THE ECONOMIC ENVIRONMENT

CHAPTER 20
CHAPTER OVERVIEW

The governments economic objectives

Economic growth and the business cycle
Inflation
Unemployment
Exchange rates
Redistributing income and wealth
The governments economic policies fiscal, monetary, and supply side policies
Market failure
INTRODUCTION

Microeconomics: The study of personal, or small finances

Individuals, families, or businesses within the economy

Macroeconomics: The study of economic systems on a large scale

National or global economies
THE GOVERNMENTS ECONOMIC OBJECTIVES
20.1
THE GOVERNMENTS ECONOMIC OBJECTIVES

Every business is affected to some degree by the national or global economy

An economy comprises millions of buyers and hundreds of thousands of
businesses
These are all making decisions to spend, hire labor, use machinery, produce more or less,
lend or borrow money, etc.

This gets even more complicated when governments intervene in order to

achieve their social and economic objectives
Most want to manage economies to maximize the standard of living
THE GOVERNMENTS ECONOMIC OBJECTIVES

Key objectives for the UK are:

Sustainable economic growth
The value of the economy's entire production of goods and services should increase over time
Should be at a sustainable rate that can be maintained over time
A steady and low rate of inflation
Aims to have prices of goods rising a certain percent each year
Low levels of unemployment
Impossible to eliminate all unemployment
Want to achieve full employment (those willing and able to work all have jobs)
Stable exchange rates
significant fluctuations in exchange rates pose problems for businesses and can affect profits and sales quickly
Redistributing income and wealth to reduce relative poverty
Especially amongst vulnerable groups such as children and the elderly
THE GOVERNMENTS ECONOMIC OBJECTIVES

Other governmental economic objectives include:

Achieving a balance between the outflows of money from its economy and the inflows
Outflows caused by expenditure of imported goods and services, investments overseas, etc.
Inflows caused by sale of exports, receipt of foreign investment, etc.
These flows are recorded in a countrys balance of payments and should be equal over time

The balance of payments is a record of a countrys financial transactions with the rest of the
world over a period of time
ECONOMIC GROWTH AND THE BUSINESS CYCLE
20.2
ECONOMIC GROWTH

Economic growth is an increase in the value of goods and services produced by a

nations economy
Fluctuations in the rate of growth result in the business cycle
If economic growth is negative (economy shrinking) for a successive 6 months, it is in a
recession

Economic growth is normally measured by an increase in gross domestic product

(GDP)
Governments seek to increase this figure over time as it represents a rise in standard of living

Most economies grow over a period of time

In the short-term they can stagnate or decline in size
ECONOMIC GROWTH

Governments aim to maintain steady and sustained economic growth over a

period of time
This is a difficult objective to achieve
Will use interest rates and taxation policies to try and eliminate fluctuations

High rates of growth are not desirable as they tend to result in slumps
A slump takes place when production is at its lowest, unemployment is high and there are
many business failures
ECONOMIC GROWTH

Short-term growth can be encouraged by cuts in interest rates and taxation

Fuels borrowing and spending, prompting greater output and economic growth
The danger is that firms and individuals purchase products from overseas

Supply-side policies may be implemented to achieve sustained growth

Increasing productive capacity of the economy by improving skills of the workforce
THE BENEFITS AND DRAWBACKS OF ECONOMIC
GROWTH
CASE STUDY: UK ECONOMY GREW UNEXPECTEDLY
FAST IN 2013
1. Explain why economic growth is an important macroeconomic objective for
most governments.
Economic growth has the potential to increase living standards. As production increases in
value, more income is generated.
Economic growth can be expected to lead to increased taxation revenues for governments.
This allows them to spend more on education, health care, and infrastructure which should
promote further growth

2. Evaluate the extent to which the economic data provided in the case study
represents excellent news for all UK businesses.
Growth was nearly 2% in annual terms
Wage rates are increasing less than 1% annually
THE BUSINESS CYCLE

A business cycle shows fluctuations in GDP over time and has four stages:
Recovery or upswing
Production and employment begin to rise
Consumers will generally spend more as confidence of job security is increased
Businesses may still be cautious but as confidence increases firms may start to invest in additional assets
Employees experience less difficulty in finding jobs and wages may begin to rise
Boom
High levels of production and expenditure by firms, consumers, and the government
Prosperity and confidence in the business community
Investment in assets is likely to increase
Many sectors will experience pressureskilled workers become scarce, competitors, etc.
Shortages and bottlenecks may occur due to insufficient raw materials to meet demand, raising prices
Rising wages and rising prices will create inflation, which typically leads to the end of the boom
THE BUSINESS CYCLE

