Bus& 101 Chapter 02How Economics affects Business

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Goals:

1. Basic Economics2. What is capitalism and how to free markets work?3. What are the major differences between socialism and

communism?4. Explain the trend toward mixed economies5. Discuss the economic system in the USA, including the

economic indicators1. GDP (Gross Domestic Product)2. Unemployment3. Price Indexes4. Productivity

6. Define Fiscal Policy and Monetary Policy, and explain how each affects the economy

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Define Economics

•The study of how society chooses to employ resources (factors of production: land, labor, capital, entrepreneurship, knowledge) to produce goods & services and distribute them for consumption among various competing groups and individuals

•The study of the allocation of scarce resources▫There are not enough resources for all 6 billion people

to have and do exactly what they want

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Resource Development

•The study of how to increase resources and to create conditions that will make better use of those resources▫Examples:

Recycling Oil conservation New energy sources New ways of growing food

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Macroeconomics•Looking at operation of nation’s economy as a whole•Topics such as:

▫GDP (Gross Domestic Product)▫Unemployment rate▫Price indexes▫Population growth

•Some Macroeconomists try to figure out what makes a country relatively wealthy or relatively poor▫Example: Hernando de Soto, an economist from Peru,

studied why entrepreneurs did not thrive and discovered that it was in large part due to the fact that there were no laws to provide property titles

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Microeconomics

•The part of economics that looks at the behavior of people and organizations in particular markets

•Topics such as:▫Pricing▫Supply and Demand

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Credit = Loan = Debt = Borrow Money

•Credit = Loan = Debt = Liability = Borrowed Money

•Really?•There are always two sides to the coin:•1 side = Borrower•2 side = Lender•Borrower Lends money•Borrower borrows money•Interest is rent on money•Borrowers pay interest (expense)•Lenders receive interest (revenue) 7

Paid Back Borrowed amount and Interest at endYears 1Amount of Loan $150.00Interest Rate per year (compounded only once) 6.95%Interest $10.43Total Paid in 1 year $160.43

Paid Back Borrowed amount and Interest at endYears 5Number of compounding Periods Per Year 12Amount of Loan $5,000.00Interest Rate per year (compounded 12 times a year) 6.95%Monthly Interest Rate 0.58%Interest $2,070.53Total Paid in 5 year $7,070.53

Paid Back Borrowed amount and Interest at endYears 5Amount of Loan $5,000.00Interest Rate for each year on original Amount 6.95%Interest paid each year $347.50Loan paid back $5,000.00Total Interest Paid = $5,000*6.95%*5 = $1,737.50 $1,737.50Total Paid $6,737.50 8

Credit and Entrepreneurs help create wealth•Entrepreneurs:

▫See problems▫Think of idea to solve problem▫To start a business they need money▫Often credit (loan money for interest) is used▫Start business▫Business employs people▫Business provided solution to problem▫Business pays taxes (remember: private property and

enforcing contacts are done by governments)▫Everyone is better off.▫But can all entrepreneurs get credit at a reasonable

rate?

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Analogy For Why Businesses Helps To Alleviate Poverty

•Teach a person to start a fish farm, and she or he will be able to feed a village for a lifetime▫This is true because entrepreneurs and businesses

provide goods and service, employment and taxes (amongst other benefits)

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Thomas Malthus

• (1766-1835) Author of an Essay on the Principles of Population in 1798 postulating that any temporary or local improvement in living conditions will increase population faster than the food supply, and that disasters such as war and pestilence, which check population growth, are inescapable features of human society. (answers.com)

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Adam Smith• (1723 – 1790) Adam Smith believed that the freedom to

own property and keep profits was the best incentive for people to work hard and long hours. With this freedom people would be self-directed to gain profit, produce goods/services, add jobs to the economy and supply new ideas which in turn would benefit society as a whole and lead to economic prosperity.

