CIMA Revision Notes - BA1
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Clint NarsiCIMA Revision Notes - BA1
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Clint NarsiCIMA BA1
Fundamentals of Business
Economics
Revision Notes
BA1 Fundamentals of business economics
Contents
Business Organisations 5 Types of Market and Cost 73
Micro- and macroeconomics 5
Organisations and sole traders 5 Effects 73
Types of organisation 7 Impact of costs on business and markets 73
And finally... 10 Outsourcing 74
Outsourcing: structures of business 77
Stakeholders 11 Transaction cost theory 77
Stakeholders 11 Alternatives to outsourcing 79
Classifying Stakeholders 12 And finally... 80
Stakeholder mapping 15
Stakeholder Conflict 18 Economies of Scale 82
The Agency problem 20 Economies of scale 82
Corporate governance 22 Long run/Short run 82
Stakeholders and not-for-profit organisations 22 Internal and external economies of scale 83
And finally... 23 Internal and external diseconomies of scale 86
Implications and outcomes 88
Shareholders 25 And finally... 89
Shareholder wealth 25
Calculating short-term shareholder wealth 26 Government Regulation of Markets
Long-term shareholder wealth 30 91
Risk and return – the required rate 33
Economic systems 91
Shareholder’s impact on management decisions
Monopolies 93
36
Competition Policy 94
And finally... 37
Inappropriate market price: too high or too low
96
Price, Demand and Supply 38 Externalities 100
The market 38 Public goods 105
Demand 39 Environmental concerns 106
Factors influencing demand 42 And Finally... 107
Giffen and Veblen Goods 45
Supply 45 Circular Flow of Income and
Factors affecting supply 48
Monetary Policy 108
Equilibrium Price 50
And finally... 52 Micro- and macroeconomics 108
The circular flow of money 108
Savings and investments 110
Price Elasticity of Demand and Imports and exports 115
Supply 54 Money 120
Price elasticity of demand 54 Consumption 121
Price elasticity and the demand curve 58 And finally... 123
Uses of price elasticity of demand 63
Factors influencing price elasticity of demand 65 Fiscal and Supply-side Policies 125
Price elasticity of supply 66
Circular flow review 125
Supply elasticity and the supply curve 69
Fiscal policy 126
Factors influencing price elasticity of supply 70
Taxation 127
And Finally... 71
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BA1 Fundamentals of business economics
Fiscal policy positions 130 The Financial System 203
Supply-side policies 133
Fund requirements 203
Government approaches to managing an
The financial system 204
economy 135
Financial instruments 207
And finally... 137
And finally... 211
The Trade Cycle 138 Financial intermediaries 213
Circular flow review 138
Types of intermediaries 213
Circular flow equilibrium 139
Credit creation 216
The accelerator 140
Government funds and the central bank 219
The multiplier 142
And finally... 222
Trade cycle 144
Employment 148
Inflation 150 Financial Markets and Instruments
And finally... 152 223
Types of financial markets 223
The Aggregate Supply and Demand Calculating the return on financial instruments
Model 154 225
Interest rates 231
Aggregate demand 154
Interest rate risk 233
Aggregate supply 157
And finally... 233
Equilibrium 159
Economic growth 164
And finally... 165 Discounting and Investment
Appraisal 235
Global trade 167 Choosing how to invest 235
Globalisation and internationalisation 167 The time value of money 235
Benefits of international trade 167 Discounting 241
The drivers of international trade and Net Present Value 244
globalisation 168 Annuity 247
Disadvantages of international trade 169 Perpetuities 249
Protectionism 170 Internal rate of return 250
Trade agreements and trading blocs 172 And finally... 256
Major institutions promoting global trade 174
The impact of globalisation 177 Data and information 257
And finally... 178 Data and information 257
Types of data 258
Foreign Exchange Markets and the What makes good data/good information? 259
Exchange Rate 180 Characteristics of good quality information 260
Sources 260
The exchange rate 180
Big data 261
The international currency market 184
Graphs 264
Government policy and the balance of
And Finally… 273
payments 186
Problems with government policies 189
Types of foreign exchange risk 190 Data Coefficients 274
PESTEL 198 Correlation coefficient 274
And finally... 201 Coefficient of determination 277
Rank correlation coefficient 279
Correlation and relationship 281
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BA1 Fundamentals of business economics
And finally... 283 Introduction 308
And finally... 316
Trends, forecasts and patterns 285
Introduction 285 Index Numbers 318
Time series analysis 286 Introduction 318
Adjusting the trend line 290 Single product index 319
Forecasting a trend line using linear regression Weighted index 321
298 Index splicing 325
Variances around the trend line 304 Quantity indices 328
And finally... 306 Retail Price Index (RPI) 330
And finally... 333
Moving Averages 308
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BA1 Fundamentals of business economics
BA1 1 Business Organisations
Micro- and macroeconomics
Economics concerns the allocation of scarce resources (e.g. income or raw materials) and can
be split into micro- and macroeconomics.
business
Definitions
Microeconomics
Deals with decisions at the level of the company based on the type of organisation and
their market.
Macroeconomics
Considers the impact of governmental decisions on the economy.
business
Organisations and sole traders
A business can either be an organisation or a sole trader.
business
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BA1 Fundamentals of business economics
Definitions
Sole trader
A single-person business where this person performs every role e.g. a freelance painter.
Organisation
A group of people organised and managed in a way that aims to follow a corporate
goal or need.
business
Features of organisations
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BA1 Fundamentals of business economics
Organisations facilitate the sharing of:
• Ideas
• Experience
• Knowledge
• Skills
• Resources
Types of organisation
There are several different types of organisation:
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BA1 Fundamentals of business economics
All business can be separated into private sector or public sector businesses.
business
Features of PLCs and Ltd companies
Private Sector Organisations Public Sector Organisations
Owned by investors Owned by the state
Responsible to shareholders/owners Responsible to the government
May be run for profit or not for profit Generally not run for profit
business
Not for profit organisations are one type of private sector organisation. Sometimes they are
known as NGOs.
business
Definition
NGO
A Non Governmental Organisation (NGO) is a private sector organisation which is not
run for profit, but focuses on other goals such as ethical standards, e.g. OXFAM.
business
Profit seeking organisations have the primary objective of maximising returns for the owners
(shareholders) and can be split into incorporated and unincorporated organisations.
business
Definition
Unincorporated organisation
When the business owners and the business itself hold the same legal identity.
business
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BA1 Fundamentals of business economics
The owners of an unincorporated business are held personally responsible for the debts: they
have unlimited liability. The two types of unincorporated organisation are:
• Sole trader – one sole owner of the business, wholly liable for debts
• Partnership – a collection of owners working together who are jointly liable for debts
business
Definition
Incorporated organisation
When the business owners and the business have separate legal identities.
business
The owners of an incorporated business are not held personally responsible for the debts of
the business: they have limited liability. There are two types of incorporated organisation:
• Private limited companies (Ltd)
• Public Limited Companies (PLC)
business
Features of PLCs and Ltd companies
Public limited companies (PLC) Private limited companies (Ltd)
Shares can be issued to the public and Shares cannot be issued to the public
traded on the stock exchange
Owners risk losing control by selling Owners retain a high degree of control
stakes to the public of the business
Large number of shareholders to report Small number of shareholders to report
and additional regulations to comply with to
Tend to be large companies who have Tend to be smaller companies e.g.
issued shares to fund business ventures market town retailers
business
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BA1 Fundamentals of business economics
Other kinds of organisation
Co-operatives and mutual organisations are both owned and controlled by the members,
rather than shareholders:
• Co-operatives – the welfare of members is a key goal. These members may be
customers or staff, e.g. UK department store John Lewis
• Mutual organisations – members are usually customers and they tend to focus on
financial products, e.g. mutual building societies such as the UK’s Nationwide
And finally...
business
Stop!
By this stage you should know:
• The difference between micro- and marcroeconomics
• The features and benefits of an organisation
• They different types and classification of organisation
• The significance of whether a business is incorporated or unincorporated
• The features between a PLC and Ltd organisations
Got it?
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
10
BA1 Fundamentals of business economics
BA1 2 Stakeholders
Stakeholders
An organisation tends to have a wide variety of stakeholders.
business
Definition
Stakeholders
Groups which have an interest in how an organisation operates .
business
Stakeholders include:
• Customers
• Employees
• Suppliers
• Creditors
• Debtors
• The community
It is important for all organisations to understand the needs of their stakeholders because
they can affect – and be affected by – an organisation's strategy and policies.
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BA1 Fundamentals of business economics
Classifying Stakeholders
To make informed decisions and policies regarding all the business's stakeholders, it is crucial
that an organisation classifies its stakeholders into various groups.
The influence of each class of stakeholder (internal, external and connected), whether
negative or positive will depend on their objectives.
Internal stakeholders
Examples of internal stakeholders are employees, managers and directors. These groups have
the following objectives:
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BA1 Fundamentals of business economics
business
Example
Employee objective: earnings
ABC Ltd has had a bad year’s trading and profits fall. The head office therefore
announces that this year they will not be able to raise wages inline with inflation, as
they have previously done.
James, an employee at ABC Ltd, is very angry about this and starts a petition which his
fellow employees sign.
As earnings are a key objective of employees, they have a strong interest when
statements are made concerning any future variations.
business
External stakeholders
Examples of external stakeholders are local residents, environmental groups, government and
trade unions. These groups have the following objectives:
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BA1 Fundamentals of business economics
business
Example
Environmental group objective: pollution
ABC Ltd announces that it is going to build a new factory on some green space in the
UK. Peacegreen, an environmental group, concerned about the possible implications
of the increased pollution resulting from the additional traffic to and from new
development, start protesting outside the ABC Ltd’s head office.
