AS Economics and BusinessCauses of uncertainty

Unit 2b

By Mrs HiltonFor revisionstation

Lesson Objectives

• To be able to discuss; shock, economic change, exchange rate movements and government intervention

• To be able to discuss why uncertainty is a problem

• To identify the effects of uncertainty on business planning and strategic decisions

Starter

• What will happen tomorrow? Next week? Do you know what is in your future? Discuss

Uncertainty

• Some things in your future you can predict:

You will go to school You will sleep late on Saturday You will eat lunch every day this

week• Some things you cannot predict:X If you will win the lotteryX If you will win a school prizeX If you will be late to school because

of a traffic jamX Who you will marry

Uncertainty in business

• A business cannot possibly know everything that will happen in the future

• But• It can have a

contingency plan for some eventualities

Definition of uncertainty from the exam board

• Uncertainty is when businesses are unable to predict external shocks or future events.

Definition of contingency planning

Business planning such as contingency planning is when a firm prepares for unwelcome or unlikely but possible

problems

BackgroundSince mid-2008, the UK economy has

faced an unprecedented series of large adverse shocks that have led companies and households to become more uncertain about future economic prospects.

These shocks include one of the United Kingdom’s largest ever financial crises, continuing problems from the euro-area debt crisis and the implementation of the Government’s fiscal consolidation programme.

The unusual size and nature of these shocks might have led households and companies to reassess their beliefs about the range of possible paths the economy can take. In other words, they may have become more ‘uncertain’ about the current and future economic climate.

Shock

• An event that produces a significant change within an economy, despite occurring outside of it. Economic shocks are unpredictable and typically impact supply or demand throughout the markets.

• Example public sector cuts cause economic shock: http://www.bbc.co.uk/news/uk-politics-11248752

Shock

• An economic shock may come in a variety of forms.

• A shock in the supply of staple commodities, such as oil, can cause prices to skyrocket, making it expensive to use for business purposes.

• The rapid devaluation of a currency would produce a shock for the import/export industry because a nation would have difficulty bringing in foreign products.

• Economic shock can be caused by natural disasters

Macroeconomic shock

• Changes in• the exchange rate• the interest rate• taxation• Government spending • the economic growth rate• the inflation rate • the rate of unemployment

Uncertainty and spending decisions

• As uncertainty about future economic conditions changes over time it can affect spending decisions.

• If one company is taken over by another, the employees may feel more uncertain about whether next year’s pay will be higher or lower than currently.

• Or businesses may become more unsure about the level of next year’s orders if there is a change of government in one of their export markets.

• Households faced with uncertainty may save more rather than spend.

• Consumers may delay the purchase of a large item such as a car or house, these industries feel effects of shock and uncertainty the most

• Companies may decide to delay an investment decision with a “wait and see” policy to see if the project is viable

How a business may protect itself from uncertainty

• A business may be involved in import and export and be affected by fluctuations in the exchange rate.

• This could cause huge problems for the business if there are a lot of fluctuations – see diagram euro to £ changes over just 90 days

• foreign exchange can be bought and sold in advance – what is known as the ‘forward’ market

How a business may protect itself from uncertainty

• A business may worry about fluctuating interest rates and so may take out a long term loan at a FIXED rate of interest. So payments stay the same and the business knows its fixed costs each month will not change.

How a business may protect itself from uncertainly

• A simple way is to take out insurance against risk• For example a DJ may have public liability insurance in

case anything goes wrong with his equipment (like it catching fire)

Structural change and uncertainty

• As an economy changes over time it will see shifts in its structure.

• For example UK move away from primary and secondary sector businesses such as manufacturing and into tertiary businesses such as; banking, insurance, law and finance. What is known as the “knowledge economy”.

• As these changes occur it can cause economic uncertainty for a country or a business.

• As areas (e.g. Manufacture of cars) grows or decline this causes structural change, maybe permanent sometimes semi-permanent and this will cause uncertainly.

Sample question 1

• Lloyds TSB Bank plc advises its business customers to prepare a contingency plan.

• Which one of the following is most likely to reduce uncertainty for a business?

