Understanding Business & Economic Systems
in BUS 110
An introduction to the primary functions of a business, the relationship between risk and profits, and major components of the business environment through the lenses of demographic, social, political, legal and competitive changes.
A PDF of these notes with additional comments and questions is provided: PDF
Goals: Students will be able to
- Describe how businesses and not-for-profit organizations help create our standard of living
- Identify the sectors of the business environment, and explain how changes in those sectors influence business decisions
- List the primary features of the world’s economic systems, and describe how the three sectors of the U.S. economy are linked
- Demonstrate how economic growth, full employment, price stability, and inflation indicate a nation’s economic health
- Determine changes in price using the basic microeconomic concepts of supply and demand
- Describe the trends reshaping the business, microeconomic, and macroeconomic environments, and competitive arena in terms of their own business ideas.
Contents:
- Understanding Businesses
- Understanding the Business Environment
- How Businesses & Economies Work
- Macroeconomic Goals
- Microeconomic Goals
- Accompanying assignment
Understanding Businesses
How to businesses and not-for-profit organizations help create our standard of living?
Take a moment to reflect on the many businesses you’ve encountered today. As you drive to class, you may have stopped at a gas station that’s part of a major national oil company, or grabbed a coffee from Starbucks, or a burger from a popular fast food chain, or simply a bagel from the local bakery.
A business is an organization that provides goods and services to customers. Businesses meet the needs of consumers by providing services such as medical care, food delivery, or even educational content (e.g., lectures/classes); business can also meet the needs of consumers by providing goods such as medical equipment, food, and textbooks. Goods are defined as tangible items manufactured by businesses, whereas services are intangible offers of a business that cannot be held, touched, or stored. Doctors, lawyers, hair stylists, and pilots all provide services. On the other hand, businesses can serve other entities, such as hospitals, aircraft factories, and governments, by providing machinery, or goods for resale.
Because we are so dependent on businesses to create goods and services, these goods and services determine our standard of living. The standard of living of any country is measured by the output of goods and services people can buy with the money they have. The United States has one of the highest standards of living in the world. Although several countries, such as Switzerland and Germany, have much higher average wages than the U.S., their standards of living aren’t high because the prices of the goods and services there are also much higher. As a result, the same amount of money buys less in those countries. To illustrate, in the U.S., the average cup of coffee costs $2.70 and the median house income is approximately $60,000 whereas in Germany, coffee is 3.43€, or $3.92 and income is approximately $35,000.
Furthermore, businesses play a key role in determining our quality of life by providing jobs in addition to goods and services to society. Quality of life refers to the general level of happiness based on criteria such as life expectancy, educational standards, health, sanitation, and leisure time. For nine consecutive years, Vienna, Austria tops the quality of living ranking, and other Western European cities continue to dominate the top of the list (Mercer’s 2018 Quality of Life Rankings). However, creating and maintaining a high quality of life is not without risks. Risk is the potential to lose time and money or simply not be able to accomplish a goal. The American Red Cross, for example, faces the risk of not meeting the demand for blood by victims of a disaster because of a lack of donors. Businesses such as Apple and Microsoft face the risk of falling short of their revenue and profit goals.
- Revenue is the money a company earns by providing services or selling goods
- Costs are expenses incurred, such as for rent, salaries, supplies, transportation
- Profit = Revenue – Cost; the money left over after an organization pays all its costs
When a company such as Microsoft uses its resources strategically, it can often increase sales, hold costs down, and earn a profit. Yet, not all companies earn a profit—a general risk of being in business. In the U.S., businesses usually show a direct relationship between risks and profit: the greater the risks, the great the potential for profit (and, by relation, for loss). A famous example is Sony and Apple on the digital music market. Sony, a Japanese electronics giant, was once a leader with its Walkman music player before it lost profits by refusing to embrace new technologies such as the digital music format and flat-panel screens. Sony misjudged what its market (aka its customers) wanted and stayed with its proprietary technologies. Apple took a risk by developing personal music and gaming devices (the iPod) and services (iTunes; App Store) and quickly replaced Sony as a digital music giant. By 2016, Sony restructured its business portfolio and has experienced substantial success with its gaming console (the PlayStation 4) and original gaming content (Game Industry Biz).
Not all organization strive to make a profit. A not-for-profit organization is instead a business that exists to achieve some goal as opposed to the usual goal of profit. Charities such as Habitat for Humanity, the American Cancer Society, and World Wildlife Fund are not-for-profit organizations, as are most hospitals, zoos, museums, civic groups, and religious organizations. Government is our largest and most pervasive non-for-profit group. Today, more than 1.5 million non-for-profit entities operate in the U.S. and contribute more than $900 billion annually to the U.S. economy . Not-for-profit organizations do not compete directly with one another in the same manner as, for example, Sony and Apple, but they do compete for talented employees, people’s limited volunteer time, and donations. Nonetheless, successful not-for-profits apply for-profit principles to operate more effectively: developing strategy, budgeting carefully, measuring performance, encouraging employee innovation and productivity, demonstrating accountability, and fostering an ethical workplace environment.