• Adam Smith assumed that wealthy people would help less fortunate people in society

• Adam Smith coined the term:▫ Invisible Hand

The process that turns self-directed gain into social and economic benefit for all

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In the 2007-2010 Financial Crisis, did the Invisible Hand work?▫Invisible Hand

The process that turns self-directed gain into social and economic benefit for all

▫Without some regulation by governments the invisible hand can turn into a greedy hand

▫There is good empirical evidence that shows that after deregulation of financial markets (Reagan, Clinton, Bush), banking and other financial crisis increased dramatically

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How Do Different Economic Systems Promote Or Hinder

•Business growth•The creation of wealth•A higher quality of life for all

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Economic Systems

•Capitalism•Communism•Socialism

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Capitalism•An economic system in which all or most of the

factors of production and distribution are privately owned and operated for profit▫Business people decide:

What to produce How much to pay workers

(Government does set minimum wage) Prices for goods/services Whether to import or export goods/services

•Capitalism goes not guarantee success, but it does provide the opportunity to create new businesses (success or failure)

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Capitalism Is Also Known As “Free-market” Or “Free Market Capitalism”

▫Market not controlled by government

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There Are Four Basic Rights Under “Free Market Capitalism”:

•The right to private property•The right to own a business and to keep all of the

business’s profits•The right to freedom of competition•The right to freedom of choice

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The Right To Private Property

• If you own the property you have the incentive to take good care of your property

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The Right To Own A Business And To Keep All Of The Business’s Profits

•Profit = Revenue – (Expenses including Tax Expense)

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The Right To Freedom Of Competition

•Within some government guidelines, individuals are free to compete with others by offering new goods/services promotions, and signing contracts as they see fit▫Guidelines like:

Uniform Commercial Code Minimum Wage Laws

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The Right To Freedom Of Choice

•Freedom to choose where to work, where to live, what to buy, what to say, who to worship, and freedom from want and fear (FDR).

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How Free Markets Work

•When consumers choose to buy or not buy certain products they send signals to producers

•When consumers raise or lower the price that they are willing to pay for a good/service they send signals to producers

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Prices (“Price Signal”)

• If everyone wants a particular item and there are not many of that item, the price goes up.▫At that point, the item can be sold at that higher price,

or more items can be made, or a substitute for the original item can be made.

•When the price goes up enough, this is a signal to producers to make more of that item. As more producers make that item and the supply of items gets large, the price will go back down again.

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How Prices Are Determined•Buyers (Demand) and sellers (Supply) negotiate in

the marketplace

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Supply (Supply Curve)

•The quantity of products that manufacturers or owners are willing to sell at different prices at a specific time.

•Supply tends to increase as the price increases (direct relationship)

•Price determines quantity

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Demand (Demand Curve)

•The quantity of products that people are willing to buy at different prices at a specific time.

•Demand tends to decrease as the price increases (indirect or inverse relationship)

•Price determines quantity

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Equilibrium Point (Market Price)

•The point at which the Supply and Demand Curves intersect▫In the long-run, the Equilibrium Point is the Market

Price•This is the “Price Signal”

▫In free markets the price of an item that is determined in the market place is called the “price signal”. This price signal is what tells producers what to make and how much to make of a particular product

• In countries without free markets, the price signal is not available and so the government does not always know what to make, or how much to make. 28

Supply & Demand Curves do not always work the same for:

•Financial Assets (Stocks, Bonds, etc.)▫When stock price go up, does a business issue more

stock?▫Would you like it if you owned stock and every time

the price went up, the company issued more stock?▫We want a stock where supply cannot be increased

to meet demand because then the price will stay high (because it is scarce).

•Fine Art & Luxury Goods:▫High Price = High Demand (because it is scarce)▫If there is a high price and high demand for a

Matisse painting, do suppliers make more? 29

If You Know Algebra and the Price is the independent variable…

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Competition Within Free Markets

•Perfect Competition•Monopolistic Competition•Oligopoly•Monopoly

•Competition is good▫Competition make you better!▫Competition between business means that the

consumer gets a better product at a cheaper price

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Perfect Competition

•The market situation in which there are many sellers in a market and no seller is large enough to dictate the price of a product

•Products appear to be identical•There are no examples of businesses that compete in

a Perfect Market. Farms may be the closest, but with fewer farms and government price supports Farms do not compete in a Perfect Competition Market

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Monopolistic Competition•The market situation in which a large number of

sellers produce products that are very similar but that are perceived by buyers as different

•As companies consolidate (companies buy other companies), there are fewer and fewer examples in the United States.

•Examples:▫Computers (could also be oligopoly)▫Candy (could also be oligopoly)▫Fast-food (could also be oligopoly)

•Product Differentiation (packaging, advertising, branding) is the key to success (more than price) 33

Oligopoly•A form of competition in which just a few sellers

dominate the market. Usually cause by the high cost of setting up the business

•Examples:▫Airlines, Soft Drinks, Autos

•Product Differentiation (packaging, advertising, branding) is the key to success (more than price)

•Prices tend to be the same (Think of airlines) because if one company lowers the price, everyone would come to them. As a result, if one drops the price, they all tend to drop the price.

