively, capital employed can also be calculated as total assets – current liabilities Profit before finance costs and tax Total assets – current liabilitie s

20Y6 15,000 110,000 – 30,000

20Y5 12,000 98,000 – 23,000

15,000 80,000

12,000 75,000

18.75%

16%

(ii) Average capital employed in 20Y6 = (closing year 20Y5 value + closing year 20Y6)/ 2 SO average capital employed in 20Y6 = (75,000 + 80,000) / 2 = 77,500

Profit before finance costs and tax Long - term debt plus equity

20Y6 15,000 77,500

19.35%

Activity 2: Exam standard 64,000 – 10,000 100,000

54c per share

42

2: Measuring returns to shareholders

Activity 3: Idea generation The risk-free rate of 6% seems quite high; this may be explained by:  

the rate of inflation in the economy the credit rating of the country's government

Investing in X carries some risk, so shareholders will want a higher return of 8% ie 2% above the risk-free rate. Y is riskier so shareholders expect a higher return of 10%. This may be due to Y operating in a riskier sector of the economy that will be more volatile in the event of an economic slowdown eg car manufacturing compared to low-cost airlines.

Activity 4: Exam standard (i)

Free cash flows to equity (after finance costs) are $50m – $4m = $46m. The discounted value (or present value) of the cash flows is $46m / 0.08 = $575m. $575m / 100m shares = $5.75 per share.

(ii)

Free cash flows to firm (before finance costs) are $50m. The discounted value (or present value) of the cash flows is $50m / 0.08 = $625m. This is the value of the company to all its investors – so then subtracting the debt of $50m leaves a value of equity of $575m or $5.75 per share.

Activity 5: Idea generation The share price will be strongly influenced by expectations of the discounted value (present value) of the company's future cash flows. The present value of future cash flows may be expected to rise if management is investing in attractive projects (more on this in Chapter 15). The share price will also rise if the cost of capital falls – this may happen if managers can take action to reduce the risk associated with the company, eg reducing the level of debt. Other factors may also impact on the share price that are outside management control, eg confidence in wider economy, actions of competitors.

43

Test your learning 1

How do shares give wealth to shareholders? A B C D

2

By By By By

paying annual dividends only rising in price only a combination of annual dividends and share price rises entitling the shareholder to votes

Which of the following, in theory, determines the price of a share? A

It will be the same as its EPS

B

It will be the same as the price it was sold at when the share was issued

C

The discounted present value of the expected future earnings of the firm divided by the number of shares in issue

D

The value of this year's dividend

3

What is the name given to the risks of investing in the shares of firms from a particular industrial sector?

4

What is the formula for return on capital employed?

5

What is the formula for earnings per share?

6

Which of the following best describes the risk-free rate?

7

A

The rate of interest on a loan

B

The rate of dividend on a preference share

C

The minimum return that a shareholder will accept on a company's shares

D

The minimum return a shareholder will accept to compensate for tying their money up and suffering loss of value due to inflation.

The present value of Megalith's forecast future cash flows is now $267 million. What will happen to this value if Megalith plc's cost of equity rises? A B C D

8

It It It It

will rise will fall will remain the same is impossible to say

What is the name of the process through which future income streams are given a present value?

44

Demand, supply and price Learning outcomes Having studied this chapter you will be able to: 

identify the equilibrium price in a product or factor market

Chapter context This chapter is a key topic because demand and supply analysis can be applied to many areas of economics. A good understanding of this chapter is required before progressing through the remainder of the course.

Syllabus context This chapter is part of syllabus Section B which looks at the 'microeconomic and organisational context of business'. This syllabus area has a weighting of 30% and is covered by Chapters 1-6.

45

Chapter overview Price determination

Functions

Market

 Allocate  Signal  Reward

Demand

Law of demand

Price ↑ Demand ↓

Supply

Conditions of demand     

Income Substitutes Complements Tastes Expectations

Law of supply

Conditions of supply  Costs of production  Availability of resources  Taxes/subsidies  Substitutes  Complements  Climate

Price ↑ Supply ↑

Interaction of demand and supply  Supply > demand = surplus Price too high  Price falls  Supply falls  Demand increases

46

Price too low

Equilibrium

 Demand > supply = shortage  Price rises  Supply increases  Demand falls

3: Demand, supply and price

1 Introduction – nature of a market A market consists of all of the buyers and sellers of a good or service, or a factor of production (a resource required for production to take place eg labour, land). The price and output decisions of a firm will be affected by market forces ie the behaviour of consumers (see Section 2) and suppliers (see Section 3).

2 Demand Demand is the amount (quantity) which consumers are willing and able to purchase of a certain good at a given market price over a certain time period. The law of demand As the price of a good falls, all other things being equal, the quantity demanded of that good increases. The Law of demand can be illustrated as a demand curve. Illustration 1 Demand curve Price contraction $20,000 $15,000 extension

$10,000 $5,000

Demand curve 10

20

30

40

Quantity units/time

As an example, the diagram shows the demand for Mini cars. • • • •

If If If If

the the the the

price price price price

is is is is

$20,000/unit $15,000/unit $10,000/unit $5,000/unit :

: demand is 10,000 pa : demand is 20,000 pa : demand is 30,000 pa demand is 40,000 pa

The demand curve slopes downwards from left to right, reflecting an inverse relationship between price and quantity. (a) Extension (or expansion) of demand: increase in quantity demanded because price has fallen. Shown by a rightward movement along the existing curve. (b) Contraction of demand: decrease in quantity demanded because price has risen. Shown by a leftward movement along the curve.

47

2.1 Explanation Consumers seek to maximise total satisfaction (utility) derived from scarce resources (disposable income). A fall in price increases the value for money of the product because it increases the satisfaction per $ spent upon it compared to that available from other goods (assuming the prices of those goods are unchanged). The demand for the good whose price has fallen will increase, with demand for other goods falling. This is called the substitution effect.

2.2 Conditions of demand A demand curve is drawn on the assumption of 'all other things being equal' ie on the assumption that, apart from price, no other potential influences on demand change in the current time period. However, there are other factors which can influence demand, and these are sometimes called the conditions of demand. Here are some examples: (a)

Level of disposable income (income after tax) (i)

A normal good is one where buyers buy more as their income increases.

(ii)

An inferior good is one where buyers buy less as their income increases.

(b)

Price of substitutes (two or more goods that satisfy the same need)

(c)

Price of complements (two or more goods that are consumed together)

(d)

The pattern of tastes and preferences for the product

(e)

Market expectations of future changes in the price of the good (or shortages of it)

If there is a change in the conditions of demand then the demand curve will shift to the left or right. Illustration (Mini cars continued) Price $20,000

Shift (rise) in demand

$15,000 $10,000 $5,000 D0 10

20

30

40

D1

Quantity units/time (000s)

The demand curve has shifted outwards (from D0 to D1). This could be caused by, for example, an increase in consumers' disposable income

48

3: Demand, supply and price

Activity 1: Exam standard Required Explain how each of the following conditions of demand might lead the demand curve for Mini cars to shift to the left (inwards)? Solution (a)

Price of substitutes

(b)

Price of complements

(c)

Pattern of tastes and preferences

(d)

Market expectations

Remember: a change in price will lead to a movement along the demand curve. A change in any of the conditions of demand will lead to a shift in the demand curve.

3 Supply Supply is the amount (quantity) which firms are willing and able to supply to the market at a given market price over a certain time period. The law of supply 'as the price of a good rises, all other things being equal, the quantity supplied of that good increases'. The relationship between price and quantity supplied can be illustrated as a supply curve; this shows the minimum prices necessary to encourage firms to supply a given quantity of a product or service.

49

Illustration 2 Supply curve Price

Supply curve

$20,000 $15,000 $10,000 $5,000

10

20

30

Quantity units/time (000s)

40

The diagram shows the supply of Mini cars. Price/unit ($)

Quantity supplied (No. of Minis pa)

5,000

10,000

10,000

20,000

15,000

30,000

20,000

40,000

A supply curve can represent a single firm (as here) or the whole market. The supply curve slopes upwards from left to right, reflecting a direct relationship between price and quantity (ie as price rises, quantity supplied rises). (a)

Extension of supply: increase in quantity supplied because price has risen. Shown by a rightward movement along the existing curve.

(b)

Contraction of supply: decrease in quantity supplied because price has fallen. Shown by a leftward movement along the existing curve. Price $20,000

Supply curve contraction

$15,000 extension

$10,000 $5,000 10

50

20

30

40

Quantity units/time

3: Demand, supply and price

3.1 Explanation Profit is the difference between total revenue and total cost. A rise in market price, all other things being equal, increases the profit available from the product and so firms will want to produce more of it ie they will supply more of the product whose price has increased, by transferring more resources into making that product instead of making alternative products whose prices have stayed constant.

3.2 Conditions of supply A supply curve is drawn on the assumption of 'all other things being equal', ie that, apart from price, no other influences on supply are changing. However, there could be other influences on supply and these are sometimes called the conditions of supply. Here are some examples: (a)

The costs of production (eg cost of labour)

(b)

The availability of productive resources (affects amount available)

(c)

Level of indirect taxes (eg a tax on the supply of petrol) or subsidies

(d)

Prices of substitutes in production (alternative products which the firm could produce)

(e)

Prices of complements in production: where goods are by-products of each other (eg sheep milk and wool)

If there is a change in the conditions of supply then the supply curve will shift to the left or right. Price S

0

$20,000

S

1

Increase in supply

$15,000 $10,000 $5,000

10

20

30

40

Quantity units/time (000s)

The supply curve has shifted outwards, from S0 to S1. This could be caused by, for example, a fall in production costs.

51

Activity 2: Exam standard Required Forecast the effect of the following factors on the supply curve of wheat in Europe. (a)

A poor growing season

(b)

A rise in the cost of farm labour

(c)

A rise in the price available for oats (an alternative crop)

(d)

Government scheme to pay $1 per tonne subsidy to wheat farmers

Solution

Remember – a change in price will lead to a movement along the supply curve. A change in any of the conditions of supply will lead to a shift in the supply curve.