Building Blocks of Business
To provide goods and services, regardless of whether they operate in the for-profit or not-for-profit sector, businesses require the following 5 building blocks (aka factors of production):
- Labor, the physical and mental effort of people
- Human capital, the knowledge and skills acquired through training and experience
- Entrepreneurship, the ability to identify opportunities and the willingness to accept risk in the pursuit of rewards (e.g., profit).
- Natural resources/land, any productive resource existing in nature (e.g., wild plants, mineral deposits, wind, and water)
- Capital, the manufactured goods that can be used in the production process (e.g., tools, equipment, buildings, machinery).
Energy and technology are often confused as factors of production. Instead, they are considered example by-products of the above five factors of production.
Consider the factors of production needed for a bakery. The shop building, mixers, and ovens are examples of capital. Natural resources include the land and rain that grow wheat for the dough. Labor will form the dough into bagels, place them into ovens, and sell them. A bagel chef will use skill and experience (human capital) to make the bagels smooth on the outside and soft on the inside. How did this shop come about? An entrepreneur invested money and used his ideas and organizational talents to develop the bakery. Thus, our bakery requires all five factors of production. In contrast, a small snack vending machine business is an example of a capital-intensive business that requires little beyond canned drinks, bagged snacks, and the machine itself to generate sales. However, organizations such as Frito-Lay and Pepsi will clearly require all five factors.
Understanding the Business Environment
What are the sectors of the business environment, and how do changes in those sectors influence business decisions?
Businesses operate in a dynamic environment composed of five main forces/sectors, five of which are described below. Each of these sectors creates a unique set of challenges and opportunities for businesses.
Economic Influences: this sector is an important external influence on businesses. Fluctuations in economic activity create cycles that affect businesses and individuals. When the economy is growing, for example, unemployment rates are low, and income levels are high. Inflation and interest rates change according to economic activity. Government attempts to manage the level of economic activity by setting policies such as taxes and investments. In addition, supply and demand determine how prices and quantities of goods/services behave in a free market.
Political & Legal Influences: the political climate of a country greatly influences day-to-day business operations. The three components of the political climate are
- the amount of government activity
- the types of laws it passes, and
- the political stability of a government.
To illustrate, a multinational company such as General Electric (GE) will evaluate the political climate of a country before deciding to establish a plant there. Is the government stable, or could a coup disrupt the country? How restrictive are the regulations for foreign businesses? What are the import tariffs, quotas, and export restrictions?
In the United States, laws passed by Congress and regulatory agencies span topics such as minimum wage, worker safety, environmental protection, and healthy competition. A few examples of how the political and legal environment affect business decisions: When Pfizer wants to put a new medication on the market, it must follow the procedures established by the Food and Drug Administration for testing and clinical trials. Before issuing stock, Pfizer must register the securities with Securities and Exchange Commission. The Federal Trade Commission will penalize Pfizer if its advertisements promoting a drug’s benefits are misleading. In additional, state and local governments can exert control over businesses by imposing taxes, issuing business licenses, and enforcing other state/city/local regulations.
Demography is the study of people’s vital statistics, such as age, gender, race, and ethnicity. Demographics help companies define the markets for their goods/services as well as determine the composition and diversity of the workforce. For example, businesses today must deal with the unique shopping preferences of different generations, which require special marketing approaching and products targeted to their needs. As of 2017, America’s largest generation is the millennial generation born between 1981 and 1997. Millennials are considered technologically savvy and prosperous young people with large disposable incomes. Other age groups, such as Gen X, people born between 1965 and 1980, have their own spending patterns. As of 2018, many Gen X individuals nearing retirement are more willing to spend their money on their health, comforts, and leisure pursuits. In addition to age populations, minority groups represent more than 38% of the total population. By 2060, the U.S. Census Bureau projects that the minority population to increase to 56% of the total U.S. population (U.S. Census 2018 Demographics Report). As a result, companies recognize the value of hiring a diverse workforce.
Social Factors: our attitudes, values, ethics, and lifestyles, influence what, how, where, when, and why people purchase certain goods and services. For example, changing roles have brought more women into the workforce. This development is increasing family incomes, changing family shopping patterns, needs for specific goods and services, and impacting individuals’ ability to achieve a work-life balance. Yet, social factors are difficult to predict, define, and measure because they are often very subjective.