Recession or downswing
Incomes and output start to fall
Recession exists when GDP has fallen for 2 successive 3 month periods (6 months)
Falling sales eat into businesses profits
Will likely delay plans to invest in new factories, offices, etc.
Level of production may stagnate or fall; spare capacity will rise
Governments may lower interest rates trying to stimulate demand and sales
Some businesses will fail and bankruptcies will rise
Slump
Often follows a recession
Production is at its lowest, unemployment is high, increasing number of firms suffer insolvency
THE EFFECTS OF THE BUSINESS CYCLE

Not all businesses are equally affected by changing trading conditions

Some may find demand of their products is relatively unaffected
Producers and retailers of basic foodstuffs, public transport, water services, etc.
Demand for essential items is not sensitive to changes in income
Firms selling basic foodstuffs might have to take little or no action to survive a recession
Demand for other categories will be more sensitive
Foreign holidays, electrical products, construction materials
Businesses supplying the construction industry could be hard hit
GOVERNMENT POLICY AND THE BUSINESS
CYCLE
Governments attempt to offset the most extreme effects of the business cycle
Counter-cyclical policies are used to limit fluctuations in GDP
Reducing spending, raising interest rates and/or raising taxes during a boom
Will discourage investment and spending avoiding scarcity
Increasing spending, reducing interest rates and/or cutting taxes during a recession or slump
Economic activity may remain relatively stable
Encourages investment
Businesses need to take into account likely effects of counter-cyclical policies when
considering their responses to changing trading conditions in the business cycle
These policies can be beneficial as they avoid the need for firms to prepare for the
worst excesses of booms and slumps
CASE STUDY: PAKISTANS CENTRAL BANK
FORECASTS 4% ECONOMIC GROWTH
1. Explain the benefits to businesses in Pakistan of the countrys rapid growth in
population.
Provide the businesses with an enlarged workforce with a high proportion of younger
workers. They may be more mobile and willing to train for new roles
Can increase demand

2. To what extent does the information in this article represent good news for
businesses in Pakistan?
Rapid growth in GDP of around 4% exceeds IMFs forecasts. Should assist the government
in spending on education and infrastructure
The loan from the IMF can be used to improve infrastructure
BUSINESS STRATEGY AND THE BUSINESS CYCLE

The business cycle is a permanent feature of the economic environment for

firms

The effects of changes vary from industry to industry

Income elastic goods (those sensitive to changes in income) may find sales rise in a boom
and fall during a recession
Designer clothes, foreign holidays, etc.
Income inelastic goods may be relatively unaffected by the business cycle
Foodstuffs, fuel, water, etc.
BUSINESS STRATEGY AND THE BUSINESS CYCLE

The business cycle may only provoke short-term responses in many firms because its effects
are relatively short-lived
Booms and slumps dont last forever and businesses can take actions to see them through
difficult periods
During booms, managers may increase prices to restrict demand and increase profitability
May subcontract work to other firms and seek supplies from overseas
In recession or slump, lay-offs may occur or short-term working may take place
Overseas markets may be targeted to increase sales
Well-managed firms will predict the onset of a slump or boom and take appropriate action in
advance
If governments are successful in eradicating the more extreme effects of the business cycle,
short-term actions might be all that are required
REVIEW

What phase of the business cycle do wages go up? When will unemployment be at its lowest?
Upswing Boom
What phase of the business cycle do wages go When will business profits be the highest?
down?
Boom
Downswing
When should you look for a new job?
When are wages at their highest?
Upswing
Boom
When are wages at their lowest?
Slump
INFLATION
20.3
INFLATION

A persistent rise in the price level

Associated with the fall in the value of money

For many businesses, a low rate of inflation is not a problem

As long as wages are rising at about the same rate or higher, a low constant rate of price
increase helps maintain demand

Inflation becomes a major problem when it is high, rising rapidly, or doing both
INFLATION

Inflation has been historically low for the past 15 years in many industrialized
nations
Venezuela is currently experiencing some of the worst inflation in history
HOW IS INFLATION MEASURED?