4 Equilibrium price Equilibrium price The price at which quantity demanded and quantity supplied will be equal, and which will be restored by market forces following any changes in the conditions of either supply or demand.

52

3: Demand, supply and price

Illustration 3 Mini cars continued from illustration 1 and 2

Price $ Supply curve

12,500

Demand curve

25

Quantity units/time (000s)

4.1 Movement to equilibrium The market mechanism operates to remove situations of disequilibrium: (a)

Shortage: where quantity demanded exceeds quantity supplied at the prevailing market price (ie there is excess demand).

(b)

Surplus: where quantity supplied exceeds quantity demanded at the prevailing market price (ie there is excess supply).

Activity 3: Preparation question Required The dotted lines on the diagrams below show the point where supply and demand for Minis are in equilibrium. Illustrate the following on the diagrams. (a)

A situation of surplus at $20,000 where too many Minis are being produced relative to the demand for them.

(b)

A situation of shortage at $5,000 where demand exceeds supply.

Also discuss how the surplus and shortage are removed.

53

Solution (a)

Quantity pa (000s)

(b)

Quantity pa (000s)

4.1.1 Removal of a shortage Where demand is above supply, consumers will find it hard to find supplies of the product. Firms will see a rise in sales. As a result firms will increase prices and extend supply by transferring resources to this product to get higher profits. As price rises, demand contracts as consumers find substitutes giving better value for money. This will continue until the shortage is eliminated. 4.1.2 Removal of a surplus Where supply is above demand, firms will see a rise in unsold products (inventory). As a result firms will cut prices and supply. As price falls, demand extends as consumers are attracted by the fall in price.

54

3: Demand, supply and price

4.2 Functions of the price mechanism The role of the price of the product in removing shortages and surpluses is sometimes referred to as the price mechanism. The price mechanism has three functions: (a)

Signalling to producers where supply is too low (shortages) or too high (surpluses).

(b)

Rationing and allocating the resources of a firm to produce those goods that are in high demand.

(c)

Rewarding firms for meeting consumer needs.

Activity 4: Exam standard Required Predict the effect of the following on the price and quantity bought and sold of chocolate biscuits using sketched diagrams to help you. Solution (a)

Rise in the price of custard cream biscuits (take custard creams as a substitute in consumption, not production)

(b)

Rise in price of instant coffee, a complement in consumption

55

(c)

56

Increase in the price of cocoa beans, a key ingredient in chocolate biscuits.

3: Demand, supply and price

Chapter summary  As price falls, quantity demanded of a good or a factor of production (eg labour) increases and quantity supplied decreases.  A change in price results in a contraction or extension along the demand and supply curve.  A change in other factors will result in a shift of the demand and supply curve.  The equilibrium price is the price at which the quantity demanded and supplied will be equal. • The competitive market process results in an equilibrium price, which is the price at which market supply and market demand quantities are in balance. In any market, the equilibrium price will change if market demand or supply conditions change. • The three functions of the price mechanism are to signal where there are shortages or surpluses, to ration scarce supply amongst potential buyers, and to reward firms and households for alleviating shortages or surpluses. • The effects of demand and supply conditions on markets can be analysed by studying the behaviour of both demand and supply curves.

57

Keywords 

The law of demand: As the price of a good falls, all other things being equal, the quantity demanded of that good increases.



The law of supply: 'As the price of a good rises, all other things being equal, the quantity supplied of that good increases'.



Equilibrium price: The price at which quantity demanded and quantity supplied will be equal, and which will be restored by market forces following any changes in the conditions of either supply or demand.

58

3: Demand, supply and price

Activity answers Activity 1: Exam standard A shift to the left represents a fall in demand. (a)

Price of substitutes: fall in price of another compact saloon (eg Beetle) making the alternative relatively more attractive than a Mini

(b)

Price of complements: rise in insurance premiums on Minis

(c)

Tastes and preferences: Minis cease to be fashionable

(d)

Expectations: Mini prices expected to fall due to more competition between dealers. (Therefore, rather than buying a Mini now, a consumer will wait and buy one at a later date once the price is lower).

Activity 2: Exam standard (a)

Fall in supply (less available) – supply curve shifts to the left

(b)

Fall in supply (as labour costs rise, the amount of profit farmers can make from selling at any given price will fall) – supply curve shifts to the left

(c)

Fall in supply (produce oats instead of wheat) – supply curve shifts to the left

(d)

Rise in supply (more produced to get more subsidy) – supply curve shifts to the right

Activity 3: Preparation question (a) Price per unit $'000

S

Surplus

20 15 12.5 10 5 D 10

20

25

30

40

50 Quantity ('000s) per annum

At $20,000

S = 40,000 } D = 10,000 } so surplus = 30,000 Minis 59

Suppliers find that inventories cannot be cleared. –

The only way to clear the surplus is for firms to lower price (the price mechanism has signalled to them that the $20,000 price is too high).

–

As price is lowered, demand extends owing to the law of demand, and supply contracts owing to the law of supply. (ie firm reduces production of Minis, so fewer resources are allocated to production of Minis)

–

This process of price reduction continues until all that is produced is sold – the equilibrium price of $12,500 is arrived at.

–

The new price of $12,500 per unit is the reward given to the resources: some pays the labour, some goes towards rent, some goes on profit to the entrepreneur and so on.

(b) Price per unit $'000

S

20 15 12.5 10 5 D

Shortage

10

20

25

30

40

50 Quantity ('000s) per annum

At $5,000

60

S = 10,000 } D = 40,000 } so shortage = 30,000 minis

–

Consumers willing to pay more to purchase desired good, so price rises.

–

Suppliers increase supply (the price mechanism has signalled to them that more profits are available).

–

As price rises, demand contracts due to the law of demand, and supply increases due to the law of supply (more resources are allocated to the production of Minis).

–

This process of price increase continues until all that is produced is sold.

–

Equilibrium price of $12,500 is arrived at.

3: Demand, supply and price

Activity 4: Exam standard (a)

P S

F P1 P0 E D1 D Q Q 0 Q1 Custard creams are a substitute for chocolate biscuits and therefore there will be a rise in demand for chocolate biscuits. The diagram above describes the chocolate biscuit market where equilibrium is initially at point E with price at P0 and quantity supplied and demanded at Q0. The rise in the price of custard creams makes chocolate biscuits relatively better value for money and so the demand curve shifts from D to D1. A new equilibrium will be restored at F with price at P1 and quantity supplied and demanded at Q1. (b)

Instant coffee is a complement to chocolate biscuits. A rise in the price of instant coffee will cause demand for coffee to contract and, to some extent, the demand for chocolate biscuits to fall. P S P0

E

P1 F D D1 Q Q1 Q0

The chocolate biscuit market is initially in equilibrium at E. The rise in coffee prices causes demand for chocolate biscuits to fall from D to D1. A new equilibrium will be found at price P1 and quantity Q1 – point F on the diagram.

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(c)

An increase in cocoa bean prices is a rise in the costs of production and will cause the supply curve for chocolate biscuits to shift to the left. S1 P S F P1 E

P0

D Q Q1 Q0

The initial equilibrium is Q0 P0 at point E. As the increase in the price of cocoa shifts the supply curve to the left, the new equilibrium will now be at F (Q1 P1).

62

3: Demand, supply and price

Test your learning 1

What factors influence demand for a good?

2

What are (a) substitutes and (b) complements?

3

What factors affect the quantity of a good supplied?

4

What is meant by equilibrium price?

5

A demand curve is drawn on all except which of the following assumptions? A B C D

Incomes do not change. Prices of substitutes are fixed. Price of the good is constant. There are no changes in tastes and preferences.

63

64

Price elasticity Learning outcomes Having studied this chapter you will be able to: 

calculate the price elasticity of demand and the price elasticity of supply



explain the determinants of price elasticity of demand and supply



calculate the effects of price elasticity of demand on a firm's total revenue following a change in prices

Chapter context When managers make decisions about price and output they must consider how responsive demand will be to changes in price. With some products, customers will be extremely sensitive to price changes so a small price increase may lead to a significant fall in sales volume. With other products, customers will not be particularly bothered about price changes so a relatively large price increase may only lead to a relatively small drop in sales volume. We call the degree of sensitivity to changes in price 'elasticity' and this chapter shows how we can measure it and understand what affects it.

Syllabus context This chapter is part of syllabus Section B which looks at the 'microeconomic and organisational context of business'. This syllabus area has a weighting of 30% and is covered by Chapters 1-6.

65

Chapter overview Elasticity

Price elasticity of demand

Calculation % change in quantity demanded % change in price

Interpretation

66

Consider    

Substitutes Brand loyalty Status Proportion of spending  Time

Price elasticity of supply

Calculation % change in quantity supplied % change in price

Consider  Time  Substitutes in production  Cost of increasing/ reducing workforce  Excess capacity  Barriers to entry Interpretation

4: Price elasticity

1 Price elasticity of demand (PED) To help an organisation make its pricing decisions, it can be useful to measure the likely responsiveness of demand to a change in price; this is referred to as price elasticity of demand. Formula to learn Price Elasticity of Demand =

% change in quantity demanded % change in price

An understanding of price elasticity of demand can also help with production decisions: to help a firm predict the change in demand for a product if its price changes.

1.1 Calculation of price elasticity of demand Price elasticity of demand can be calculated in two slightly different ways, but both are based on the formula above: 

Simple point method



Average (midpoint) method

1.1.1 Simple point method This measures the responsiveness of demand compared to the starting or initial demand and price. Formula to learn – simple point method

New demand – Initial demand  100 Initial demand New price – Initial price  100 Initial price

Illustration 1 Company X has decreased the price of daily ski passes from $105 to $100. As a result, demand has risen from 12,000 to 15,000. Elasticity of demand is therefore: 15,000 –12,000 100 12,000 100 –105 100 105 =

25 = 5.2 –4.8

67

Note. Although, mathematically, price elasticity of demand is usually a negative number, the minus sign tends to be ignored. So, in this case, although mathematically PED = –5.2, it would be more common just to say that PED = 5.2.