Technology is the application of engineering and science to solve productions and organization issues. New equipment and software that improve productivity and reduce costs can be among the company’s most valuable assets. Productivity is measured as the number of goods and services one worker can produce. Example: a production-possibilities frontier (PPF graph) for a simplified economy that can use its resources to produce either cotton or wine (Investopedia Economics Basics).
When we use resources to produce one good or service, the opportunity cost is that we cannot produce a different good or service. When we manufacture cotton, we don’t use the same resources to make wine. The choices an economy faces and the opportunity cost of making one good rather than another is illustrated using a PPF. But, if there were a change in technology while the level of land, labor, and capital remained the same, the time required to pick cotton and grapes would be reduced. The number of goods per total resources would increase and the PPF curve would be pushed outwards. If a business operates on the PPF curve, this is considered efficient; below the curve (e.g., at point X) would be inefficient. Businesses use technology to create change, improve efficiencies, and streamline their operations.
Furthermore, advances in cloud computing provide businesses the ability to access and store data without running programs on a physical computer/server in their offices. Such programs can now be accessed through the Internet. Robots that automate manufacturing procedures free up workers to focus on more knowledge-based tasks critical to the business operations.
How Businesses & Economies Work
What are the features of the world’s primary economic systems? How are the three sectors of the U.S. economy linked?
Economic Systems
A nation’s economic system is the combination of policies, laws, and choices made by its government that determines what goods and services are produced and how they are allocated. Economics is the study of how to allocate scarce/limited resources among competing ends. Spanning from endangered species, marriage, time, and concert tickets, economics is the study of choices—what people, firms, or nations choose from the available yet limited resources. The major economic systems of the world are the following:
Capitalism (aka the private enterprise system) is based on competition in the market and private ownership of the five factors of production. A capitalist system guarantees certain economic rights, such as the right to own property, make a profit, free choices, and to compete.
Communism is the opposite of capitalism. In a communist economic system, economic decision-making is centralized—the government owns virtually all resources and controls all markets, offering little if any choice to the country’s citizens. In the early 20th century, countries that practiced communism, such as the former Soviet Union and China, believed that it would improve their standard of living. However, the strict controls over most aspects of people’s lives such as which careers they can choose, where they can work, and what they can buy, led to lower productivity. A domino effect, workers had no reason to work harder or produce quality goods because there were no rewards for excellence, which (due to errors in resource allocation and planning) led to shortages of even the most basic and essential items.
Socialism is an economic system in which the basic industries are owned by the government or by the private sector under strong government control. A socialist state will control critical, large-scale industries such as communication, transportation, and utilities. As compared to many capitalist countries, socialist countries provide its citizens with a higher level of services such as health care and unemployment benefits. As a result, tax and unemployment rate are usually higher in socialist countries. Many countries, including the United Kingdom, India, and Denmark, have socialist systems, but the systems vary from country to country. For example, in Denmark, most businesses are privately owned, but two-thirds of the population is sustained by the state through government welfare programs.
Pure capitalism or pure communism is extreme. Most real-world economies fall between these two systems. The U.S. economy is more on the capitalist side but still uses government policies to promote economic stability and growth. Furthermore, the U.S. government transfers money to the poor, the unemployed, and the elderly or disabled. To protect small firms and entrepreneurs, the government has passed legislation that requires industry giants (e.g., General Motors and Microsoft) to compete fairly against smaller competitors. Such a mixed system is called a mixed economy.
Macroeconomics & Microeconomics
As you’ve seen, the state of the economy affects both people and businesses. How you spend your money is a personal economic decision. Whether you continue in school or some time off to pursue an entrepreneurial venture are also economic decisions. The ideas of personal economic management also carry over to businesses that operate within the larger economy. Based on economic expectations, businesses decide what products to produce, what their prices are, how many people to employ, what their salaries are, and so on.
Economics has two main subfields: macroeconomics, the study of the economy as a whole using aggregate data, and microeconomics which focuses on individual parts of the economy (e.g., a household or a firm). Businesses must consider both macroeconomics (e.g., national average of personal income, the unemployment rate, interest and inflation rates) and microeconomics factors (e.g., consumer demand for a particular product, existing supply, competing models, labor and material costs/availability, current prices) when making an economic decision.
Economic Circular Flow
Macroeconomic Goals
How does economic growth, employment rates, price stability, and inflation indicate a nation’s economic health?
Growth
Since the production of goods and services is so essential, it is perhaps the most important way to judge a nation’s economic health. An increase in a nation’s output of goods and services is economic growth. A basic measure of this growth is the gross domestic product (GDP). GDP is the total market value of all final goods and services produced inside a nation each year. When GDP is increasing, the economy is growing.