It is measured using the Consumer Price Index (CPI)

Introduced in 2003 and measures the average monthly change in the prices of
goods and services purchased by the households in that country
THE CAUSES OF INFLATION

A number of factors may cause inflation

Classified as:
Demand-Pull inflation occurs when the demand for the countrys goods and services
exceeds its ability to supply these products
Cost-Push inflation happens when firms face increasing costs due to rising wages or
increasing costs of raw materials and components

The cause of inflation can be an important factor for businesses

Provides some indication of likely future government policies
DEMAND-PULL INFLATION

Occurs when demand for the countrys goods and services exceeds its ability to
supply these products
Prices generally rise to restrict demand to the available supply
The underlying cause might be due to the government cutting taxes or interest rates
Normally occurs at the boom stage
Shortages and bottlenecks occur in supply

Because resources and labor are relatively scarce, firms offer higher prices and
wages and this results in inflation
Governments will need to increase interest rates to prevent prices rising
COST-PUSH INFLATION

Occurs when firms face increasing costs due to factors such as rising wages or
increasing costs of raw materials and components
Can arise from:
Wage rises
If pay increases significantly above the rate of inflation, further prices rises may be the result
Becomes more likely if productivity doesnt increase
Imported inflation
A hidden cause of inflation is rises in import prices
Open economies that import large amounts of raw materials, components, and finished goods are
especially susceptible
Import prices rise when the exchange rate is falling and more domestic currency is required
Rising exchange rates help control inflation
CASE STUDY: COMPARING THE RATE OF INFLATION
IN CHINA AND RUSSIA
1. Explain the likely effects of Russias high rate of inflation on its businesses.
Businesses may lose price competitiveness on world markets
May be forced to accept lower profit margins if they are to compete with competitors
overseas

2. Chinese businesses have operated in a better macroeconomic environment

than those in Russia. Do you agree with this statement?
Chinese firms have benefited from lower rates of inflation helping to control costs
The impact of inflation rates will depend on exchange rates over the same period
This data doesnt cover many other aspects such as GDP growth
THE IMPACTS OF INFLATION ON BUSINESS

Inflation can have a number of effects:

Many businesses suffer falling sales in a period of inflation
People tend to save more due to uncertainty
Its difficult to maintain competitiveness (especially internationally)
Rising wages and raw material costs may force firms to raise prices or accept lower profit
margins
Firms operating in countries with lower rates of inflation may gain an edge in price
competitiveness
THE IMPACT OF GOVERNMENT ANTI-INFLATIONARY
POLICIES
High rates of inflation put pressure on governments
Businesses are frequently affected more by anti-inflationary policies than by inflation
Can be controlled in a number of ways:
Rises in interest rates
Increasing the base or prime rate reduces the possibility of demand-pull inflation occurring
Consumers are discouraged from spending money due to higher rates on savings accounts and do
not want to buy on credit as it is more expensive
Output and sales decline and inflationary pressure is lowered
Reducing the expectation of inflation
Helps businesses to be confident in setting prices; persuades foreign firms to invest in the country;
dissuades employees from putting in excessive pay claims; etc.
THE IMPACT OF GOVERNMENT ANTI-INFLATIONARY
POLICIES
Other approaches include:
Restricting the power of trade unions
This decreases the chances of cost-push inflation by restricting wage increases and reduces the
number of days lost to strikes, etc.

Inflation can offer some benefits:

Low and stable rates can help businesses
A steady rise in profits can create favorable expectations and encourage investment
Can encourage long-term borrowing
UNEMPLOYMENT
20.4
UNEMPLOYMENT

Unemployment exists when people are looking for work but are unable to find it

Unemployment remains one of the most important issues in most countries

It represents a waste of resources if labor is unused
If all available workers are being used, a countrys citizens would enjoy a higher standard of living

High and prolonged rates of unemployment can be devastating

Leads to poor health, crime, poverty, etc.
STRUCTURAL UNEMPLOYMENT

Occurs due to fundamental changes in the economy whereby some industries reach the end of
their lives
Adoption of new methods of production
Significant and permanent changes in demand
Increasing competition from overseas
Rising income levels meaning demand for some products declines

Also offers opportunities:

Rising incomes and technological developments led to the development of the mobile phone industry
A difficult problem for governments to solve
A large number of employees may no longer have the skills required
Training will be an important part of any solution
Encourage foreign producers to establish themselves in the country
CYCLICAL UNEMPLOYMENT