Activity 1: Exam standard Required The figures below show how demand for Goods A and B has changed following changes to their prices. Calculate price elasticity of demand (PED) for Good A and Good B, to one decimal place. Good A Before After

Price 60c 50c

Good B Quantity 150 170

Price $2.99 $3.20

Quantity 500 440

Solution Simple method

PEDA=

PEDB=

1.1.2 Drawback of simple point method A problem with the simple (point) method is that the value of price elasticity of demand depends on the starting point. Illustration 2 Let's look at Company X from the previous illustration again, and imagine that it has increased the price of daily ski passes from $100 to $105. In response to this change, demand falls from 15,000 to 12,000. The simple point method of calculating price elasticity of demand, which we had previously calculated as 5.2 using the same data now becomes: 12,000 –15,000 100 15,000 –20 = 4.0 = 5 105 –100 100 100

68

4: Price elasticity

So the management of Company X would have a different assessment of price elasticity of demand (4.0 vs 5.2) depending on the starting point for this analysis. This does not seem sensible. The alternative method of calculating price elasticity of demand, the average or midpoint method, removes this problem. 1.1.3 Average (midpoint) method The average (midpoint) method: measures the responsiveness of demand compared to the average demand and price. Formula to learn – average method

New demand – Initial demand 100 Average demand New price – Initial price 100 Average price

Illustration 3 Company X has increased the price of daily ski passes from $100 to $105. Demand falls from 15,000 to 12,000. Average price is (100+105)/2 = $102.5. Average demand is (12,000+15,000)/2 = 13,500. Elasticity of demand is therefore: 12,000 –15,000 ×100 –22.2 13,500 = 4.5 (ignoring the negative sign) = 105–100 4.9 ×100 102.5 Note that with this method the answer is the same whether starting from a price of $100 and increasing it to $105, or starting from $105 and decreasing it to $100.

Activity 2: Exam standard Required Calculate the price elasticity of demand for Goods A and B, using the midpoint (average) method. Give your answer to one decimal place. Good A Before After

Price 60c 50c

Good B Quantity 150 170

Price $2.99 $3.20

Quantity 500 440

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Solution Midpoint method

PEDA=

PEDB=

1.1.4 In the exam The midpoint (average) method is the preferred method for the exam. However, the simple method may be required if questions ask you to predict a change in price or quantity demanded. Illustration 4 If we look at Company X again and imagine that you have been told that the price elasticity of demand is –4.0. You may be asked to assess the impact on demand if the price rises from $100 to $105 and demand is currently 15,000. It would be too complex to apply the mid-point method here so the simple method can be used. If price has risen by 5% then, if the price elasticity of demand is –4.0, demand must fall by 4  5% = 20%. So 15,000  (1 – 0.2) = 12,000

2 Interpreting price elasticity of demand 2.1 Value greater than 1: elastic demand Elastic demand If price elasticity of demand (ignoring the minus sign) is greater than 1 this means that the % change in demand is greater than the % change in price. Demand is said to be price elastic; ie responsive to price changes. When demand is elastic, companies will experience:  

70

A rise in revenue if prices are cut, and A fall in revenue if prices are increased.

4: Price elasticity

Illustration 5 When Company X decreased the price of daily ski passes from $105 to $100, demand rose from 12,000 to 15,000. Elasticity of demand was above 1 (by either method). Demand for ski passes is price elastic. Because demand has risen at a faster rate than price has fallen, Company X will experience a rise in revenue if it cuts price (or a fall in revenue if it increases price). At a price of $105: revenue = $105  12,000 = $1.26 million At a price of $100: revenue = $100  15,000 = $1.50 million Note: We are only looking at the impact on revenue here. This does not necessarily mean that Company X's profits would rise, because higher output would mean higher costs. The value of elasticity is affected by the slope of the demand curve for a product. Higher values of price elasticity of demand will result from a flatter demand curve. Price

D

Quantity demanded

Activity 3: Exam standard The data below shows the price elasticity of demand for Good C (using the simple method) and the data used to calculate these values.

Before

Good C Price elasticity of demand = 2 Price Quantity $200 500

Required How much will the revenue of Good C change by (in $s) if a price cut of 10% is implemented?

71

Solution

2.2 Value less than 1: inelastic demand Inelastic demand If price elasticity of demand (ignoring the minus sign) is less than 1 this means that the % change in demand is less than the % change in price. Demand is said to be price inelastic; ie unresponsive to price changes. When demand is price inelastic, companies will experience: 

a fall in revenue if prices are cut, and



a rise in revenue if prices are increased.

The value of elasticity is affected by the slope of the demand curve for a product. Lower values of price elasticity of demand will result from a steeper demand curve.

72

4: Price elasticity

Illustration 6 A large drop in price will only cause a small rise in demand (meaning that total revenue will fall as a result). Price

D

Quantity demanded

If a product has a low price elasticity of demand (for example) this would seem to imply that firms producing these products should always be increasing their prices (revenue would rise and costs would be lower because less is produced). The reason that this is not the case is that a straight line demand function suggests that whenever price rises by a set amount, for example by $5 (using the ski pass example) the fall in demand is also a set amount (eg 3,000 units in the ski pass example). So a $5 price rise will be a lower percentage change as prices rise. So price elasticity demand will change as price changes.

73

Illustration 7 If Company X increases the price of daily ski passes by $5, demand falls by 3,000 units. Its price elasticity of demand will rise as prices rise, as demonstrated in the table below.

Initial price & demand

% change in demand

% change in price

PED (simple method)

Price $50

Price $100

Demand 45,000

Demand 15,000

3,000 / 45,000  100 =

3,000 / 15,000  100 =

6.7%

20.0%

5 / 50  100 =

5 / 100  100 =

10.0%

5.0%

6.7 / 10 =

20 / 5 =

0.67

4.0

So if a product has a low price elasticity of demand (for example) this does not imply that firms producing these products should always increase their prices. In fact we can see that demand will become more elastic (more responsive to price rises) at higher price levels (as you might expect). This relationship between price and price elasticity of demand can also be shown as a diagram: Price

PED rises as price rises

D Quantity demanded

Footnote: the mid-point of the demand function can be shown to have a PED of 1, but only if the demand curve is straight which is rare in reality.

74

4: Price elasticity

Activity 4: Exam standard The data below shows the price elasticity of demand for Good D (using the simple method) and the data used to calculate these values.

Current

Good D Price elasticity of demand = 0.8 Price Quantity $60 150,000

Required What percentage change in revenue will result from a price cut of 10% for Good D? Solution

2.3 Determinants of price elasticity of demand. There are a number of factors that will influence elasticity. For example, price elasticity of demand will be higher if: 

Many substitute products are available at a competitive price



Brand loyalty is weak so consumer demand is very price sensitive



The product is a luxury (not a necessity) – for example soft drinks have an estimated PED of 2.4 compared to 0.8 for fruit and vegetables (Eyles, 2012)



A high proportion of income is spent on the product – because price rises have a bigger impact on the consumer where this is the case



The time period since the price changed is longer – consumers tend not to notice or react strongly to price changes in the short term. However, over time, they react to price rises (for example) by searching for and finding cheaper alternatives. The internet has increased the ability of consumers to research price differences and has therefore helped to increase the price elasticity of demand. 75

Activity 5: Exam standard In the illustration earlier in the chapter we identified that Company X has calculated that the PED for ski passes is 4.0. Required Which of the following statements best explains this? A B C D

Elasticity Elasticity Elasticity Elasticity

is is is is

low because there are few substitute providers high because prices are low high because the time period of the analysis was short term high because the ski pass is expensive compared to income

2.4 Special values of price elasticity of demand (a)

Perfectly inelastic ie 0 P

D Demand totally unresponsive to change in price. Raise price to increase revenue PED : 0

Q1

(b)

Q

Unitary ie 1 Revenue is the same at any price level

(c)

Perfectly elastic ie infinite (∞) P

Demand totally responsive to change in price. Any price change leads to total loss of demand. Raise price lose all revenue

D P1

PED ∞

Q

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4: Price elasticity

3 Price elasticity of supply 3.1 Definition A measure of the responsiveness of quantity supplied to a change in price. Formula to learn: elasticity of supply

% change in quantity supplied % change in price Price elasticity of supply reflects the ability of firms to increase output when demand rises.

3.2 Influences on price elasticity of supply If the market price of a product rises, producers will want to increase supply. Their ability or willingness to do this (ie the price elasticity of supply) will be greater if: 

The time period since the price changed is longer (allowing a firm more time to organise extra production)

•

The cost of attracting more factors of production (eg labour, capital) is lower

•

Excess inventories are available which can be used to supply the market

•

There is spare capacity (meaning that it is easy for a firm to increase production levels)

•

Technology permits an increase in supply at little or no extra cost eg provision of e-services such as online music downloads incur little if any extra cost.

Activity 6: Exam standard Required The figures below show how the supply of Good F has changed following changes to their prices. Calculate price elasticity of supply for Good F, to one decimal place. Good F Price Before After

$2.20 $4.40

Quantity supplied 140 168

Solution

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Chapter summary • Price elasticity of demand indicates the responsiveness in the quantity demanded of a good to a change in the price of that good. • For the assessment, you need to be able to understand the factors influencing elasticity, to measure price elasticity from given price and demand data, to draw appropriate conclusions from such information, and to draw the correct implications for the producer's total revenue of changes in the price of the product. • The main factors affecting PED are the percentage of income spent on the good, the availability of substitutes, whether the good is a necessity or a luxury, the time horizon, and the degree of brand loyalty for the product. • Elasticity of supply measures the responsiveness of the quantity of a good supplied following a change in the price of that good.

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4: Price elasticity

Keywords 

Elastic demand: If price elasticity of demand (ignoring the minus sign) is greater than 1 this means that the % change in demand is greater than the % change in price. Demand is said to be price elastic; ie responsive to price changes.