• A Market research• B Government intervention• C Macroeconomic change• D Exchange rate movements

Answer question 1

Answer A – Market research• A definition of contingency planning e.g. when a firm prepares for

unwelcome or unlikely but possible problems OR definition of market research e.g. the collection of data about current and future customer needs and/or factors affecting the marketplace (1 mark)

• Contingency planning often requires market research and can provide the business with information on future trends (1 mark)

• Market research can help businesses to prepare for possible problems in order to survive (1 mark)

Up to two of the marks above can be achieved alternatively by explaining distracters, e.g.

• B is wrong because government intervention is likely to increase uncertainty because the Government can change laws, taxes and affects how businesses run which leads to more uncertainty (1 mark)

• C is wrong because macroeconomic change such as unemployment will cause uncertainty to increase rather than decrease because businesses will be unable to predict future consumer demand for its products/services (1 mark)

• D is wrong because exchange rate movements affect businesses who import/export increasing uncertainty(1 mark)

Sample question 2

• Assess two methods the fashion business could use to reduce uncertainty caused by macroeconomic change [10]

• 5 marks for each method

Answer question 2

• Knowledge 2, Application 2, Analysis 4

• Knowledge/understanding: up to 2 marks are available for identifying reasons e.g. customer service, differentiated products, short product development leadtime, community supporting local businesses (1 mark per reason), diseconomies of scale (1 mark), batch production (1 mark)

• Application: up to 2 marks are available for contextualising the response by referring to a micro business/large businesses e.g. the business sells menswear clothing (1 mark); the business manufactures from old fabrics (1 mark); the business operate in a niche market (1 mark); Primark operates in a mass market (1 mark)

• Analysis: up to 4 marks are available for giving a reason/cause/consequence of the business surviving e.g. the business may charge a premium price for its garments which may ensure sufficient revenues/profits (1 mark) and therefore survival/growth (1 mark); the business produces unique designs for more specific tastes (1 mark) which limits competition (1 mark); the business may have better customer service than a mass clothing retailer (1 mark) which gives it a USP (1 mark);

• It has lower costs (1 mark) due to smaller batch production methods (1 mark);the business can respond to changes in consumer tastes and preferences (1 mark) because it has a more flexible batch production process (1 mark)

Sample question 3

Answer question 3

• Answer – (A) prepares resources for possible problemsBusiness planning such as contingency planning is when a firm prepares for

unwelcome or unlikely but possible problems• Uncertainty is when businesses are unable to predict external shocks or

future events (1 mark)• ASDA has prepared a contingency plan for bad weather which may

include things such as supplies, staffing, grit, snow ploughs (1 mark).• ASDA may not need to implement its plan if it doesn’t snow but this will

reduce the uncertain effects of bad weather such as customers not being able to park/suppliers getting food to ASDA (1 mark)

Up to two of the marks above can be achieved alternatively by explaining distracters, e.g.

• B is wrong because market research may help reduce uncertainty but planning will still be needed by ASDA (1 mark)

• C is wrong because business planning is not just about planning for changes in consumer behaviour but also considers external economic influences such as shocks (1 mark)

• D is wrong because business planning can only reduce uncertainty not ever eliminate it (1 mark)

Sample question 4

• Structural change in an emerging economy such as China is likely to involve all ofthe following except

• A changing patterns of demand.• B a decline in certain industries.• C a reduction in uncertainty.• D new industries expanding.

Answer question 4• C – a reduction in uncertainty

Some understanding of what is meant by structural change e.g. Structural change involves permanent or semi-permanent changes in the composition of an economy as areas grow or dwindle (1 mark)

Some industries in China will decline and others will flourish and grow (1 mark) e.g. growth in toy manufacturing

The transition is likely to involve greater uncertainty (1 mark)

There may be uncertainty due to the changing nature of industries (1 mark) as employees fear job losses in the future (1 mark)

Structural change is closely linked to changes in the patterns of demand(1 mark) and China will have changes to the patterns of demand withinthe economy.

Quiz..

2.3.5b(1) Causes of uncertainty

Q133: What particular legal uncertainties do firms face when operating in foreign countries?