Arises from the operation of the business cycle

The boom stage will see this type of unemployment minimized

Even those who have been unemployed for some time and have relatively few skills may
find work

During a slump or recession unemployment will increase

Led to introduction of profit-related pay (allows pay to fall if profits fall)
Reduces number of workers made redundant (losing their jobs)
FRICTIONAL UNEMPLOYMENT

Occurs if a person leaves one job but is unable to move into a new position
immediately
Temporarily unemployed while searching for a new job

By providing information on job vacancies, a government may reduce the level

of frictional unemployment

A healthy economy will always have some amount of frictional unemployment

BUSINESS AND CHANGING UNEMPLOYMENT
LEVELS
Rises in unemployment can have serious implications on businesses
Depends upon circumstances and the type of unemployment
Cyclical might result in businesses suffering from falling sales
In the short term, firms may add any surplus production to inventories
May seek new markets
Structural unemployment can have a significant effect as it is frequently highly
localized and often very persistent
The high levels of unemployment in coal mining communities has affected most local
businesses
Falling production in the UKs shipbuilding industry contributed to the decline of the
countrys steel industry
CASE STUDY: GLOBAL MIGRATION

1. Explain the benefits that Australian businesses might receive from a net
inflow of migrants.
Growth in population will provide an enlarged workforce with a high proportion of younger
workers
May be highly skilled which has the potential to raise labor productivity

2. To what extent does a net inflow of migrants affect the competitiveness of

businesses in the receiving nation?
May increase competitiveness by solving labor shortages and could bring down wage rates
May bring skills lacking in the domestic workforce
May lack suitable language skills or not be of working age
BUSINESS AND CHANGING UNEMPLOYMENT
LEVELS
If there is a need to reduce output rationalization and redundancy might
follow
Factories and offices might be closed
R&D plans may be abandoned or postponed
A predicted fall in level of demand may encourage diversification, mergers,
broadening product ranges, etc.
Periods of low unemployment
Result in skill shortages
Training schemes and vocational courses should be implemented by the government
BUSINESS AND CHANGING UNEMPLOYMENT
LEVELS
Skills shortages
Encourage the development of capital-intensive methods of production such a technology
Can enhance international competitiveness
Lead to businesses relocating
Encourages investment in training schemes
Allows junior or unskilled employees to take on additional activities
Creates difficulties for many but opportunities for others
Recruitment agencies benefit
EXCHANGE RATES
20.5
EXCHANGE RATES

An exchange rate is the price of one currency expressed in terms of another

Exchange rates between most currencies vary regularly according to the

balance of supply and demand for each individual currency
WHY DO FIRMS BUY FOREIGN CURRENCIES?

The main reason is to pay for goods and services bought from overseas
Firms purchasing products from abroad are expected to use the currency from the
exporting country
Tesco buys wine Francethe wine maker would expect Tesco to pay in Euros not Thai
Baht

Demand for foreign currencies may also arise because individuals and
businesses wish to invest in enterprises overseas
A Hong Kong citizen wishing to invest in Brunei would need Brunei dollars to complete the
transaction
THE EFFECTS OF EXCHANGE RATE CHANGES

Exchange rates can change significantly over time

Appreciation is a rise in the value of a currency against another
Depreciation is a decline in the value of a currency against another
Small changes in the exchange rates of most countries occur all the time
Altered by demand for the currency and supplies of it
A series of slight rises and falls over a period of time is not a major problem
Its concerning when:
There is a sustained rise or fall
A sudden and substantial change
MATH MOMENT

In June 2014, an American company exported cars to Uruguay at an average

price in dollars of $32,000 per car.
1. Assuming no other changes, how much would an average car sell for in
Uruguay?
$32,000 x 22.97 = $735,040
THE EFFECTS OF EXCHANGE RATE CHANGES

Exchange rate changes can create uncertainty

Firms agree deals placed in foreign currencies
May receive more or less revenue from that transaction
Prices and sales in overseas markets
If a firm demands payment in their currency, importers might have to charge more if exchange rates change, and
this may lead to lower sales
Competitors responding in unexpected ways
Foreign firms may reduce prices to offset the effects of an exchange rate change
Price elasticity is an important part of the discussion on possible effects of exchange rate
changes
If overseas demand is price inelastic, the an increase in the exchange rate may not be too harmful
If demand is price elastic, a rise in exchange rates would hurt, but a fall could be beneficial
CASE STUDY: ARGENTINA'S CURRENCY FALLS
AGAINST THE DOLLAR
1. Explain the effects of the significant fall in the value of the Argentine peso on the
countrys employees.
Imports become more expensive reducing living standards; products employees might purchase
include electronic equipment, food, etc.
It may enhance employment prospects as Argentinean products will be more price competitive
on world markets