Inelastic demand: If price elasticity of demand (ignoring the minus sign) is less than 1 this means that the % change in demand is less than the % change in price. Demand is said to be price inelastic; ie unresponsive to price changes.

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Activity answers Activity 1: Exam standard

PED A =

(170 150)/150 (50  60)/60

PED B =

= 0.8

(440  500)/500 (3.20  2.99)/2.99

= 1.7

Activity 2: Exam standard Average quantity Average price PED A =

Good A 160

Good B 470

55c

$3.095

(170 150)/160 (50  60)/55

PED B =

= 0.7

(440  500)/470 (3.20  2.99)/3.095

= 1.9

Activity 3: Exam standard Revenue = price x quantity = $200  500 = $100,000 A price cut of 10% means that the new price will be $200  0.9 = $180 If elasticity = 2 the change in demand is twice the change in price ie demand will rise 2  10% = 20% so new demand is by 1.2  500 = 600 So new revenue = $180  600 = $108,000 This is a rise of $8,000 When demand is elastic then a price cut should cause an increase in revenue.

Activity 4: Exam standard Revenue = price x quantity = 60  150,000 = $9,000,000 If elasticity = 0.8 the change in demand is 80% of the change in price ie demand will rise by 10%  0.8 = 8% So new revenue = ($60  0.9)  (150,000  1.08) = $54  162,000 = $8,748,000 This is a fall of $252,000, in % terms this is

80

252,000 ×100 = –2.8% 9,000,000

4: Price elasticity

Activity 5: Exam standard Correct answer – D The ski prices are expensive (they are daily ski passes) A

– elasticity is not low (ie not high investment  High interest rates => low investment

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7: National income

1 National income The key measure of overall economic activity in a country is national income. Broadly speaking, national income is a measure of the value of goods and services produced in a year. The value of the spending on these goods and services creates income for suppliers, which is why this is referred to as national income.

1.1 Different measures of economic activity Other measures of overall economic activity also exist, including gross domestic product (GDP) and gross national product (GNP). In the exam these terms are normally used to mean the same thing as national income ie as a measure of overall economic activity. However, technically there is a slight difference between these measures. GDP = the market value of final goods and services produced within an economy. GNP = GDP + net property income (NPI) from abroad (NPI = profits, dividends, interest earned from foreign investments less those paid out to foreign investors) National income = GNP – depreciation (depreciation is an estimate of the decline in the value of the assets within the economy during the period; it is often referred to as capital consumption) In the remainder of this material, as is normal in the exam, the terms GDP, GNP and national income are used interchangeably.

1.2 Different measures of economic activity The percentage change in national income during a year is often used as an indicator of the economic success of an economy, ie as an indicator of changes in living standards. However, there are some problems with this assumption: 

Not all economically valuable goods and services are bought at their market value.



No distinction is made between consumer goods and capital goods (eg a factory).



Economic growth may be occurring simply because population is increasing.



Economic growth may create environmental problems that are not measured.



Economic growth may not result in an increase in living standards for the average person.



Rising national income may be due to increases in price levels, ie inflation. 121

Activity 1: Preparation question Required Analyse why the problems described in Section 1.2 above may mean that faster economic growth (over time or versus other countries) may not mean higher average living standards. Solution

2 Factors affecting national income We have already seen how the equilibrium level of output for individual firms is determined by demand and supply. The equilibrium level of output (national income) in an economy is determined in a similar way, but in this case instead of looking at demand from individual consumers and supply from individual firms we are looking at aggregate demand and aggregate supply. Aggregate demand

total demand for goods and services in a country.

Aggregate supply

total supply of goods and services in a country.

Prices Aggregate supply

P Aggregate demand 0

Y

YF

National income ie output

As with a normal demand curve, aggregate demand (AD) is downward sloping, because when prices are high people cannot afford to buy many products. 122

7: National income

As with a normal supply curve, aggregate supply is upward sloping as higher prices will encourage suppliers to produce more. However, aggregate supply becomes vertical at YF because at this output level we will be using all the resources in our country and cannot make anything else; this is full-employment output.

2.1 Influences on national income Demand and supply curves can be used to illustrate some basic influences on national income. National income may increase due to: An increase in aggregate demand ie the demand curve moves to the right.



The components of aggregate demand are covered in detail in Section 3, but one example could be an increase in government spending. Governments may act to stimulate demand using 'demand management' policies – these are considered in the next chapter. An increase in aggregate supply ie the supply curve moves to the right



This could be due to increased investment in technology and capital equipment, or improvements in training, or increased incentives for firms to employ workers and expand output in the economy. Governments may act to stimulate these increases in supply using 'supply-side policies' – these are also considered in the next chapter.

Activity 2: Preparation question Required Using the AD and AS curves below, contrast the effect of 'demand management' and 'supply side' policies that are designed to stimulate economic growth. AS

Price

P

AD National income Y

123

AS

Price

P

AD National income Y

3 The circular flow of income Another way of illustrating why national income may change is to use the circular flow of income model. A simplified version of this model is shown below. This divides the economy up into households and firms. Income (Y) Factor services (employment)

Firms

Households Goods & services (welfare)

Expenditure (E)

Figure 7.2: Circular flow of income Households purchase goods and services using income that is received from providing 'factors of production' to firms, eg income from employment, rent of land, profits from running companies etc. Firms provide goods in exchange for expenditure from households.

3.1 Consumer spending The amount households plan to spend on goods and services produced in their own country during a year is called consumer spending (or consumption). Consumer spending is normally analysed into two elements: 1

124

Income induced consumption rises as income rises. The proportion of any additional income which will be devoted to consumption is referred to as the marginal propensity to consume, or MPC.

7: National income

Marginal propensity to consume (MPC) A measure of the proportion of extra income that is spent on consumer goods. 2

Autonomous consumption is not dependent upon the current level of income. It depends upon past savings, welfare benefits, and attitude to – and availability and cost of – borrowing.

3.1.1 Formula for consumer spending Consumer spending can be expressed as a formula C = a + bY Where a = autonomous consumption, b = the marginal propensity to consume, and Y = national income.

3.2 The full circular flow So far, in our circular flow model, we have suggested that an economy only includes two components (households and firms) and that households only consume domestically produced goods and services. However, this is not the case. So we need to extend our model. Income (Y) Factor services (employment)

Firms

Households Goods & services (welfare)

Expenditure (E)

Withdrawals

Injections

Figure 7.3: Full income flow 3.2.1 Injections and withdrawals In reality, some spending takes place that is not directly financed by household incomes – these types of spending are called injections and include investment spending, government expenditure and export demand). In addition, some household income is not spent on the purchase of domestically produced goods or services – collectively instances when this occurs are called withdrawals and include savings, taxation and purchases of imports.

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Income (Y) Firms

Households Consumption (C)

Total expenditure (E)

Saving (S)

Financial sector

Taxation (T)

Government sector

Import demand (M)

Foreign sector

Investment spending (I)

Government spending (G)

Export demand (X)

Figure 7.4: Injections and withdrawals 3.2.2 Equilibrium condition The economy will be stable where national income (Y) shows no tendency to change through time. This is a state of macroeconomic equilibrium (macroeconomic means 'the economy as a whole'). This will occur when planned expenditure (ie demand) equals national income (ie supply). E=Y This equilibrium will also occur where injections = withdrawals.

Activity 3: Exam standard Autonomous consumer spending is $100m and the marginal propensity to consume = 0.3. Injections are $250m. Required Using the formula C = a + bY for consumer spending and E = Y for equilibrium, calculate the equilibrium level of national income. Solution

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7: National income

4 Causes of changes in national income 4.1 Reasons for a fall in national income National income may fall due to a reduction in planned expenditure. This will encourage firms to cut output and employment in response to the lower demand. Decreases in demand can be stimulated by increases in 'withdrawals' ie savings, imports, tax.

4.2 Reasons for a rise in national income National income may increase due to an increase in planned expenditure (consumer spending + injections). This will encourage firms to increase output and employment to meet higher demand. Increases in demand can be stimulated by increases in 'injections' ie investment, government spending and exports. 4.2.1 Investment (I) Investment spending Investment is spending on creating new assets for the economy. Examples include investment in inventory, machinery and industrial and new residential buildings. Note that in this context investment does NOT mean the purchase of financial assets such as shares (this is referred to as 'savings' by economists). Investment spending can be encouraged by lower interest rates, which make it cheaper for firms to borrow to finance this spending. Also, it is only 'efficient' to use capital to finance an investment project if the returns from the investment project are greater than the cost of finance. So, if the cost of finance (the interest rate) is lower, investment spending will rise (ie more investment projects become efficient). This is illustrated below: Interest rate

Marginal efficiency of investment (MEI)

Figure 7.5: Marginal efficiency of investment

127

Other factors may also affect investment, for example: (a)

Increase in the relative cost of using labour compared to capital (eg pay rises) In such circumstances, firms will try to substitute capital for labour (and therefore capital investment will increase)

(b)

Improved productivity of capital equipment (eg due to innovation)

(c)

Fall in the price of capital goods

(d)

Expectations of higher demand for products in the future (eg economic growth)

4.2.2 Government spending (G) Government expenditure is determined by the government's policy on spending and taxation. This is called 'fiscal policy' and is covered in more detail in the next chapter. 4.2.3 Exports (X) Demand from foreign consumers will be determined by a number of factors including: 

Competitiveness of domestic industries: exports will increase if domestic goods are perceived to be high quality with low production costs.



Income in foreign countries: if incomes are high abroad, demand will be high from consumers in those countries.



The exchange rate (covered later in the course)

4.2.4 Multiplier effect The circular flow model can be used to demonstrate the potential for a relatively small increase in injections to cause a large impact on national income. This is often referred to as the multiplier effect.

