Business and the economy
The definition of national income is the total value of the goods and services produced by a
country’s resources over a year.
The economy as a whole
Macroeconomics and international economics are concerned with how the economy as a
whole functions and how it relates to other economies
In addition to concentrating on elements of the economy such as business organisations,
markets and the financial system, it is also necessary to look at the economy as a whole,
as a system. This makes it possible to answer some important questions including:
How large is the economy?
How fast is the economy growing?
Why do inflation and unemployment occur?
How might businesses use macroeconomic data?
The starting point is to measure the size of the economy by using the concept of national
income.
National income is measured in order to assess the performance of an economy over a
period of time, usually a year. This, in turn, will give some idea of changes in living
standards and enable international comparisons to be made.
Given the scale of economic activity in a modern economy, the accounting needed to
measure national income is very complex. Measurement is done in three ways:
1. By national output
2. By national income
3. By national expenditure
When goods and services are produced people receive incomes and thus, in theory, the
addition of the prices of all the goods and services should equal the sum of all the income
of the population.
National income is a measure of the size of the economy and can show whether the
economy is expanding or contracting
National income data is of particular use to governments in formulating economic
policy and to business when making strategic business choices. For businesses,
especially large businesses operating in more than one country, national income data is
helpful in making several types of strategic decision.
Sales and production strategy
Using predictions of changes in national income, a business can forecast the growth of
incomes in the markets in which it sells its products. If it also knows the extent to which its
sales respond to changes in income (known as the income elasticity of demand), it can
estimate its potential sales growth in those markets. This is valuable information when
planning future output and marketing effort.
,New markets
Data on growth of income in different countries helps businesses to identify potential new
markets. Many international businesses clearly see that rapid economic growth in China
will make it a major future market for a wide range of both consumer and capital goods.
Location decisions
National income data may also help businesses to choose appropriate locations for
production facilities. Businesses prefer to locate in prosperous and dynamic countries.
However, other data indicating the competitiveness of particular locations including costs,
taxation levels, the exchange rate, may be more significant in these decisions.
the circular flow model
The determination of national income
The circular flow model refers to the movement of money resulting from economic
transactions between different groups of people in an economy.
A simple model can be devised to show the income flows. It assumes:
o a two-sector economy of firms and households.
o there is no government and no overseas sector.
o all income is spent on consumption and all production is sold to the
households.
In the circular flow model, there is extensive use of symbols to represent variables in the
model. The most important of these are as follows:
Equilibrium
An economy making full use of its resources will be moving towards a state of rest, or
equilibrium. For equilibrium to be established in the circular flow, planned injections must
equal planned withdrawals.
,Thus if:
J > W, additions to the circular flow exceed withdrawals and so the level of national
income will rise.
J < W, additions to the circular flow are less than withdrawals so the level of
national income will fall.
From this analysis we can derive the concept of aggregate monetary demand
Aggregate demand is the total demand for goods and services in an economy and has two
main components:
Consumption, the original expenditure in the simple circular flow model
Injections of investment, government expenditure and exports
The withdrawals of taxation and savings are taken into account (consumption
is after savings and tax) this only leaves imports to be considered. These can be
accounted for by making exports net exports i.e. exports minus imports
Aggregate demand (AD) is important since changes in aggregate demand are the main
cause of changes in the level of national income in an economy.
Components of Aggregate Demand
Consumption and saving
Consumption is by far the largest of the elements that make up total aggregate demand.
Consumption (C) is primarily a function of the level of income (Y); as incomes rise so does
the level of consumption. The extent to which consumption rises as incomes rise is known
as the marginal propensity to consume (MPC). This measures the proportion of an
extra unit of income which is spent rather than saved.
, MPC= 0.9 (90% of any extra unit of income is spent and 10% is saved)
The marginal propensity to save (MPS) is the proportion of an extra unit of income
which is saved rather than spent.
