Business economics by mankiw taylor

3 2 Economics and Business Decision Making 23 3 The Business Environment 35 PART 2 Microeconomics – The Market System 53 4 Supply and Demand: How Markets Work 55 5 Elasticity and Its App

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Business Economics, 1st Edition

N Gregory Mankiw, Mark P Taylor, and Andrew Ashwin

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1 2 3 4 5 6 7 8 9 10 – 15 14 13

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About the Authors viii

1 What Is Business Economics? 3

2 Economics and Business Decision Making 23

3 The Business Environment 35

PART 2 Microeconomics – The Market System 53

4 Supply and Demand: How Markets Work 55

5 Elasticity and Its Applications 87

PART 3 Microeconomics – The Limitations of Markets 119

6 Market Failure 121

7 The Consumer and Consumer Behaviour 150

PART 4 Microeconomics – The Economics of Firms In Markets 177

8 Business Goals and Behaviour 179

9 Firm Behaviour and the Organization of Industry 208

10 The Firm’s Production Decisions 237

11 Corporate Strategy and Pricing Policy 255

12 Market Structures 272

13 Other Types of Imperfect Competition 301

PART 5 Microeconomics – Factor Markets 331

14 Labour Markets 333

15 Financial Markets 361PART 6 Introduction to Macroeconomics 385

16 The Macroeconomic Environment 387

17 Aggregate Demand and Aggregate Supply 423

18 Macroeconomics – Employment andUnemployment 449

19 Macroeconomics – Inflation and PriceStability 466

20 Macroeconomics – Fiscal, Monetary andSupply-Side Policy 490

PART 7 Global Business and Economics 517

21 The Global Economy 519

Glossary 543

Index 549

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About the Authors viii

THE ECONOMIC AND BUSINESS

The ten principles of economics 4

How people and businesses make decisions 4

How people interact 11

How the economy as a whole works 15

Conclusion 20

Summary 21

Key concepts 21

Questions for review 21

Problems and applications 21

2 Economics and Business Decision

Economics as the science of decision making 24

Business decision making 27

Conclusion 32

Summary 34

Key concepts 34

What is business– the transformation process 36

The PESTLE framework 40

Shareholder value and stakeholders 46

Conclusion 47

Summary 50

Key concepts 50

The market forces of supply and demand 56

Markets and competition 56

Supply 58

Demand 63

Demand and supply together 70

How prices allocate resources 82

Summary 84

Key concepts 84

5 Elasticity and Its Applications 87

Elasticity and its application 88

Price elasticity of supply 88

The price elasticity of demand 96

Other demand elasticities 104

Applications of supply and demand elasticity 110

Summary 116

Key concepts 117

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7 The Consumer and Consumer Behaviour 150

PART 4

ECONOMICS OF FIRMS IN

8 Business Goals and Behaviour 179

The goals of firms 180

9 Firm Behaviour and the Organization

of Industry 208

The costs of production 209

What are costs? 209

Production and costs 212

The various measures of cost 216

Costs in the short run and in the long run 222

Isoquants and isocosts 226

Conclusion 232

Summary 234

Key concepts 234

1 0 The Firm ’s Production Decisions 237

Introduction 238

The supply curve in a competitive market 246

Conclusion: Behind the supply curve 251

Summary 253

Key concepts 253

1 1 Corporate Strategy and Pricing Policy 255

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Price discrimination 288

Public policy towards monopolies 292

Conclusion: The prevalence of monopoly 296

Summary 298

Key concepts 298

1 3 Other Types of Imperfect

Competition 301

Introduction 302

Competition with differentiated products 303

Oligopoly 308

Markets with only a few dominant sellers 308

Game theory and the economics of competition 314

Public policies toward oligopolies 322

Conclusion 325

Summary 327

Key concepts 327

PART 5

1 4 Labour Markets 333

The markets for the factors of production 334

The demand for labour 334

The supply of labour 340

Equilibrium in the labour market 341

The other factors of production: Land and capital 347

Earnings and discrimination 349

The economics of discrimination 352

Conclusion 356

Summary 358

Key concepts 358

1 5 Financial Markets 361

Introduction 362

Financial institutions in the economy 362

Measuring the time value of money 367

The economy’s income and expenditure 389

The measurement of gross domestic product 390

The components of GDP 392

Real versus nominal GDP 394

Measuring the cost of living 396

The consumer prices index 397

Production and growth 401

Economic growth and public policy 402

Unemployment 405

Specialization and trade 409

Open-economy macroeconomics: Basic concepts 410

The prices for international transactions: Real andnominal exchange rates 414

A first theory of exchange rate determination: Purchasingpower parity 416

Conclusion 419

Summary 420

Key concepts 421

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1 7 Aggregate Demand and Aggregate Supply 423

Introduction 424

Three key facts about economic fluctuations 424

Explaining short-run economic fluctuations 425

The aggregate demand curve 428

The aggregate supply curve 433

Two causes of economic fluctuations 440

Conclusion 445

Summary 446

Key concepts 447

Minimum wage laws 457

Unions and collective bargaining 458

The theory of efficiency wages 460

Conclusion 463

Summary 464

Key concepts 464

1 9 Macroeconomics – Inflation and Price Stability 466

Money growth and inflation 467

The classical theory of inflation 467

The costs of inflation 470

Inflation and unemployment 474

The Phillips curve 474

The role of expectations 477

The role of supply shocks 482

The cost of reducing inflation 483

Conclusion 486

Summary 488

Key concepts 488

and Supply-Side Policy 490

Monetary policy, fiscal policy and supply-side policy 491

Monetary policy 491

Fiscal policy 496

Supply-side policies 502

How monetary policy influences aggregate demand 506

How fiscal policy influences aggregate demand 511

Conclusion 513

Summary 514

Key concepts 515

PART 7

GLOBAL BUSINESS AND ECONOMICS 517

2 1 The Global Economy 519

Business in emerging markets 520

The Single European Market and the euro 524

Common currency areas and European monetaryunion 526

Fiscal policy and common currency areas 530

Glossary 543

Index 549

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N GREGORY MANKIWis Professor of Economics at Harvard University As a student,

he studied economics at Princeton University and the Massachusetts Institute of ogy As a teacher he has taught macroeconomics, microeconomics, statistics and principles

Technol-of economics PrTechnol-ofessor Mankiw is a prolific writer and a regular participant in academicand policy debates In addition to his teaching, research and writing, Professor Mankiwhas been a research associate of the National Bureau of Economic Research, an advisor tothe Federal Reserve Bank of Boston and the Congressional Budget Office From 2003 to

2005, he served as chairman of the US President’s Council of Economic Advisors sor Mankiw lives in Wellesley, Massachusetts, with his wife Deborah, their three childrenand their border terrier Tobin

Profes-MARK P TAYLOR is Dean of Warwick Business School at the University ofWarwick and Professor of International Finance He obtained his first degree in philoso-phy, politics and economics from Oxford University and his master’s degree in economicsfrom London University, from where he also holds a doctorate in economics and interna-tional finance Professor Taylor has taught economics and finance at various universities(including Oxford, Warwick and New York) and at various levels (including principlescourses, advanced undergraduate and advanced postgraduate courses) He has also worked

as a senior economist at the International Monetary Fund and at the Bank of England and,before becoming Dean of Warwick Business School, was a managing director at Black-Rock, the world’s largest financial asset manager, where he worked on international assetallocation based on macroeconomic analysis His research has been extensively published

in scholarly journals and he is today one of the most highly cited economists in the world.Professor Taylor lives with his family in a 15th century farmhouse near Stratford uponAvon, Warwickshire, where he collects clocks and keeps bees

ANDREW ASHWINhas over 20 years experience as a teacher of economics He has anMBA and is currently researching for a Ph.D investigating assessment and the notion ofthreshold concepts in economics Andrew is an experienced author writing a number oftexts for students at different levels, journal publications related to his Ph.D research andhas a recently published a text on the business environment for undergraduates with

Dr Phil Kelly Andrew was Chair of Examiners for a major awarding body in Englandand Wales for business and economics and is Editor of the Economics, Business andEnterprise Association (EBEA) journal Andrew also acts as a consultant to the qualifica-tions regulator in England and Wales and is pursuing Chartered Assessor status with theChartered Institute of Educational Assessors Andrew lives in Rutland with his wife Sueand their twin sons Alex and Johnny

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How much of business is economics and how much of economics is business? This is adifficult question to answer but perhaps what is at the heart of both is decision-making.