As pollution is a key objective of environmental groups, their members will have a
strong interest when new factories are built.
business
Connected shareholders
Examples of connected stakeholders are shareholders, customers, suppliers and banks. These
groups have the following objectives:
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BA1 Fundamentals of business economics
business
Example
Supplier objective: future orders
ABC Ltd announces that they are looking to become a paper-free organisation. One
of their current suppliers, Paperclips, is very concerned about potentially losing their
business and contacts the company for further clarification.
As future orders is a key objective of suppliers, suppliers have a strong interest in
ensuring that they continue to supply goods to the business.
business
Primary and secondary stakeholders
Stakeholders can also be categorised into primary and secondary stakeholders:
• Primary stakeholders – direct interest in the business e.g. internal and connected
stakeholders
• Secondary Stakeholders – indirect interest in the business e.g. external stakeholders
Stakeholder mapping
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BA1 Fundamentals of business economics
The degree to which stakeholder needs are considered as part of the objective setting
process depends on the level of power they have to impact the organisation and its results.
business
Mendelow’s Matrix
Mendelow's matrix identifies four levels of relationship that should be built with
different stakeholders based on:
• Power – the power to influence the organisation and affect its decision-
making
• Interest – the interest which the stakeholder has in the organisation
business
Minimal effort (low interest, low power)
• They have little to no influence on business decision making
• e.g. small suppliers, temporary employees
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BA1 Fundamentals of business economics
Example
Minimal effort
An independent contractor who only occasionally carries out work has very little
power and interest in the day to day running of a business.
Minimal effort should be put into maintaining this relationship by the business.
business
Keep informed (low power, high interest)
• They have no great influence on business decision making, but may influence other
more powerful stakeholder groups who could influence decisions
• e.g. full time employee or local community groups
business
Example
Keep informed
A full time employee, unhappy about a situation, may have little power to affect a
decision by themselves. However, they may have recourse to a trade union who would
have considerably more power.
The business should therefore keep them informed and involve them in the decision
making process regarding any decisions which will impact them.
business
Keep satisfied (high power, low interest)
• They may have no direct interest, but have the potential to have a huge impact on
decision making if the business activity concerns or involves them.
• e.g. government departments, tax authorities
business
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BA1 Fundamentals of business economics
Example
Keep satisfied
A business requires a licence which is issued by the local council. The local council will
generally not have a very high interest in the business on a day to day basis, however
if they were found to be contravening the rules of the licence, then the council could
revoke the licence.
The business should discuss any changes that may affect their licence with the council
and provide any required documentation.
business
Key players
• It is critical to keep this group informed and involve them in decision making.
• e.g. major shareholders or key customers.
Example
Key players
A business with a one major customer would lose a significant income if they were to
choose to change their supplier.
The business should keep therefore keep them involved in any big decisions which
might affect them.
business
Stakeholder Conflict
Stakeholders have different sets of needs and expectations, which may result in conflict. It is
critical to understand the needs of varying stakeholders to resolve conflicts wherever
possible.
business
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BA1 Fundamentals of business economics
Example
Polly’s Perfect Pets – Stakeholder conflict
Polly owns a chain of pet shop in which her brother is a major shareholder. They have
been having managerial discussions.
Polly's brother is concerned that they might be overstaffed in one of the shops. He is
proposing to make one full time employee redundant. The employees are all outraged
as they don't want to be made redundant and feel that with one less employee the
shop will be understaffed.
business
Cyert and March proposed four ways in which a company can look to resolve stakeholder
conflict: satisificing, sequential attention, side payments and exercise of power.
business
Definition
Satisficing A mash-up of ‘satisfying’ and ‘sacrificing’.
Involves negotiating between key stakeholder
groups and arriving at an accepted compromise.
Sequential attention Taking turns focusing on the needs of different
stakeholder groups.
Side payments The stakeholder is compensated for their unmet
needs.
Exercise of power The conflict is resolved by a senior figure who
exercises their power to force through a decision.
business
We can see how these methods of stakeholder conflict resolution are used at Polly’s Perfect
Pets.
business
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BA1 Fundamentals of business economics
Example
Satisficing Polly's brother and the employees meet and decide
to reduce all employees’ hours, instead of making
one of them redundant.
Sequential attention The employee is not made redundant, but the
agreement is that next time redundancies need to be
made, it will be from this shop.
Side payments One employee is made redundant, but is given a
larger than expected redundancy package.
Exercise of power Polly decides that the redundancy is the best option
and pushes through the decision.
business
The Agency problem
Another example of stakeholder conflict, also known as the principal – agent problem, arising
because the shareholders employ the management – the 'agent' - to run the business on
their behalf and their respective objectives may not be aligned. This is demonstrated in
Baulmol’s theory of sales maximisation.
business
Baumol’s theory of sales maximisation
Management are often more concerned with maximising sales because
• Bonuses are more likely to be related to sales rather than profits
• Higher sales give the perception of company growth which helps: 1) raise
funds from banks and 2) secure more jobs
However, shareholders want higher profits which do not necessarily result from higher
sales, hence the conflict.
business
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BA1 Fundamentals of business economics
Williamson observed another misalignment of managerial and shareholder interests.
business
Williamson's Model of Managerial discretion
In satisfying their own needs management may incur costs e.g. bonuses, elaborate
offices etc. As long as profits are supporting these costs they will have little
motivation to improve company performance beyond this.
business
Another general cause of the agency problem is information asymmetry.
business
Definition
Information Asymmetry
When the information available to each party isn’t equal
e.g. the directors have more information about the company than the shareholders and
as a result the shareholders are not able to fully hold directors accountable for decisions
made.
business
Possible solutions to the agency problem:
• Bonus payments linked to profit levels
• Employee profit sharing schemes
• Management given company shares as part of their remuneration package thereby
becoming owners as well
• Management shared by a number of directors so less likely that objectives will be
dominated by the interests of one party
• Corporate Governance, see below
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BA1 Fundamentals of business economics
Corporate governance
Through fulfilling its main objective of balancing the demands of all a businesses
stakeholders, corporate governance also provides a solution to the agency problem.
business
Definition
Corporate governance
The set of rules and procedures which are put in place to determine how an
organisation is controlled and managed.
business
Achieved through:
business
Method Outcome
Set levels of reporting and disclosure. All stakeholders can clearly see how their needs
are being met.
Rules are created for how the board of Ensures adequate knowledge and experience
directors is run and managed and decisions within a company’s management so required
are made. duties can be successfully completed.
Compulsory regular communication with Timely, clear information is delivered to
shareholders. shareholders.
Independent directors (non-executive Ensures that the business is operated in a legal
directors) sit on the board. and ethical way.
business
Stakeholders and not-for-profit organisations
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BA1 Fundamentals of business economics
In a not-for-profit organisation, major shareholders will not be the key stakeholders; profits
paid out as dividends is not the main objective. The organisation will therefore have to aim to
balance the needs of competing groups of stakeholders which may involve compromise.
business
The agency problem in the non-profit sector
While not-for-profits are not set up to maximise profits and generally don’t have
shareholder owners, they can still suffer from a variant of the agency problem.
For example, from workers focussing on swish offices or earning higher salaries, rather
than concentrating on the objectives of the organisation.
business
And finally...
business
Stop!
By this stage you should know:
• What as stakeholder is
• How stakeholders are classified
• Areas of interest for different types of stakeholder
• How to map stakeholders on Mendelow’s matrix
• Options for resolving stakeholder conflict
• Why the agency problem occurs and possible solutions
Got it?
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
23
BA1 Fundamentals of business economics
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
24
BA1 Fundamentals of business economics
BA1 3 Shareholders
Shareholder wealth
Incorporated companies sell shares of their business to investors to raise finance for business
growth.
business
Definition
Shares
Represent the proportion of the company owned by an investor – can be referred to
as equity
e.g. profits, losses and assets.
business
It is possible to calculate what proportion of the business the shareholder owns using the
following formula:
business
Formula
Proportion of the business owned by the shareholder
Number of shares owned
X 100 = % of company owned
Total number of shares issued
business
There are two different types of share an investor can buy:
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BA1 Fundamentals of business economics
business
Shareholder Objectives
The main objective for most private companies will be to maximise the wealth of its
investors/shareholders. This is achieved by maximising profits and:
• Paying these profits to shareholders as dividends
• OR reinvesting these profits into the company to increase the share price
business
Calculating short-term shareholder wealth
Short term measures are any measures that give an indication of likely returns over the
course of the next financial year. One such measure is ROCE.
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BA1 Fundamentals of business economics
business
Definition
ROCE (Return On Capital Employed)
ROCE shows how efficient a company is at generating profits from the amount
invested.
business
Shareholders compare the figure generated by ROCE to their expectations and use this to
make further investment decisions.
business
Formula
ROCE
Profit before interest and tax (PBIT)
ROCE = X 100%
Total assets less current liabilities
business
Profits before interest and tax can be found by adding the profit to interest and tax paid.
business
Definition
Current Liabilities
Any items owed by the company which are expected to be paid back within a year.
Business
business
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BA1 Fundamentals of business economics
Example
Calculating ROCE
This year Fox PLC earned profit before tax of £425,200 and paid back interest of
£38,010. Total assets less current liabilities were £1,560,000.