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7: National income

Illustration 1 The government spends $200m on a new hospital, funded by borrowing. This money flows back to households as extra income (eg to construction workers). Assuming that 60% of this income is withdrawn (ie savings, tax, imports) then 40% of this extra income is spent on consumer goods, ie the marginal propensity to consume, or MPC, is 0.4. So consumer spending rises by $200m  0.4 = $80m. This extra spending again flows back to households as extra income. Assuming that 40% of this extra income is spent on consumer goods, then consumer spending rises. Consumer spending rises by $80m  0.4 = $32m. And so it continues; this extra spending flows back to households as extra income. Assuming that 40% of this extra income is spent, then consumer spending rises by $32m  0.4 = $13m (to the nearest million). Once again, this extra spending flows back to households as extra income, so consumer spending rises by $13m  0.4 = $5m. And this extra spending flows back to households as extra income, so consumer spending rises by $5m  0.4 = $2m. This extra spending again flows back to households as extra income, so consumer spending rises by $2m  0.4 = $1m. And then the effect becomes negligible. In summary, we can see that the overall effect of increasing an injection (here government spending) by $200m has been to increase national income by: $200m + $80m + $32m + $13m + $5m + $2m + $1m = $333m. 4.2.5 The multiplier In the illustration above, the initial increase in income of $200m will result in a final increase in national income of $333m. The effect of a $200m injection is to increase national income by a multiplicative effect of $333m / 200m = 1.67. This 1.67 is called a multiplier. A short cut to calculating the multiplier is to use this formula: Formula to learn – the multiplier

1 1 MPC

In the above example this gives

1 = 1.67 1– 0.4 129

Footnote: Income can either be spent or withdrawn. 1 – MPC (here 1 – 0.4 = 0.6) is the same as the marginal propensity to withdraw (MPW); ie if 40% of income is spent (MPC) then 60% is withdrawn. An exam question may give you the MPW (here 0.6) and if so the formula for the multiplier becomes 1 / MPW. The fact that (in the previous example) an initial injection of $200 million leads to an increase of $333m in national income is called the multiplier effect. A short cut to calculating the multiplier effect is to use this formula: Formula to learn – the multiplier effect The change in national income =

1  rise in injections 1 MPC

In the previous example this gives $200m  1.67 = $333m

Activity 4: Idea generation Required Identify factors that would make the MPC greater (therefore making the multiplier greater). Solution

Activity 5: Exam standard Required Calculate and insert the missing figures in the following table using the multiplier. Solution Change in injections 50m

130

MPC

MPW

0.4

Value of multiplier

Change in national income

Change in consumption

7: National income

4.2.6 Implications of the multiplier effect The potential to create a multiplier effect in order to increase aggregate expenditure (national income) by more than the initial injection creates a logic for government intervention to stimulate demand if the economy is depressed. This is considered in more detail in the following chapter, where we look at government macroeconomic policy. However, we can note here that the size of the multiplier will be an important influence on the effectiveness of this approach.

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Chapter summary  National income is the output produced in the economy. It is determined by aggregate demand and aggregate supply. • The economy will be in equilibrium where E=Y and injections = withdrawals. • Small increases in expenditure will lead to larger increases in output (multiplier effect). • Consumption is determined by autonomous consumption and income-induced consumption (MPC). • Investment spending can be stimulated by lower interest rates. • Governments may spend money to stimulate the economy through a multiplier effect.

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7: National income

Keywords 

GDP = the market value of final goods and services produced within an economy.



GNP = GDP + net property income (NPI) from abroad (NPI = profits, dividends, interest earned from foreign investments less those paid out to foreign investors)



National income = GNP – depreciation (depreciation is an estimate of the decline in the value of the assets within the economy during the period; it is often referred to as capital consumption)



Marginal propensity to consume (MPC): A measure of the proportion of extra income that is spent on consumer goods.



Investment spending: Investment is spending on creating new assets for the economy. Examples include investment in inventory, machinery and industrial and new residential buildings.

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Activity answers Activity 1: Preparation question 

Not all economically valuable goods and services are bought at their market value. Some goods are unpaid, for example some leisure activities such as gardening, walking. So if the working week is getting longer and people are enjoying less leisure time then, although national income may be rising, living standards may be falling. Some services are unpaid; for example if more people are moving out of the home and into paid work then the value of free services (eg unpaid home workers providing child care or care of the elderly) is being lost, so living standards may be falling. Some goods and services are not purchased at their true market price (eg publicly provided healthcare, defence). So if one economy has lower national income but provides more of these types of services, then living standards in that economy may be understated.



No distinction is made between consumer goods and capital goods (eg a factory). Economies with heavy spending on capital goods but with lower spending on consumer goods will not be providing an increase in living standards in the short term but will have greater potential to increase living standards in the longer term. Consumer goods give an immediate boost to standards of living (eg a new car) but capital goods will increase standards of living over a longer period of time.



Economic growth may be occurring simply because population is increasing. The greater the number of people, the more can be produced. National income needs to be divided by the number of people to give a better indication of living standards. This is sometimes called national income per capita (ie per head).



Economic growth may create environmental problems that are not measured. For example – pollution, congestion.



Economic growth may not result in an increase in living standards for the average person. For example – if inequality is high and rising.

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7: National income

Rising national income may be due to increases in price levels, ie inflation



So national income needs to be adjusted for the impact of inflation, this adjusted national income is called 'real' national income and is covered in a later chapter.

Activity 2: Preparation question Demand management is likely to increase prices (from P to P1) as well as output (from Y to Y1). This will create inflation. Price

AS

P1 P AD1 AD Y

Y1

National income

Supply-side policies, if effective, are likely to increase output (from Y to Y1), without creating inflation. AS

Price

AS1

P P1

AD Y

Y1

National income

Activity 3: Exam standard E = Y at equilibrium So So So So

consumer spending + injections = Y 100 + 0.3Y + 250 = Y 350 = Y – 0.3Y = 0.7Y 350 / 0.7 = Y = $500m

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Activity 4: Idea generation 

Reduction in interest rates (less incentive to save)



Reduction in taxation (more disposable income to spend)



Fall in exchange rate (making imports more expensive, meaning domestically produced goods become more attractive, so spending on these will increase in place of spending on imports.)

Note: These factors also reduce MPW, which also makes the multiplier greater. (Since saving, taxation and imports are the three components of 'withdrawals' from the economy.)

Activity 5: Exam standard Change in injections 50m

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MPC

MPW

0.6

0.4

Value of multiplier 2.5 (1/0.4)

Change in national income 125m (50  2.5)

Change in consumption 75m (125m – 50m)

7: National income

Test your learning 1

What is the marginal propensity to consume?

2

How might a government try to influence the volume of investment by firms?

3

Injections into the economy are: A B C D

4

Consumption and Investment Investment and Government Expenditure Investment, Government Expenditure and Export Demand Consumption, Investment, Government Expenditure and Export Demand

If a consumption function has the formula C = 750 + 0.4Y where Y is the change in national income, and injections are 500, then equilibrium national income will be at: A B C D

833 1,250 2,083 3,125

5

What is the multiplier effect?

6

In an economy, the marginal propensity to consume is 0.85. What is the multiplier in that economy? (Give your answer to two decimal places.)

137

138

The trade cycle Learning outcomes Having studied this chapter you will be able to: 

explain the stages of the trade cycle and the consequences of each stage for the policy choices of government



describe the impacts on business of potential policy responses of government to each stage of the trade cycle

Chapter context Businesses will be affected by general economic conditions beyond their control. While they cannot influence these conditions, managers must understand the causes and effects of different stages in the trade cycle so they can take appropriate steps to maximise their firms' profits in time of economic prosperity and protect their investors' interests in times of economic downturn.

Syllabus context This chapter is part of syllabus Section A which looks at the 'macroeconomic and institutional context of business'. This syllabus area has a weighting of 25% and is covered by Chapters 7-12

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Chapter overview The trade cycle Objectives of government policy Monetary policy

Tools of government economic policy

Supply-side policy

Fiscal policy

Stages of the trade cycle Implications of the trade cycle

Economic growth and the trade cycle

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Balance of trade and the trade cycle

Recession Depression Recovery Boom

Unemployment and the trade cycle

Inflation and the trade cycle

8: The trade cycle

1 Objectives of government economic policy Governments have a number of economic objectives. At any given point in time, some objectives may be more important than others.

Economic growth

Balance of trade stability

Objectives

Control of inflation

Low unemployment

1.1 Economic growth Economic growth has been discussed in the previous chapter. Economic growth implies an increase in national income in real terms (ie after adjusting for inflation – an area that is covered further in Chapter 9). Increases caused by price inflation are not real increases at all.

1.2 Low unemployment The unemployment rate is normally defined as the percentage of the population (of working age) and who are actively seeking work (ie not full-time students, unpaid home makers, pensioners etc) who are unemployed.

1.3 Low inflation Inflation An increase in the general level of prices of goods and services in the economy. Keeping inflation to a low level has become a central economic objective for many governments, because experience has shown that high and unstable inflation has a number of undesirable consequences.

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

Industrial relations conflict Different expectations over inflation levels increase the probability of conflict between employers and employees during wage negotiations; this makes strikes more likely.



Interference with the price mechanism The price mechanism will signal that goods are in high demand by increasing the market price. This should attract an increase in supply. Inflation makes it harder for this mechanism to operate effectively, because it may be unclear to producers whether higher inflation or higher demand is causing price increases.



Redistribution of income and wealth Inflation often causes those living off their savings to experience a loss in purchasing power, ie the amount of goods and services they can buy with that income. On the other hand, those who have borrowed money may gain as the real value of their repayments falls. Income may also be distributed from suppliers to customers. For example, if you owed $1,000, and prices then doubled, you would still owe $1,000, but the real value of your debt would have been halved.



Balance of payments effects If a country has a higher rate of inflation than its major trading partners, its exports will become relatively more expensive and imports into it will be relatively cheaper. As a result, the balance of trade (export revenue less the cost of imports) may worsen. International trade is covered in more detail in Chapter 11.



Creates expectations of inflation Once the rate of inflation has begun to increase, there is the danger that, whether the factors that have caused inflation still exist or not, there will be an expectation of further inflation in the future which leads to continued increases in wages and prices.