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Monopoly

•A Market in which there is only one seller for a product/service

•Examples: Utility companies•Monopoly:

▫Microsoft Windows?▫Apple iTunes?

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Benefits And Limitations Of Free Markets

•Benefits▫Quality Products at Fair Prices

If companies do not do this, they will lose business▫Entrepreneurial activity helps to reduce poverty▫Wealth

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Benefits And Limitations Of Free Markets

•Limitations▫Income inequality

Owners are wealthier than workers. Over time, the gap between wealth and poor can increase

▫The old and sick may not be able to start businesses▫Greed leads to company failures such as Enron,

Anderson International, Fannie Mae and AIG, Lehman Brothers The managers of these companies pursued personal

wealth in a reckless and irresponsible manner. The result was that many workers and ordinary people lost jobs, houses and more. In some cases tax payers had to pay Fannie Mae and AIG).

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Benefits And Limitations Of Free Markets▫Unchecked greed and cruelty can lead to activities such

as slavery and child labor▫Free-market mechanisms haven’t been responsive

enough to the needs of the poor, the old, the disables and the environment. Voters can elect politicians who will adopt social and environmental programs

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Communism (Also Known As Command Economies)

•An economic and political system in which the state makes almost all the economic decisions and owns almost all the major factors of production, and limits personal choices

•There are no price signals for the government to help make production decisions▫Shortages and surpluses are common

•Because people do not own personal property, the incentive to work hard in low

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Socialism

•Most businesses should be owned by the government so that profits can be distributed evenly. Some small businesses may be owned individually, but taxes are very high

•The benefits can be such things as▫Less income inequality▫Longer vacations▫Fewer hours worked▫Medical benefits

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Socialism

•The draw backs can be things such as▫Less incentive to work hard▫Brain drain (brightest and smartest may move to

capitalist countries because of high taxes)▫Fewer innovations▫Less wealth

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Mixed Economies

•Economic system in which some of the allocation of resources is made by the market place and some by the government

•USA is a Mixed Economy▫Social Security▫Regulation of stock markets▫Take over Insurance Companies!?

•USA more government involvement•China & France less government

involvement42

Major Key Economic Indicators:

•GDP•Unemployment Rate•Price Indexes•Productivity Measures

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GDP (Gross Domestic Product)

•Total value of final goods and services produced in a country in a given year

•This measure is important because the more that is made, the more people are working and can support their families

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Productivity

•The higher the productivity (make more with fewer inputs), the lower the cost of production, the lower the price to the consumer

•Service industry▫Although technology has increased the quality in fields

like teaching and health care, productivity measures have not increased much (because productivity measures do not measure quality as much)

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Unemployment Rate

•The number of civilians at least 16 years old who are unemployed and tried to find a job within the prior four weeks

•Four types of unemployment: Frictional Unemployment Structural Unemployment Cyclical Unemployment Seasonal Unemployment

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Frictional Unemployment

•People who have quit because they wanted to quit, because they are searching for their first job, or have been away from the job market for a while▫There is always Frictional Unemployment

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Structural Unemployment

•Caused by businesses that restructure or is due to a mismatch between skills (or location) of job seeker and requirements of available jobs

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Cyclical Unemployment

•Recession or downturn in the business cycle (normal ups and downs of business throughout the years)▫This is the most serious

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Seasonal Unemployment

•The demand for labor varies throughout the year due to things like harvesting crops or Christmas sales

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Purchasing Power of $1 in future• Inflation

▫The general rise in prices of goods and services over time▫Purchasing power of $1 goes down

• Disinflation▫The situation in which price increases are slowing (the

inflation rate in declining)• Deflation

▫A situation in which prices are declining▫Purchasing power of $1 goes up

•Stagflation▫Economy goes down and prices go up

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Inflation / Deflation

• Inflation▫Purchasing power of $1 goes down▫Debt repayment is benefited

•Deflation▫Purchasing power of $1 goes up▫Debt repayment becomes more burdensome

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Price Indexes

▫Consumer Price Index (CPI) and Chained Consumer Price Index (C-CPI)▫Monthly statistics that measure the pace of inflation or

deflation•Producer Price Index (PPI)

▫Prices measurement at wholesale level

* Chained Consumer Price Index (C-CPI) tried to take into account that people can switch when price go up.