This book is about decision making Alfred Marshall, the great 19th-century Britisheconomist, in his textbook, Principles of Economics published in 1890 wrote:‘Economics

is a study of mankind in the ordinary business of life.’ For many people the ordinarybusiness of life is interwoven with relationships with business Every single day, billions

of people around the world make decisions When we make decisions we are being omist A great proportion of these decisions are made by people in the context of theirwork which in turn is part of business So Business and Economics are very closelylinked So wrote

econ-A study of economics in a business context will help you understand the world inwhich you live There are many questions about businesses and the economy thatmight spark your curiosity Why do airlines charge less for a return ticket if the travellerstays over a Saturday night? Why are movie businesses prepared to pay some actorsextremely large sums to star in films whilst others struggle to even get a bit part? Whyare living standards so meagre in many African countries? Why do some countries havehigh rates of inflation while others have stable prices? Why do businesses produce manyproducts that are so similar – surely they succeed only in cannibalising their market?

Why is it so important to have a better understanding of how consumers behave? Whyhave some European countries adopted a common currency? These are just a few of thequestions that a course in Business Economics will help you answer

The second reason to study Business Economics is that it will make you a more astuteparticipant in the economy and in business As you go about your life, you make manyeconomic decisions While you are a student, you decide how many years to stay in full-time education When you have completed your degree you will have to decide on acareer path and (which may be difficult despite being highly qualified) find a job Onceyou take a job, you decide how much of your income to spend, how much to save andhow to invest your savings In your daily work you will have to make many decisionsand respond to an ever-changing environment One day you may find yourself runningyour own small business or a large firm, and you will decide what prices to charge foryour products and what products to offer for sale The insights developed in the comingchapters will give you a new perspective on how best to make these decisions

A study of Business Economics will give you a better understanding of the potentialand limits of economic policy and how such policy can influence business behaviour Inyour business career you may find yourself asking various questions about economics

What are the burdens associated with alternative forms of taxation? What are the effects

of free trade with other countries? To what extent do businesses have a responsibility toprotect the environment? How does the government budget deficit affect the economyand thus your business?

A study of Business Economics will go some way towards helping you make moresense of the world, your place in it and how business is affected and behaves as aconsequence

FOR WHOM IS THIS BOOK WRITTEN?

The book has been written with the non-specialist economist in mind but who has toembark on a course of study in economics as part of a degree in Business Your degreemight be Business Economics, it might be Business Management or it might be Sports

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Coaching and Management An increasing number of degree courses will include somecoverage of economic principles and this book is designed for just such courses We havetried to put ourselves in the position of someone seeing economics for the first time andnot necessarily looking forward to the prospect Our goal has been to emphasize thematerial that students should and do find interesting about the study of the economyand business.

One result is that this book is briefer than many books used to introduce students toeconomics Throughout this book we have tried to return to applications and policyquestions as often as possible All the chapters include case studies illustrating how theprinciples of economics are applied In addition, ‘In the News’ boxes offer highlightsfrom news events showing how economic ideas shed light on current issues facingbusiness and society along with questions to help you apply your knowledge to newcontexts– a vitally important part of learning

HOW IS THIS BOOK ORGANIZED?

In deciding what topics to include in the book we started with the typical course tures at universities offering some sort of Business Economics modules as part of adegree programme Some lecturers will choose to study topics is a slightly differentorder but our thinking was to try and present what we felt was a logical way of present-ing an introduction to economics as it applies to a business context

struc-Introductory Material

Chapter 1,‘What is Business Economics’, sets the scene by introducing students to theeconomists’ view of the world through the ‘Ten Principles of Economics’ and businessdecision making It previews some of the big ideas that recur throughout economics,such as opportunity cost, marginal decision making, the role of incentives, the gainsfrom trade, and the efficiency of market allocations Throughout the book, we refer reg-ularly to the Ten Principles of Economics introduced in Chapter 1 to remind studentsthat these ideas are the foundation for all economics Chapter 2, ‘Economics andBusiness Decision Making’, explores decision making in more detail and includes a dis-cussion about a crucial part of any business – recruiting and retaining customers.Chapter 3,‘The Business Environment’, presents an overview of what we mean by busi-ness activity, how businesses transform inputs into outputs, the meaning of adding valueand the internal and external environment within which businesses have to operate

We have looked at this environment through what is called the PESTLE framework –political, economic, social, technological and environmental

The next two chapters introduce the market system through looking at the basic tools ofsupply and demand Chapter 4, ‘The Market Forces of Supply and Demand’, developsthe supply curve, the demand curve and the notion of market equilibrium Chapter 5,

‘Elasticity and Its Application’, introduces the concept of elasticity and uses it to analyzeevents in three different markets

Microeconomics – The Limitations of the Market System

Whilst many economies work based on market systems, they do, like most things, havetheir limitations The next two chapters use the tools developed to look at Market Failure

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and The Consumer and Consumer Behaviour You will learn that the costs and benefits

of market activity are not always taken into account by decision makers and as a resultthe allocation of resources is less than efficient In Chapter 7 you will learn that consu-mers (both businesses and individuals) do not always behave rationally and this can alsolead to a less than efficient resource allocation An understanding of consumer behaviour

is an important aspect of business – after all, if we do not understand how the duals and businesses we want to sell products to then businesses will suffer and bemore likely to fail

indivi-Microeconomics – The Economics of Firms in Markets

Part 4 includes 6 chapters devoted to understanding and analysing the actions andbehaviour of firms Chapter 8 looks at business goals and behaviour to get an under-standing of why businesses exist, what they aim to do and how changes to businessgoals can lead to different behaviour Chapter 9 builds on some of the concepts intro-duced in Chapter 8 and covers firms’ costs and revenues in the short and long run

Chapter 10 presents a model of the firm in equilibrium and how production decisionsare made in competitive conditions Chapter 11 follows up on this by looking at pricingdecisions and an introduction to business strategy before Chapter 12 covers the effect onbusiness behaviour of operating in different market structures such as when a firm hasmonopoly power This enables you to understand how degrees of market power influ-ence the way firms behave Chapter 13 follows on by looking at other forms of marketstructure including monopolistic competition (not to be confused with monopoly) andoligopoly– competition amongst the few

Microeconomics – Factor Markets

We complete our look at microeconomics with Part 5 which looks at the markets forlabour and capital, two key components of factor inputs for a business Chapter 14,emphasizes the link between factor prices and marginal productivity and discusses thedeterminants of equilibrium wages Chapter 15 introduces important concepts in thetheory and practice of financial markets including the time value of money, how assetprices are determined and the supply and demand for loanable funds

a transitory deviation from the economy’s long-run growth path, studying the transitorydeviations is more natural after the long-run equilibrium is understood Fourthly, themacroeconomic theory of the short run is more controversial among economists thanthe macroeconomic theory of the long run For these reasons, most upper-level courses

in macroeconomics now follow this long-run-before-short-run approach; our goal is tooffer introductory students the same advantage There would be nothing to stop lecturerswho prefer to approach the short run first from so doing– the book is flexible enough toallow this approach to be adopted

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Chapter 16, introduces some basic macroeconomic concepts including a discussion ofthe meaning of gross domestic product and related statistics from the national incomeaccounts, the measurement and use of the consumer price indices, real and nominalinterest rates, trade and exchange rates These concepts are developed in the next fourchapters which look in more detail at aggregate demand and supply, employment andunemployment, inflation and price stability and macroeconomic policy.

Global Business and Economics

We complete our journey through Business Economics by looking at the impact of doingbusiness globally Increasingly firms are involved in global trade and having some under-standing of emerging markets, different business cultures and the European Union andthe single market provides a foundation for what will be likely to be further study as youprogress through your degree

LEARNING TOOLS

The purpose of this book is to help students learn the fundamental lessons of economicsand to apply these lessons to a business context Towards that end, we have used variouslearning tools that recur throughout the book

• Case Studies Economic theory is useful and interesting only if it can be applied tounderstanding actual events and policies This book, therefore, contains numerouscase studies that apply the theory that has just been developed in a business context

• ‘In the News’ boxes One benefit that students gain from studying economics is a newperspective and greater understanding about news from around the world To high-light this benefit, we have incorporated discussions of news events including excerptsfrom newspaper articles from around Europe, the Middle East, Africa and India.These articles, together with our brief introductions, show how basic economic theorycan be applied and raise important questions for discussion in business To help fur-ther develop application skills we have included some questions at the end which caneither be used as practice for self-study or as the basis for seminar or tutorialdiscussion

• ‘FYI’ Boxes These boxes provide additional material ‘for your information’ Some ofthem offer a glimpse into the history of economic thought Others clarify technicalissues Still others discuss supplementary topics that instructors might choose either

to discuss or skip in their lectures but which students should find useful in menting their knowledge and understanding

supple-• Definitions of key concepts When key concepts are introduced in the chapter, they arepresented in bold typeface In addition, their definitions are placed in the margins.This treatment should aid students in learning and reviewing the material

• Pitfall Preventions The authors have used their collective teaching wisdom to outlineareas where students make frequent mistakes and which can be a cause of confusion.The Pitfall Prevention boxes alert students to the potential for these mistakes

• Jeopardy Problems These are problems designed to help you think as an economist.You will be given end- points or solutions and you have to think through the differentways in which the solutions or end-point given might have been arrived at using yourknowledge of economics and business

• What if…? Questions designed to get you thinking about different scenarios in ness and economics

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busi-• Quick quizzes After most major sections, students are offered a‘quick quiz’ to checktheir comprehension of what they have just learned If students cannot readily answerthese quizzes, they should stop and reread material before continuing.

