Chapter 02

Understanding Economics and How It

Affects Business
Learning Objectives

• Understand and explain basic forms of economics

• Explain what capitalism is and how free markets work
• Differentiate socialism and communism
• Identify the trends toward mixed economies
• Explain fiscal policy and monetary policy and how each affects economy
 Economics and Its Major Branches
• Economics is the study of how society chooses to
employ resources to produce goods and services and
distribute them for consumption among various
competing groups and individuals.
• Macroeconomics
• The part of economics study that looks at the
operations of a nation's economy as a whole. (ex.
government spending) (GDP, unemployment rate, and
price indexes)
• Microeconomics
• The part of economics study that looks at the
behavior of people and organizations in particular
markets.
What is better for an economy than teaching a
man to fish?
• The secret to economic development is contained in the additional
statement to the quote,
"Give a man a fish and you feed him for a day, but teach a
man to fish and you feed him for a lifetime”

• Teach a person to start a fish farm, and he or she will be able to feed a
village for a lifetime.
• Business owners provide jobs and economic growth for their employees
and communities as well as for themselves.
Resource Development
• Resource Development
• The study of how to increase resources and create
conditions that will make better use of them.
• Businesses can contribute to an economic system by
inventing new products that increase the availability
and development of an economy’s resources.
• New energy sources
• New ways of growing foods
• New ways of creating goods and services
The Secret to Creating a Wealthy Economy
Thomas Malthus & The Dismal Science Population as a Resource
• Malthus believed that if the rich had most of the • Contrary to Malthus, some economists believe a large
wealth and the poor had most of the population can be a resource.
population, resources would run out.
• This belief led the writer Thomas Carlyle to call • An educated population is highly valuable.
economics “The Dismal Science.”
• Business owners provide jobs and economic growth
• Followers of Malthus (Called neo-Malthusians) still for their employees and communities as well as for
believe there are too many people in the world themselves.
and that the solution to poverty is radical birth
control, including forced abortions and • Malthus viewed a large population as a negative.
sterilization However, many economists today see a highly
educated population as a valuable, scarce resource.
• Malthus believed that if people were left to their • Countries like Japan and Germany are examples of
own devices there would be chaos; therefore the nations that have become economically successful
government needed to be heavily involved in due to large well-educated populations producing
controlling the economy. sophisticated high-value products.
Two Classical Economists
Adam Smith and the Creation of Wealth
• Adam Smith envisioned creating more resources so that everyone could
become wealthier.
• Smith believed that freedom was vital to the survival of any economy, especially
the freedom to own land or property and to keep profits from working the land
or running a business.
• People will work hard if they believe they will be rewarded.
• Adam Smith’s ideas were laid out in his seminal book, An Inquiry into the Nature
and Causes of the Wealth of Nations was published in1776.
• Smith believed strongly in more “natural liberty” and less government
intervention into the economy
• Smith argued that allowing people the freedom to own land and the right to keep profit would
not create chaos as Malthus had argued, but rather would create greater resources for all.
The Invisible Hand Theory
• As people improve their own situation in
life, they help the economy prosper
through the production of goods, services
and ideas.
• Invisible Hand means
• When self-directed gain leads to social and
economic benefits for the whole community.

• The invisible hand was at the heart of

Adam Smith’s theory describing the
process of turning self-directed gain into
social and economic benefits for all.
How does the invisible hand create wealth for a
country?
• In Adam Smith's view, businesspeople don't necessarily deliberately set out to help
others.
• They work primarily for their own prosperity and growth.

• When people try to improve their own situation in life, their efforts serve as an
'invisible hand' that helps the economy grow and prosper through the production
of needed goods, services, and ideas.
• The phrase invisible hand is used to describe the process that turns self-directed
gain into social and economic benefits for all.
• The only way farmers can become wealthy is to sell some of their crops to others.
• To become even wealthier, they have to hire workers to produce more food.
• So the farmers' self-centered efforts to become wealthy lead to jobs for some and food for almost
all.
How Corruption Harms The Economy
• In many countries, a businessperson
must bribe the government to gain
permission to own land, build, and
conduct business operations.
• Imagine you are a restaurant owner in
need of a liquor license, but have been
unable to get one. You know people in
government. Would you be tempted to
make large contributions to their re-
election campaign to receive that license?
CAPITALISM
• Capitalism means
• State Capitalism
• All or most of the land, factories and
stores are owned by individuals, not • When the state, rather than private
the government, and operated for owners, run some businesses.
profit. • Well-known countries practicing
• Countries with capitalist foundations state capitalism are-
are • China
• United States
• Russia
• England
• Australia • These countries have experienced
• Canada some success using capitalistic
principles, but the future is still
uncertain.
Capitalism’s Four Basic Rights
• The four basic rights under a
capitalist system are straightforward
• The right to own private property. • Roosevelt’s Four Additional Rights
• The right to own a business and keep all • Freedom of speech and expression.
that business’s profits.
• Freedom to worship in your own way.
• Profits act as important incentives for
business owners. • Freedom from want.
• The right to freedom of competition. • Freedom from fear.
• The right to freedom of choice.