The ROCE for this year is:
Profit before interest and tax (PBIT)
ROCE = X 100%
Total assets less current liabilities
Profit before interest and tax = Profit before tax + interest
£425,200 + £38,010
Profit before interest and tax = £463,210
£463,210
ROCE = X 100%
1,560,000
ROCE = 29.7%
business
Using ROCE to make investment decisions:
ROCE Outcome
Above shareholder expectation Yes – invest; No – consider alternatives
Higher than an alternative investment Yes – invest; No – move money
business
Failures of ROCE
The biggest failure of ROCE is that it does not take into account where profits go. A
company may have a high ROCE, but if the level of tax and interest payable are also
high shareholders may end up with a much smaller dividend than expected.
business
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BA1 Fundamentals of business economics
This is taken into account by an alternative calculation: EPS.
business
Definition
EPS (Earning Per Share)
EPS enables investors to see the profit earned for each share they own.
business
EPS calculates the potential dividend that could be paid out per share. The actual value of the
dividend may be much lower if the directors decide to use profits to invest in growth.
business
Formula
EPS
Profit after tax and preference dividends
EPS =
Number of equity shares issued
business
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BA1 Fundamentals of business economics
Example
Calculating EPS
Fox PLC have issued 100,000 equity shares. Their profit after tax and payment of
preference dividends is £149,000.
Profit after tax and preference dividends
EPS =
Number of equity shares issued
£149,000
EPS =
100,000
EPS = £1.49
If last year’s EPS was £1.20, the shareholder will be happy as the EPS (potential
dividend) has risen.
business
Long-term shareholder wealth
To calculate the expected return over a given future period, a shareholder could add up the
estimated:
• Dividends over the period
• Increases in price per share
business
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BA1 Fundamentals of business economics
Issues
• Estimated values may differ significantly from actual results
• It does not take in to account the cost of capital
• The shareholder may not know their cost of capital - return level required
• It ignores the time value of money, i.e. money now is worth more than money
earned later, and inflation means the real value of money decreases over time
• Secure more jobs
business
An alternative approach would be to work out the value of a company. This will be higher if it
is expected to have higher returns in the future and vice versa. One method would be Net
Present Value.
business
Net Present Value features
• Based on cash flows, e.g. increased cash inflow equals increased value
• Takes into account the cost of capital and time value of money
business
Factors which affect the future value of shares:
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BA1 Fundamentals of business economics
business
Example
Internal factors
If Apple released a new iPhone it is likely share price will increase. Conversely, news
that Apple had been exploiting workers may cause share prices to decrease.
External factors
If Samsung release a phone with more advanced features than the new iPhone it may
cause Apple’s share price to fall. If one of Apple’s key markets became more wealthy
Apple’s share price may rise.
Financial factors
If a company releases statements indicating earnings are higher than expected share
prices are likely to increase, and vice versa.
business
Market expectations also play a key role in future profitability of shares – often more so than
actual results.
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BA1 Fundamentals of business economics
business
Market expectation’s affect on share price
Positive information and estimations create an impression of future profitability of an
organisation and will therefore lead to increases in share price encouraging
shareholders to invest. Negative information will have the opposite effect.
business
Risk and return – the required rate
There are two types of risk when investing in a business:
business
Definitions
Systematic risks
Uncertainty inherent in a particular market
e.g. the property market which tends to react in line with economic conditions.
Unsystematic risks
The uncertainty inherent in a particular company
e.g. risk that employee costs will be high in a company experiencing local shortages in
skilled labour and with a highly unionised labour force.
business
To avoid facing these risks, many people choose to invest their money into a bank rather
than investing in shares. The risks for investing in a bank are much lower.
business
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BA1 Fundamentals of business economics
Bank Investing in shares
Interest will be consistent and guaranteed Annual dividends from shares will vary year on
year
The investment in the bank stays the The market value of shares varies
same
Banks are often guaranteed by Investors will lose the whole investment if the
governments company gets closed down
business
Because of the risks associated with investing in shares, shareholders require increasing rates
of return. This is shown in the risk vs return graph:
business
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BA1 Fundamentals of business economics
Definition
Risk free rate
The rate of return which would satisfy investors if they were guaranteed the return
e.g. 4% in the graph, risk = 0 – there is no risk.
business
The risk free rate is based on two things:
• The rate required to compensate the individual for not being able to spend the
money now.
• The rate of inflation
The higher the risk, the larger the expected return should be.
Factors affecting risk and return
The company’s strategy:
• Returns may be low if the company reinvests profits
• Shareholders may accept lower returns in the short term for high returns
following investment
Economic Conditions (during a recession):
• Profits tend to fall so investing becomes riskier – investors expect a higher
return on their investment
• The returns available decrease across the economy as profits in general
decrease – investors may accept a lower level of return than previously
Expectations about the industry:
• High returns in one industry push up the required rate of returns across the
whole industry, as there are now expectations of high returns in that industry
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BA1 Fundamentals of business economics
business
Shareholder’s impact on management decisions
Management need to keep their shareholders happy to ensure they keep receiving
investment. One tool management use to keep shareholders happy is their dividend policy.
business
Definition
Dividend Policy
This is the determination of how much and how frequently cash is paid out of profits
to shareholders in the form dividends.
business
In coming up with this policy the company has to consider other financial needs of the
business, so that any project it takes on fits within it. Every project decision needs to consider:
• Their shareholders’ cost of capital
• The level of risk their shareholders want to take
business
Signalling
Dividend announcements convey information to the market affecting share prices.
Management will tend to choose projects which promise positive announcements.
business
Shareholder communication
To limit negative reactions from assumptions, organisations need to keep in close contact
with their shareholders by:
• Holding shareholders meetings
• Communicating details of all project decisions
• Communicating details of all dividend announcements
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BA1 Fundamentals of business economics
And finally...
business
Stop!
By this stage you should know:
• How to define and calculate ROCE and EPS
• The difficulties of predicting long-term shareholder wealth
• What factors affect shareholder wealth
• The different types of risk affecting shareholders
• How to define the risk free rate and the factors affecting return
• The impact of shareholders on management decisions
Got it?
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
37
BA1 Fundamentals of business economics
BA1 4 Price, Demand and Supply
The market
The term market can be used in several different ways – as an international market – e.g. the
market for oil, or the local housing market.
business
Definition
Market
A medium through which buyers and sellers of goods or services come together to
trade.
business
There are four types of market:
• Goods – trading finished goods and services
• Factor – trading the factors of production: land, labour, capital and entrepreneurship
• Commodity – trading raw materials
• Financial – trading shares and loans
In every market there is a party who supplies the good and a party who demands the good.
business
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BA1 Fundamentals of business economics
B2C and B2B
B2C (Business to Consumer)
This is where suppliers are companies and buyers are households.
B2B (Business to Business)
This is where companies sell to other companies or government authorities.
business
Demand
In general, demand refers to how much people want something.
business
Definition
Demand
The extent to which consumers are willing and able to buy a good or service at any
given price over a set time period.
business
The usual relationship between price and demand is illustrated by the demand curve:
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BA1 Fundamentals of business economics
There is an inverse relationship between price and demand: as price increases, the quantity
demanded of the product or service decreases. Changes in price cause a move along the
demand curve, known as an extension or contraction of demand.
business
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BA1 Fundamentals of business economics
Extension and contraction of demand
Extension of demand
There is an increase in quantity demanded when the price falls.
For example, the move along the demand curve from 2 to 5 units demanded as price
falls from 4 to 2 units of currency.
Contraction of demand
There is a decrease in quantity demanded when the price rises.
For example, the move along the demand curve from 5 to 2 units demanded as the
price rises from 2 to 4 units of currency.
business
This inverse relationship between price and demand arises because consumers look to
maximise utility from their scarce resources, e.g. their income.
business
Definition
Utility
The measurement of the amount of satisfaction or enjoyment that a customer gets from
consuming a given good or service.
business
The relationship between price and demand can also be thought about in therms of
opportunity cost.
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BA1 Fundamentals of business economics
Definition
Opportunity Cost
The amount the individual has to give up in order to buy the good or service
e.g. when the price of a good or service rises the consumer has to give up more in
comparison to other goods/services they could buy i.e. less value for money.
business
Demand can be discussed in two different ways: individual and aggregate demand.
business
Definition
Individual Demand
The demand for a specific product at one company.
Aggregate Demand
The demand for one product at any given price level in the whole market.
business
Factors influencing demand
Changes in price cause a move along the demand curve, but changes in the factors
influencing demand lead to a shift in the demand curve itself.
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BA1 Fundamentals of business economics
The factors influencing demand are:
• Levels of income – e.g. as disposable income rises, consumers spend more, resulting
in increased demand
• Market expectations – e.g. if prices are expected to increase in the future, consumers
will increase expenditure in the short term
• Size of the population – e.g. an increase in population in a specified area may result
in a rise in demand for many goods
• Competitor prices – e.g. substitute and complementary goods
• Factors that affect consumers preferences – e.g. fashion, taste, whether the good is
inferior or normal all affect consumer preference
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BA1 Fundamentals of business economics
Definitions
Substitute goods
Satisfy the same need for the buyer as the original. If the price of a substitute is low, the
demand for the original good or service may decrease.
Complementary goods
Goods whose purchase triggers the purchase of another. A fall in price for one is likely
to increase demand for the other.
Normal goods
Demand increases as income increases, e.g. branded products.
Inferior goods
Demand falls as income increases e.g. a value range product at a supermarket.
business
These factors will cause the demand curve to shift to the right or left. Even if the price
remains the same, there will be either an increase or decrease in total consumer expenditure
due to the change in quantity demanded.
business
Formula
Total consumer expenditure
Total consumer expenditure = Price x Quantity demanded
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BA1 Fundamentals of business economics
Example
Calculating the total consumer expenditure
In the graph above we can see that when the price is £3, 2 units are demanded.
Therefore:
Total consumer expenditure = £3 x 2
= £6
When the demand curve shifts to the right, at £3, 4 units are demanded.
Therefore:
Total consumer expenditure = £3 x 4
= £12
business
Giffen and Veblen Goods
In general, demand increases when price falls. However, there are some goods where an
increase in price can lead to an increase in demand:
• Veblen Goods – as price increases, Veblen Goods become more exclusive (not
everyone can afford them) and so demand increases, e.g. Rolex watches.