A: Transparent access to justice and a framework of reasonable laws is both desirable but also not that common. Oil workers are regularly kidnapped in Nigeria, British householders in Spain have had their houses demolished because they thought (incorrectly) their paperwork was in order, courts may blatantly prefer local companies in commercial disputes

2.3.5b(1) Causes of uncertainty

Q134: What technological change has all but wiped out public telephone boxes?

A: The invention of the cheap mobile phoneComment: One common strategy on the part of

established companies is to invest in new technologies which may supplant their own. So an oil company might invest in green energy on the grounds that if environmental concerns ever led to a reduction in oil consumption it would be well placed to survive

2.3.5b(1) Causes of uncertainty

Q135: Social changes cause few shocks. Why is this?

A: The term covers matters like cultural and demographic changes, which are almost always relatively slow moving

Comment: Firms still need to respond to them, not least because social change often precedes legal change. For example, the growing social disapproval of smoking led to smoking bans in public places in England in 2007. This hastened the demise of many traditional male-oriented pubs

2.3.5b(1) Causes of uncertainty

Q136: The following causes of macroeconomic shocks are listed in what kind of order? Changes in: the exchange rate, the interest rate (r), taxation (T), gov’t spending (G), the economic growth rate, the inflation rate & the rate of unemployment (N)

A: The speed and surprise with which they can happen. A single piece of news can change the sterling exchange rate within minutes, interest rate changes are announced once a month by the Bank of England, and so on.

2.3.5b(1) Causes of uncertainty

Q137: What types of company would be affected by exchange rate shocks?

A: Major net exporters or net importers – with a fall in the exchange rate being bad (good) news for importers (exporters), and vice versa for a rise

Comment: Exchange rate fluctuations can be cheaply insured against, so the short-term danger to a company of this sort of shock is much diminished – as with the case of fire or flooding on company premises

2.3.5b(1) Causes of uncertainty

Q138: What types of business are sensitive to interest rates, and would view a sudden increase in the rate as an unpleasant shock?

A: Any business connected with housing or cars, in other words big ticket items whose buyers normally have to borrow money to complete the purchase. Companies which have borrowed large sums of money to invest in expansion at variable interest rates will also be vulnerable to increases

2.3.5b(1) Causes of uncertainty

Q139: Which types of tax increase are most likely to come as a nasty shock to companies?

A: Any taxes which they pay themselves. Employers’ National Insurance contributions (currently 12.8% of all employees’ earnings above the threshold of £5,700), business rates on company premises and corporation tax on company profits are the main ones. Also excise duties on alcohol, tobacco and petrol.

2.3.5b(2) Why uncertainty is a problem

Q140: What is the general effect of uncertainty on the amount of business activity undertaken?

A: It will be reduced. Companies normally need bigger potential rewards to compensate for greater risk – and there will be fewer business opportunities offering those bigger rewards

Comment: At its simplest, companies offering security services have to be paid much more if the assignment is based in Iraq or Afghanistan

2.3.5b(2) Why uncertainty is a problem

Q141: Apart from physical risks, what other business risks are faced by companies choosing to work in parts of the world with less stable governments?

A: The attitude of the government may be unpredictable – for example, a foreign business may be nationalised, told to quit – or its life made difficult if it fails to offer favours to the well-connected. These might include finding jobs for those with influential relatives and offering bribes

2.3.5b(2) Why uncertainty is a problem

Q142: What sorts of events could lead to a business facing a collapse in demand for its products?

A: For a retailer, a competitor might open nearby or the character of an area decline. For a manufacturer, a technological innovation by a rival could leave it with an unsaleable product, as could the opening of an industry to international trade when it was previously protected

2.3.5b(2) Why uncertainty is a problem

Q143: What sort of events could leave a company with an inability to supply a product?

A: Loss of its premises through fire, loss of its information through a virus attack on its computer network, an effective strike by its staff – or an inability to source a key raw material e.g. a mining enterprise hits a geological problem

Comment: Collapses of demand, or of supply, or the hostility of government are the main causes of events leading to a firm’s demise