ECONOMIC ENVIRONMENT

By

Vaibhav Aggarwal

Assistant Professor

INTRODUCTION :

Economic environment refers to all those economic factors which have a bearing on the functioning of the business unit.

Business depends on the economic environment for all the needed inputs. It also depends on the economic environment to sell the finished goods.

Components of Economic Environment

1) Economic System : Capitalism, Socialism or Mixed

2) Nature of the economy: Low /Middle or High Income

3) Structure of the economy : Primary, secondary and tertiary

4) Economic policies : Monetary/Fiscal/industrial/Foreign exchange

5) Economic conditions : Boom/Recession etc

6) Infrastructure : Good or bad

7) Removal of regional Imbalances

Economic System

• An economic environment system refers to the organization arrangements and process through which a society makes its production and consumption decision.

• It is the method used by society to produce and distribute goods and services.

• Types of Economic System– Capitalism– Socialism– Mixed Economy

It comprises of all Institutions, Organizations and Policy mechanisms by which the people of a country manage and utilize the country’s resources to obtain things they need.

BASIC UNITS OF ECONOMIC SYSTEM:• Household• Firm• Industry• Government

BASIC UNITS OF ECONOMIC SYSTEM (contd.)

HOUSEHOLD• Simplest yet most significant.• Limited means but multiple needs.

Problem of allocation of scarce resources.• A household decides what part of income to consume

and what to save.

FIRM• Unit of Ownership, Management and Control.• A business unit owns and controls one or more

factory, branch/office and is engaged in production and/or distribution of some product/services.

• Household represents demand side, whereas Firm represents Supply side.

• Person who launches a firm is called Entrepreneur.• Entrepreneur takes decisions regarding size, location

of plant/office- nature & quality of product, factors & means of production, fixation of price, sales promotion, distribution channel, source of finance etc.

BASIC UNITS OF ECONOMIC SYSTEM (contd.)

INDUSTRYMeaning: All firms producing same or similar products.According to P.S. Florence; “An industry is a group of firms

tending to specialize in the same transactions or series of transactions”.

• Single unit of production, whereas Industry comprises of all the firms producing the same type of product.

e.g; Mercedes Benz is a firm, while all the firms producing cars constitutes Car industry.

GOVERNMENTAll public Agencies, State bodies and other units which govern

the country. GOVERNMENT

STATE GOVERNMENTCENTRAL GOVERNMENT

BASIC UNITS OF ECONOMIC SYSTEM (contd.)

GOVERNMENT (CONTD.)

STATE GOVERNMENT

CENTRAL GOVERNMENT

•Maintenance of Law & Order

•Provides public Services (e.g Education,

Health, Water, Electricity,

Telephone, Public transport etc.)

Several government/ public

enterprises:e.g: Indian Oil

Corporation, State Bank of India,

Steel Authority of India (SAIL)

FUNCTIONS OF ECONOMIC SYSTEM

What to produce

How to produce

Economic Growth

For whom to produce

Choice b/w Current needs &

Future needs

FUNCTIONS

TYPES OF ECONOMIC SYSTEM

TYPES OF ECONOMIC SYSTEM

MIXED ECONOMY

SOCIALISM

CAPITALISM

FREE MARKET ECONOMY

CAPITALISM

ECONOMIC SYSTEM

CAPITALISTIC ECONOMIC

SYSTEM

Features of Capitalism

Private ownership Free enterprise Consumer liberty Freedom to choose of occupation Freedom to save and invest The market system Competition Absence of central plan Limited role of government

Advantages of Capitalism

• Provides optimum allocation of resources, development of enterprise, invention and use of new technology etc. due to individual freedom

• Provides freedom to save and invest, result in higher growth rate because saving made by sacrificing the consumption are invested for growth.

• In capitalism consumers liberty to buy or not to buy goods and freedom of enterprise leads to competition. Therefore, price and other factors are set to equilibrium by market forces, i.e., demand and supply, etc

• Rational talents are better utilizing due to individual freedom and therefore productivity Increases. 

Limitations of Capitalism

• Right to property and freedom of enterprise will lead to accumulation of wealth and income disparities

• Theoretically, expressed that there will be free competition but generally larger firms will take advantage, which will lead to monopoly

• Absence of central planning results in no definite guidelines for national development.

• Cut-throat competition among individual may result in imperfection in market & adoption of unfair practices

• Once the upward and downward cycle starts there is no situation to normality. This results in price hike, inflation, deflation, unemployment etc.