• Giffen Goods – inferior, staple goods with no substitutes, hence even if the price
increases consumers have no choice but to continue buying them, e.g. rice.
Supply
Supply is all about how buyers and sellers react differently to changing prices.
business
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BA1 Fundamentals of business economics
Definitions
Supply
The extent to which companies are willing and able to supply a product at any given
price over a set time period.
business
The usual relationship between price and supply is illustrated by the supply curve:
The supply curve demonstrates that as price increases, the quantity supplied increases and
vice versa. Changes in price cause a move along the supply curve and are known as an
extension or contraction of supply.
business
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BA1 Fundamentals of business economics
Extension and contraction of supply
Extension of supply
There is an increase in quantity supplied when the price increases.
e.g. the move along the supply curve from 2 to 4 units supplied when the price
increases from £2 to £3.
Contraction of supply
There is a decrease in quantity supplied when the price decreases.
e.g. the move along the supply curve from 4 to 2 units supplied when the price
decreases from £3 to £2.
business
This positive relationship between price and supply occurs because supplying more at a
higher price yields a higher profit per unit and therefore, greater rewards.
business
Formula
Profit per unit
Profit per unit = price per unit – costs per unit
business
Example
Calculating the profit per unit
Say that the price per unit is £2, and the cost per unit is 50p.
Profit per unit = £2 - 50p
= £1.50
However, if the price per unit is £3
Profit per unit = £3 - 50p
= £2.50
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BA1 Fundamentals of business economics
The profit per unit is higher at £3, hence the supplier is incentivised to supply more.
business
Supply can be discussed in 2 different ways: individual and aggregate supply:
business
Definition
Individual Supply
Supply at the individual level
e.g. an individual company’s supply schedule.
Aggregate Supply
Supply at the level of the market
e.g. the supply level of one product at any given price level from all suppliers in the
market.
business
The factors influencing aggregate supply are:
• Companies leaving or joining the market
• Current suppliers increase or decrease production
Factors affecting supply
Changes in price cause a move along the supply curve, but changes in the factors influencing
supply lead to a shift in the supply curve itself.
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BA1 Fundamentals of business economics
The factors influencing supply (at an individual level) are:
• Costs associated with make the good/service – changes in the price of raw
materials, or factors of production, will affect profit per unit
• Price or cost of producing substitutes – changes in the price or cost of producing a
substitute will determine how much of which product is supplied
• Market expectations – anticipated future price rises may result in lower current
supply, or possibly lower long term supply if considered a long term trend
• Number of competitors – as the number of companies in an industry increases, the
level of supply will increase and vice versa
• Technological Changes – effects of these on the costs of production can result in
shifts of the supply curve
• Climate / Weather – primarily affecting companies in the primary sector e.g.
agricultural or building. Good weather conditions increase supply and vice versa
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BA1 Fundamentals of business economics
The effects of the factors
These factors will cause the supply curve to shift to the right or left. Even if the price
remains the same, there will be either an increase or decrease in total consumer
expenditure due to the change in quantity supplied.
business
Example
Calculating the total consumer expenditure
In the graph above we can see that when the price is £3, 2 units are supplied.
Therefore:
Total consumer expenditure = £3 x 2
= £6
When the supply curve shifts to the right, at £3, 4 units are supplied.
Therefore
Total consumer expenditure = £3 x 4
= £12
business
Equilibrium Price
When the supply and demand curves for the same product are plotted on the same graph, it
is possible to see the equilibrium price.
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BA1 Fundamentals of business economics
Definitions
Equilibrium price
The price at which market supply and market demand are balanced
business
The market mechanism ensures points of disequilibrium:
• Supply and demand curves do not intersect at the given price point
• Supply and demand curves only exist in the short run
The best way to see this is on a demand and supply graph:
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BA1 Fundamentals of business economics
Excess Supply (C-D)
At a price of £4 Demand = 2 units Supply = 4 units
Supply is greater than demand, so there is excess supply
Suppliers will sell their excess stock at a cheaper price, with price eventually falling to £3.
Excess Demand (A-B)
At a price of £2 Demand = 4 units Supply = 2 units
Demand is greater than supply, so there is excess demand
Suppliers will sell their stock at a higher price so prices rise, eventually settling at £3.
business
The equilibrium price
Eventually, in both the scenarios, supply and demand will meet at P0, the equilibrium
price.
business
And finally...
business
Stop!
By this stage you should know:
• How to define a market
• The role price plays in the extension and contraction of demand and supply
• What factors affect demand and supply
• The difference between Giffen and Veblen goods and why they are important
• What the equilibrium price is and how the market reacts to ensure it is the long
run end point
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BA1 Fundamentals of business economics
Got it?
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
53
BA1 Fundamentals of business economics
Price Elasticity of Demand and
BA1 5
Supply
Price elasticity of demand
Some goods and services can increase their prices and the demand will only drop a little,
while a price increase in other goods and services results in a dramatic reduction in demand.
business
Definition
Price elasticity of demand
How the demand for a product changes when its price changes.
business
Most goods and services can be split into two categories: price elastic and price inelastic
goods and services.
business
Definitions
Elastic goods
The demand for the good changes dramatically when the price changes.
Inelastic goods
The demand for the good only changes a little when the price changes.
business
The elasticity of a product can be found using a simple formula.
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BA1 Fundamentals of business economics
Formula
Price elasticity of demand
% change in quantity demanded
Price elasticity of demand =
% change in price
business
There are three variations of this formula, but you only need to know two (note: ‘arc’ refers to
the curve of the demand curve):
• Non-average arc method
• Average arc method
business
Example
Calculating the price elasticity of demand – non average arc method
Original demand - D1 = 1,000 Demand after price change - D2 = 890
Initial price - P1 = £6.00 Price after change - P2 = £7.00
Step 1: Work out the percentage change in demand:
D2 - D1 890 – 1,000
= = - 11%
D1 1,000
Step 2: Work out the percentage change in price:
P2 - P1 £7 - £6
= = - 17%
P1 £6
Step 3: Put it all together:
% change in quantity demanded - 11
= = -0.66
% change in price - 17
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BA1 Fundamentals of business economics
business
Example
Calculating the price elasticity of demand – average arc method
We will use the same example above.
Step 1: Work out the average price between the starting and finishing price
£6.00 + £7.00
= £6.50
2
Step 2: work out the percentage change in price using the average price
£7.00 - £6.00
= 15.4%
£6.50
Step 3: work out the average change in demand
890 + 1,000
= 945
2
Step 4: Work out the percentage change in demand
890 - 1,000
= -11.6%
945
Step 5: Put it all together:
% change in quantity demanded - 11.6
= = -0.75
% change in price - 15.4
business
The value calculated determines the degree of elasticity:
Range of Price Elasticity Outcome
Between 0 and -1 Inelastic – percentage change in demand is less than the
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BA1 Fundamentals of business economics
percentage change in price
-1 Unit elasticity – percentage change in price is the same as
the percentage change in demand
Between -1 and minus infinity Elastic – percentage change in demand is larger than the
percentage change in price
business
Formula
Demand curves’ straight line formula
Although the demand curve is a curve, it is sometimes represented as a straight line
for simplification. The standard format in this case would be:
Qd = a -bP
Qd Quantity demanded
a The point where the curve starts on the Y axis
b The gradient (slope) of the line
P Price
business
Example
Using the demand curve straight line formula
Let’s say the demand curve is:
Qd = 100 – 6P
The product price (P) rises from £5.00 to £6.00
The affect on quantity demanded will therefore be:
Price is £5:
Qd = 100 - (6x5) = 70
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BA1 Fundamentals of business economics
Price is £6:
Qd = 100 - (6x6) = 64
Therefore the overall fall in demand is £6.
business
Price elasticity and the demand curve
It’s possible to read the price elasticity of demand from the demand curve gradient. The price
elasticity of demand can be perfectly elastic, elastic, perfectly inelastic or inelastic.
business
Definition
Perfectly elastic demand
Any increase in price leads to a total loss of demand
e.g. if there is a substitute available more cheaply.
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BA1 Fundamentals of business economics
business
Definition
Elastic demand
Demand is very responsive to changes in price, so change in price leads to a higher
change in demand.
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BA1 Fundamentals of business economics
business
Definition
Perfectly inelastic demand
Demand is completely unresponsive to changes in price. Any increases in price will
result in the same level of demand and increased revenues.
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BA1 Fundamentals of business economics
business
Definition
Inelastic demand
Demand is not very responsive to changes in price, so any change in price leads to a
small change in demand.
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BA1 Fundamentals of business economics
Unitary elastic demand
The income of some goods or services remains the same no matter how much the price
changes.
business
Definition
Unitary elastic demand
Changes in demand are exactly proportional to changes in price – if prices are raised or
lowered, revenue remains same.
business
business
Giffen and Veblen Goods
Giffen goods and Veblen goods increase in sales as price rises. These have an upwards
sloping demand curve, meaning an upwards change in price will be met by an
increase in demand and vice versa. The price elasticity is therefore positive.
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BA1 Fundamentals of business economics
business
Uses of price elasticity of demand
There are three main ways price elasticity of demand can be used:
• By companies to forecast revenue changes
• By companies to choose a level of production or purchases
• By government to forecast the effect on sales tax revenue
Forecasting revenue changes
Elasticity of demand Total revenue
Price Increase Inelastic Increase
Unitary elastic Remains the same
Elastic Decrease
Price decrease Inelastic Decrease
Unitary elastic Remain the same
Elastic Increase
business
Example
Forecasting Revenue Changes
Company A:
Price elasticity of demand = -0.6 P1 = £20
Q1 = 20,000 units P2 = £30
What would the effect on demand and total revenue be of the price change?
