Economic Influences (Edexcel A Level Business)

The Effects on Businesses of Changing Economic Variables

• Economic influences can present significant opportunities and threats to business activities 

• Businesses need to anticipate and respond to changing economic variables in order to maximise their chance of success

• The following economic variable need to be considered

Changes in Inflation

• Inflation is the general rise in prices in an economy over time

  • The Consumer Price Index (CPI) measures monthly changes in the prices of a range of goods and services and compares these changes to earlier periods, calculating the rate of inflation

  • In the UK government, monetary policy focuses on achieving a 2% inflation rate and tasks the Bank of England to take steps to maintain this (e.g. raising the interest rate)

• After several decades of relatively low levels of inflation, the UK has recently experienced rapidly increasing levels

Rapid inflation is causing problems for businesses and households in the UK

• High or fluctuating levels of inflation can be problematic for businesses for several reasons

Problems Caused by Inflation

• Increased costs

  • Workers often demand higher wages to compensate for the increase in the cost of living

  • Suppliers increase the cost of raw materials and components

  • Utilities such as electricity become more expensive

• Higher repayments on loans

  • Interest rates usually rise as the Bank of England uses the base rate as a tool to control inflation, making new and  variable rate  borrowing more expensive

• Consumers change spending habits

  • Deters consumers from making significant purchases and they may reduce demand for usual lower priced wants too e.g cinema tickets

  • Purchasing on credit becomes more expensive

• International competitiveness

  • Where domestic inflation rates are higher than those in other countries:

    • UK businesses are less likely to be competitive and lose sales

    • Imports of overseas competitors are likely to cheaper than domestic goods

• Uncertainty

  • Occurs when businesses cannot predict prices even in the short term

  • Survival may need to become the key business objective until stability returns

  • Spending and contract decisions are likely to be delayed

Changes in exchange rates

• The exchange rate is the value of one currency expressed in terms of another

• Exchange rates are an important economic influence for businesses that  import  raw materials and components and for businesses that export their products

• Exchange rates fluctuate for a range of reasons, including

  • Changing demand for a currency

  • Economic growth

  • Changes to interest rates

The Impact on Business of Currency Appreciation & Depreciation

Changes in interest rates

• The interest rate is a percentage reward offered for saving money and the percentage charged for borrowing money

• Lenders commonly charge interest on borrowing at a rate higher than that of the Bank of England base rate  

  • They then offer a lower rate on savings and investments

• If interest rates rise businesses will have to pay more on new or variable rate borrowing, which will increase their costs

• Businesses may be less willing to make  capital investments when their retained profit may be more profitably invested into savings schemes

• Customers are less likely to purchase goods on credit when interest rates are high leading to a fall in sales 

• Exporting businesses may see demand for their products overseas fall as higher interest rates usually strengthen the value of the domestic currency and make their products comparably more expensive abroad

Changes in taxation and government spending

• Governments impose direct and indirect taxes on businesses and households

  • Direct taxes are levied on income, e.g. Income tax and Corporation Tax

  • Indirect taxes are levied on spending, e.g. Value added tax (e.g. VAT)

The Impact of an Increase in Taxation

• Increased government spending is usually funded by increases in tax or increases in public sector borrowing

  • Increased investment spending (e.g. on roads or regeneration) can encourage businesses to invest and lead to economic growth

  • Increased public sector spending can lead to targeted improvements (e.g in public health or education levels) that can improve  productivity

• In recent years, the UK government has focused increasingly on the reduction of government spending

  • Infrastructure projects have been scaled back or cancelled

    • E.g. The scale of the planned HS2 (High Speed 2) rail line intended to connect London with cities in the North has been significantly reduced

      • Businesses in cities such as Leeds and Manchester are now unlikely to benefit from more efficient transport links affecting access to markets and workers

  • Spending on key services such as health and education has been reduced

  • Public sector wage rises have been limited

    • Businesses have been affected by ongoing strike action across the public sector, which have increased employee absence levels and made it difficult to function effectively

Changes in the business cycle

• The business cycle describes the upturns and downturns in the level of a country’s economic activity (Gross Domestic Product or GDP) over time

  • A recession occurs when an economy experiences two consecutive quarters (6 months) or more of negative economic growth

  • A boom is defined as a period of time where an economy experiences increasing/high rates of economic growth

 
Stages in the Business Cycle

Recession

• Characteristics

  • Increasing/high unemployment

  • Low confidence for firms/households

  • Low inflation or deflation

  • Increase in government expenditure

• Impact on businesses

  • Customers have less  disposable income  and are likely to reduce spending or postpone significant spending decisions, leading to lower revenue

  • Businesses may find it relatively easy to recruit workers from a larger pool of candidates

  • Businesses may delay spending decisions and focus on reducing risk and survival

  • Production levels are likely to be reduced 

  • Businesses often stockpile products

  • Increased spending on welfare benefits and spending on infrastructure projects to inject demand into the economy may benefit some businesses

Boom

• Characteristics

  • Decreasing unemployment and increasing job vacancies

  • High confidence and more risky decisions taken

  • Increasing rate of inflation

  • An improvement in the government budget as tax revenues rise and government expenditure falls

• Impact on businesses

  • Customers’ disposable income increases leading to higher sales revenue

  • Recruitment and staff retention may become more challenging and businesses may need to pay higher wages

  • Businesses look to expand and maximise profit

  • Production levels are likely to increase 

  • Product or market development strategies are more likely

  • Interest rates are likely to rise and the higher cost of borrowing will increase the risk of capital investment

  • Lower government spending may impact on business growth plans

  • Public sector pay controls may cause Industrial unrest and affect business operations

The Effect of Economic Uncertainty on the Business Environment

• Economic uncertainty occurs when it is difficult to forecast the level of supply and demand in an economy

• Businesses will find planning difficult and are likely to be reluctant to make significant decisions, especially with regards to capital expenditure

• Economic uncertainty may occur as a result of

  • Fluctuating exchange rate

  • Economic growth uncertainty

  • Turbulence in the price of key  commodities such as oil

• Businesses must always be prepared for economic uncertainty by

  • Building up  cash reserves  when times are good

  • Keeping informed about the economic climate

  • Being ready to take advantage of opportunities when they arise