Socialism

• Socialism means an economic system in which the means of production are owned by the state.

• In most important aspect of this type of economy is that all major decision related to the production, distribution, commodity and service prices are all made by the govt.

• Govt. is the final authority to take decision regarding production, utilization of the finished industrial products and the allocation of the revenues earned from their distribution

Features of Socialism

• Abolition of private property

• Collective ownership of means of production

• Central planning

• Elimination of unfair gaps in income

• Provision of necessaries of life

Advantages

• Elimination of wastage of resources• Elimination of concentrate of wealth• Elimination of unequal distribution of

wealth• Provision of necessaries of life• Immunity from Economic crisis• Elimination of unemployment

Disadvantages

• End of liberty• Weakening of the will to work• Error in planning• Failure in practice

• Where both Public & Private sectors exist. • Some resources and enterprises controlled

by the State, other economic activities are left to the private initiative.

• Private sector allowed to work for private motive but under certain regulations decided by the government.

• Extent of State participation & regulation may vary from time to time.

MIXED ECONOMY

2) Nature of the Economy World Bank has divided economies into 3 categories

a) Low income Economies (Thirdworld): Per capita income up to $1005

b) Middle income economies( Second world): Per capita income b/w $1006-$12,275

c) High income economies (First world) : Per capita income above $12,275

But Cost of living is different in different countries. For example USA is much more expensive as compared to India . So a concept of PURCHASING POWER PARITY is developed . It helps in converting income of country into another country income .

For example :PPP between USA and India is 3 , which means what 300 rs buys in USA can be bought for Rs 100 in India.

So we can also say $1000 income in India= $3000 earned in USA .

3) Structure of Economy :An economy consists of the PRIMARY,SECONDARY AND TERTIARY Sector

Normally ,as an economy develops the share of service sector rises in GDP and employment and primary sector decreases. After a certain stage the share of manufacturing sector also declines.

In developed countries 70% of GDP is in service sector…………………….

Country Nominal GDP

Primary Secondary Tertiary

USA 14,657,800 1.1% 22.1% 76.8%

INDIA 1,537,966 18.5% 26.3% 55.2%

CHINA 5,878,257 10.2% 46.9% 43%

UK 2,247,455 0.7% 21.8% 77.5%

4) ECONOMIC POLICIES There are several economic policies like - Trade policy, monetary policy,

fiscal policy, income tax policy etc.

Some businesses are favourably affected by government policy, some adversely affected, while it is neutral in respect of others.

Monetary Policy

• Monetary policy refers to the process by which the central bank or monetary authority of a country controls the supply of money, often target Government appointed central bank, RBI in India, usually administers monetary policy.

• It is the process by which central bank of a country controls – Supply of money– Availability of money– Cost of money/rate of interest

Objectives Of Monetary Policy

To achieve price stability by controlling inflation and deflation.

To promote and encourage economic growth in the economy.

To ensure the economic stability at full employment or potential level of output.

Instruments of Monetary Policy

The instruments of monetary policy (method of credit control) maybe broadly divided into-

General credit control or quantitative methods

Selective credit control or qualitative methods

General Credit Control

Its main instruments are:– Bank rate

– Open market operations

– Reserve requirements

Bank Rate Policy

Bank Rate in India is decided by RBI.   This is the rate at which central bank (RBI)  lends money to other banks or financial institutions.   If the bank rate goes up, long-term interest rates also tend to move up, and vice-versa. Thus, it can said that if bank rate  is hiked,  in all likelihood,  banks will  soon hikes their own lending rates to ensure that they continue to make profit.

Open Market Operations

• The open market operations is sale and purchase of government securities and Treasury Bills by the central bank of the country.

• When the central bank decides to pump money into circulation, it buys back the government securities, bills and bonds.

• When it decides to reduce money in circulation it sells the government bonds and securities.

• The central bank carries out its open market operations through the commercial banks.

Cash Reserve Ratio(6.5%)

• The cash reserve ratio is the percentage of total deposits which commercial banks are required to maintain in the form of cash reserve with the central bank.

• The objective of cash reserve is to prevent shortage of cash for meeting the cash demand by the depositors.

Statutory Liquidity Ratio(24%)

• In India ,the RBI has imposed another reserve requirement in addition to CRR. It is called statutory liquidity requirement.

• The SLR is the proportion of the total deposits which commercial banks are statutorily required to maintain in the form of liquid assets in addition to cash reserve ratio.