Step 1: Find the revenue before the price change:
Q1 X P1 = Revenue 1
20,000 X £30 = £600,000
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BA1 Fundamentals of business economics
Step 2: Find % change in price
20 - 30
% change in price = = -0.33
30
Step 3: Find % change in quantity demanded
Using formula for calculating the price elasticity of demand:
% change in quantity demanded
Price elasticity of demand =
% change in price
And rearranging:
% change in quantity demanded
= -0.6
-0.33
So:
% change quantity in demanded = -0.6 x -0.33
= 0.198
Step 4: Find the new level of revenue
The demand for units at the new price increases by 19.8% so:
New quantity demanded = 20,000 x 1.198
= 23,960
So the new level of revenue is:
P2 x Q2 = Revenue 2
23,960 X £20 = £479,200
The change in revenue is therefore a fall of:
£600,000 - £479,200 = £120,800
Price elasticity of demand was relatively inelastic, expectation was therefore that
revenue would fall, which was borne out by the calculation.
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BA1 Fundamentals of business economics
Choosing a level of production or purchasing
As companies can forecast the effect on demand of a change in price, they can use this
information to choose a level of production or purchases.
Forecasting the effect of a sales tax revenue
Governments can use price elasticity of demand to forecast the effect on sales tax revenue
(e.g. VAT) of a change in tax on a good/service as such a tax affects the price.
Factors influencing price elasticity of demand
The factors which influence the price elasticity of demand are:
• Percentage of income spent on the good/service – small percentage of income,
demand will be price inelastic and vice versa
• The availability of substitutes – number of substitutes is low, demand will be price
inelastic and vice versa
• Product status: necessity or luxury – demand for necessities is likely to be relatively
price inelastic. The opposite is true for luxury goods
• Time since price changed – the more time that passes, the more likely consumers
will realise that the price has increased and have more time to look for alternatives
• Brand loyalty – if consumers are very loyal to a particular brand, demand is likely to
be relatively price inelastic
• Competitor pricing – The decision to match, exceed or ignore the pricing levels and
movements of competitors will affect the price elasticity of a company's product.
• Habit – demand for habit-forming goods is likely to be inelastic
• Definition of the market – the broader the definition, the less elastic the demand
will often be
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BA1 Fundamentals of business economics
Price elasticity of supply
Increases in price will affect the supply of some goods more than others.
business
Definition
Price elasticity of supply
The sensitivity of the level of supply to any change in price.
business
The elasticity for the supply of a product can be found using a simple formula:
business
Formula
Price elasticity of supply
% change in quantity supplied
= Price elasticity of supply
% change in price
This can also be seen as:
Q2 - Q1
Q1 = Price elasticity of supply
P2 - P1
P1
Q1 Original quantity demanded
Q2 Post price change quantity demanded
P1 Original price
P2 Post change
business
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BA1 Fundamentals of business economics
Example
Finding the price elasticity of supply
Original supply - Q1 = 100,000 Supply after price change - Q2 = 150,000
Initial price- P1 = £0.10 Price after change - P2 = £0.15
Using the price elasticity of supply formula:
Q2 – Q1
Q1
= Price elasticity of supply
P2 - P1
P1
150,000 - 100,000
100,000
= 1
0.15 - 0.10
0.10
business
The level of price elasticity of supply:
Range of price elasticity Outcome
Greater than 1 Elastic – a change in the price level results in a greater
change in supply
1 Unit elasticity – the change in supply is directly
proportional to the change in price
Less than 1 Inelastic – the change in supply is smaller than the change
in price
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BA1 Fundamentals of business economics
Formula
Straight line formula of a supply curve
Although the supply curve is a curve, it is sometimes represented as a straight line
formula for simplification:
Qs = C + dp
Qs Quantity supplied
C The point where the curve starts on the x axis
d The gradient of the line
P Price
business
Example
Using the supply curve straight line formula
If the formula for the supply curve is:
Qs = -4 + 42P
If the price rises from £2 to £3 what is the price elasticity of supply?
Firstly when the price is £2:
Qs = -4 + (41 x 2)
Qs = -4 + 82
Qs = 78
When the price rises to £3, it has the following effect on supply:
Qs = -4 + (41 x 3)
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BA1 Fundamentals of business economics
Qs = 119
So the price elasticity of supply is:
119 - 78
78 0.53
= = 1.05
3 - 2 0.5
2
business
Supply elasticity and the supply curve
As with price elasticity of demand, there are some extreme cases of supply elasticity.
business
Definition
Perfectly inelastic supply
No matter how the price changes, the level of supply will remain the same.
Business
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BA1 Fundamentals of business economics
business
Definition
Perfectly elastic supply
Supply occurs at a given price only.
business
Factors influencing price elasticity of supply
The factors that influence the price elasticity of supply are:
• Availability of inputs – readily available raw materials enabling an easy change in
production levels, resulting in relatively elastic supply and vice versa
• Availability of factors of production – as for inputs, ready availability will result in
relatively elastic supply levels
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BA1 Fundamentals of business economics
• Stock – retention of stock of finished or part finished components facilitates a change
of supply. Supply if therefore relatively elastic
• Number of competitors – if there is a large number of suppliers, supply is likely to
be elastic
• Developments in technology – advancements in technology could change supply
from being inelastic to elastic
• Long run vs short run – availability of inputs, factors of production or competitors
may be restricted in the short run, but not the long run
• Production capacity – spare capacity will result in supply being elastic to price
• Definition of the market – the level of supply elasticity will also be related to how
broad the definition of the market is
And Finally...
business
Stop!
By this stage you should know:
• How to calculate the price elasticity of demand using both the average arc
method and the non-average arc method
• Whether a good or service is elastic, inelastic or has unitary demand or supply
based on the value of their price elasticity
• The straight line formulas for both demand and supply curves
• How to represent totally elastic and inelastic demand and supply graphically
• Why the price elasticity of demand is important and how it is used
• The factors which influence the price elasticity of demand and supply
Got it?
If not, go back and re-read the study text before moving on.
business
71
BA1 Fundamentals of business economics
Question Time
It's now time to practise questions.
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72
BA1 Fundamentals of business economics
Types of Market and Cost
BA1 6
Effects
Impact of costs on business and markets
Costs have an important role to play in determining how easy it is to enter and compete
within an industry.
business
Types of cost
There are five types of cost:
• Fixed costs – do not change with the level of output e.g. rent, advertising or
salaries
• Variable costs – vary according to output e.g. raw material or energy costs
• Total costs – sum of fixed costs and variable costs
• Marginal costs – the amount the total cost increases with each additional unit
of output
• Average costs – total cost divided by the level of output i.e. total cost per unit
business
These costs can be considered graphically:
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BA1 Fundamentals of business economics
Price is often determined using average cost for the specified level of output as a basis, plus
the required profit margin.
Outsourcing
Companies sometimes get tasks completed by individuals or organisations outside of their
own business. This is known as outsourcing.
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BA1 Fundamentals of business economics
Definition
Outsourcing
The contracting out of all or part of a business operation to an external organisation
business
Advantages of outsourcing:
• Lower costs and higher quality – due to the expertise of the external provider
• Known fee – a price for the work is agreed upon in advance
Disadvantages of outsourcing:
• Loss of control overall – companies cannot directly control external providers
• Companies are unlikely to gain a competitive advantage – all competitors use the
same external providers
• Companies become dependent on the external providers – leaving them
vulnerable to possible price rises or refusal/failure to provide the service
• Lose internal expertise – hard to bring expertise back in-house, and no longer an
intelligent customer when negotiating future contracts
• The external provider has a limited understanding of the business – resulting in a
less than optimal service being provided.
• Loss of confidentiality – external parties require access to internal systems
Categorising a business’s tasks in terms of the nature of their competency, can help in
making the decision as to whether to outsource them or not.
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BA1 Fundamentals of business economics
Definition
Competencies
The skilled processes within an organisation, split into three categories:
Core competencies
Essential to the business maintaining its competitive advantage.
Complementary competencies
Important, but not key to competitive advantage.
Residual competencies
Not directly linked to business operations, like payroll etc.
business
Competencies should be outsourced accordingly:
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BA1 Fundamentals of business economics
Outsourcing: structures of business
Depending on which tasks are outsourced, the structure of the business will changed. Two
standard structures have emerged:
• Network organisations – dependent on the relationships built with others
• Virtual organisations – uses IT as the main communication tool between its
employees and contractors
business
Network organisations Virtual organisations
Keeps the number of directly employed staff Staff or contractors may be located in
to a minimum geographically dispersed locations
communicating via IT solutions.
Many activities outsourced
The role of the organisation is to co-
ordinate outsourced activities
Only key drivers are kept ‘in-house’
Flexible – can easily increase or reduce
capacity through using outsource company
business
Transaction cost theory
Transaction cost theory helps companies decide whether to outsource activities (also known
as market solutions) or employ people (also known as hierarchy solutions).
It states that all the costs associated with outsourcing should be recognised and taken into
account, not just the cost of the contract fee, when deciding whether to outsource a task or
not.
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BA1 Fundamentals of business economics
Outsourcing transaction costs
• Contract negotiation whenever circumstances change
• Monitoring of the quality of the outsourced work
• Possible legal costs of non-conformance to contract
business
The factors affecting how significant the transaction cost is likely to be include asset
specificity and bounded rationality.
business
Definition
Asset specificity
How specific an asset is to one particular area of work
business
Example
Asset specificity:
• An employee with a high level of knowledge in a specific area
• A building gaining an advantage from being in a particular area e.g. close to
potential clients
• A piece of equipment with only one application.
business
The more specific an asset is, the higher the transaction costs will be and it is therefore more
likely to be kept in-house where possible. The opposite is also true.