• Chapter summaries Each chapter ends with a brief summary that reminds you of themost important lessons that you have just learned Later in your study it offers anefficient way to revise for exams

• List of key concepts A list of key concepts at the end of each chapter offers you a way

to test your understanding of the new terms that have been introduced

Page references are included so that you can review the terms you do not understand

All key terms can also be found in the glossary at the end of the book

• Questions for review At the end of each chapter are questions for review that over thechapter’s primary lessons You can use these questions to check your comprehensionand to prepare for exams

• Problems and applications Each chapter also contains a variety of problems andapplications that ask you to apply the material you have learned Some instructorsmay use these questions for homework assignments Others may use them as a start-ing point for classroom discussions

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Learning Objectives and ’After reading this chapter you should be able to ’ Bullet points appear

at the start of each chapter in order to highlight to the student chapter ’s key ideas

Glossary Terms Key terms relevant to Buisness Economics are defined throughout the text and also featured in the glossary at the back of the book.

Case studies are provided throughout the text that apply the theory that has been developed to understanding events and policies.

Pitfall Preventions The authors have used their collective teaching wisdom to outline areas where students make frequent mistakes and which can be a cause of confusion The Pitfall Prevention boxes alert students to the potential for these mistakes.

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FYI provides additional material ‘for your information’;

the boxes offer a range of supplementary material, such as a glimpse into the history of economic thought, technical issues and current topics that can

be discussed in lectures.

Quick quizzes are provided at the end of each section and allow students to check their comprehension of what they have just learned.

Jeopardy Problems These are problems designed to help you think as an economist You will be given end- points or solutions and you have to think through the different ways in which the solutions or end-point given might have been arrived at using your knowledge of economics and business.

’what if’ boxes Questions designed to get you thinking about different scenarios in business and economics.

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Problems and applications allow students to apply the material they have learned within the chapter These can also be used for classroom discussions or homework assignments.

In the News articles relate key ideas covered in the chapter to topical news events to highlight the application of economic ideas and introduce new angles to consider in topical debates.

Summaries at the end of each chapter remind students of what they have learned so far, offering a useful way to review for exams.

Questions for review cover each chapter ’s primary lessons These can be used to check comprehension and to prepare for exams.

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The authors would like to thank the following reviewers for their comments:

Andrew Abbott– University of Hull

Dr Turner Anna– CEU Business SchoolEmanuele Bracco– Lancaster University

Dr Yu-Fu Chen– Economic Studies, Dundee UniversityMatthew T Col– University College Dublin

Gary Cook– University of Liverpool

Dr John Duignan– University of the West of ScotlandAat van Eeden– Zuyd University of Applied ScienceRobert Elliott– University of Birmingham

John Forde – University of SalfordRichard Godfrey– Cardiff School of ManagementMarco Gundermann– Cardiff Metropolitan University

Dr Hala Helmi El Hadidi– British University, EgyptJuan Garcia Lara – Universidad Carlos III Madrid, SpainPaul L Latreille – Swansea University

Dr Bobby Mackie – University of the West of ScotlandTim Maxfield – University of Worcester

Natalie Moore– University of NottinghamYoko Nagase – Oxford Brookes UniversityAdel Nemeth – Jacobs University Bremen

Dr Matthew Olczak– Aston University, UKQuentin Outram – Leeds University Business SchoolBruce Philp – Nottingham Business School

Julia Planko – Hogeschool UtrechtNeil Reaich – Economic, Business and Enterprise AssociationJose R Sanchez-Fung– Kingston University London, UKUlrich Schüle – School of Business FH Mainz-University of Applied sciencesCemil Selcuk – Cardiff University

Vasilios Sogiakas – University of GlasgowNicholas Spearman – University of the Witwatersrand, South Africa

Dr F Steffen– University of Liverpool Management SchoolMichael Wood – London South Bank University

Dr Michael Wynn-Williams – University of GreenwichGaston Yalonetzky – Leeds University Business School

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Cengage Learning offers various digital resources for instructors and students who use this book These resources are designed

to make teaching the principles of business economics easy for the instructor and learning them easy for the student

ABOUT THE DIGITAL

RESOURCES

More information about the digital support resources

accom-panying this book can be found on page xix

For instructors

Teaching the principles of business economics can be a

demanding job The supplements designed for the instructor

make the job less difficult

• Instructor’s Manual – a detailed outline of each chapter

of the text that provides earning objectives, identifiesstumbling blocks that students may face, offers helpfulteaching tips and provides suggested in-classroom activi-ties for more cooperative learning experience TheInstructor’s Manual also includes solutions to all of theend-of-chapter exercises, Quick Quizzes, Questions forReview and Problems and Applications found in the text

• PowerPoint™ Lecture Slides and Exhibit Slides –

Instruc-tors can save valuable time as they prepare for classesusing these fully adaptable comprehensive lecture presen-tations with integrated graphs, tables, lists and concepts Aseparate exhibit presentation provides instructors with all

of the tables and graphs from the main text

For students

The supplements designed for the student enrich and

sup-port the learning experience, providing excellent revision

tools and further study opportunities

• Learning Objectives – listed for each chapter, they helpthe student to monitor their understanding and progressthrough the book

• Exhibit Slides– provided in PowerPoint™, the exhibit sentations provide students with animated figures fromthe main text

pre-• Glossary– the full glossary of key terms that appears atthe end of the book in downloadable PDF file

• Self-test questions - a wide array of different types ofquestions, including objective tests, short-answer ques-tions and problems, topical case studies and advance crit-ical thinking questions, providing variety for the studentand testing all areas of their knowledge and skills Thestudent can check their work by revealing the correctanswers, where appropriate, providing instant feedback

OTHER SUPPLEMENTARY RESOURCES

• Exam View® The computerized test generator softwarecontains a testbank of questions for each chapter, allow-ing instructors to create online, paper or local area net-work (LAN) tests This product is only available fromyour Cengage Learning sales representative

• Virtual Learning EnvironmentAll of the web material isavailable in a format that is compatible with virtual learn-ing environments such as Moodle and Blackboard Thisversion of the product is only available from your CengageLearning sales representative

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THE ECONOMIC AND BUSINESS

THE SCENE

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LEARNING OBJECTIVES

In this chapter you will:

• Learn that economics is about the allocation of scarce

resources

• Examine some of the trade-offs that people face

• Learn the meaning of opportunity cost

• See how to use marginal reasoning when making

decisions

• Discuss how incentives affect people’s behaviour

• Consider why trade among people or nations can be

good for everyone

• Discuss why markets are a good, but not perfect, way to

• Explain the classic trade-off between‘guns and butter’

• Add up your particular opportunity cost of attendinguniversity

• Compare the marginal costs and marginal benefits ofcontinuing to attend school indefinitely

• Consider how a quadrupling of your tuition paymentswould affect your decision to educate yourself

• Explain why specialization and trade improve people’schoices

• Give an example of an externality

• Explain the source of large and persistent inflation

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THE TEN PRINCIPLES OF ECONOMICS

The word‘economy’ comes from the Greek word oikonomos, which means for ‘one whomanages a household’ At first, this origin might seem peculiar But, in fact, businessesand economies have much in common

A business faces many decisions It must decide how many people to employ, whateach of those people will do to contribute to the business, how much each employee gets

in return, who should receive a bonus scheme and who should not, how to increase outputper worker, how best to manage costs, when to invest, how much to invest and where best

to get the funds to invest from, what products to produce, what products not to produce,when to stop producing products, when to expand, when to contract, how best to managethe sales process and customer relations, whether to be environmentally friendly orwhether to give the impression of being so, how to deal with competitors and whether tocharge a high price or a low price (or one in between) In short, business must allocatescarce resources among competing uses, taking into account a range of stakeholder wantsand needs A stakeholder is any group or individual with an interest in a business.Like businesses, a society faces many decisions A society must decide what jobs will bedone and who will do them It needs some people to grow food, other people to makeclothing and still others to design computer software Once society has allocated people(as well as land, buildings and machines) to various jobs, it must also allocate the output

of goods and services that they produce It must decide who will eat caviar and who willeat potatoes It must decide who will drive a Ferrari and who will take the bus

