Part II: Business Environment Introduction to Business 3e 4 Copyright © 2004 South-Western. All rights reserved. Assessing Economic Conditions

Copyright © 2004 South-Western. All rights reserved.4–2 Business Environment

Copyright © 2004 South-Western. All rights reserved.4–3 Learning Goals Identify macroeconomic factors that affect business performance. Explain how market prices are determined. Explain how the government influences economic conditions.

Copyright © 2004 South-Western. All rights reserved.4–4 Assessing Economic Conditions

Copyright © 2004 South-Western. All rights reserved.4–5 Economic Conditions Reflect the level of production and consumption for a particular country, area, or industry –Macroeconomic conditions  Overall economic state of a country –Microeconomic conditions  Focus on conditions in a particular business or industry

Copyright © 2004 South-Western. All rights reserved.4–6 Impact of Economic Conditions Economic conditions can affect: –Revenues of a business –Expenses of a business –Total value of a business

Copyright © 2004 South-Western. All rights reserved.4–7 Impact of Economic Conditions Some firms are more sensitive to changes in economic conditions than others: –Demand for fast food demand is not very sensitive to declining economic conditions. –Demand for new automobiles is more sensitive to weak economic conditions than food products.

Copyright © 2004 South-Western. All rights reserved.4–8 Harley Davidson Example Demand for motorcycles is stronger when: –The economy is strong. –Customers have more income to buy motorcycles. High demand for Harley Davidson’s motorcycles: –Generates greater revenue. –Improves company performance.

Copyright © 2004 South-Western. All rights reserved.4–9 Harley Davidson Example Demand for motorcycles is weaker when: –The economy is weak. –Customers have less income to buy motorcycles. Lower demand for Harley Davidson’s motorcycles: –Generates less revenue. –Weakens company performance.

Copyright © 2004 South-Western. All rights reserved.4–10 Harley Davidson Example Harley Davidson tries to predict demand so it will have a sufficient supply of motorcycles to meet future demand. –Demand for motorcycles depends on economic conditions. –Number of motorcycles produced also depends on economic conditions. Government policies also affect economic conditions.

Copyright © 2004 South-Western. All rights reserved.4–11 Harley Davidson Example Harley Davidson must determine: –How prevailing economic conditions will affect the demand for the motorcycles it produces. –How prevailing government policies will affect the demand for its motorcycles.

Copyright © 2004 South-Western. All rights reserved.4–12 Macroeconomic Effects The performance of most firms depends on three macroeconomic factors: –Economic growth  Changes in the general level of economic activity –Inflation  Increases in general level of prices over specific period of time –Interest rates  Changes in the cost of borrowed money

Copyright © 2004 South-Western. All rights reserved.4–13 Economic Growth When the change in the general level of economic activity is higher than normal: –Total income level of all U.S. workers is relatively high. –There is a higher volume of spending on products and services. –Firms that sell products and services should generate higher revenues.

Copyright © 2004 South-Western. All rights reserved.4–14 Recession Occurs when economic growth is negative for two consecutive quarters Lowers demand for products and services –Reduces the revenue of firms that sell products and services. –Can cause firms to shut down factories in response to low economic growth.  General Motors  Ford

Copyright © 2004 South-Western. All rights reserved.4–15 Indicators of Economic Growth Gross Domestic Product (GDP) –The level of total production of products and services in the economy –Total market value of all final products and services produced in the U.S. Aggregate Expenditures –Total amount of expenditures

Copyright © 2004 South-Western. All rights reserved.4–16 Trend of Gross Domestic Product (GDP) Exhibit 4.1

Copyright © 2004 South-Western. All rights reserved.4–17 Indicators of Economic Growth In the U.S., these indicators are closely related: –High level of consumer spending reflects a large demand for products and services. –Total production level depends on total demand for products and services.

Copyright © 2004 South-Western. All rights reserved.4–18 Alternative Indicators of Economic Growth Unemployment level Industrial production level New housing starts Personal income level

Copyright © 2004 South-Western. All rights reserved.4–19 Unemployment Levels Frictional unemployment –People who are between jobs. Seasonal unemployment –People whose services are not needed during some seasons. Cyclical unemployment –People unemployed due to poor economic conditions. –Best indicator of economic conditions. Structural unemployment –People who do not have adequate skills.

