The Economic Environment

Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given period. The law of demand: as price rises, quantity demanded falls (and vice versa) — the demand curve slopes downward.

Determinants of demand (factors that shift the demand curve):

• Consumer income: Higher income increases demand for normal goods; decreases demand for inferior goods
• Prices of related goods: Substitutes (if the price of tea rises, demand for coffee increases) and complements (if the price of printers rises, demand for ink cartridges falls)
• Consumer preferences/tastes: Fashion, advertising, trends, health concerns
• Population/demographics: More consumers = higher demand
• Expectations: If consumers expect prices to rise, they may buy now (increasing current demand)

Supply is the quantity of a good or service that producers are willing and able to offer for sale at a given price. The law of supply: as price rises, quantity supplied rises — the supply curve slopes upward.

Determinants of supply (factors that shift the supply curve):

• Costs of production: Higher input costs (wages, raw materials, energy) decrease supply (shift left)
• Technology: Improved technology reduces costs and increases supply (shift right)
• Government policy: Subsidies increase supply; taxes and regulation decrease supply
• Number of producers: More firms in the market = greater total supply
• Expectations: If firms expect higher future prices, they may withhold supply now
• Natural factors: Weather (agriculture), natural disasters

Market equilibrium: The price at which quantity demanded equals quantity supplied. At this price the market "clears" — there is no excess supply or excess demand. If price is above equilibrium, there is a surplus (excess supply) and price falls. If price is below equilibrium, there is a shortage (excess demand) and price rises.

Shifts vs movements along the curve: A change in price causes a movement along the curve. A change in a non-price determinant (income, costs, technology, etc.) causes a shift of the entire curve.

Price elasticity of demand measures the responsiveness of quantity demanded to a change in price.

PED = % change in quantity demanded ÷ % change in price

PED is normally negative (price up → demand down), but the absolute value is typically used.

Determinants of PED (factors making demand more elastic):

• Availability of close substitutes: More substitutes → more elastic (consumers switch easily)
• Proportion of income: Higher proportion → more elastic (a price change is more noticeable)
• Necessity vs luxury: Necessities tend to be inelastic; luxuries tend to be elastic
• Time horizon: Demand tends to be more elastic in the long run (consumers have time to find alternatives)
• Brand loyalty: Strong loyalty → more inelastic (consumers less willing to switch)
• Definition of the market: Narrowly defined products (Coca-Cola) tend to be more elastic than broadly defined categories (soft drinks)

Business significance: PED determines pricing strategy. If demand is inelastic, a firm can raise prices to increase total revenue. If elastic, price cuts may increase revenue (through higher volume). Understanding PED is essential for pricing decisions, tax incidence analysis, and revenue forecasting.

Market structure describes the competitive environment in which a firm operates. The four main structures are:

Key characteristics by structure:

Perfect competition: Many small firms selling identical products. No single firm can influence the market price — each is a "price taker." Firms earn normal profit in the long run (supernormal profit attracts new entrants, increasing supply and driving price down). A theoretical benchmark rather than a common real-world structure.

Monopolistic competition: Many firms selling differentiated products (through branding, quality, design, location). Each firm has a small degree of market power due to differentiation. Low barriers allow new firms to enter, eroding supernormal profits in the long run. Most consumer-facing industries resemble this structure.

Oligopoly: A market dominated by a few large firms. Each firm's actions significantly affect the others — strategic interdependence is the key feature. Firms may compete aggressively (price wars) or collude (cartels — illegal in most jurisdictions). Behaviour is often analysed using game theory. High barriers to entry (economies of scale, capital requirements, brand loyalty, patents) protect existing firms. Kinked demand curve theory suggests prices tend to be "sticky" (firms match price cuts but not price rises).

Monopoly: A single seller dominates the market with no close substitutes. Maximum market power — the firm is a "price maker." Can earn supernormal profit in the long run because very high barriers prevent entry. May lead to higher prices and lower output than competitive markets. Governments regulate monopolies through competition law (Competition and Markets Authority — CMA — in the UK) to prevent abuse of dominant position, predatory pricing, and anti-competitive mergers.

GDP measures the total value of all goods and services produced within a country in a given period (usually a year or quarter). It is the primary measure of the size and health of an economy.

Three approaches to measuring GDP (all should give the same result):

• Output (production) approach: The total value of goods and services produced, minus intermediate consumption (to avoid double-counting). Value added at each stage of production.
• Income approach: The total income earned by factors of production — wages, profits, rents, interest.
• Expenditure approach: The total spending on final goods and services: GDP = C + I + G + (X − M), where C = consumer spending, I = investment, G = government spending, X = exports, M = imports.

Nominal GDP vs Real GDP:

• Nominal (current prices): GDP measured at the prices prevailing in the current period. Increases in nominal GDP may reflect price inflation rather than real growth.
• Real (constant prices): GDP adjusted for inflation using a base year's prices. Shows the true change in output. Real GDP growth is the key indicator of economic performance.

GDP per capita = GDP ÷ Population. A better indicator of living standards than total GDP, as it accounts for population size.

Limitations of GDP: Does not capture: income distribution (inequality), informal/black economy, non-market activities (household work, volunteering), environmental degradation, quality of life, leisure time.