The management of society’s resources is important because resources are scarce.Scarcity means that society has limited resources and therefore cannot produce all thegoods and services people wish to have Just as a household cannot give every membereverything he or she wants, a society cannot give every individual the highest standard ofliving to which he or she might aspire

Economicsis the study of how society manages its scarce resources In most societies,resources are allocated not by a single central planner but through the combined actions ofmillions of households and firms Economists therefore study how people make decisions:how much they work, what they buy, how much they save and how they invest their sav-ings Economists also study how people and people in businesses interact with oneanother For instance, they examine how the multitude of buyers and sellers of a goodtogether determine the price at which the good is sold and the quantity that is sold Econ-omists analyse forces and trends that affect the economy as a whole, including the growth

in average income, the fraction of the population that cannot find work and the rate atwhich prices are rising Many of the concepts that economists use are also directly appli-cable and of relevance to businesses In a sense, economics can be described as the science

of decision making and since businesses all around the world have to make millions ofdecisions every day then having some understanding of the process of decision makingand the consequences that might arise from such decision making is important

Although the study of economics has many facets, the field is unified by several centralideas, all of which are of direct relevance to business In the rest of this chapter we look atTen Principles of Economics Don’t worry if you don’t understand them all at first, or if youdon’t find them completely convincing In the coming chapters we will explore these ideasmore fully The ten principles are introduced here just to give you an overview of whateconomics is all about You can think of this chapter as a‘preview of coming attractions’

HOW PEOPLE AND BUSINESSES MAKE DECISIONS

We use the term ‘the economy’ on a regular basis but have you ever stopped to thinkabout what the term really means? Whether we are talking about the economy of agroup of countries such as the European Union or the Middle East, or the economy of

stakeholder any group or individual with an interest in a business such as workers, managers, suppliers, the local community, customers and owners

scarcity the limited nature of society’s resources

economics the study of how society manages its scarce resources

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one particular country, such as South Africa or the United Kingdom, or of the wholeworld, an economy is just a group of people interacting with one another as they goabout their lives This interaction is invariably through a process of exchange Whether

it be an individual buying a morning newspaper, a business buying several hundredtonnes of steel for a construction project or a government funding a higher educationinstitution, the interaction consists of millions of individuals all making decisions andtogether we describe these interactions as ‘the economy’ Because the behaviour of aneconomy reflects the behaviour of the individuals, both acting on their own and as part

of businesses who make up the economy, we start our study of economics with fourprinciples of individual decision making

The question is, how should this capacity increase? South Africa is relativelyrich in coal supplies The country is the fourth largest coal exporter in the worldand produces around 244 million tonnes of coal a year Over 90 per cent of theelectricity generated in South Africa comes from coal fired power stations Despitethis rich endowment of a valuable resource, the country’s people and businessessuffer from regular power shortages The demand for electricity has risen at a fas-ter rate than the ability of the country to generate it and as a result electricityprices are high and could lead to slower economic growth

Given the endowment of coal supplies, one way to increase electricity supplieswould be to build new coal fired power stations and also upgrade existing olderstations The benefits of such a programme would be an increase in the amount

of electricity available to businesses and people in the country, but the downside

is that coal fired power stations are alleged to be a major contributor to carbonemissions and climate change Other options open to South Africa include invest-ing more in solar and wind energy– so called ‘clean energy’

Indeed, the World Bank agreed in October 2011 to help the South African ity company, Eskom, fund the construction of a 100 megawatt wind and solarpower plant in Uppington in the Northern Cape province The funding willamount to $250 million This sounds like a positive step forward but critics arguethat the plant will not increase the supply of electricity sufficiently to have mucheffect on the power shortage the country experiences

util-The World Bank had previously been criticized for helping to fund anotherpower generation project for Eskom, the construction of new coal fired power sta-tions worth around $3.75 billion Critics argued that this would just exacerbateEskom’s carbon footprint but the company countered by saying it had to adopt abalanced approach to power generation and would have to not only upgrade exist-ing coal fired stations to become more efficient (in terms of reducing carbon emis-sions and producing more electricity with lower inputs and at lower cost) but tobuild new stations to meet the growing demand of the country

The sun is a natural resource in South Africa which can be utilized to provide energy as in this case of a solar power field designed to capture the energy of the sun and convert it to electricity.

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The case here highlights the trade-offs facing businesses in making decisions Ineconomics, there are rarely‘right answers’ – businesses have to make decisions andface trade-offs On the one hand, demand for electricity in South Africa means it isonly‘right’ and ‘sensible’ to exploit its natural resources and provide for the needs

of its people In doing so it has to recognize the negative impact of using coal as ameans of generating electricity Solar and wind may be cleaner sources of energybut can enough investment be generated in these sources, quickly, to meet themore immediate demands of the nation for power which will help to boost eco-nomic growth and help it deal with the pockets of chronic poverty that exist?There is no right answer to the predicament that Eskom finds itself in– it has tochart a path to balance out the costs and benefits to try and maximize the benefitsbut reduce the costs to a minimum and that involves recognizing and accepting thetrade-offs that exist

Principle 1: Decision Making Involves Trade-Offs

The first lesson about making decisions is summarized in an adage popular with mists:‘There is no such thing as a free lunch’ To get the benefits of one thing that welike, we usually have to give up the benefits of another thing that we also like, or acceptthat we might have to give up something else and incur a cost of some sort (cost herebeing used in its widest sense not just a monetary one) Making decisions requires trad-ing off one goal or the benefits against another

econo-Consider a business manager who must decide how to allocate her most valuableresource – her time She can spend all of her time reflecting on strategy in her office;she can spend all of her time walking around the business premises talking to staff; orshe can divide her time between the two fields For every hour she spends reflectingand strategizing, she gives up an hour she could have used talking to staff And forevery hour she spends doing either, she gives up an hour that she could have spent talk-ing to customers, being out promoting the business, working with suppliers to improveefficiency or networking with colleagues at conferences

Or consider employees of this business deciding how to spend the income theyreceive from working at the business They can buy food, clothing or a family holiday

Or they can save some of the family income for retirement or perhaps to help thechildren buy a house or a flat when they are grown up When they choose to spend

an extra euro on one of these goods, they have one less euro to spend on some othergood

When people are grouped into societies, they face different kinds of trade-offs Theclassic trade-off is between ‘guns and butter’ – these two products just representdefence and consumer goods in general The more we spend on national defence(guns) to protect our country from foreign aggressors (the benefit), the less we canspend on consumer goods (butter) which brings the benefit of raising our standard

of living at home Also important in modern society is the trade-off between a cleanenvironment and a high level of income Laws that require firms to reduce pollutionraise the cost of producing goods and services but bring the benefit to society as awhole (and possibly to the firm in the form of good publicity) Because of the highercosts, these firms end up earning smaller profits, paying lower wages, charging higherprices, or some combination of these three Thus, while pollution regulations give usthe benefit of a cleaner environment and the improved levels of health that come with

it, they have the cost of reducing the incomes of the firms’ owners, workers andcustomers

Another trade-off society faces is between efficiency and equity Efficiency can belooked at in three different ways In essence, efficiency is about getting the most we can

efficiency the property of society getting the most it can from its scarce resources

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from scarce resources More specifically we can look at it in four ways related tobusiness:

• Technical efficiency– a business can improve its technical efficiency if it could find away of using its existing resources to produce more It may be that it could usemachinery instead of people that do the same job but do it much faster without hav-ing to take a break!