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BA1 Fundamentals of business economics
Definition
Bounded rationality
The idea that when making outsourcing decisions, individuals are confined by three
constraints:
1. A limited amount of time
2. The limited capacity of the human mind
3. The limited information available
business
Due to these constraints, it is possible that the external providers chosen by the company
may not produce work of a high enough quality and therefore the work will have to be
redone. This cost of error must be added in to the transaction costs.
Alternatives to outsourcing
Two alternatives to outsourcing include shared services organisations and flexible
staffing.
business
Shared services organisations
Created when any repeated services throughout the organisation are put into one
division to serve the whole organisation – e.g. human resources, IT and accounting.
business
Positives Negatives
Avoids duplication of staff and tasks The level of efficiency will depend on how
performed well the organisation is set up
Staff performing the same functions for the The level of efficiency will also depend on
entire organisation increase expertise and the effectiveness of communication
efficiency between departments
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BA1 Fundamentals of business economics
business
Flexible staffing
Flexible staffing can be achieved through three different routes:
• Employment agencies – employed temporarily, so kept on the agency’s
payroll
• Leased employees – employed longer term, but kept on the agency’s payroll
• Contractors – employees work on a freelance basis on fixed term contracts
business
Positives Negatives
Less staff time spent on recruitment, no job Less loyalty to the company, possibly
advertisement fees or interview costs resulting in a lower quality of work
Company only having to pay when staff are Flexible staff will require a higher hourly
needed rate than paying for staff directly
Internal staff not paid overtime
Payroll being performed elsewhere
No costs for long term staff development
business
Making decisions
The decision as to whether to outsource, use network organisations, shared service
centres or flexible staffing will depend on continued review and comparison of the
costs involved by the business.
business
And finally...
business
Stop!
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BA1 Fundamentals of business economics
By this stage you should know:
• The different types of cost
• The advantages and disadvantages of outsourcing
• What is transaction cost theory and the factors affecting it
• The advantages and disadvantages of the alternatives to outsourcing
Got it?
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
business
business
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BA1 Fundamentals of business economics
business
BA1 7 Economies of Scale
Economies of scale
Large companies are often able to offer lower prices than small companies due to
economies of scale.
business
Definition
Economies of scale
The organisation benefits from discounts because of their size, resulting in an average
cost per unit which falls as output increases.
Diseconomies of scale
When a company becomes less efficient as a result of being too large, resulting in the
average cost per unit rising as output increases.
business
Long run/Short run
The reduced costs economies of scale result from can be either short or long run.
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BA1 Fundamentals of business economics
Definition
Short run
The time period when businesses have some fixed costs, i.e. costs that they can’t
change.
Long run
When all costs faced by a firm are variable, i.e. costs that change depending on factors
like output.
business
Example
Jeremy the window cleaner needs a special suspended platform, but cannot afford to
buy it outright. He starts a 6 month contract to hire the platform. For these six months
this is a fixed cost: Jeremy is contractually obliged to pay the monthly rate regardless
of whether the platform is used or not.
After 6 months Jeremy can decide to use a different provider or none at all. Given that
he now has a choice this is Jeremy's long term.
business
Internal and external economies of scale
Economies of scale can either be internal or external.
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BA1 Fundamentals of business economics
Definition
Internal economies of scale
Caused by factors inside the organisation, i.e. they are due to organisation increasing
its own level of output.
External economies of scale
Caused by factors outside of the organisation, generated either by the growth of the
firm’s industry or the economy as a whole.
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Internal economies of scale fall into the following headings:
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Example
Company X used to buy its raw materials for £200 a tonne, but following a surge in
demand they need more raw materials. With an increased order size they can now
purchase their raw materials at £100 per tonne.
Company X are benefiting from a purchasing internal economy of scale.
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External economies of scale fall into the following headings:
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Example
Jeremy’s window cleaning is very successful and leads to many other firms entering the
market. One of these other companies developed a revolutionary new window
washing system that meant one person could wash windows in half the time. Jeremy
bought one.
Jeremy is benefiting from the technological improvements external economy of scale.
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Internal and external diseconomies of scale
Diseconomies of scale can be classed as either internal or external economies of scale in the
same way as economies of scale.
Internal diseconomies of scale fall into the following headings:
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business
Example
Growing Really Fast Ltd has recently doubled its output and taken on lots of new staff,
including a management accountant responsible for creating monthly presentations
for the board showing output per team and a team supervisor who prepares his own
data to track the team output. Both work from raw data and are unaware of the
crossover.
Growing Really Fast Ltd is suffering from an internal diseconomy of scale known as
duplication of roles, as work is needlessly being done twice.
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External diseconomies of scale fall into the following headings:
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business
Example
Advanced Tech Ltd is based in a science park with several other technology
companies. Although the science park is a great space for information sharing, the
concentration of technology companies means there is very competition for labour
from the surrounding few towns. So Advanced Tech Ltd are therefore pressured to
offer high wages to entice prospective employees.
Advanced Tech Ltd is suffering from an external diseconomy of scale of wage costs
increasing.
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Implications and outcomes
To work out the optimum size of the organisation management need to know:
• What economies and diseconomies of scale are
• That they exist in their industry
• The impact of economies and diseconomies of scale on costs
Economies of scale can have both positive and negative outcomes on an organisation.
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Outcomes of economies of scale
Positives Negatives
Lower costs due to economies of scale Barrier to entry for smaller firms
Lower prices due to lower costs There is reduced competition due to
the barrier to entry
A competitive advantage due to lower
costs Reduced competition could lead to
higher prices
Increased profits due to competitive
advantage
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Definition
Barrier to entry
Anything that makes it difficult for new firms to enter into a particular industry.
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And finally...
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Stop!
By this stage you should know:
• What economies and diseconomies of scale are
• How costs differ in the short and long run
• The difference between internal and external economies and diseconomies of
scale
• What the implications of economies of scale are for management
• The positives and negatives outcomes of economies of scale
Got it?
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BA1 Fundamentals of business economics
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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Government Regulation of
BA1 8
Markets
Economic systems
There are several different ways economies can be run, known as economic systems. The
main three types are:
• Market economy (aka free market)
• Command economy
• Mixed economy
In a market economy the price, products and distribution of goods are decided by market
forces.
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In a command economy the price, products and distribution of goods are dictated by the
government.
In a mixed economy the price, products and distribution of goods are decided by a mixture
of market forces and the government.
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In a mixed economy the government will tend to intervene where they are market failures.
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Definition
Market failure
When a market fails because supply demand do not result in an outcome that satisfies
both customers and suppliers.
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Examples of market failure include:
• Monopolies
• Demerit goods
• Inappropriate price
Monopolies
Often monopolies are an example of market failure.
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Definition
Monopoly
Where there is a sole supplier of a good or service in a market.
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However, there are both negatives and positive effects of monopolies.
Positives:
• Some industries are served more efficiently by a monopoly provider, e.g. utilities
• Large companies can have a positive impact in industries where research and
development costs are high
Negatives:
• Large companies with significant market control can set excessively high prices
• Companies in industries with only a few large companies may decide to form a cartel
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Definition
Cartel
Companies work together to keep prices high and/or restrict supply and ensure limited
competition in the industry. Cartels my be official or unofficial.
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Competition Policy
Governments use competition policy to ensure competition thrives. Competition policy
covers:
• Monopolies
• Abusing market power
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• Mergers and acquisitions
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Monopolies
In general governments try to prevent monopolies from occurring as they are
incongruous with competition.
However, some industries are more efficiently run by monopolies e.g. utilities
industries. These industries may be nationalised.
Alternatively the government may choose to privatise these industries, but set up an
industry regulator to ensure prices to not become excessively inflated due to a lack of
competition.
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Definition
Nationalisation
When the state owns and runs an industry, e.g. the NHS in the UK.
Privatisation
When a state owned and run industry is sold to a private owner, e.g. British Rail was
privatised in the 1990s.
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Abusing market power
Examples of an abuse of market power are:
• A company acting in collusion with others to restrict supply – inflates prices
• Creating barriers to entry – large companies can reduce some of their prices below
the average total cost, making it non-viable for any company to set up as a
competitor
• Exclusive distributor/retail/supplier agreements – preventing new entrants to the
market
• Imposing switching costs – customers find it financially punitive to switch providers
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• Collusion between two suppliers – competition is reduced, leaving the consumer
facing inflated prices
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Definition
Collusion
Two or more organisation privately agreeing to a pricing strategy.
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Mergers and acquisitions
Governments will regulate to prevent mergers or acquisitions which are against the public
interest. A merger or acquisition is against the public interest if it results in competition which
limits choice and inflated prices.
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Definition
Merger
When two companies combine.
Acquisition
When one company buys another.
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Inappropriate market price: too high or too low
In a market economy price is set by the forces of demand and supply. However, with no
government intervention there are times when the equilibrium price is too low.
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Example
Agricultural produce
When agricultural produce grows easily in an environment there is likely to be a large
supply of this good, which pushes prices down.
A low price for agricultural produce can lead to unemployment in the agricultural
sector. If this unemployment persists in the long run there will be a reduction in the
supply of agricultural produce.
A reduction in supply of agricultural produce is likely to see its price rise. High food
prices could push many into poverty as they can no longer afford to eat, or following
there food bill, there is no money left for other necessities.
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To prevent market forces of demand and supply pushing people into poverty many
governments offer subsidies to farmers, paying the difference between current low price and
the preferred price. An example of this would be CAP.
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Definition
CAP (Common Agricultural Policy)
An EU agricultural policy to provide various programmes and subsidies to farmers.