• One benefit of these rights is that

people are willing to take more risks
than they might otherwise.
 Free Markets

• Free Market defines the decisions about what

and how much to produce are made by the
market.
• Consumers send signals about what they
like and how they like it.
• Price tells companies how much of a product
they should produce.
• If something is wanted but hard to get, the
price will rise until more products are
available.
The Circular Flow Model
• In a free market economy, business activity involves two major
players:
• individuals (households) who own the resources that are the key
inputs into the productive process, and
• businesses who use these inputs (factors of production) to create
goods and services.

• In the Resource Market (top part of the model)

a) Businesses demand resources.
b) Households own the resources (factors of production).
c) Income from providing these resources flows back to the
households.
d) The prices of these resources are set by the laws of supply and
demand.

• In the Product Market (lower part of the model)

a) Businesses use these resources to create goods and services.
b) Households (individuals) demand these goods and services.
c) Individuals use their income to purchase goods and services.
Four Degrees of Competition
Perfect Competition
• Perfect Competition
• all firms sell an identical product
• large number of buyers and sellers
• Monopolistic Competition • no barriers to entry or exit
• prices are determined by supply and demand
• Oligopoly
Monopolistic Competition
• Monopoly • the degree of competition in which a large number sellers and
buyers
• sellers produce very similar but differentiated products

Oligopoly

• a few sellers dominate a market

Monopoly

• when one seller controls the total supply of a product or service,

and sets the price
Free Market Benefits and Limitations

• Benefits:
• It allows for open competition among companies.
• Provides opportunities for poor people to work their way out of poverty.

• Limitations:
• People may start to let greed drive them.
Socialism

• Socialism is an economic system based on the

premise that some basic businesses, like
utilities, should be owned by the government
in order to more evenly distribute profits
among the people.
• Entrepreneurs run smaller businesses.
• Citizens are highly taxed.
• Government is more involved in protecting the
environment and the poor.
Socialism: Pros and Cons

Benefits Negatives
• Social equality • Few incentives for businesspeople to take
risks.
• Free education
• Brain Drain
• Free healthcare • Some of a country’s best and brightest
• Free childcare workers (i.e. doctors, lawyers and
business owners) move to capitalistic
• Longer vacations countries.
• Shorter work weeks • Fewer inventions and innovations
because the reward is not as great as in
• Generous sick leave capitalistic countries.
Communism
• An economic and political system
in which the government makes
almost all economic decisions and
owns almost all the major factors
of production.
• Prices don’t reflect demand which
may lead to shortages of items,
including food and clothing.
• Most communist countries today
suffer severe economic depression
and citizens fear the government.
Two Major Economic Systems
• Free-Market Economies • Command Economies
• The market largely determines what • The government largely determines
goods and services are produced, what goods and services are
who gets them, and how the economy produced, who gets them, and how
grows. the economy will grow.
MIXED ECONOMIES
• Mixed Economies means some
allocation of resources is made by
the market and some by the
government.
• Neither free-market nor
command economies have
created sound economic
conditions so countries use a mix
of the two economic systems.
Understanding An Economic System
Three major indicators of economic conditions are:
Gross domestic product Unemployment rate Price indexes
(GDP)
the total value of final goods The percentage of civilians at The Price Index measures the
and services produced in a least 16 years old who are overall change in consumer
country in a given year. unemployed and tried to find a prices over time based on a
job within the prior four weeks. representative basket of goods
and services.
Both domestic and foreign- Unemployment adversely The consumer price index (CPI)
owned companies can produce affects the disposable income is the most widely used
the goods and services of families, erodes purchasing measure of inflation and
included in GDP, as long as the power, diminishes employee deflation.
companies are located within morale, and reduces an
the country's boundaries economy's output.
Four Types of Unemployment
Inflation and Price Indexes
• Price indexes help gauge the health of the economy by measuring the
levels of inflation, disinflation, deflation, and stagflation

Inflation Disinflation Deflation Stagflation

A persistent rise in prices Inflation rate is Prices are declining. It Economy is slowing,
over time. Also defined as declining occurs when countries but prices continue
“a persistent increase in produce so many goods to increase
the level of consumer that people cannot afford
prices or a persistent to buy them all (too few
decline in the purchasing dollars are chasing too
power of money. many goods)
 The Business Cycle
• Business cycles are the periodic
rises and falls that occur in
economies over time.
1. An economic boom: business is
booming
2. Recession: two or more consecutive
quarters of decline in the GDP
3. Depression: A severe recession, usually
accompanied by deflation
4. A recovery: economy stabilizes and
starts to grow and leads to an
economic boom
Stabilize An Economy Through -
Fiscal Policy Monetary Policy

• the federal government's efforts to • It involves managing the money

keep the economy stable by supply and interest rates.
increasing or decreasing taxes or
government spending. • The more money the Fed makes
available to businesspeople and
• Government spending on highways, others, the faster the economy is
social programs, education, supposed to grow.
infrastructure (e.g., roads and
utilities), defense, and so on
Thank you all
Any Query?