• Productive efficiency – a business can improve productive efficiency by producingoutput at the lowest cost possible If it can find a way of producing its productscheaper, for example, by sourcing cheaper raw materials, then it can improve its pro-ductive efficiency

• Allocative efficiency– this looks at efficiency from the perspective of consumers Arethe products being produced by businesses actually wanted and valued by consumers(both individual consumers and business consumers)? Efficiency occurs where thegoods and services being produced match the demand by consumers Allocative effi-ciency occurs where the cost of resources used to produce the products is equal to thevalue placed on the product by consumers represented by the price they are willing topay

• Social efficiency– when businesses produce products they incur costs – raw materials,wages, rents, interest payments, insurance, plant and equipment and so on– the pri-vate costs However, there are also costs which businesses may not take into accountsuch as the pollution they generate in production These are costs borne by society as

a whole Social efficiency occurs where the private and social cost of production isequal to the private and social benefits derived from their consumption

Equity means that the benefits of those resources are distributed fairly amongsociety’s members In other words, efficiency as an overall concept, refers to the size ofthe economic cake, and equity refers to how the cake is divided Often, when govern-ment policies are being designed, these two goals conflict; in addition, when businessesmake decisions conflicts arise between equity and efficiency

Pitfall Prevention If you are writing about efficiency, be careful to distinguishwhich measure of efficiency you mean– each may have different implications and con-sequences for businesses

Consider, for instance, policies aimed at achieving a more equal distribution of nomic well-being Some of these policies, such as the social security system or unemploy-ment insurance, try to help those members of society who are most in need Others, such

eco-as the individual income tax, eco-ask the financially successful to contribute more thanothers to support the government Although these policies have the benefit of achievinggreater equity, they have a cost in terms of reduced overall efficiency When the govern-ment redistributes income from the rich to the poor, it reduces the reward for workinghard; as a result, people work less and produce fewer goods and services In other words,when the government tries to cut the economic cake into more equal slices, the cake getssmaller

Equally, when a business decides to outsource some of its production abroad, workers

in the domestic economy may find that they lose their jobs For the business as a whole,the decision may increase productive efficiency but workers would consider the decisionunfair and the consequences in terms of morale and motivation could affect productivityelsewhere in the business in a detrimental way

Recognizing that people and businesses face trade-offs does not by itself tell us whatdecisions they will or should make A chief executive officer (CEO) should not abandontime set aside for reflection and thinking just because doing so would increase the timeavailable to talk to workers Society should not stop protecting the environment just

equity the property of distributing economic prosperity fairly among the members of society

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because environmental regulations reduce our material standard of living The poorshould not be ignored just because helping them distorts work incentives Nevertheless,acknowledging life’s trade-offs is important because people and businesses are likely tomake good decisions only if they understand the options that they have available andcan quantify them in some way to enable them to make informed decisions.

Quick Quiz Does the adage‘there is no such thing as a free lunch’ ply refer to the fact that someone has to have paid for the lunch to be pro-vided and served? Or does the recipient of a‘free lunch’ also incur a cost?

sim-Principle 2: The Cost of Something Is What You Give Up

to Get It

Because people and businesses face trade-offs, making decisions requires comparing thecosts and benefits of alternative courses of action In many cases, however, the cost ofsome action is not as obvious as it might first appear

Consider, for example, the decision by a business to cease production of a productthat is not selling very well any more The benefit is that resources can be made available

to invest in other parts of the business that are more successful But what is the cost? Toanswer this question, you might be tempted to add up the money the business has to pay

in redundancy to workers who may no longer be needed, to close down plant, get rid ofdefunct machinery and equipment Yet this total does not truly represent what the busi-ness gives up when it ceases production of a product

The first problem with this answer is that it ignores many wider issues that the ness might face as a result of its decision How do competitors view the decision? Willthey seek to use it as an example of the decline of the business? What about customers–will they be disappointed that the product has disappeared? A number of businesses havefound themselves under pressure to bring back much loved products that may not havebeen financially viable and have incurred disappointment from customers and possibleloss of loyalty as a result Then there is the attitude amongst workers – is this closurethe first of others, does it send negative signals to the rest of the workforce and result

busi-in a declbusi-ine busi-in motivation and busi-increases busi-in staff turnover as workers seek to get outbefore they are pushed out?

The second problem is that it does not include the lost revenue from sales of theproduct It may be that sales were low and not that it was not viable to continue withproduction Assuming that sales were not zero there was some revenue being generatedand this will now be lost That has to be taken into consideration

The decision, therefore, has costs far greater than pure money costs The cost of loss

of goodwill, worker and customer loyalty and bad publicity also has to be taken into sideration in assessing the costs of the decision and these may not be immediately obvi-ous and sometimes not easy to work out

con-The opportunity cost of an item is what you give up to get that item When makingany decision, such as whether to close down production of a product, decision makersshould be aware of the opportunity costs that accompany each possible action

Quick Quiz A bakery is planning to invest€20 000 in a new machinewhich will increase its production of croissants by 10 per cent The finan-cial director of the company points out that account needs to be taken ofwhat that€20 000 could earn if invested in another way, such as in aninterest-bearing account at a bank, as part of the cost calculations Why doyou think she insisted that this was taken into consideration and why is itclassed as a cost?

opportunity cost whatever must be given up to obtain some item – the value

of the benefits foregone (sacrificed)

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Principle 3: Rational People and Businesses Think at the Margin

Decisions in life are rarely black and white but usually involve shades of grey The decision

by a company worker of whether to put in the extra hour at the end of the working day isnot a case of working all day or not but about that extra time to finish a project before goinghome A publisher may have to make a decision about whether to print an extra thousandcopies of a textbook when it is not certain that all these extra books will sell Many workershave to make decisions about whether to spend a bit more time with their families orwhether to shut themselves away and get on with the bit of work that needs finishing for adeadline the next week Economists use the term marginal changes to describe small incre-mental adjustments to an existing plan of action Keep in mind that‘margin’ means ‘edge’,

so marginal changes are adjustments around the edges of what you are doing

In many situations, people make the best decisions by thinking at the margin Suppose,for instance, that you asked a friend for advice about how many years to stay in education

If he were to compare for you the lifestyle of a person with a PhD to that of someone whofinished secondary school with no qualifications, you might complain that this comparison

is not helpful for your decision Perhaps you have already been at university for a few yearsbut you’re getting a little tired of studying and not having enough money and so you’redeciding whether or not to stay on for that last year To make this decision, you need toknow the additional benefits that an extra year in education would offer (higher wagesthroughout your life and the sheer joy of learning) and the additional costs that you wouldincur (another year of tuition fees and another year of foregone wages) By comparing thesemarginal benefits and marginal costs, you can evaluate whether the extra year is worthwhile

As another example, consider an airline company deciding how much to chargepassengers who fly standby Suppose that flying a 200-seat aeroplane from London toWarsaw costs the airline €100 000 In this case, the average cost of each seat is

€100 000/200, which is €500 One might be tempted to conclude that the airline shouldnever sell a ticket for less than€500 In fact, however, the airline can raise its profits bythinking at the margin Imagine that a plane is about to take off with ten empty seats,and a standby passenger is waiting at the gate willing to pay€300 for a seat Should theairline sell it to him/her? Of course it should If the plane has empty seats, the cost

of adding one more passenger is minuscule Although the average cost of flying apassenger is€500, the marginal cost is merely the cost of the airline meal that the extrapassenger will consume (which may have gone to waste in any case) and possibly anextremely slight increase in the amount of aircraft fuel used As long as the standbypassenger pays more than the marginal cost, selling him or her a ticket is profitable

As these examples show, individuals and firms can make better decisions by thinking

at the margin A rational decision maker takes an action if and only if the marginal efit of the action exceeds the marginal cost For businesses this principle is extremelyimportant because there are more likely to be attempts to rationalize decision makingthan individuals do on a day-to-day basis

ben-Principle 4: People and Businesses Respond to Incentives

Because people and businesses make decisions by comparing costs and benefits, theirbehaviour may change when the costs or benefits change That is, people respond toincentives When the price of an apple rises, for instance, people decide to eat morepears and fewer apples because the cost of buying an apple is higher At the same time,apple orchards decide to hire more workers and harvest more apples, because the benefit

of selling an apple is also higher As we shall see, the effect of price on the behaviour ofbuyers and sellers in a market– in this case, the market for apples – is crucial for under-standing how the economy works

marginal changes small incremental adjustments to a plan of action

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Public policy makers should never forget about incentives, because many policieschange the costs or benefits that people face and, therefore, alter behaviour A tax on pet-rol, for instance, encourages people to drive smaller, more fuel-efficient cars For vehiclemanufacturers this change in demand has to be accommodated and shifts resources intothe production of smaller, more fuel efficient cars and away from larger, more fuel expen-sive cars It also encourages people to use public transport rather than drive and to livecloser to where they work This in turn has an effect on decisions about provision of publictransport and what type of transport and affects businesses in the construction industry Ifthe tax were large enough, people would start driving electric cars, which requires invest-ment by vehicle manufacturers in this technology and a host of other businesses who may

be involved in setting up the infrastructure to facilitate the use of electric cars

When policy makers fail to consider how their policies affect incentives, they oftenend up with results they did not intend For example, consider public policy regardingmotor vehicle safety Today all cars sold in the European Union, South Africa and mostcountries in the Middle East have to have seat belts fitted by law (although actual seatbelt use– especially by rear-seat passengers – varies widely, with official estimates rang-ing from about 30 per cent of car occupants in some member states of the EU to around

90 per cent in others, notably Sweden)

How does a seat belt law affect car safety? The direct effect is obvious: when a personwears a seat belt, the probability of surviving a major car accident rises But that’s not theend of the story, for the law also affects behaviour by altering incentives The relevantbehaviour here is the speed and care with which drivers operate their cars Drivingslowly and carefully is costly because it uses the driver’s time and energy When decidinghow safely to drive, rational people compare the marginal benefit from safer driving tothe marginal cost They drive more slowly and carefully when the benefit of increasedsafety is high It is no surprise, for instance, that people drive more slowly and carefullywhen roads are icy than when roads are clear

Quick Quiz The emphasis on road safety throughout Europe hasincreased over the last 25 years Not only are cars packed with safetytechnology and devices but roads are also designed to be safer with theuse of safety barriers and better road surfaces, for example Is there a case,therefore, for believing that if people feel that they are safer in their carsthere is an incentive to drive faster because the marginal cost is now out-weighed by the marginal benefit?