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Governments may subsidise farmers because they operate in a unique economic climate:
• Weather or disease can severely restrict supply even if the demand for goods is high
• Large retailers with significant market share can strongly influence product prices
• New technologies/products can change the level of supply and therefore prices
• Many governments place a high importance on a secure food supply
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An overview of CAP
• CAP initially provided guaranteed prices of goods, but this lead to over-supply
• One method to avoid surpluses was set-aside schemes, where payments were
made to farmers for percentages of land left unused
• Another method to avoid surpluses were quotas to limit the amount of
production
• In the 1990’s subsidies were introduced
• In the 2000’s single farm payments were introduced (unrelated to production)
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There are both advantages and disadvantages to schemes like CAP:
Advantages Disadvantages
Producers are guaranteed a stable income Possibility of surplus products
This stable income can be invested into Misallocation of resources
research and development
Customers get a stable supply at a stable
affordable price
Other issues such as the environment can
be addressed
Maximum pricing
When left to market forces, there are times when the equilibrium price is too high and the
government has to intervene by introducing maximum pricing.
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Definition
Maximum Pricing
When prices for certain goods get too high the government caps them by imposing a
price.
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Maximum pricing is used when:
• Customers are being exploited by a monopoly situation
• There is an unexpected shortage in a product threatens an increase in price
• To ensure that the product is affordable for all sectors of society
• To reduce inflationary pressures
Setting the price level
To be effective a maximum price must be below the equilibrium price. However this can
cause problems:
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At P₁ (£2), the maximum price, production is too low: supply is at A, but demand for the
product is at B. As demand is higher than supply, not everyone who wants to purchase the
product will be satisfied.
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Potential outcomes of extended shortages
• May lead to the creation of a black market
• Reduced supply
• Reduction in the quality of the good as suppliers cut costs to increase their
profit margin without increasing price
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Example
WW2 rationing in the UK
During WW2 severe shortages of food in the UK led to a government set maximum
price for food, to ensure it was affordable for everyone.
To deal with these shortages, the UK government introduced a rationing system, to
ensure food goods were available to everyone.
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Externalities
When goods are bought and sold they do not only effect the buy or seller, but also those not
directly associated with the transaction.
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Definition
Externality (spill over effects)
They way anyone who is not the seller or consumer (a third party) is affected by a
transaction.
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Negative externalities
Some externalities can have negative impacts.
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Definition
Negative externality (external costs)
An externality that has a negative effect on a third party
i.e. third parties are affected by passive smoking, which in turn increases public health
costs to cover non-smokers.
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Methods for dealing with negative externalities
Taxation The taxes can be used to pay for negative externalities, e.g.
cigarette tax.
Evaluation of the social Finding the figure of the social cost can help governments
cost know how to best use resources.
Regulation A level of acceptable usage is agreed and imposed.
Increased information Educating the consumers to stop using the product, e.g.
for consumers smoking education.
Compensation schemes Compensation is given to the affected third parties.
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Example
Plastic bag charge in the UK
Until 2015 plastic bags in the UK were given freely by supermarkets. However, these
plastic bags had negative externalities, as they caused damage to the environment
through their production and subsequent waste.
In 2015 the government introduced a 5p plastic bag charge, which reflected the real
price of purchasing a plastic bag, and incentivised customers to use more sustainable
methods.
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Methods such as taxation increase the price paid by consumers to cover more of the cost
they have on society, as shown in the intervention line here:
Positive externality
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Some externalities can actually have a beneficial impact on third parties.
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Definition
Positive externality
An externality that has a positive effect on a third party
i.e. education benefits the public at large (third party) through increased knowledge
and skills in the economy.
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Methods to encourage positive externalities include:
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Increase supply Governments subsidise suppliers to reduce cost and increase
supply.
Increase demand Prices for consumers are subsidised – lower price leads to
increased demand.
Consumption is made compulsory.
Increased information on the benefits of certain goods.
Evaluation of the social Finding the figure of the social benefit can help governments
benefit know how to best use resources.
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Merit and demerit goods
There are particular goods which inherently have either positive or negative externalities.
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Definition
Merit goods
Goods which are considered suitably important and necessary so as to warrant being
provided through public finances, e.g. education.
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Merit goods are often provided by the state to avoid under-consumption.
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Definition
Demerit goods
Products that potentially harm the consumer in some way or is socially unacceptable.
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Governments discourage the use of demerit goods through:
• Taxation, e.g. cigarettes
• Laws banning consumption or supply, e.g. recreational drugs
• Regulations over advertising or packaging, e.g restriction of cigarette advertising and
packaging
Public goods
Some goods are provided by the state – not the market.
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Definition
Public goods
Goods which are not produced through the market but which are necessary and are
therefore provided through government intervention.
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Advantages and disadvantages of state provision of public goods:
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Advantages and disadvantages of public goods
Advantages
• Goods and services that would never be produced, despite the public benefits,
are made available
• State provision on a large scale means that economies of scale are benefited
from
• The cost to each individual is kept low
Disadvantages
• No one can opt out
• No allocative efficiency as production levels are dictated by government, not
market forces
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Definition
Allocative efficiency
Where the level of production is consistent with consumer demand.
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Environmental concerns
The operations of the free market may not take the affect on the environment into
consideration. The government may deal with environmental concerns by:
• Taxing companies responsible for pollution and using this money to clean the
affected areas
• Regulating the acceptable amount of pollution
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And Finally...
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Stop!
By this stage you should know:
• The different types of economic systems
• What a monopoly is, as well as its advantages and disadvantages
• Why and how governments intervene in market forces
• What externalities are and how governments intervene in them
• The features of merit, demerit and public goods
• Why and how the government deals with environmental concerns
Got it?
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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Circular Flow of Income and
BA1 9
Monetary Policy
Micro- and macroeconomics
Economics concerns the allocation of scarce resources, e.g. income or raw materials. It is split
into micro- and macroeconomics depending on who is doing the allocating.
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Definitions
Microeconomics
Deals with decisions at the level of the company based on the type of organisation and
their market.
Macroeconomics
Considers the impact of governmental decisions on the economy.
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In macroeconomics the economy is made up of:
• Production – what is made and bought, e.g. producing a car
• Consumption – what is consumed, e.g. eating food
• Income – also called the money supply
The circular flow of money
The circular flow digram shows the flow of money in the whole economy. The size of the
economy is measured using aggregate demand (total demand).
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In this simple circular flow model, money goes from businesses to households to businesses.
No money ever leaves the economy. However in real life there are withdrawals and
injections of funds into an economy.
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Definitions
Withdrawals
Money taken out of the circular flow of funds
e.g. when someone decides to save some money in a bank account.
Injections
Money entering the circular flow of funds
e.g. when someone decides to pay for a new car.
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Withdrawals Injections
Saving Borrowing
Taxes Government spending
Imports Exports
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Definitions
Imports
Products bought from overseas (funds go to a foreign country).
Exports
Products sold overseas (funds come from the buying country).
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If a government wants to grow an economy they increase injections and reduce withdrawals,
e.g. by spending money on a new road. If a government wants to slow economic growth they
increase withdrawals and reduce injections, e.g. by taxing more.
Savings and investments
Savings are a type of withdrawal, the majority of which will go through some kind of financial
intermediary like a bank or building society.
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Definitions
Savings
Any amount of income that it not spent.
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Factors affecting savings:
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The interest rate High interest rates mean larger interest payments, which makes
saving more attractive.
Income High earners tend to have a larger disposable income and are
therefore able to save more.
Job security When people are confident about receiving future income they
save less and vice versa.
Availability of credit Easily available credit may cause people to save less, as money is
readily available in case of emergency, e.g. loans from banks.
Contractual saving Some people agree to save specific regular amounts, e.g. through
pension schemes.
Tax relief If levels of tax relief on products such as pensions increases,
people are more likely to save.
Inflation When inflation is higher than interest rates people are dis-
incentivised to save, as the real value of their money will fall.
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Definitions
Interest rates
The amount of money banks (or other institutions) pay one for leaving money in one
of their accounts.
Disposable income
Income above the level of one’s outgoings.
Tax relief
Taxes which have already been paid are reimbursed.
Inflation
The amount by which prices rise over time
e.g. if inflation is running at 5% per annum £1,000 one year will be equal to £1,050 the
next.
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Investments are a type of injection which also go through a financial intermediary.
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Definitions
Investment
The purchase of an item in the hope it will generate income or accrue value.
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Investments can be:
• Capital items, e.g. new machinery
• Increasing inventory, e.g. buying more stock
Factors affecting investment:
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New or replacement Replacement investment is spending on replacing items. There is
investment an increase in investment when net investment is positive:
Net investment = New investment – replacement investment
Expected future Expectations of high future returns increase investment.
returns
Business confidence Low confidence about future returns will decrease investment.
Interest rates High interest rates will encourage people to save rather than
invest, while borrowing will also get more expensive.
Government policy Government actions can change investment amounts, e.g. tax
breaks on investments made.
Flow of funds with savings and investments
We can see the affect of savings and investments in the circular flow model:
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Investments are injections, so are shown entering the circular flow. Savings are withdrawals,
so are shown leaving the circular flow. If injections are greater, then the national income will
rise – the reverse is true if withdrawals are greater.
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Definitions
National income
The total amount of goods and services produced over the course of a year, which is
equal to the total amount earned by all people and businesses.
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Managing economic growth using savings and investments
As a reminder, the total size of the economy is measured by the total amount spent (the
aggregate demand). The more money that enters the flow, the higher the growth.