MPS= 0.1 (10% of any extra unit of income is saved and 90% is spent)
Since economists define saving as ‘not spending’, any income which is not spent must, by
definition, be saved. Therefore:
MPC + MPS = 1
Investment
Business investment in this context means the purchase of any capital equipment that the
business uses to develop, produce and market its product or service. The level of business
investment may be affected by a variety of factors. However, two main factors seem to
dominate the decisions made by businesses about future levels on investment.
Judgements about the profitability of an investment project over its lifetime:
The higher the estimated return on the investment, the more likely a particular
project will be undertaken. Such estimates are difficult partly because predicting
future flows of incomes and costs are inherently difficult, especially for very long-
term investment projects, and partly because of the time value of money. This
reflects the fact that future flows of income should be given a lower current
valuation than present flows of income. This problem is dealt with by using
a discounting model. This is considered in a later unit.
The expected level of demand: Businesses normally want to meet the demand for
their goods or services – the level of output they aim for reflects the expected level
of demand. Thus, changes in the expected level of demand will lead to planned
changes in the production capacity of the business. If demand is expected to rise
(fall) in the future, the level of business investment will probably rise (fall) as well.
One model of the relationship between demand and investment is
the accelerator mode. This is explained in the final section of this unit.
Government expenditure
Government expenditure (public expenditure) can be classified into two categories:
Expenditure on goods and services: Here the level of expenditure is determined
by government decisions about what sort of functions the government will
undertake. In most countries, the state provides education largely without charge.
Thus, the goods (schools, books) and services (teachers) purchased will be a
significant element of public expenditure. In many countries, health services are
also provided by the state. In those where this is not so, the level of government
expenditure tends to be lower.
Transfer payments: These include such payments as pensions, unemployment
pay and social security support paid to various groups. In the short to medium term,
the level of transfer payments is not directly controlled by the government. In a
recession when unemployment is rising and incomes are falling, these payments
automatically rise. In a boom, the reverse happens.
In addition, the government may deliberately alter the level of public expenditure as part of
its policy to manage the economy. This is called fiscal policy and is discussed in detail in a
later unit.
The definition of national income is the total value of the goods and services produced by a
country’s resources over a year.
The economy as a whole
Macroeconomics and international economics are concerned with how the economy as a
whole functions and how it relates to other economies
In addition to concentrating on elements of the economy such as business organisations,
markets and the financial system, it is also necessary to look at the economy as a whole,
as a system. This makes it possible to answer some important questions including:
How large is the economy?
How fast is the economy growing?
Why do inflation and unemployment occur?
How might businesses use macroeconomic data?
The starting point is to measure the size of the economy by using the concept of national
income.
National income is measured in order to assess the performance of an economy over a
period of time, usually a year. This, in turn, will give some idea of changes in living
standards and enable international comparisons to be made.
Given the scale of economic activity in a modern economy, the accounting needed to
measure national income is very complex. Measurement is done in three ways:
1. By national output
2. By national income
3. By national expenditure
When goods and services are produced people receive incomes and thus, in theory, the
addition of the prices of all the goods and services should equal the sum of all the income
of the population.
National income is a measure of the size of the economy and can show whether the
economy is expanding or contracting
National income data is of particular use to governments in formulating economic
policy and to business when making strategic business choices. For businesses,
especially large businesses operating in more than one country, national income data is
helpful in making several types of strategic decision.
Sales and production strategy
Using predictions of changes in national income, a business can forecast the growth of
incomes in the markets in which it sells its products. If it also knows the extent to which its
sales respond to changes in income (known as the income elasticity of demand), it can
estimate its potential sales growth in those markets. This is valuable information when
planning future output and marketing effort.
,New markets
Data on growth of income in different countries helps businesses to identify potential new
markets. Many international businesses clearly see that rapid economic growth in China
will make it a major future market for a wide range of both consumer and capital goods.
Location decisions
National income data may also help businesses to choose appropriate locations for
production facilities. Businesses prefer to locate in prosperous and dynamic countries.