Consider how a seat belt law alters a motorist’s cost–benefit calculation Seat beltsmake accidents less costly because they reduce the likelihood of injury or death Inother words, seat belts reduce the benefits to slow and careful driving People respond

to seat belts as they would to an improvement in road conditions – by faster and lesscareful driving The end result of a seat belt law, therefore, is a larger number of acci-dents and so it will affect both motorists and pedestrians The decline in safe drivinghas a clear, adverse impact on pedestrians, who are more likely to find themselves in

an accident but (unlike the motorists) don’t have the benefit of added protection

At first, this discussion of incentives and seat belts might seem like idle speculation.Yet a 1981 study of seat belt laws in eight European countries commissioned by the UKDepartment of Transport showed that the laws did appear to have had many of theseeffects Similar evidence was also presented in a 1975 study of US seat belt laws by theAmerican economist Sam Peltzman It does indeed seem that seat belt laws produce bothfewer deaths per accident and more accidents The net result is little change in the num-ber of motorist deaths and an increase in the number of pedestrian deaths

This is an example of the general principle that people respond to incentives Manyincentives that economists study are more straightforward than those of the car-safetylaws No one is surprised that people drive smaller cars in Europe, where petrol taxes

Music, TV and television ducer and executive Simon Cowell understood opportunity cost and incentives He decided to leave school before completing his post-16 education and is reported to earn in excess of £50 million a year!

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are relatively high, than in the United States, where petrol taxes are lower Yet, as theseat belt example shows, policies can have effects that are not obvious in advance.

When analysing any policy, we must consider not only the direct effects but also theindirect effects that work through incentives If the policy changes incentives, it willcause people to alter their behaviour

Quick Quiz List and briefly explain the four principles of individualdecision making

HOW PEOPLE INTERACT

The first four principles discussed how individuals and businesses make decisions As we

go about our lives, many of our decisions and the decisions of businesses affect not onlyourselves but other people and businesses as well The next three principles concern howpeople and businesses interact with one another

Principle 5: Trade Can Make Everyone Better Off

The Americans, South Africans and the Japanese are often mentioned in the news asbeing competitors to Europeans in the world economy In some ways this is true,because American, South African and Japanese firms do produce many of the samegoods as European firms Airbus and Boeing compete for the same customers in themarket for aircraft Toyota and Citroën compete for the same customers in the marketfor cars South African and American fruit growers compete in the same market as Euro-pean fruit growers and South African and American wine producers compete in thesame market as French, Spanish and Italian wine makers

Yet it is easy to be misled when thinking about competition among countries Tradebetween Europe and South Africa or the United States, or between Europe and Japan, isnot like a sports contest where one side wins and the other side loses (a zero-sumgame) In fact, the opposite is true: trade between two economies can make each econ-omy better off

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To see why, consider how trade affects a business When a business produces a product itcompetes against other businesses that are also producing similar products Despite thiscompetition, a business would not be better off isolating itself from all other businesses If itdid, the business would have to supply all its own raw materials and components, find itsown staff, arrange its own insurance, do its own banking, arrange its own security and so on.Clearly, businesses gain much from their ability to trade with others Trade allows eachbusiness to specialize in the activities it does best, whether it is farming, making clothes orhome building By trading with others, businesses can buy a greater variety of goods andservices at lower cost and therefore (potentially) increase both productive and technicalefficiency.

Countries as well as businesses benefit from the ability to trade with one another.Trade allows countries to specialize in what they do best and to enjoy a greater variety

of goods and services The Japanese and the Americans, as well as the Egyptians andthe Brazilians, are as much our partners in the world economy as they are ourcompetitors

Principle 6: Markets are Usually a Good Way to Organize Economic Activity

The collapse of communism in the Soviet Union and Eastern Europe in the 1980s may

be the most important change in the world during the past half century (although ing out the European debt crisis, which arose partly because of market failure, has alsobeen cited as being at least on a par with this and possibly even more significant in thecoming 50 years) Communist countries worked on the premise that central planners inthe government were in the best position to guide economic activity These plannersdecided what goods and services were produced, how much was produced, and who pro-duced and consumed these goods and services The theory behind central planning wasthat only the government could organize economic activity in a way that promoted eco-nomic well-being for the country as a whole

sort-Today, most countries that once had centrally planned economies have abandonedthis system and are trying to develop market economies In a market economy, the deci-sions of a central planner are replaced by the decisions of millions of firms and house-holds Firms decide whom to hire and what to make Households decide which firms towork for and what to buy with their incomes These firms and households interact in themarketplace, where prices and self-interest guide their decisions

At first glance, the apparent success of market economies in raising standards ofliving for many of the population in countries is puzzling After all, in a market econ-omy, no one is considering the economic well-being of society as a whole Free marketscontain many buyers and sellers of numerous goods and services, and all of them areinterested primarily in their own well-being Yet, despite decentralized decision makingand self-interested decision makers, market economies have proven remarkablysuccessful in organizing economic activity in a way that promotes overall economicwell-being

In his 1776 book An Inquiry Into the Nature and Causes of the Wealth of Nations, theBritish economist Adam Smith made the most famous observation in all of economics:households and firms interacting in markets act as if they are guided by an ‘invisiblehand’ that leads them to desirable market outcomes One of our goals in this book is tounderstand how this invisible hand works its magic As you study economics, you willlearn that prices are the instrument with which the invisible hand directs economicactivity Prices reflect both the value of a good to society and the cost to society of mak-ing the good Because households and firms look at prices when deciding what to buyand sell, they unknowingly take into account the social benefits and costs of theiractions As a result, prices guide these individual decision makers to reach outcomesthat, in many cases, maximize the welfare of society as a whole

market economy an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services

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However, a caveat has to be put on this principle It is that markets are usually a goodway to organize economic activity We emphasize usually because markets are notdevoid of problems as we will outline in the next principle We alluded above to theEuropean debt crisis which has been rumbling on since the financial crisis of 2007–

2008 and may well be continuing after this book is published We will look at the sons why markets may not work properly all the time in later chapters but we willassume that a market system, which is adopted by the vast majority of countries in theworld, is the standard economic system which we will use and analyse

rea-FYI

Adam Smith and the Invisible Hand

Adam Smith’s great work The Wealth ofNations is a landmark in economics Inits emphasis on the invisible hand of themarket economy, it reflected a point ofview that was typical of so-called

‘enlightenment’ writers at the end ofthe 18th century– that individuals areusually best left to their own devices,without the heavy hand of governmentguiding their actions This political phi-losophy provides the intellectual basisfor the market economy

Why do decentralized market omies work so well? Is it because peo-ple can be counted on to treat oneanother with love and kindness? Not

econ-at all Here is Adam Smith’s description

of how people interact in a marketeconomy:

Man has almost constant occasionfor the help of his brethren, and it isvain for him to expect it from theirbenevolence only He will be morelikely to prevail if he can interesttheir self-love in his favour, andshow them that it is for their ownadvantage to do for him what herequires of them … It is not fromthe benevolence of the butcher,the brewer, or the baker that weexpect our dinner, but from theirregard to their own interest …Every individual … neither intends

to promote the public interest, norknows how much he is promoting

it.… He intends only his own gain,and he is in this, as in many othercases, led by an invisible hand topromote an end which was no part

of his intention Nor is it always theworse for the society that it was

no part of it By pursuing his owninterest he frequently promotesthat of the society more effectuallythan when he really intends to pro-mote it

Wealth of Nations 1776Smith is saying that participants in theeconomy are motivated by self-interestand that the‘invisible hand’ of the mar-ketplace guides this self-interest intopromoting general economic well-being Many of Smith’s insights remain

at the centre of modern economics Ouranalysis in the coming chapters willallow us to express Smith’s conclusionsmore precisely and to analyse fully thestrengths and weaknesses of the mar-ket’s invisible hand