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8: The trade cycle

Activity 1: Preparation question Required Do changes in the distribution of income caused by inflation matter from an economic perspective? Solution

1.4 Balance of trade stability (to achieve a balance between exports and imports). If imports (a cost to the economy) are higher than exports (generating revenue for the economy) for a sustained period of time this may cause financing problems. Issues related to a country's balance of trade are covered in Chapter 11.

2 Tools of government economic policy In order to achieve its objectives, a government has several types of macroeconomic policy instruments at its disposal.

2.1 Fiscal policy Fiscal policy relates to government policy on taxation, public borrowing and public spending.

2.2 Monetary policy Monetary policy is mainly concerned with government policy on the money supply, interest rates and exchange rates. Fiscal and monetary policy attempt to attain the macroeconomic policy objectives by influencing aggregate demand in an economy.

2.3 Supply-side policy Supply-side policies, on the other hand, attempt to increase the level of aggregate supply by increasing efficiency, motivation or productive capacity. Examples include deregulation, re-training, privatisation and cutting corporation tax.

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2.4 Merits of these policies The relative merits of these policies are discussed in Chapter 10, but here we examine the potential use of such policies (except exchange rate policy which is covered in later chapters) by a government to achieve its economic goals.

3 Economic growth and the trade cycle Trade cycle A trade cycle is a repeated pattern of changes in economic growth. Trade cycles are a continual sequence of growth in national income, followed by a slow-down in growth and then a fall in national income (recession). After this recession comes growth again, and when this has reached a peak, the cycle turns into recession once more.

3.1 Phases of the trade (or business) cycle Actual output

Output

D Trend in output

A C B

Time

Figure 8.1: The trade cycle

3.2 Recession At point A in Figure 8.1, the economy is entering a recession (normally defined as two consecutive quarters of negative growth). In the recession phase, output is falling. Business failures will occur as firms find themselves unable to sell their goods. Production, investment and employment will fall. This creates a wave of unemployment and falling incomes spreading across the economy as a downward multiplier effect.

3.3 Depression Eventually, in the absence of any stimulus to aggregate demand, a period of full depression sets in and the economy will reach point B. 144

8: The trade cycle

This stage may last for a long period of time unless the government can act to stimulate an economic recovery.

3.4 Recovery At point C the economy has reached the recovery phase; this will feature modest rates of economic growth and improved consumer confidence. Rising production, sales and profits will mean that to new investment will be more readily undertaken. This creates a wave of employment and rising incomes spreading across the economy as a multiplier effect kicks in.

3.5 Boom This is shown as point D in Figure 8.1. As recovery proceeds, the output level climbs above its trend path, in the boom phase of the cycle. During the boom, capacity and labour will become fully utilised.

4 Economic growth and the trade cycle 4.1 Impact on business Business decisions will be affected by the stage of the trade cycle. Key business decisions include:    

Investment Pricing Recruitment Production levels

Activity 2: Exam standard Required Higher / Lower / No change Insert the appropriate term above into the following table, to identify whether the level of each of the following will be higher or lower during the recession stage of the trade cycle, compared to recovery. Investment

Pricing

Recruitment

Production

Business decisions will also be affected by government action (see below) to deal with the various stages of the trade cycle.

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4.2 Government action We have identified three main economic policy tools: fiscal and monetary policy (mainly tools of managing demand) and supply-side policy. Each has a potential role to play in smoothing out the effects of the trade cycle on the rate of economic growth. Here, the key roles of government are often seen as: 1

Taking action to boost demand if the economy is in recession or depression. Government action is often required because, during a downswing in economic activity, private sector investment is normally low. Consumer spending also falls because of concerns about rising unemployment – this means that consumers try to cut back on spending funded by credit cards and try to increase savings. (In fact, lower consumer spending may cause a fall in national income so total savings may even fall – this idea that saving can actually cause economic harm is sometimes called the paradox of thrift).

2

Policy decisions to increase the efficiency, motivation and capacity of the economy so that it is capable of growing at a faster rate for a longer period of time, eg tax cuts to encourage private sector investment. These are supply-side policies and are covered in more detail in Chapter 10.

Activity 3: Preparation question Required Insert examples of how fiscal, monetary and supply-side policies may be used to stimulate economic growth during the trade cycle. Fiscal policy

146

Monetary policy

Supply-side policy

8: The trade cycle

4.3 Automatic stabilisers In fact, the need for direct, planned, government initiatives is lessened by the automatic effect of the trade cycle on government spending (an injection) and taxation (a withdrawal). Total spending on welfare benefits will automatically rise because unemployment rises if the economy moves towards a recession. Withdrawals will also fall because taxation of incomes will automatically fall as incomes fall in a recession. These 'automatic stabilisers' help to support aggregate demand during a recession.

5 Unemployment and the trade cycle Cyclical unemployment The type of unemployment that is caused by a decline in the general level of economic activity is called cyclical unemployment. If the level of aggregate demand is below the level need to sustain full employment, there is said to be a deflationary gap (Figure 8.2).

Figure 8.2: Deflationary gap

5.1 Deflationary gap and cyclical unemployment In Figure 8.2, the economy is currently in equilibrium at Ye (with aggregate demand AD) but it would need to be at Yf (with aggregate demand AD2) to achieve full employment. A deflationary gap can be described as the extent to which the aggregate demand function will have to shift upward to produce the full employment level of national income.

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5.2 Other types of unemployment However, not all types of unemployment relate to fluctuations in aggregate demand. Economists identify two other key categories of unemployment which are not due to a downturn in the trade cycle: structural unemployment and frictional unemployment. Structural unemployment The long-term unemployment that exists even when the economy is growing at a normal rate. It may be due to a general lack of skills, or a lack of appropriate skills (eg due to a collapse in a sector of the economy), or due to wages being set at artificially high levels (perhaps due to a minimum wage). Frictional unemployment This is short-term unemployment due to the time it takes workers to find jobs, or due to seasonal factors. Taken together, the amount of unemployment that is due to frictional and structural factors is sometimes called the 'natural rate of unemployment'.

5.3 Government action We have identified three main economic policy tools: fiscal and monetary policy (mainly tools of managing demand) and supply-side policy. Each has a potential role to play in managing the level of unemployment. The appropriate policy will depend on the type of unemployment that a government is trying to tackle.

Activity 4: Exam standard Required It is winter, and Country Z is experiencing high levels of unemployment due to the relocation of some major employers from the east of Country Z to Country Y. During winter there is little work available in the agricultural sector, so unemployment is always higher at this time. Match two of the following government policy options to the categories of unemployment that are being experienced in Country Z.

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8: The trade cycle

Government policy options Increase government spending

Subsidise retraining of workers

Remove minimum wages

Anti-union legislation

Type of unemployment

Appropriate government policy

Cyclical Frictional Structural

6 Inflation and the trade cycle Demand-pull inflation The type of inflation that is caused by an increase in the general level of economic activity is called demand-pull inflation. In a situation where the trade cycle is at its boom phase, aggregate demand may rise above aggregate supply. If labour is at full employment, and factories are at full capacity, then firms will be unable to increase output to meet higher demand and so will simply increase prices, causing inflation.

6.1 Inflationary gap If the level of aggregate demand is above the level needed to sustain full employment, there is said to be an inflationary gap (Figure 8.3). Prices

AS

P Inflationary gap PF AD1 AD2 YF

Real national income

Figure 8.3: Inflationary gap

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An inflationary gap can be described as the extent to which the aggregate demand function would have to shift downward to produce the full employment level of output without price rises. In Figure 8.3, an inflationary gap can be removed by shifting the aggregate demand curve to the left, from AD1 to AD2.

6.2 Cost-push inflation Cost-push inflation If firms are forced to increase prices because of a general increase in their costs, this is called cost-push inflation. As with unemployment, not all types of inflation relate to fluctuations in aggregate demand. Cost-push inflation can result from: 

Upward pressure on wages exerted by powerful unions



Upward pressure on commodity prices (eg oil): sudden shocks in the price of key commodities can cause a combination of high inflation and lower output/higher unemployment. This is sometimes called stagflation (a combination of a stagnant economy and high inflation levels).



A fall in the value of the domestic exchange rate meaning that the cost of imported goods and services increase (this is covered in Chapter 11).

6.3 Government action Fiscal and monetary policy and supply-side policy all have a potential role to play in managing the level of inflation. The appropriate policy will depend on the type of inflation that a government is trying to tackle.

Activity 5: Exam standard Required Country Y is experiencing an economic boom and inflation levels are high. Choose the correct government policy option for this situation. A B C D

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Increase interest rates Decrease welfare payments Cut income tax Anti-union legislation

8: The trade cycle

7 Balance of trade and the trade cycle We have mentioned that an economy will need to achieve a balance between exports and imports. If an economy is in the boom phase of the trade cycle then this balance may be harder to achieve due to the high levels of demand in the economy. For example, if the economy in the UK is booming, and levels of aggregate demand in the UK are high: 

Imports will also be high due to high levels of consumer spending



But exports are not necessarily high because the level of exports depends on demand outside the UK (eg in Europe and the US)

This area is covered in Chapter 11.

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Chapter summary  The main macroeconomic policy goals of governments are to sustain economic growth, limit price inflation, achieve low unemployment and to achieve balance of payments equilibrium. • To achieve these aims, governments can use fiscal, monetary or supply-side policies. • Fiscal policy provides a method of managing aggregate demand in the economy through taxation and government spending. • Monetary policy focuses on the relationship between interest rates and the supply of money in an economy, and how the two of them together can influence aggregate demand.  Trade cycles (sometimes called business cycles) describe the tendency for economies to swing between years of growth and high employment, and years of stagnation and high unemployment on a regular basis.  The impacts of the trade cycle on business include the direct effects of the changes in aggregate demand and employment, and the secondary effects of the resulting intervention by governments to correct it. • Unemployment is where not all workers willing to take a job at the present level of wages can find work. Unemployment can be related to the trade cycle (cyclical) or to other factors (frictional, structural). The appropriate government action depends on the type of unemployment. • High rates of inflation are harmful to an economy. Inflation redistributes income and wealth. Uncertainty about the value of money makes business planning more difficult. 1 Demand-pull inflation arises from an excess of aggregate demand over the productive capacity of the economy. 2 Cost-push inflation arises from increases in the costs of production. 3 The appropriate government action depends on the type of inflation.