2. Do you think that Argentine businesses benefited or suffered as a consequence of

the changes in the value of the peso against the American dollar between
September 2013 and March 2014?
Export businesses could have benefited due to price competitiveness
Importers will face difficulties as costs have increased significantly
BUSINESS STRATEGY AND EXCHANGE RATES

Fluctuations in exchange rates create a great deal of uncertainty for

businesses trading internationally
When exchange rates are volatile, businesses become uncertain about earnings
Adds to the risk
Firms like to operate in relatively risk-free environments to reduce uncertainty
Forward foreign currency markets set a guaranteed exchange rate at some future date
The amount received from overseas trading is more certain
Fixing an exchange rate in this way does not guarantee a particular level of sales
The bank arranging this service may require a fee
BUSINESS STRATEGY AND EXCHANGE RATES

Exchange rate changes are more of a problem in markets where fierce price
competition occurs
Demand is more likely to be price elastic
Businesses are under pressure to respond quickly to any change in exchange rates

May respond by:

Creating productive capacity overseas
Foreign motor manufacturers located in the UK want to relocate in the euro zone to avoid
difficulties imposed by fluctuations in the value of the pound against the euro
Toyota has argued for the UK to adopt the euro to eliminate exchange risk
Require suppliers to price their products in a different currency
Toyota will pay UK suppliers in euros since its cars sold throughout Europe are sold in that currency
REDISTRIBUTING INCOME AND WEALTH
20.6
REDISTRIBUTING INCOME AND WEALTH

Income and wealth are not equally distributed between the citizens of most
countries
Many societies include people with large amounts of wealth and those who are poor
Income is a regular flow of money
Wealth is a store of assets (i.e. savings, investment, property, etc.)
Redistribution is intended to deal with inequality
Governments may:
Impose taxes on income and wealth
Provide welfare benefits.
THE SCALE OF THE PROBLEM OF INEQUALITY

One way of measuring income inequality is through the Gini coefficient

Measures the degree of equality using a scale of 0 to 1
1 equals perfect equality
The closer to 0, the greater the degree of inequality
The distribution of wealth is generally more unequal than that of income
China
2000: relatively equal distribution of wealth
2012: 10% control 86.7% of total wealth
USA
Richest 20% own approximately 83% of the countrys wealth
Malaysia
20% control 53.8% of the wealth
The poorest 60% own 21.3% of the wealth
THE RESPONSE OF GOVERNMENTS

A Gini coefficient higher than 0.4 can result in social problems

Due to gross inequality in income distribution
Can result in large numbers of people suffering poor living standards
May slow growth in an economy due to have little or no access to education and training
May lead to less consumption, reducing demand for products
THE RESPONSE OF GOVERNMENTS

Governments have implemented policies to redistribute income and wealth

Imposing taxes on income and wealth
Those with more wealth or higher incomes will pay more taxes
Providing welfare benefits
Poorer households receive cash and non-cash benefits
May be in the form of pensions, state provided healthcare, education, etc.
THE GOVERNMENTS ECONOMIC POLICIES
20.7
THE GOVERNMENTS ECONOMIC POLICIES

Governments operate a number of different policies to provide the best possible

economic environment for businesses
Entails adjusting the level of activity in the economy to avoid excesses of booms and slumps

Divided into three categories:

Monetary policy
Manipulating the amount of money and/or interest rates within the economy
Fiscal policy
Taxation and public expenditure
Supply-side policies
Improves free operation of markets and the total amount produced or supplied
Privatization; limiting trade union power; providing training for the unemployed
MONETARY POLICY

Involves adjusting the amount of money in circulation

Affects the level of spending and economic activity

This has three elements:

Adjusting interest ratestypically favored by governments
Controlling the money supply
Manipulating the exchange rate
MONETARY POLICY

The power to set interest rates is typically given to the central bank of that
country
Rises in interest rates depress the level of economic activity
Reductions in interest rates promote an expansion of economic activity
Interest rates are the price of borrowed money
The precise rate of interest charged on a loan depends on several factors
Base rates set by central bank
Time period of the loan
Degree of risk attached to it
MONETARY POLICY