Employment
Another macroeconomic goal is full employment, which is having jobs for everyone who wants to and can work. Full employment doesn’t really mean 100% of people are employed. Some individuals choose not to work (for reasons such as attending school, raising children, etc.) or are temporarily unemployed while they are waiting to start a new job. Therefore, the government says that when approximately 95% of those available to work have jobs, the nation has reached full employment. During the 2007-2009 U.S. recession, the unemployment rate peaked at 10%. Today, the unemployment rate is around 4% (McGrath on 2018 Unemployment Rates).
Prices & Stability
Another macroeconomic goal is to keep overall prices for goods and services steady. Inflation happens when the average of all goods and services is increasing. When inflation occurs, our purchasing power (the value of what money can buy) is reduced; a simplified example: instead of 5 cheeseburgers for $5, our same $5 can buy only 1 burger—we pay more for less. Inflation affects both personal and business decisions. When prices are rising, people tend to spend more money—before their purchasing power declines further. Businesses that expect inflation do the same; they increase their supplies/stock, and customers speed up planned purchases.
Microeconomic Goals
What are the basic microeconomic concepts of supply and demand, and how do they influence prices?
Microeconomics, as the study of households, businesses, and industries, is concerned with how prices and quantities of goods and services behave in the free market. People, firms, and governments try to get the most from their limited resources. Consumers want to buy the best quality products at the lowest price possible. Businesses want to do the same: keep costs down and revenues high in order to earn large profits. Governments use their revenues to provide effective goods and services to keep the economic circular flow.
With the rising sneaker culture, the high demand for certain sneakers attracts entrepreneurs who produce new and innovative shoes. They compete for the consumers’ money by supplying better quality sneakers at lower prices. So, how do business and consumer choices/demand influence the price and availability/supply of goods and services?
The demand curve displays the relationship between price and the quantity demanded of a good within a given period.
Notice that when prices are high, consumers demand fewer avocados; when prices are low, consumers are willing to buy more avocados. This relationship between price and quantity is called the law of demand. This also makes sense in terms of marginal utility. The first avocado will go towards the consumer’s greatest need—perhaps extreme hunger—but as the consumer eats more avocados, he/she becomes less hungry, and the extra (aka marginal) avocados are used to satisfy less and less important needs (e.g., fertilizer, batting practice)—hence, the demand for avocados decreases. The decreasing satisfaction gained from additional products in a given period is called the law of diminishing marginal utility.
The market demand curve is a demand curve created by adding up the demands of all the individual demanders in the market.
The supply curve shows the relationship between price and quantity supplied by a firm within a given period. Imagine you have an avocado business. At a price of $0.25 per avocados, you wouldn’t be very enthused about the prospects and would rather spend your time and resources on something else (e.g., watching re-runs of your favorite TV show). However, if the price rose to $0.50 per avocado, you may decide to give up something in order to pursue growing avocados. The opportunity cost of your time will increase as you have to give up more valuable alternatives in order to grow more avocados. To avoid getting less and less out of each additional product, selling your avocados at a high price may serve as an incentive. For these reasons, a supply curve shows an upward trend: as prices increase, the number of avocados produced also increased:
The market supply curve indicates the total quantities of a good that all suppliers are willing and able to provide at various prices during a given period of time—the summation of all quantities of avocados produced at a certain price.
In order to determine the equilibrium between price and quantity, demand and supply, we can overlap the market demand and market supply curves (image reference).
Shifts in Demand
Several things can increase or decrease demand. For example, if avocados are not in season, consumers may decide to buy more pineapples. If incomes fall, the consumer who was planning to buy a laptop might instead pay for transportation costs to the campus computer lab. A few factors that cause the demand curve to shift are:
- A change in buyers’ tastes or preferences
- A change in the price of related products
- A change in buyers’ incomes
- A change in expectations about future prices
- A change in the number of buyers
In general, a demand shift to the right means that the demand for a product has increased. A shift to the left means that demand has decreased.
Shifts in Supply
Other factors can influence the supply-side. New technology can lower the cost of production and increase supply (a right-ward shift of the supply curve). If the price of avocados goes up, farmers may decide to grow fewer pineapples in order to spend more time growing avocados—ultimately, making more of a profit. Furthermore, if the government decides to impose a tax for every avocado produced, the farmer’s profits will fall, and few avocados will be offered at every price. The following table summarizes a few factors that can shift the supply curve:
- Technology that impacts costs
- A change in a product’s resource prices
- Changes in prices of related products
- A change in taxes
- A change in the number of suppliers