Inflation is a sustained increase in the general price level of goods and services over time. The purchasing power of money falls as prices rise.

Measurement:

• Consumer Prices Index (CPI): The UK's primary inflation measure. Tracks the change in the cost of a representative basket of goods and services purchased by households. Used by the Bank of England for its inflation target (currently 2%).
• Retail Prices Index (RPI): An older, broader measure that includes mortgage interest payments (CPI does not). Still used for some purposes (e.g., index-linked gilts, some pension calculations) but is considered a less accurate measure than CPI.

Causes of inflation:

• Demand-pull: Too much money chasing too few goods. Aggregate demand exceeds the economy's productive capacity. Caused by: excessive consumer spending, government spending, investment, or exports; loose monetary policy (low interest rates, quantitative easing).
• Cost-push: Rising production costs push up prices. Caused by: higher raw material prices (oil, commodities), higher wages, higher import prices (exchange rate depreciation), higher indirect taxes, supply chain disruptions.
• Monetary: The quantity theory of money (MV = PQ) — excessive growth in the money supply leads to inflation. Central bank printing money (quantitative easing) can contribute if the extra money feeds into consumer spending.

Consequences of inflation for businesses:

• Rising input costs (materials, wages) squeeze profit margins unless prices can be increased
• Uncertainty makes planning and investment decisions harder
• Menu costs (the cost of changing prices — reprinting price lists, updating systems)
• Shoe-leather costs (the time and effort spent managing cash balances to minimise the loss of purchasing power)
• Distortion of financial statements (historical cost figures become less meaningful)
• Impact on borrowers (real value of debt decreases — benefits borrowers at the expense of lenders) and savers (real returns eroded)
• Wage-price spiral: workers demand higher wages to compensate for inflation, which increases costs, pushing prices higher still

Unemployment occurs when people who are willing and able to work cannot find employment. The unemployment rate = (number unemployed ÷ labour force) × 100.

Types of unemployment:

Consequences: Lost output (GDP below potential), government costs (benefits, lost tax revenue), social costs (poverty, health, crime), skills erosion (long-term unemployed lose skills and employability), regional inequality.

The balance of payments (BoP) is a record of all economic transactions between residents of a country and the rest of the world during a given period. It has two main accounts:

1. Current account:

• Trade in goods (visible trade): Exports minus imports of physical goods. A surplus (exports > imports) improves the current account; a deficit (imports > exports) worsens it. The UK typically runs a goods trade deficit.
• Trade in services (invisible trade): Exports minus imports of services (financial services, insurance, tourism, consulting). The UK typically runs a services trade surplus.
• Primary income: Income from investments abroad (dividends, interest, wages from overseas employment) minus income paid to foreign investors in the UK.
• Secondary income (transfers): Unilateral transfers with no corresponding goods/services — e.g., foreign aid, remittances, EU budget contributions.

2. Capital and financial account:

• Records capital transfers and transactions in financial assets/liabilities — foreign direct investment (FDI), portfolio investment (shares, bonds), bank loans, changes in official reserves
• A current account deficit is financed by a capital/financial account surplus (net inflow of foreign capital)

The BoP always balances in accounting terms (current account + capital/financial account + errors and omissions = 0). A persistent current account deficit may indicate structural competitiveness issues.

Governments and central banks use two main types of policy to manage the economy:

Monetary Policy

Fiscal Policy

The exchange rate is the price of one currency expressed in terms of another. It determines how much foreign goods and services cost in domestic currency and vice versa.

Determinants of exchange rates (under a floating rate system):

• Interest rates: Higher interest rates attract foreign capital (investors seeking better returns), increasing demand for the currency → appreciation
• Inflation differentials: Higher inflation (relative to trading partners) makes exports less competitive, reducing demand for the currency → depreciation (purchasing power parity theory)
• Balance of payments: A current account surplus increases demand for the currency (foreigners buy domestic currency to pay for exports) → appreciation. A deficit has the opposite effect.
• Speculation: Traders buying/selling currencies based on expectations of future movements can cause significant short-term volatility
• Political stability and economic confidence: Countries perceived as stable and well-managed attract foreign investment → currency appreciation
• Government/central bank intervention: Direct buying/selling of currency in foreign exchange markets to influence the rate

Effects of exchange rate changes on businesses:

The business cycle (economic cycle, trade cycle) describes the fluctuations in economic activity over time. The economy moves through recurring phases of expansion and contraction around a long-term growth trend.

The four phases:

Implications for business planning:

• Investment decisions: Expand capacity during recovery; consolidate during contraction
• Working capital: Build inventory during expansion (anticipating demand); reduce during contraction (conserve cash)
• Pricing: Stronger pricing power during boom; pressure to discount during recession
• Employment: Hire during growth; risk of redundancies during downturn
• Financing: Easier to raise finance during expansion (lenders/investors more willing); harder during recession (tighter credit, higher risk premiums)
• Risk management: Build reserves during good times to weather downturns

Counter-cyclical policy: Governments use monetary and fiscal policy to smooth the cycle — stimulating during downturns and cooling during booms. However, perfect stabilisation is impossible due to time lags, forecasting difficulties, and political constraints.