There is an important corollary tothe skill of the invisible hand in guidingeconomic activity: when the govern-ment prevents prices from adjustingnaturally to supply and demand, itimpedes the invisible hand’s ability tocoordinate the millions of households

and firms that make up the economy.This corollary explains why taxesadversely affect the allocation ofresources: taxes distort prices andthus the decisions of households andbusinesses It also explains the evengreater harm caused by policies thatdirectly control prices, such as rentcontrol And it also explains the failure

of communism In communist tries, prices were not determined inthe marketplace but were dictated bycentral planners These plannerslacked the information that getsreflected in prices when prices arefree to respond to market forces Cen-tral planners failed because they tried

coun-to run the economy with one hand tiedbehind their backs– the invisible hand

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Principle 7: Governments Can Sometimes Improve Market Outcomes

If the invisible hand of the market is so wonderful, why do we need government? Oneanswer is that the invisible hand needs government to protect it Markets work only ifproperty rights are enforced A farmer won’t grow food if he expects his crop to be sto-len, and a restaurant won’t serve meals unless it is assured that customers will pay beforethey leave In many countries the idea that a business should have the sole right toexploit its inventions, processes, ideas, brands and trademarks is based in law In othercountries such ideas are viewed with a degree of scepticism and curiosity We all rely ongovernment-provided police and courts to enforce our rights over the things we produce.Yet there is another answer to why we need government: although markets are usu-ally a good way to organize economic activity, this rule has some important exceptions.There are two broad reasons for a government to intervene in the economy– to promoteefficiency and to promote equity That is, most policies aim either to enlarge the eco-nomic cake or to change the way in which the cake is divided

Although the invisible hand usually leads markets to allocate resources efficiently, that

is not always the case Economists use the term market failure to refer to a situation inwhich the market on its own fails to produce an efficient allocation of resources Onepossible cause of market failure is an externality, which is the uncompensated impact

of one person’s actions on the well-being of a bystander or third party For instance,the classic example of an external cost is pollution Another possible cause of marketfailure is market power, which refers to the ability of a single person (or small group)

to unduly influence market prices For example, if everyone in a remote village in theScottish Highlands needs water but there is only one well, the owner of the well is notsubject to the rigorous competition with which the invisible hand normally keeps self-interest in check In the presence of externalities or market power, well designed publicpolicy can enhance economic efficiency

? what if …The intervention by government actually leads to a worse outcome

than if it had not done anything in the first place Does this mean governmentsshould never interfere in the market?

The invisible hand may also fail to ensure that economic prosperity is distributed bly A market economy rewards people according to their ability to produce things forwhich other people are willing to pay The world’s best footballer earns more than theworld’s best chess player simply because people are willing to pay more to watch footballthan chess The invisible hand does not ensure that everyone has sufficient food, decentclothing and adequate health care Many public policies, such as income tax and thesocial security system, aim to achieve a more equitable distribution of economic well-being

equita-To say that the government can improve on market outcomes at times does not meanthat it always will Public policy is made not by angels but by a political process that isfar from perfect Sometimes policies are designed simply to reward the politically power-ful Sometimes they are made by well intentioned leaders who are not fully informed orwho are unduly swayed by lobbying from businesses with a great deal of influence andpower One goal of the study of economics is to help you judge when a government pol-icy is justifiable to promote efficiency or equity, and when it is not

Quick Quiz List and briefly explain the three principles concerning nomic interactions

eco-market failure a situation in which a market left on its own fails to allocate resources efficiently

externality the uncompensated impact of one person’s actions on the well-being of a bystander or third party

market power the ability of a single economic agent (or small group of agents) to have a substantial influence

on market prices

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HOW THE ECONOMY AS A WHOLE WORKS

We started by discussing how individuals make decisions and then looked at how peopleinteract with one another All these decisions and interactions together make up ‘theeconomy’ The last three principles concern the workings of the economy as a whole Akey concept in this section is economic growth– the percentage increase in the number

of goods and services produced in an economy over a period of time, usually expressedover a quarter and annually

Principle 8: An Economy ’s Standard of Living Depends on Its Ability to Produce Goods and Services

Table 1.1 shows gross domestic product (GDP) per head of the population in a number

of selected countries In 2012 the average annual income per head of population in theNetherlands, Finland, Singapore and Canada was about $52 000, while it was a littlelower in the UK and Germany at around $41 000 and $45 000, respectively, somewhat

Source: International Monetary Fund, World Economic Outlook Database,

economic growth the increase in the amount of goods and services in an economy over a period of time

gross domestic product per head the market value of all final goods and services produced within a country in a given period of time divided

by the population of a country to give a per capita figure

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higher in Norway at around $98 600 and an enviable $126 326 in Luxembourg By trast, we can see differences in income and living standards around the world that arequite staggering For example, in the same year, 2012, average income in South Africa,

con-at around $8600, was about a quarter of the level in Spain, while in Egypt it was around

$3100, in India around $1600, in Yemen about $1500 and in Burkina Faso it was onlyabout $700 – around one half of one per cent of the annual income per person inLuxembourg! Not surprisingly, this large variation in average income is reflected in vari-ous other measures of the quality of life and standard of living Citizens of high-incomecountries have better nutrition, better health care and longer life expectancy than citizens

of low-income countries, as well as more TV sets, more DVD players and more cars.Changes in the standard of living over time are also large Over the last 50 years, aver-age incomes in Western Europe and North America have grown at about 2 per cent peryear (after adjusting for changes in the cost of living) At this rate, average income dou-bles every 35 years, and over the last half-century average income in many of these pros-perous economies has risen approximately three-fold On the other hand, averageincome in Ethiopia rose by only a third over this period – an average annual growthrate of around only 0.5 per cent

What explains these large differences in living standards among countries and overtime? The answer is surprisingly simple Almost all variation in living standards is attrib-utable to differences in countries’ productivity – that is, the amount of goods and ser-vices produced from each hour of a worker’s time In nations where workers canproduce a large quantity of goods and services per unit of time, most people enjoy ahigh standard of living; in nations where workers are less productive, most people mustendure a more meagre existence Similarly, the growth rate of a nation’s productivitydetermines the growth rate of its average income Productivity is not only important to

a country’s well-being but is also vital to that of businesses

The fundamental relationship between productivity and living standards is simple, butits implications are far-reaching If productivity is the primary determinant of livingstandards, other explanations must be of secondary importance For example, it might

be tempting to credit trade unions or minimum wage laws for the rise in living standards

of European workers over the past 50 years Yet the real hero of European workers istheir rising productivity

The relationship between productivity and living standards also has profound cations for public policy When thinking about how any policy will affect living stan-dards, the key question is how it will affect our ability to produce goods and services

impli-To boost living standards, policy makers need to raise productivity by ensuring thatworkers are well educated, have the tools needed to produce goods and services andhave access to the best available technology These policies are important in providingthe resource infrastructure that businesses need to be able to thrive Without welleducated workers with high levels of employability skills, business costs would be higherbecause they would have to pay to train workers in these skills themselves Without anadequate transport and communications network, business activity is hampered andagain costs are higher and productivity lower

Principle 9: Prices Rise When the Government Prints Too Much Money

In Germany in January 1921, a daily newspaper was priced at 0.30 marks Less than twoyears later, in November 1922, the same newspaper was priced at 70 000 000 marks Allother prices in the economy rose by similar amounts This episode is one of history’s mostspectacular examples of inflation, an increase in the overall level of prices in the economy.While inflation in Western Europe and North America has been much lower over thelast 50 years than that experienced in Germany in the 1920s, inflation has at times been aneconomic problem During the 1970s, for instance, the overall level of prices in the UK

Differences in standards of living not only occur between countries but also within countries.

standard of living a measure of welfare based on the amount of goods and services a person’s income can buy

productivity the quantity of goods and services produced from each hour of

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more than tripled By contrast, UK inflation from 2000 to 2008 was about 3 per cent peryear; at this rate it would take more than 20 years for prices to double In more recenttimes, Zimbabwe has experienced German-like hyper inflation In March 2007 inflation

in the African state was reported to be running at 2200 per cent This means that a goodpriced at the equivalent of€2.99 in March 2006 would be priced at €65.78 just a year later

In July 2008 the government issued a Z$100 billion note At that time it was just aboutenough to buy a loaf of bread Estimates for inflation in Zimbabwe in July 2008 put therate of growth of prices at 231 000 000 per cent In January 2009, the Zimbabwean govern-ment issued Z$10, 20, 50 and 100 trillion dollar notes– 100 trillion is 100 followed by 12zeros Because high inflation imposes various costs on businesses and society, keepinginflation at a low level is a goal of economic policy makers around the world