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8: The trade cycle

Keywords 

Inflation: An increase in the general level of prices of goods and services in the economy.



Trade cycle: A trade cycle is a repeated pattern of changes in economic growth.



Cyclical unemployment: The type of unemployment that is caused by a decline in the general level of economic activity is called cyclical unemployment.



Structural unemployment: The long-term unemployment that exists even when the economy is growing at a normal rate. It may be due to a general lack of skills, or a lack of appropriate skills (eg due to a collapse in a sector of the economy), or due to wages being set at artificially high levels (perhaps due to a minimum wage).



Frictional unemployment: This is short-term unemployment due to the time it takes workers to find jobs, or due to seasonal factors.



Demand-pull inflation: The type of inflation that is caused by an increase in the general level of economic activity is called demand-pull inflation.



Cost-push inflation: If firms are forced to increase prices because of a general increase in their costs, this is called cost-push inflation.

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Activity answers Activity 1: Preparation question The impact on distribution of income refers to the impact on borrowers and savers. High and erratic inflation discourages saving – serious economic problems could flow from this. It could lead to a shortage of funds available for lending to firms to finance investments, and possibly to a shortage of savings to finance pensions. High and erratic inflation may encourages reckless borrowing; this can also lead to serious economic consequences because high borrowing can lead to economic instability as consumer and commercial debt levels increase.

Activity 2: Exam standards The recession and depression stages of the trade cycle feature low or falling national income. Business confidence will be low and demand levels will be low. Investment

Pricing

Recruitment

Production

Lower

Lower

Lower

Lower

Activity 3: Preparation question Fiscal policy

Monetary policy

Higher government spending (financed by borrowing) can be used to generate a multiplier effect during a downswing in economic activity. If government spending is higher than taxation revenue this is called a budget (or fiscal) deficit.

Lower interest rates may be used to try to stimulate higher levels of investment.

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Supply-side policy Any policies designed to increase efficiency, productive capacity or motivation are unlikely to have a short-term impact but over the longer term may allow for a more prolonged upswing in economic activity (as it takes longer for the economy to reach maximum capacity).

8: The trade cycle

Activity 4: Exam standard Winter unemployment is seasonal – this is an aspect of frictional short-term unemployment. The high levels of unemployment due to the relocation of some major employers from the east of Country Z means that workers in this region have the wrong skills – this is an example of structural unemployment. There is no indication that cyclical unemployment is a problem here – or that powerful trade unions are a problem either. Type of unemployment

Appropriate government policy

Cyclical Frictional

Subsidise retraining of workers

Structural

Subsidise retraining of workers

Activity 5: Exam standard Correct answer: A Increasing interest rates should help to reduce aggregate demand which is essential where inflation is 'demand-pull' as is the case here. Decreasing welfare payments will also reduce demand but is unlikely to be effective during a boom where unemployment will be low. Cutting income tax will boost demand and worsen inflation. Anti-union legislation may be appropriate if inflation is cost-push but this is not the case here.

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Test your learning 1

What is the difference between fiscal policy and monetary policy?

2

What are the stages of the trade cycle (in the correct order)?

3

Outline how the government may use fiscal policy to influence aggregate demand.

4

What type of inflation is due to changes in the trade cycle?

5

What type of unemployment is due to changes in the trade cycle?

6

Give an example of a monetary policy action that will address demand-pull inflation.

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Index numbers Learning outcomes Having studied this chapter you will be able to: 

calculate indices for price inflation and national income growth using either base or current weights and use indices to deflate a series.

Chapter context An understanding of index numbers is important in order to be able to interpret economic data.

Syllabus context This chapter is part of syllabus Section A which looks at the 'macroeconomic and institutional context of business'. This syllabus area has a weighting of 25% and is covered by Chapters 7-12.

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Chapter overview Index numbers

Fixed base Deflating a time series

Chain base

Price and quantity indices

Base weights (Laspeyre)

158

Current weights (Paasche)

9: Index numbers

1 Introduction to index numbers Index numbers are used to provide a standardised way of comparing values over time. Economists often use index numbers when making comparisons over time. An index starts in a given year, the base year, at an index number of 100. Single item index numbers can be calculated by comparing the price (or quantity levels) over two periods and multiplying by 100. Illustration 1 If the price of a cup of coffee was 40c in 20X0 and 50c in 20X1, then using 20X0 as a base year (value = 100) the price index number for 20X1 would be 50/40 × 100 = 125. This means that the price has risen by 25%.

1.1 Fixed base and chain base methods There are two ways in which index numbers can be compared: using a fixed base or a chain base. Fixed base In the fixed base method, a base year is selected (index 100), and all subsequent changes are measured against this base. Chain base In the chain base method, changes are calculated with respect to the value of the item in the period immediately before.

159

Illustration 2 The price of Product A was $2.70 in 20X0, $3.11 in 20X1, $3.42 in 20X2 and $3.83 in 20X3. A chain index would be as follows: 20X0

100

20X1

115

(3.11/2.70 × 100)

20X2

110

(3.42/3.11 × 100)

20X3

112

(3.83/3.42 × 100)

A fixed index would be as follows: 20X0

100

20X1

115

(3.11/2.70 × 100)

20X2

127

(3.42/2.70 × 100)

20X3

142

(3.83/2.70 × 100)



The chain base numbers show the rate of change in prices from year to year (eg 112 in 20X3 means that prices rose by 12% in 20X3)



The fixed base numbers show changes relative to prices in the base year (eg 142 in 20X3 means that price has risen by 42% since 20X0).

1.2 Price indices and quantity indices Index numbers can be used to measure the change in the monetary value of a group of items over time. These are called price indices. For example the Consumer Prices Index (CPI) is used in the UK, and internationally, to measure changes in the rate of inflation. Index numbers can also be used to measure the change in the non-monetary values of a group of items over time. These are quantity indices (or volume indices). An example is an index number for production volume showing the production achieved by a factory over time.

2 Using price indices to calculate inflation The consumer prices index (CPI) measures the change in the average basket of goods and services. It is published every month, and its principal use is as a measure of monthly and annual inflation. The CPI measures the percentage changes, month by month, in the average level of prices of 'a representative basket of goods'. 160

9: Index numbers

The composition of the basket of goods is reviewed every year to ensure that CPI calculations reflect up-to-date shopping patterns. The data is presented as a fixed index with reference to a base year. Illustration 3 In the UK in 2015 e-cigarettes and subscriptions for music streaming were added to the basket, and yoghurt drinks and satnavs were removed. In the UK the base year is 2005, so an index of 127.1 (the actual value for the UK in January 2015) means that prices have risen by 27.1% since January 2005.

Activity 1: Exam standard Required Using the CPI data below calculate the annual rate of inflation in 20X8 (to one decimal place). Year CPI

20X5 100

20X6 106

20X7 112

20X8 110

Solution

2.1 Base weighted price indices One way of working out the change in price of a basket of goods is to weight the price rises by the quantities purchased at the start of the period (ie in the base year). This type of index is called a base weighted price index (or Laspeyres index).

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Illustration 4 Imagine that only three products are being purchased, bread, tea and caviar, in the quantities and at the prices shown below. Item

Quantity in 20X1 (millions)

Price in 20X1

Q0 6 2 0.067

P0 $20 $25 $450

Bread Tea Caviar

During 20X2 the price of bread has risen to $40, the price of tea has risen to $30, and the price of caviar has fallen to $405. What is the overall price index for this 'basket' of goods, using a base weighted approach? The 20X2 price index value could be calculated by weighting the price changes using the quantities purchased as the weights. Item

Quantity

Price in

(millions)

20X1

Base-year value

Q0

P0

P0 x Q0

Bread

6

20

120

Tea

2

25

50

Caviar

0.067

450

30

Price relative

P1 / P0 40/20 = 2 30/25 = 1.2 405/450 = 0.90

200

Index in 20X2 =

Base year value x price relative 240 60 27 327

327  100 = 163.5 200

In other words, the weighted average price rise is 63.5% 2.1.1 Formula The base weighted price index uses quantities consumed in the base period as weights. The approach we have used in the previous illustration can be expressed mathematically as:

  w   P1 / Po   w where P1 represents the prices in the current year, P0 represents prices in the base year and w represents weights using base-year values.

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9: Index numbers

2.2 Current weighted indices Another way of working out the change in price of a basket of goods is to weight the price rises by the quantities currently being purchased. This type of index is sometimes called a current weighted price index (or the Paasche index). With this approach, the weights are changed every time period. This is time consuming, but it does mean that the price rises reflect the change in the current cost of living; CPI is calculated using current weights for this reason. The calculations for the current weighted index are similar to those demonstrated for the base weighted index but use the up-to-date purchasing behaviour of consumers. Illustration 4 Imagine that only three products are being purchased, bread, tea and caviar, in the quantities and at the prices shown below.

Item

Bread Tea Caviar

Quantity (millions) Q0 6 2 0.067

Price in 20X1 P0 20 25 450

Quantity (millions) Qn 5 1.5 0.12

Price in 20X2 Pn 40 30 405

What is the overall price index for this 'basket' of goods, using a current weightings approach? The 20X2 price index value can be calculated by weighting the price changes, using the quantities currently purchased as the weights. Item

Quantity

Price in

(millions)

20X1

Qn

P0

Bread

5

20

Tea

1.5

25

Caviar

0.12

Value

Price relative

P0 x Qn 100

450

Value x price relative

P1 / Po 2

200

37.5

1.2

45

54

0.9

48.6

191.5

293.6

293.6 Index in 20X2 = 191.5  100 = 153.3 In other words, the average price rise is 53.3%

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2.2.1 Formula The current weighted price index uses quantities consumed in the current period as weights. The approach we have used can be expressed mathematically as:

  w   P1 / Po   w where ܲଵ represents the prices in the current year, ܲ଴ represents prices in the base year and w represents weights using current-year values.