Copyright © 2004 South-Western. All rights reserved.4–20 Trend of U.S. Unemployment Exhibit 4.2

Copyright © 2004 South-Western. All rights reserved.4–21 Inflation An increase in the general level of prices of products and services over a specified period of time. –Estimated by measuring percentage changes in the consumer price index (CPI). –CPI is a market basket of prices on a wide variety of consumer products:  Grocery products, housing, gasoline, medical services, electricity, etc.

Copyright © 2004 South-Western. All rights reserved.4–22 U.S. Inflation Rates over Time Exhibit 4.3

Copyright © 2004 South-Western. All rights reserved.4–23 Impact of Inflation Can affect a company’s operating expenses –Can increase cost of supplies and materials. –Can impact indexed wages (labor cost). –Higher inflation can cause large increases in operating expenses. Can affect a company’s revenues –Companies may charge higher prices to compensate for their higher expenses.

Copyright © 2004 South-Western. All rights reserved.4–24 Cost-Push Inflation Occurs when firms must charge higher prices because their production (input) costs are higher. –Change in price of oil impacts gasoline prices and transportation costs. –Change in aluminum prices impacts packaging cost of beer production. –Change in pulp prices impacts the cost of paper towel production.

Copyright © 2004 South-Western. All rights reserved.4–25 Demand-Pull Inflation Occurs when product and services prices are pulled up by consumer demand. –Strong consumer demand can cause shortages in the production of products.  Firms that anticipate shortages may increase prices for their products. –Strong consumer demand may put pressure on wages and reduce unemployment.  Firms may increase prices to recover higher operating expenses.

Copyright © 2004 South-Western. All rights reserved.4–26 Interest Rates Represent the cost of borrowing money –Firm’s interest expense is based on market interest rates and can have significant impact on a firm’s profitability.  Firms may postpone expansion and other projects when interest rates are too high. –Interest rates also impact a firm’s revenue  The increased cost of financing new homes reduces demand for new homes.  Revenues for construction firms and equipment manufacturers also decline.

Copyright © 2004 South-Western. All rights reserved.4–27 Effect of Interest Rates on Interest Expenses and Profits Exhibit 4.4 Note: Assume that the firm’s revenue equals $400,000 and its operating expenses equal $300,000.

Copyright © 2004 South-Western. All rights reserved.4–28 business online

Copyright © 2004 South-Western. All rights reserved.4–29 How Macroeconomic Factors Affect a Firm’s Profits Exhibit 4.5

Copyright © 2004 South-Western. All rights reserved.4–30 Market Price Determination Market price of a product is influenced by: –The total demand for that product by all customers –Supply of that product produced by firms The interaction between demand and supply determines the market price.

Copyright © 2004 South-Western. All rights reserved.4–31 Demand and Supply Demand schedule –Indicates the quantity of the product that would be demanded by customers at each possible price. –Quantity demanded is higher when the price is lower.

Copyright © 2004 South-Western. All rights reserved.4–32 How the Equilibrium Price is Determined by Supply and Demand Exhibit 4.6a

Copyright © 2004 South-Western. All rights reserved.4–33 How the Equilibrium Price is Determined by Supply and Demand Exhibit 4.6b

Copyright © 2004 South-Western. All rights reserved.4–34 Demand and Supply (cont’d) Supply schedule –Indicates the quantity of the product that would be supplied (produced) by manufacturers at each possible price. –Quantity supplied (produced) is higher when the price is higher.

Copyright © 2004 South-Western. All rights reserved.4–35 Interaction of Supply and Demand Interaction of demand and supply schedules determines the market price –Surplus: the quantity supplied by firms is more than the quantity demanded by customers. –Shortage: the quantity supplied by firms is less than the quantity demanded by customers. –Equilibrium price: occurs when quantities supplied and demanded are equal.

Copyright © 2004 South-Western. All rights reserved.4–36 Impact of Shifts in Demand Changing conditions can cause a demand schedule or supply schedule for a specific product to change. –Changes the equilibrium price of a product.  Increased product popularity (demand) results in a shortage of the product.  The shortage is corrected when the price is increased to the level at which the quantity supplied equals the quantity demanded.