Selective Credit Control

• Minimum margin of lending against specific securities

• Fixing a ceiling on the amounts of credit for certain purposes

• Discriminatory rates of interest charged on certain types of advances

• Direct action against commercial banks that violate the rules & regulations

• Moral persuasion may restrict commercial banks to deal in speculative business or from liberal lending

• Legislation adopted for expanding or contracting credit money in the market

• Publicity may be resorted, suggesting commercial banks to control credit by either expansion or contraction

Increase OR Decrease the lending Rates

• The RBI makes an adjustment in its lending rate in order to influence the cost of credit.

The Central Bank does this by issuing fresh bonds and treasury bills in open market.

CRRCRR

By increasing the CRR, the RBI decreases the lending By increasing the CRR, the RBI decreases the lending capacity of the capacity of the bankbank to the extent of the increase in the to the extent of the increase in the ratioratio.

Fiscal Policy

The term fiscal policy refers to the expenditure a government undertakes to provide goods and services and to the way in which the government finances these expenditures.

• Government spending policies that influence macroeconomic conditions are known as fiscal policies.

Objectives of Fiscal Policy

• Economic Growth

• Equitable Distribution of Wealth

• Full Employment

• Exchange Stability

• Balanced Regional Development

Instruments of Fiscal Policy• Budget- Keeping budget in balance, surplus or deficit is in itself a

fiscal instrument. When the govt. keeps its total expenditure equal to its revenue as a matter of policy it means it has adopted a balanced budget policy.

• Taxation- Tax is an important source of raising revenue, taxes maybe direct or indirect.

• Public Expenditure- Public expenditure results in overall rise in the economic activity. Therefore, govt.’s tax revenue will also increase. Hence, there is no increase in the fiscal deficit in such cases.

• Government Borrowings- In developing economies, the govt. resorts to borrowing in order to finance schemes of economic development. Public borrowing becomes necessary because taxation alone cannot provide sufficient funds for economic development.

Regulatory Role

• By regarding the countries, persons or business firm through the several policies and act.E.g. Industrial licensing policy, MRTP (Monopoly Restricted Trade Practices)

• By regulating the conduct of business firm through laying down general standardE.g. 8 hours of week, prohibition, of child labor etc.

• Regulating and result of business that is profit and dividend through limiting the profit utility, ceiling of dividend, high tax imposition on excess profit, etc.

• By regulating the relationship between various part of business.

• Government regulation of the economy broadly divided into direct control and indirect control

Promotional Role

• The promotional role played by the government is very important in developed countries as well as developing countries. Following are the main objectives behind the promotional role of the government.• To assist and develop industrial, agricultural labor

and consumer interest.• By providing various fiscal monetary and other

incentive government can promote overall economic development.

• E.g.. Tax holiday for 5 years, tax free dividend etc.• By establishing financial institution such as

IFC,ICICI,IDBI, SFC, etc.

Entrepreneurial Role

In many countries, states also play the role of an entrepreneur where state establish the business and bear the risk. The government act as on entrepreneur because of the following reason:-• To balance economic ups and down such as inflation and

deflation.• To take over on profitable business to services are required

to general public.• To prevent the wastage of natural resources such as coal

fuel petroleum products steel etc.• To prevent monopoly or oligopoly.

Planning Role

• Especially in developing countries, the states place a very important role as a planner. The need for economic planning is implied in the famous scarcity definition of economics. As Robbins point out in the scarcity of the scares resources. Hence proper planning is required for optimum allocation of scares resources.

5) Business cycle/Economic conditions ?

Business Studies You MUST focus on the impact on

businesses!

Business Cycle Phases..

Business Cycle & Long term trends…

The recession of the early 1990s

Characteristics of an Economic Recession

Declining aggregate demand for output Contracting employment / rising unemploymentSharp fall in business confidence & profits Decrease in fixed capital investment spendingReduced inflationary pressureFalling demand for importsIncreased government borrowing Lower interest rates from central bank

Business and a Boom!

• A boom occurs when national output is rising at a rate faster than the trend rate of growth…i.e. faster than Govt expects!

• It is characterised by HIGH consumer spending, high business confidence, investments and profits!

• There is a lot more output

Characteristics of an Economic Boom

• Strong and rising level of AD• Often driven by fast growth of consumption• Rising employment and real wages• High demand for imported goods & services• Government tax revenues will be rising quickly• Company profits and investment increase• Increased utilisation rate of existing resources• Danger of demand-pull and cost-push inflation if the

economy overheats

USA BUSINESS CYCLE(2006-2010)