Activity 2: Preparation question The price index in Ruritania is made up from the prices of five items. The price of each item and the average quantities purchased by manufacturing and other companies each week were as follows, in 20X0 and 20X2. Item

Quantity 20X0 '000 units 60 30 40 100 20

P Q R S T

Price per unit 20X0 Roubles 3 6 5 2 7

Quantity 20X2 '000 units 80 40 20 150 10

Price per unit 20X2 Roubles 4 5 8 2 10

Required Calculate the price index in 20X2, if 20X0 is taken as the base year, using the following: (a) (b)

Base weightings (Laspeyre) Current weights (Paasche)

Solution

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9: Index numbers

3 Using price indices to deflate a time series 3.1 Adjusting time series data for inflation A time series is a series of data over time – it may be historic or forecast data. Analysis of time series data will be complicated by the existence of inflation. One of the uses of a price index is to deflate data that includes inflation, often called 'nominal' data, by stripping out the effect of inflation so that the data becomes 'real' (ie not distorted by inflation). Illustration 5 In Country E, average wages have increased between 20X2 and 20X6 from $10,000 per head to $16,000 in nominal terms. CPI data for Country E is given below as a fixed index. Year CPI

20X2

20X3

20X4

20X5

20X6

100

106

110

117

125

How much better off are workers in real terms? This can be addressed by expressing wages in terms of base year (ie 20X2) prices. 20X2 wages are already in terms of 20X2 prices. 20X6 wages of $16,000 can be adjusted by dividing by 125/100 ie $16,000 / 1.25 = $12,800. So 'real' wages have risen by (

12,800 –1) x 100 = 12.80% 10,000

Activity 3: Exam standard M Co has seen an increase in annual revenue from $212 million to $225 million between 20X3 and 20X6, in nominal terms. CPI data is given below as a fixed index. Year

20X2

20X3

20X4

20X5

20X6

CPI

100

106

110

117

125

Required Calculate how much annual revenues have changed in real terms between 20X3 and 20X6. Solution

165

4 Calculating quantity indices We have seen that price indices are usually weighted by quantities. We will now look at quantity indices, which measure changes in quantities and use prices as weights. One application of this is to measure changes in national income. Illustration 6 Country F produces four types of goods and services. In 20X0 the quantities of good produced and their average price were as follows.

Good Good Good Good

A B C D

Quantity (billions) Units 20 5 40 15

Price per unit $ 2 10 3 6

The total value of output (national income) is (20bn  $2) + (5bn  $10) + (40bn  $3) + (15bn  $6) = $300 billion. In 20X2 the quantities of good produced were as follows.

Good Good Good Good

A B C D

Quantity Units 15 6 36 25

Using 20X0 as a base year, calculate the quantity index value in 20X2 for national income of Country F.

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9: Index numbers

Solution

Good Good Good Good

A B C D

Quantity index =

Price Po $2 $10 $3 $6

348 300

Quantity produced in 20X0 Qo 20 5 40 15

PoQo ($) 40 50 120 90 300

Quantity relative Q1/Qo 15/20 = 0.750 6/5 = 1.200 36/40 = 0.900 25/15 = 1.667

PoQo x relative 30 60 108 150 348

 100 = 116

This would suggest that the level of national income has grown by 16% since 20X2.

4.1 Formula This is an example of a quantity index using base year price weightings; it can be expressed as:

  w   Q1 / Qo   w where ܳଵ represents the quantity in the current year, ܳ଴ represents quantity in the base year and w represents weights using current or base year values.

Activity 4: Preparation question The following data relates to production in Country D in 20X3 and 20X4.

Good Good Good Good

A B C D

Quantity produced 20X3 '000 3 6 1 4

Price per unit 20X3 $ 1.20 0.95 1.40 1.10

Quantity produced 20X4 '000 4 5 2 3

Price per unit 20X4 $ 1.50 0.98 1.30 1.14

167

Required Calculate the following quantity indices for 20X4 (with 20X3 as the base year). (a)

A quantity index using base year weightings

(b)

A quantity index using current year weightings

Solution

168

9: Index numbers

Chapter summary • An index is a measure, over time, of the average changes in the value (price or quantity) of a group of items. • Index numbers can be calculated using the fixed base method or the chain base method. • Time series deflation is a technique used to obtain a set of index numbers that measure the changes in the real value of some commodity with respect to some given indicator. • Weighting is used to reflect the importance of each item in the index. • Weighted average of relative indices are found by calculating indices and then applying weights either based on current year or base year weights. • The consumer prices index (CPI) is used to measure price inflation and can be used to deflate data and for index linking.

169

Keywords 

Fixed base: In the fixed base method, a base year is selected (index 100), and all subsequent changes are measured against this base.



Chain base: In the chain base method, changes are calculated with respect to the value of the item in the period immediately before.

170

9: Index numbers

Activity answers Activity 1: Exam standard 110 / 112 x 100 = 98.2 ie inflation is 98.2 – 100 = –1.8% This indicates that on average prices are falling.

Activity 2: Preparation question Item

Base weightings

P

Qo 60

Po 3

Qn 80

P1/Po 1.333

PoQo 180

Q

30

6

40

0.833

R

40

5

20

S

100

2

150

T

20

7

10

PoQo x price relative

Current weightings PoQn x price relative 320

240

PoQn 240

180

150

240

200

1.60

200

320

100

160

1.0

200

200

300

300

1.429

140

200

70

100

900

1,110

950

1,080

20X2 index numbers are as follows. (a)

base weighted index

= 100 

(b)

current weighted index

= 100 

1,110 = 123.3 900

1,080 = 113.7 950

The current weighted index for 20X2 reflects the decline in consumption of the relatively expensive items R and T since 20X0. The base weighted index for 20X2 fails to reflect this change.

Activity 3: Exam standard This can be addressed by expressing sales in terms of base year (ie 20X2) prices. 20X3 sales can be adjusted by dividing by 106/100 ie $212m / 1.06 = $200m. 20X6 sales of $225m can be adjusted by dividing by 125/100 ie $225m / 1.25 = $180m. So 'real' sales have fallen by (

180 –1) x 100 = –10% 200

171

Activity 4: Preparation question Workings Base year

Good Good Good Good

A B C D

Qo 3 6 1 4

Po 1.20 0.95 1.40 1.10

Quantity relative (Q1 / Qo) 1.333 0.833 2 0.750

Pn 1.50 0.98 1.30 1.14

PoQo 3.60 5.70 1.40 4.40 15.10

Quantity index numbers for 20X4 are as follows. (a)

100 

15.65 = 103.64 15.10

(b)

100 

16.92 = 104.19 16.24

172

PoQo x relative 4.80 4.75 2.80 3.30 15.65

Current year

PnQo 4.50 5.88 1.30 4.56 16.24

PnQo x relative 6.00 4.90 2.60 3.42 16.92

9: Index numbers

Test your learning 1

2

Complete the following equations using the symbols in the box below. (a)

Price index =

(b)

Quantity index =

 100  100

P1

P1

Q1

Q0

Match the description to the appropriate method. Fixed base method

Changes are measured against base period

Chain base method

Changes are measured against the previous period

3

In 20Z6 the retail price index was 198 with 20X7 = 100. Convert a weekly wage of $421 in 20Z6 back to 20X7 prices (to two decimal places).

4

The chain base index for an item last year was 130. The price of the item has risen by 10% between last year and this year. What is the chain base index for this year?

5

In 20Y8, a price index based on 20X4 = 100 stood at 139. In that year it was rebased at 20Y8 = 100. By 20Z0, the new index stood at 120. For a continuous estimate of price changes since 20X4, the new index may be expressed in terms of the old as (to one decimal place)

173

174

Government economic policy Learning outcomes Having studied this chapter you will be able to: 

explain the main principles of public finance (ie deficit financing, forms of taxation) and macroeconomic policy

Chapter context The approach taken by a government to managing its finances will need to be assessed by a business to understand the potential impacts that the government's actions could have on the business; these can be direct (eg tax rises) and indirect (eg impact on economic stability). Also, the approaches that a government adopts to managing the economy may create a number of opportunities and problems for a business.

Syllabus context This chapter is part of syllabus Section A which looks at the 'macroeconomic and institutional context of business'. This syllabus area has a weighting of 25% and is covered by Chapters 7-12.

175

Chapter overview

Government economic policy

Fiscal policy

Influence demand by taxation and government expenditure

Monetary policy

 Influence demand by restricting availability of credit

Supply-side policies  Attempt to improve quality and quantity of supply  Increase competition  Encourage investment

 Too much money  inflation

 Improve labour effectiveness

Fiscal stance  Budget deficit    Cyclical  deficit   Structural deficit

176

Taxation

Principles Functions Types Incentives

Interest rates Central Bank

Money stock

Exchange rates

10: Government economic policy

1 Government spending The amount of money that a government plans to spend will depend on the attitude to government involvement in the economy and other factors such as the stage of the trade cycle (as discussed in Chapter 8). The table below shows the significance of government spending. Country

Government expenditure (% of GDP)

Finland

57.5

France

57.0

Sweden

52.4

Italy

51.1

United Kingdom

44.9

Germany

44.5

Spain

44.1

United States

38.8

(OECD, 2013) This demonstrates the powerful impact of government spending, which is more than half of total aggregate demand in some developed countries.

1.1 Types of government spending The three main categories of government expenditure are: (a)

Government final consumption expenditure: this is the provision of goods and services to be used by the population, eg health care (such as the NHS in UK).

(b)

Government investment (gross fixed capital formation): the building of roads and other infrastructure

(c)

Transfer payments: Welfare payments including pensions, welfare benefits and social care.

177

For example, in the UK in 2014/2015, about 33% of government spending was on welfare payments, split as follows: UK welfare payments 2014/15

% welfare budget

% government spending

Pensions

42%

14%

Family benefits

17%

6%

Incapacity benefits

16%

5%

Personal social services

13%

4%

Housing benefits

10%

3%

1%