Expenditure is particularly sensitive to changes in interest rates

Due to mortgage interest payments (large loans to purchase homes, buildings, etc.)
A rise in interest rates increases payments
Leaves less money available to pay for other types of expenditure
A cut in rates reduces mortgage payments, freeing money for other things
EFFECTS OF CHANGES IN INTEREST RATES

The impact of rising interest rates will depend upon

The size of the change
The initial rate

A small increase at a high level of rates will have little impact

A larger increase from a low base rate will have significant impact
EFFECTS OF CHANGES IN INTEREST RATES

Not all businesses are affected equally

Changes in interest rates particularly impact on:
Small firms
Have smaller financial reserves and a greater need for borrowing
Significant rises in interest rates can lead to increases in bankruptcies or insolvencies
Those with high levels of borrowing
An increase rates leads to bigger interest payments
Firms may have to cut costs elsewhere or charge customers higher prices
A cut in rates can improve competitiveness
Those who trade internationally
Rising interest rates tend to lead to an increase in exchange rates
A fall in interest rates leads to a decrease in exchange rates
CASE STUDY: CREDIT CARD WORRIES IN
SINGAPORE
1. Explain the likely effects on businesses in Singapore of the continued rises in
unsecured borrowing if the authorities did not take steps to control it.
Demand may increase in the short-term and may lead to rising prices of products and higher
profit margins
In the long-term, due to heavy borrowing, consumers may not be able to afford repayments. If
this occurs on a wide scale, profits may decline and banks may be less willing to make loans to
anyone
2. Would the effects of a continued rise in unsecured borrowing be entirely bad for
businesses in Singapore?
Too much credit can result in a financial crash where banks decide not to loan money
Investment may fall as banks charge higher rates or refuse to lend money
Consumer demand may fall as they seek to repay existing debts
EFFECTS OF CHANGES IN INTEREST RATES

Altering rates can also affect:

Levels of unemployment
Inflation
Economic growth
Managers expectations and day-to-day decisions
QUANTITATIVE EASING (QE)

When interest rates can go no lower, a central banks only monetary policy is
to pump money into the economy directly
Buys financial assets, like government and corporate bonds using money it has simply
created
The institutions selling those assets will then have new money in their accounts
This boosts the money supply
The hope is that this money is then used to purchase goods and services which
boosts output and growth
FISCAL POLICY

The use of government expenditure and taxation to control the level of

activity within the economy
A fiscal policy is the relationship between government expenditure and the
amount raised in taxation in a given year
FISCAL POLICY

The government can operate two broad types of fiscal policy

1. Expansionary fiscal policy
Entails cutting taxation and/or increasing govt expenditure on items like health,
education, social services, defense, transport, etc.
Increases the amount the government borrows (known as the public sector net cash
requirement or PSNCR) or
Reduces surplus on money in govts coffers
2. Contractionary fiscal policy
Reducing govt expenditure and/or increasing taxation
Cuts governments borrowing or reduces the deficit on its budget for the fiscal year
FISCAL POLICY

Fiscal policy can help to stabilize the economy through automatic stabilizers
Avoids the worst effects of the business cycle

Examples:
Lower unemployment when economic activity is high means temporarily lower social
security spending and higher income tax receipts
Higher company profits generates higher tax receipts
Higher spending by consumers yields higher receipts from indirect taxes

These factors will have a contractionary effect, dampening an economic boom

THE EFFECTS OF TAX AND EXPENDITURE POLICIES

Tax and expenditure policies can have immediate effects on the level of economic
activity
Precise effects will depend upon:
The types of tax altered
The nature of government expenditure
Direct taxes
Taxes on income and profits
Take larger amounts from individuals earning high salaries and companies making high profits
The government can forecast the effects arising from an increase/reduction in income tax
The implications for individual businesses vary according to the product
Luxury goods might be significantly affected by a change in income tax rates
Foodstuffs may be relatively unaffected
THE EFFECTS OF TAX AND EXPENDITURE POLICIES

Indirect taxes
Includes VAT (value added tax) and duties
Classified as indirect
Can have a rapid effect on the level of economic activity
Its effects are difficult to predict
An increase in VAT may lower consumer spending, reducing demand in goods, and
lowering economic activity
The extent of fall in demand will depend upon price elasticity of demand
A side effect of increasing indirect taxes is that it is inflationary
THE EFFECTS OF TAX AND EXPENDITURE POLICIES