However, other data indicating the competitiveness of particular locations including costs,
taxation levels, the exchange rate, may be more significant in these decisions.
the circular flow model
The determination of national income
The circular flow model refers to the movement of money resulting from economic
transactions between different groups of people in an economy.
A simple model can be devised to show the income flows. It assumes:
o a two-sector economy of firms and households.
o there is no government and no overseas sector.
o all income is spent on consumption and all production is sold to the
households.
In the circular flow model, there is extensive use of symbols to represent variables in the
model. The most important of these are as follows:
Equilibrium
An economy making full use of its resources will be moving towards a state of rest, or
equilibrium. For equilibrium to be established in the circular flow, planned injections must
equal planned withdrawals.
,Thus if:
J > W, additions to the circular flow exceed withdrawals and so the level of national
income will rise.
J < W, additions to the circular flow are less than withdrawals so the level of
national income will fall.
From this analysis we can derive the concept of aggregate monetary demand
Aggregate demand is the total demand for goods and services in an economy and has two
main components:
Consumption, the original expenditure in the simple circular flow model
Injections of investment, government expenditure and exports
The withdrawals of taxation and savings are taken into account (consumption
is after savings and tax) this only leaves imports to be considered. These can be
accounted for by making exports net exports i.e. exports minus imports
Aggregate demand (AD) is important since changes in aggregate demand are the main
cause of changes in the level of national income in an economy.
Components of Aggregate Demand
Consumption and saving
Consumption is by far the largest of the elements that make up total aggregate demand.
Consumption (C) is primarily a function of the level of income (Y); as incomes rise so does
the level of consumption. The extent to which consumption rises as incomes rise is known
as the marginal propensity to consume (MPC). This measures the proportion of an
extra unit of income which is spent rather than saved.
, MPC= 0.9 (90% of any extra unit of income is spent and 10% is saved)
The marginal propensity to save (MPS) is the proportion of an extra unit of income
which is saved rather than spent.
MPS= 0.1 (10% of any extra unit of income is saved and 90% is spent)
Since economists define saving as ‘not spending’, any income which is not spent must, by
definition, be saved. Therefore:
MPC + MPS = 1
Investment
Business investment in this context means the purchase of any capital equipment that the
business uses to develop, produce and market its product or service. The level of business
investment may be affected by a variety of factors. However, two main factors seem to
dominate the decisions made by businesses about future levels on investment.
Judgements about the profitability of an investment project over its lifetime:
The higher the estimated return on the investment, the more likely a particular
project will be undertaken. Such estimates are difficult partly because predicting
future flows of incomes and costs are inherently difficult, especially for very long-
term investment projects, and partly because of the time value of money. This
reflects the fact that future flows of income should be given a lower current
valuation than present flows of income. This problem is dealt with by using
a discounting model. This is considered in a later unit.
The expected level of demand: Businesses normally want to meet the demand for
their goods or services – the level of output they aim for reflects the expected level
of demand. Thus, changes in the expected level of demand will lead to planned
changes in the production capacity of the business. If demand is expected to rise
(fall) in the future, the level of business investment will probably rise (fall) as well.
One model of the relationship between demand and investment is
the accelerator mode. This is explained in the final section of this unit.
Government expenditure
Government expenditure (public expenditure) can be classified into two categories:
Expenditure on goods and services: Here the level of expenditure is determined
by government decisions about what sort of functions the government will
undertake. In most countries, the state provides education largely without charge.
Thus, the goods (schools, books) and services (teachers) purchased will be a
significant element of public expenditure. In many countries, health services are
also provided by the state. In those where this is not so, the level of government
expenditure tends to be lower.
Transfer payments: These include such payments as pensions, unemployment
pay and social security support paid to various groups. In the short to medium term,
the level of transfer payments is not directly controlled by the government. In a
recession when unemployment is rising and incomes are falling, these payments
automatically rise. In a boom, the reverse happens.
In addition, the government may deliberately alter the level of public expenditure as part of
its policy to manage the economy. This is called fiscal policy and is discussed in detail in a
later unit.