Copyright © 2004 South-Western. All rights reserved.4–37 How the Equilibrium Price is Affected by a Change in Demand Exhibit 4.7

Copyright © 2004 South-Western. All rights reserved.4–38 How the Equilibrium Price is Affected by a Change in Demand Exhibit 4.7

Copyright © 2004 South-Western. All rights reserved.4–39 Impact of Shifts in Supply Change in supply can impact the equilibrium price of the product. –Technological improvements can lead to reduced production costs causing firms to produce a larger supply at any given price.  The supply schedule changes and yields a surplus which can be sold only by lowering the price.  The surplus is eliminated when the price decreases to a level at which the quantity supplied equals the quantity demanded.

Copyright © 2004 South-Western. All rights reserved.4–40 How the Equilibrium Price is Affected by a Change in Supply Exhibit 4.8

Copyright © 2004 South-Western. All rights reserved.4–41 How the Equilibrium Price is Affected by a Change in Supply Exhibit 4.8

Copyright © 2004 South-Western. All rights reserved.4–42 Factors Influencing Market Prices Consumer income –Determines the amount of products and services individuals can purchase  High levels of economic growth result in more income for consumers.  Increased demand causes demand schedule shifts and price increases. –When consumer income declines:  Demand decreases and creates a surplus as the demand schedule shifts and prices decrease.

Copyright © 2004 South-Western. All rights reserved.4–43 Factors Influencing Market Prices Changes in consumer tastes and preferences: –Impact the quantity of products and services demanded by consumers  Increased demand leads to price increase.  Decreased demand leads to price decrease.

Copyright © 2004 South-Western. All rights reserved.4–44 Factors Influencing Market Prices Change in production expenses –A decrease in expenses can lead to increase in quantity supplied and create a surplus.  Firms must lower prices in order to eliminate the surplus. –An increase in expenses can lead to decrease in quantity supplied and create a shortage.  Firms can increase prices until shortage is corrected.

Copyright © 2004 South-Western. All rights reserved.4–45 Monetary Policy Impacts Economic Conditions Monetary policy –Made by the Federal Reserve System  “Fed” is the central bank of the U.S. –Decisions by Fed about the money supply:  Impact interest rates.  Impact firms’ interest expenses.  Impact demand for products purchased with borrowed funds.

Copyright © 2004 South-Western. All rights reserved.4–46 Fed’s Impact on Interest Rates Maintains funds outside the banking system that are not loanable to firms or individuals  Used to buy Treasury securities held by individuals and companies  Provide individuals and firms with new funds for deposit in commercial banks –Deposits increase the money supply and the supply of loanable funds. –Should result in decreased interest rates and stimulate economic growth.

Copyright © 2004 South-Western. All rights reserved.4–47 Fed’s Impact on Interest Rates Fed can pull funds out of commercial banks and other financial institutions to reduce the money supply. –Reduces the supply of funds available to lend to borrowers (shortage) causing:  Interest rates to increase.  Individuals and companies to borrow less.  Spending levels to decrease.  The level of inflation to decline.

Copyright © 2004 South-Western. All rights reserved.4–48 Fiscal Policy How the federal government sets tax rates and spends money: –Personal income tax rates  Reduced tax rates produce higher after-tax incomes that stimulate spending and increase demand for products and services. –Corporate taxes  Impacts after-tax earnings –Excise taxes  Taxes on particular products that increase prices consumers pay for these products.

Copyright © 2004 South-Western. All rights reserved.4–49 Fiscal Policy Sets the amounts of federal tax revenue government and federal spending –Federal budget deficit  Occurs when federal spending exceeds federal taxes and other revenue collected by the federal government.  Government borrowing to make up the difference creates higher demand for loanable funds and can drive up interest rates.

Copyright © 2004 South-Western. All rights reserved.4–50 Example of How a Budget Deficit Occurs Exhibit 4.9

Copyright © 2004 South-Western. All rights reserved.4–51 How Government Policies Affect Business Performance Exhibit 4.10

Copyright © 2004 South-Western. All rights reserved.4–52 Federal Government’s Dilemma A restrictive monetary or fiscal policy can be used to: –Maintain low rate of economic growth  Prevent inflationary pressure caused by excessive demand  Can also create unemployment –Also requires a trade-off

Copyright © 2004 South-Western. All rights reserved.4–53 Chapter Summary Firm performance depends on three macroeconomic factors: economic growth, inflation, and interest rates. Demand and supply conditions determine market prices. Federal government uses monetary and fiscal policies to influence macroeconomic conditions.