Government expenditures is the other half of fiscal policy

Governments may spend more in two broad categories:
Transfer payments
Expenditure on unemployment benefits, pensions, social security payments, etc.
Will have a rapid impact as they are spent on poor members of society who will spend the
increase or cut back if necessary almost immediately
Increases often result in substantial increases in demand for food, public transport, gas, etc.
The infrastructure
Spending on housing, roads, flood protection, etc.
Increases level of economic activity by boosting demand for construction firms, etc. while
reducing costs for other firms
Slower method of altering the level of economic activity
SUPPLY SIDE POLICIES

Range of measures intended to improve the operation of free markets and

the amount produced by the economy
Makes markets and industries operate more efficiently

Most governments believe that improved supply-side performance is the key

to achieving sustained growth without causing a rise in inflation
LABOR MARKET MEASURES

Intended to allow labor markets to operate more effectively

Policies include:
Reducing the power of trade unions
Allows businesses to use labor more flexibly and efficiently
Employees carry out a range of duties rather than a limited role
Leads to fewer disputes and confrontations
Training programs
Equips unemployed with new skills
Limiting availability of unemployment benefits
Cutting income tax rates on low earners
Encourages people into the labor force
PRIVATIZATION

Transferring organizations from the state to individuals/other businesses

Many analysts argue privatized industries dont operate more effectively

Shortcomings of the idea have led to mild backlash

CASE STUDY: JAPAN'S ECONOMY SHOWS SIGNS
OF RECOVERY
1. Explain the likely effects of rising consumer confidence and spending on
businesses in Japan.
Spending will increase prices if supply is unable to keep up
Businesses may enjoy increased profit margins and being more willing to invest
Businesses may face higher costs from suppliers meaning higher prices for consumers

2. Discuss how the Japanese authorities might use economic policies to ensure
that the economy continues to grow steadily over the next few years.
Ensure demand does not grow too quickly or inflation may damage economic performance.
Raising interest rates would help prevent this by controlling demand
Could use fiscal policy to manage level of demand
MARKET FAILURE
20.8
MARKET FAILURE

Governments can intervene in the economy for reasons other than adjusting
the level of economic activity
Market failure occurs when a market does not work properly and resources are not
allocated correctly

When a market operates correctly, it responds to the signals given by prices

and
Increases the resources used by businesses in the market to supply more of the product
Reduces the resources used by businesses in the market to supply less of the product
Oil has gone from $19/barrel to $100/barrel due to demand
In response to the signal of rising prices, oil companies increased production
MARKET FAILURE

The failure of markets to work properly comes about for a number of reasons
Monopolies and cartels
Producers have too much power
Results in insufficient output and high prices
Consumers may receive too little of certain products, resulting in a lower standard of living
Damage to the environment
Producers dont bear the full costs of production
Society bears some of these costs (pollution)
These are called external costs
Can result in severe damage to the environment and can impose high costs on future
generations
Creates oversupply of certain products
MARKET FAILURE

Consumers and producers possess insufficient information about products

Consumers may underestimate their need for certain goods (health, education, etc.)
Results in inadequate supply without government intervention
Results in under supply with not enough resources allocated
It can result in over consumption of some products (drugs, etc.) if consumers are unaware of
dangers posed
Poaching of skilled labor
Investing in training provides job-related skills and an increase in productivity
But highly skilled employees may be attracted to rival companies offering higher wages
Can result in too few resources being allocated to training for fear of poaching
RESPONSES TO MARKET FAILURES

Monopolies and cartels

Many governments have enacted laws to encourage competition and restrict anti-competitive
activities
Prohibit the abuse of monopoly power (i.e. raising prices excessively)
Protects consumers
Offending firms are fined

Damage to the environment

Impose indirect taxes to raise costs of production
Should lead to higher prices and lower profit margins
Levy heavy fines on businesses that damage the environment
May pass laws to ban processes and products that cause external costs
RESPONSES TO MARKET FAILURES

Lack of information
Governments provide information about the benefits or drawbacks of products
Health information programs (i.e. campaigns on dangers of smoking, etc.)
Poaching of skilled labor
Difficult for any government
Governments can offer incentives for workers to stay
Providing training itself
Offering tax benefits to businesses providing training
Can be very costly