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Business Cycle

•The periodic rises and falls that occur in all economies over time

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Four Phases Of Long-term Business Cycles

•Boom▫Businesses are doing well

•Recession▫Two or more consecutive quarters of decline in the GDP▫In general, prices fall, fewer consumer purchases,

businesses fail, high unemployment, Drop in living standards

•Depression▫A severe recession which usually has deflation

•Recovery▫Economy stabilizes and starts to grow

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Fiscal And Monetary Policy

•Governments try to use Fiscal and Monetary Policy to prevent Business Cycles from getting too extreme

•Fiscal:▫Taxes (down spurs growth)*▫Government spending (up spurs growth)*

•Monetary (Federal Reserve):▫Interest rates (down spurs growth)*▫Money supply (up spurs growth)*▫Lender of last resort (to prevent bank runs)*

•Keynesian Fiscal And Monetary Economic Theory:▫During recession increase spending & reduce taxes*in theory 56

National Debt

The Outstanding Public Debt as of 25 Mar 2010 at 08:51:13 PM GMT is:Total debt $12,666,299,517,353.90The estimated population of the United States 308,074,045.00 so each citizen's share of this debt = $41,114.46Debt added per day (since Sep 2008) $4,030,000,000.00Debt added per hour $167,916,666.67Debt added per minute $2,798,611.11Debt added per second $46,643.52

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Fiscal Policy

•The federal government’s efforts to keep the economy stable by increasing or decreasing taxes or government spending

•Taxes▫High taxes theoretically slow economy▫Low taxes theoretically boost economy

•Government spending during a recession can help people get back to work:▫Roads▫Unemployment payments

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Monetary Policy•The management of the money supply and interest rates

by the Federal Reserve▫Money Supply

If you increase the money supply too much, inflation may grow because there will be lots of money chasing fewer products

▫ Interest Rates Low Interest rates can encourage borrowing and may lead to

more investment in capital goods and in turn help the economy grow

Low interest rates for long periods of time can increase the money supply too much and may cause speculative bubbles (housing prices)

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Compare And Contrast The Economics Of Despair With The Economics Of Growth

•The Economics Of Despair▫Governments do little to promote:

Private property and contact laws Entrepreneurship

•The Economics Of Growth▫Governments promote:

Private property and contact laws Entrepreneurship

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What Is Capitalism And How To Free Markets Work?

•Capitalism▫An economic system in which all or most of the factors of

production and distribution are privately owned and operated for profit

▫Free Markets: The right to private property The right to own a business and to keep all of the business’s

profits The right to freedom of competition The right to freedom of choice

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What Is Capitalism And How To Free Markets Work?

▫Free Markets work Supply and Demand Price Signals help to efficiently allocate

scare resources

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What Are The Major Differences Between Socialism And Communism?

•The amount of government control▫Communism

Controls almost everything More shortages because price signals are not

available▫Socialism

Controls fewer elements of society Smaller business are allowed to be owned

privately Fewer shortages

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Explain The Trend Toward Mixed Economies•Free Market inefficiencies such as:

▫Owners have more wealth than workers and income inequality can become great as the years pass Elected officials therefore enacts social programs

such as Social Security and Unemployment programs▫The profit motive can encourage greed

The Credit Crisis in 2007 and 2008 exposed exploitive lending practices that damaged the economy

No regulation by government contributed to these exploitive practices, therefore government will regulate to prevent exploitive activities

▫The credit Crisis 0f 2007 & 2008 caused the government to take over banks

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Discuss The Economic System In The USA, Including The Economic Indicators

1. The economic system in the USA is a mixed economy where free markets and government programs work to allocate the factors of production

2. GDP (Gross Domestic Product)1. Total produced by USA in a time period

3. Productivity1. Output/Input; 6/2 = 3 8/2 = 4

4. Business Cycle1. Boom, Recession, Depression, Recovery

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Define Fiscal Policy And Monetary Policy, And Explain How Each Affects The Economy

•Fiscal Policy▫Government spending▫Taxation

•Monetary Policy▫Federal Reserve

Changes interest rates Changes the money supply In the 2007 and 2008 Credit Crisis, the Federal Reserve

has extended their activities to include loaning money to or taking over private companies (mixed economy)

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Chapter 2• Unemployment Numbers reported for March 2010:

▫9.7% (unchanged)▫162,000 new jobs▫How is this possible?

• Fiscal & Monetary Policy?▫Fiscal = Fed. Gov. adjust taxes or spending▫Monetary = Fed. Reserve adjusts interest rates or $

supply• Real and Nominal Interest Rates

▫Real = inflation takes out▫Nominal = actual rate

• Demography▫Census?

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