What causes inflation? In almost all cases of high or persistent inflation, the culpritturns out to be the same– growth in the quantity of money When a government createslarge quantities of the nation’s money, the value of the money falls In Germany in theearly 1920s, when prices were on average tripling every month, the quantity of moneywas also tripling every month Although less dramatic, the economic history of otherEuropean and North American countries points to a similar conclusion: the high infla-tion of the 1970s was associated with rapid growth in the quantity of money and the lowinflation of the 2000s was associated with slow growth in the quantity of money

Principle 10: Society Faces a Short-Run Trade-Off Between Inflation and Unemployment

When the government increases the amount of money in the economy, one result isinflation Another result, at least in the short run, is a lower level of unemployment

The curve that illustrates this short-run trade-off between inflation and unemployment

is called the Phillips curve, after the economist who first examined this relationshipwhile working at the London School of Economics

The Phillips curve remains a controversial topic among economists, but most mists today accept the idea that society faces a short-run trade-off between inflation andunemployment This simply means that, over a period of a year or two, many economicpolicies push inflation and unemployment in opposite directions Policy makers face thistrade-off regardless of whether inflation and unemployment both start out at high levels(as they were in the early 1980s), at low levels (as they were in the late 1990s) or some-where in between

econo-The trade-off between inflation and unemployment is only temporary, but it can lastfor several years The Phillips curve is, therefore, crucial for understanding many devel-opments in the economy In particular, it is important for understanding the businesscycle– the irregular and largely unpredictable fluctuations in economic activity, as mea-sured by the number of people employed or the production of goods and services

unemploy-Because these instruments of monetary and fiscal policy are potentially so powerful,how policy makers should use these instruments to control the economy, if at all, is asubject of continuing debate

Phillips curve a curve that shows the short-run trade-off between inflation and unemployment

business cycle fluctuations in economic activity, such as employment and production

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Quick Quiz List and briefly explain the three principles that describehow the economy as a whole works.

IN THE NEWS

Accepting Principles?

The ten principles of economics presented in this chapter are fundamental to the understanding

of economics However, these principles do not mean that everyone will agree or adhere tothem even if research suggests links between some of these principles and improvements inwelfare and well-being This article shows how countries and businesses will choose to ignoresome of these principles if they believe it benefits certain sections of society, despite recognizingthat their decisions may have adverse effects on other people and businesses

Cotton Ban Imposed by EgyptPrices of raw cotton in the 2010/11 seasonwere relatively high These high pricesacted as an incentive for farmers to growmore cotton in Egypt and so reap the ben-efit of the higher prices However, a yearlater, global cotton prices are not as highand so the harvest has seen Egyptian cot-ton growers facing much lower prices thanthey anticipated Cotton traded on globalmarkets is measured in qintirs with oneqintir being around 160 kg of cotton

Cotton growers in Egypt not onlysupply the local domestic market butalso export a major proportion of theiroutput The cotton crop for 2011/12 wasexpected to be around 3.7 million qintirs

and of that amount about 54 per centwill be sold abroad

Growers had been expecting prices ofaround 1700 Egyptian pounds per qintirbut market prices were nearer to 1500Egyptian pounds per qintir As a result,growers put pressure on the Egyptiantrade minister to impose a ban on imports

of cotton allowing domestic growers tosell their remaining stock of cotton withinthe country first Such an idea is of coursecontrary to the principle that markets areusually the best way of allocatingresources (in this case cotton) and thattrade can make everyone better off Theinitial incentives provided by higher pricesacted as a spur to growers to plant morecotton but now they fear being left withstocks of cotton they won’t be able to sell

at high enough prices to cover their costs

The ban on imported cotton meansthat domestic buyers will not be able toaccess cotton at the cheaper prices andinstead they will be forced to pay higherprices to domestic Egyptian growers

The trade-off is clear; Egyptian growersare able to maintain their incomes as aresult of the import ban and thereforebenefit from the decision, but domesticbuyers of cotton will face higher pricesthan would be the case under ‘freetrade’ and so their costs will rise andpossibly damage their competitiveness

The trade minister noted that theban on imports was only likely to be

temporary, perhaps for a three-monthperiod until stocks had been sold Thismight be of small comfort to the buyers

of cotton who know that the 1.7 millionqintirs of cotton left for the domesticmarket after export sales have beenmet is less than the total domesticdemand for cotton When supply isless than demand the result is thatprices will rise and so domestic buyerswill have to pay higher prices than theyotherwise would if they were able tosatisfy demand through buying cheaperimports If their costs are lower, consu-mers will face lower prices– one of thebenefits of trade

Questions

1 What might have caused cottonprices to be ‘relatively high’ in2010/11?

2 Explain some of the problems ing cotton farmers through having tomake production decisions manymonths in advance of receiving rev-enues from the harvest

fac-3 Explain the likely effect on cottonprices in Egypt if the governmentbanned foreign imports

4 How will the import ban affectclothing manufacturers in Egypt?

5 How might clothing manufacturers

in Egypt respond to the market ditions they face?

con-Incentives to plant cotton are dependent on the price at planting time rather than what price is received at harvest.

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How to Read This Book

Business Economics is fun – it isdynamic, always raising new issuesand problems, interesting approachesand perspectives, but it can also behard to learn Our aim in writing thistext has been to make it as easy and

as much fun as possible to apply basiceconomic principles to a business con-text But you, the student, also have arole to play Experience shows that ifyou are actively involved as you studythis book, you will enjoy a better out-come, both in your exams and in theyears that follow Here are a few tipsabout how best to read this book

1 Highlighting is not enough Running

a yellow marker over the text orusing the highlight function in ane-book is too passive an activity tokeep your mind engaged Instead,when you come to the end of a sec-tion, take a minute and summarizewhat you have just learnt in yourown words, writing your summary

in the wide margins we’ve provided

or in the notes section provided inthe e-book or, if you don’t want to (orare not allowed to) write on the bookitself, use a notepad of somedescription (electronic or paper)

When you’ve finished the chapter,compare your summary with theone at the end of the chapter Didyou pick up the main points?

2 Test yourself Throughout the book,Quick Quizzes offer instant feedback

to find out if you’ve learned what youare supposed to Take the opportu-nity Write your answer using what-ever notes writing option you have

The quizzes are meant to test yourbasic comprehension If you aren’tsure your answer is right, you prob-ably need to review the section

These quizzes will also help you to

think about the issues that havebeen covered in the text Thinking

in economics is vital if you want toimprove and learn what the subject

is all about Never be frightened tothink and question – some of thebest ideas in economics and busi-ness have arisen because peoplethink and question You may makemistakes when you think but that isone way that we learn

3 Practise, practise, practise At theend of each chapter, Questions forReview test your understanding, andProblems and Applications ask you

to apply and extend the material allset in different business contexts

Perhaps your lecturer will assignsome of these exercises as course-work If so, do them If not, do themanyway The more you use your newknowledge, the more solid itbecomes

4 Study in groups After you’ve readthe book and worked through theproblems on your own, get togetherwith other students to discuss thematerial You will learn from eachother– an example of the gains fromtrade

5 Don’t forget the real world In themidst of all the numbers, graphsand strange new words, it is easy

to lose sight of what business nomics is all about The Case Studyand In the News boxes sprinkledthroughout this book should helpremind you Don’t skip them Theyshow how the theory is tied to busi-ness events happening which affectall of our lives If your study is suc-cessful, you won’t be able to read anewspaper again or look at a busi-ness without thinking about supply,demand and the wonderful world ofbusiness economics

eco-6 Relate concepts to concrete ples Throughout this book we willintroduce a number of new concepts– ways of representing things whichallow us to bring meaning to ourlives Many of the concepts weintroduce will have specific mean-ings in business economics butalso have other meanings in every-day use For example, the term‘cap-ital’ is widely understood by non-economists as meaning ‘money’ Inbusiness economics capital has afar more precise meaning We willencounter a number of examples ofthese concepts which are also ineveryday use but which may beinterpreted differently in the world

exam-of business economics Ensure,therefore, that you are comfortable

in the meaning and use of theseconcepts

7 Think like an economist After usingthis book we hope that you will start

to think like an economist This can

be taken to mean that there is a body

of knowledge, a set of skills andmethods that are used by businesseconomists to identify, analyse andevaluate problems which constitute

‘thinking like an economist’ In sodoing, those problems become‘eco-nomic problems’ because they are to

do with scarcity, choice, decisionmaking and the outcome of thatdecision making To enable econo-mists to be able to represent thoseproblems and provide commentaryand solutions, an understanding of

a series of concepts is necessary.Some of these concepts are con-crete whilst others are veryabstract

8 Think threshold concepts One of thepossible approaches to understand-ing some of these very important

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