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Growing and slowing the economy
To grow the economy:
• Increase injections – reduce interest rates/ reduce restrictions on borrowing to
encourage borrowing and increase investments
• Decrease withdrawals – reduce interest rates to discourage savings
To slow growth of the economy:
• Decrease injections – increase interest rates/ restrictions on borrowing to
discourage borrowing to investment
• Increase withdrawals – increase interest rates to encourage savings
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Monetary policy can also be used to manage the economy. Governments will manage the
economy with monetary policy by:
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• Changing interest rates
• Making borrowing and lending easier or harder
Interest rates
Changing interest rates is a key element of monetary policy.
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Consequences of increased interest rates
Decreased investment Borrowing is more expensive and so decreases.
Attraction of foreign Foreign investors move their funds to take advantage of
funds high interest rates.
Effects on the exchange An inflow of foreign funds increases demand for that
rate currency, leading to an increased exchange rate.
Decreased inflation rates High interest rates will encourage people to save rather than
spend, reducing the pressure on prices.
Decrease in asset value Assets which depend on the interest paid for their value
(corporate or government bonds) may fall in value.
Affect on sales Sales may fall as people choose to save more and borrow
less.
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Decreased interest rates will have the opposite affect.
Imports and exports
Exports are injections, where payment goes back to the country where they were produced.
Imports are withdrawals, where money leaves the home economy as payment for goods.
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On the circular flow diagram exports and imports are shown like this:
Imports and exports go through the balance of payments.
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Definitions
Balance of payments
Looks at the value of imports and exports and the difference between them.
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The balance of payments is made up of three accounts: the current account, the capital
account and the financial account.
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business
Definitions
Reserve assets
These are assets held by the government in reserve, e.g. gold or foreign currency.
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Balancing item
The balance of payments is set up so that the sum of all three accounts is 0. This is achieved
by using the balancing item:
Current Ac. + Capital Ac. + Financial Ac. + Balancing item = 0
Balance of payments and economic growth
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A surplus in the balance of payments current account is an injection into the economy. A
deficit in the balance of payments current account is a withdrawal from the economy.
Imbalance in the current account
The balance of the current account depends on the amount of imports/exports.
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Definitions
Import penetration
The extent to which imports are increasing.
Export performance
The extent to which exports are being sold.
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Import performance is affected by a number of factors:
• Exchange rates make overseas products look cheaper
• Imports are more competitive on price, e.g. cheaper manufacturing processes/cost of
labour
• Imports are more competitive on non price factors, e.g. design, reliability, etc.
• Foreign producers are willing and able to export their goods
Export performance is affected by a number of factors:
• Exchange rates make domestic products appear cheaper
• Exports are more competitive on price
• Exports are more competitive on non price factors
• Domestic producers are willing and able to export their goods
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How governments manage the balance of payments
Do nothing If the exchange rate is allowed to move freely it is thought that
it will naturally move to correct any imbalances.
Actively affect Governments can buy and sell currencies to make exchange
exchange rates rates more favourable.
Trade barriers Governments can reduce imports through high tariffs and
quotas on imported goods.
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These techniques for managing the balance of payments also come under monetary policy.
Monetary policy includes:
• Changing interest rates
• Making borrowing and lending easier or harder
• Buying and selling currencies to change foreign exchange rates
• Imposing or removing trade barriers to make foreign trade easier or harder
We can add monetary policy to our model:
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Money
There are many different measures of money. The most important measures of money are:
• M0 – notes and coins in use and amounts within accounts held at the central bank,
e.g. the US Federal Reserve
• M4 – notes and coins within circulations and all private sector bank accounts (referred
to as broad money in the UK)
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Money supply and interest rates
Low money supply The government may reduce spending, leading to reduced
money supply. Less money in circulation means banks can
increase interest rates.
High money supply The government may increase spending, leading to
increased money supply. More money in circulation means
banks may have to decrease interest rates.
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Consumption
The level of injections and withdrawals will affect the level of consumption in the economy.
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Definitions
Consumption
The amount of goods and services demanded in the economy.
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The main factor affecting consumption is income level: as income increases, consumption
increases. The measure of this is called the marginal propensity to consume.
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Formula
Marginal propensity to consume
Change in consumption, (ΔC)
MPC =
Change in income (ΔY)
Δ = change in amount
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The MPC will generally rise as income rises – until the point where more consumption is not
needed or desired.
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Example
Marginal propensity to consume
Steve gets paid £400 per week. His bills are £280 so he has £120 disposable income.
Steve saves £20 and spends £100.
Steve gets a pay rise, so now he has £430 per week. His bills are the same but he now
has £150 disposable income. Steve now saves £30 and spends £120.
Steve’s MPC can be calculated as:
£20
MPC = = 0.6
£30
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Other factors affecting consumption:
• Previous income – some people will continue to consume at the same level as
previously even if their income increases
• Future income – some people will increase their consumption if they think their
income will increase in the future
• Windfall gains or losses – people may react differently to receiving/losing money
differently, e.g., some may spend, some may save
• Government policy – governments can use monetary policy or taxation/public
spending to encourage spending or saving
• Wealth – the wealthier an individual the higher their level of consumption is likely to
be
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Definitions
Wealth
The market value of all assets less any amounts owed.
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And finally...
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Stop!
By this stage you should know:
• The difference between micro and macroeconomics
• What the circular flow diagram is and what it depicts
• The difference between injections and withdrawals
• What monetary policy is
• How governments can impact saving, investments, imports and exports
• What the balance of payments is and how it operates
• How to calculate the MPC
Got it?
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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BA1 Fundamentals of business economics
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BA1 Fundamentals of business economics
BA1 10 Fiscal and Supply-side Policies
Circular flow review
The circular flow diagram shows how monetary policy can impact investments (injections),
savings (withdrawals) and the level of exports (injections) and imports (withdrawals).
The circular flow diagram so far:
• Money flows form households to businesses
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• The more money that flows, the greater the size of the economy
• Money removed from the circular flow is a withdrawal, e.g. savings or imports
• Money added to the circular flow is an injection, e.g. borrowing or exports
• Governments manage the economy by controlling withdrawals and injections
• Monetary policy involves controlling the economy using interest and exchange rates
Fiscal policy
The government uses taxes and public spending as withdrawals and injections into the
economy respectively. This is known as fiscal policy.
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Definitions
Fiscal policy
The management of the economy using government spending and tax.
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Managing the economy using fiscal policy:
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Growing the economy Slowing growth
Increase public spending, thereby Decrease public spending, thereby reducing
injecting money into the economy injections into the economy
Reduce taxation, thereby reducing Increase taxation, thereby increasing
withdrawals from the economy withdrawals from the economy
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Taxation
Taxation is used to raise funds for governments.
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The purposes of taxation
There are three main purposes of taxation:
• To allocate resources efficiently – e.g. to intervene in market failure
situations by funding merit goods, discouraging demerit goods and providing
public services
• To distribute income more evenly, or to meet certain needs – e.g.
unemployment pay
• To manage the economy – e.g. growing the economy through injections
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Taxes can be split into direct and indirect taxes.
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Definitions
Direct taxes
Taxes on people’s or an organisation’s earnings or increases in wealth
e.g. taxes on income (corporation tax, income tax)
e.g. taxes on capita gains (tax on gains made on the disposal of assets).
Indirect taxes
Those taxes which are imposed on one section of the economy, but it is intended that
the burden of paying the tax will be borne by another section of the economy.
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Indirect taxes may be known under different names around the world, but operate in
principally the same way.
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Business strategy issues
Ad valorem taxes E.g. VAT, Sales tax, where the tax is charged based on the value
of the transaction.
Unit taxes Expressed as a value in currency related to a specified number
of items sold, or weight of an item, e.g. tax on a packet of
cigarettes.
Excise duties Levied on the sale or use of certain products e.g. alcohol. Can
be either ad valorem or unit taxes.
Property taxes Levied on the sale or rent of property, or on transactions linked
to the sale of property, e.g. stamp duty in the UK is a tax on
the sale of commercial or private property.
Wealth taxes Charged as a percentage of an individual’s wealth annually.
Consumption taxes Taxes on the purchase value of a goods or services. They can
be single stage (levied only at one stage in the
production/sales process) or multistage (levied every time the
product is sold).
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Taxes can also be classed as being progressive, regressive and proportional.
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Example
Sales tax as a regressive tax
Say there is a sales tax of 10%. Bob earns £20,000 p.a. and spends all of it on essential
items. He pays £2,000 sales tax (10% of £20,000), which is 10% of his income.
Jill earns £200,000 p.a. but only spends £100,000 of it. She pays £10,000 sales tax (10%
of £100,000), which is 10% of her spending but only 5% of her total income.
As the person with the lower wage Bob is paying a greater proportion of his wage on
the tax it is a regressive tax.
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Fiscal policy positions
The difference between the amount received in tax and the amount paid in government
spending will determine the level of government borrowing.
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Definitions
Public sector net borrowing
The amount governments borrow to cover the shortfall between taxation revenue and
government spending.
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There are three fiscal positions: deficit, surplus and balanced budget.
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Definitions
Fiscal deficit
Where government spending is greater than taxation revenue. It is also known as a
budget deficit, or an expansionary fiscal policy.
Fiscal surplus
Where taxation revenue is greater than government spending.
Balanced budget
Where where taxation revenue is equal to government spending.
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There are both advantages and disadvantages to a fiscal deficit:
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Advantages Disadvantages
Increased growth in the economy as Higher interest rates as the government agrees to
injections > withdrawals pay higher rates of interest to encourage lenders,
resulting in generally higher interest rates
Higher interest payments as high borrowing leads
to larger interest payments in future
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Types of fiscal deficit
There are two types of budget deficit:
Cyclical
A deficit often arises when the economy is on a downward trend, as governments
spend more and taxation levels drop. It will be off set by a surplus during an upward
trend in the economy.
Structural
This arises from a more permanent imbalance in the budget and leads to an ever
growing national debt. Structural deficits can arise from:
• An ageing population – a large proportion of the population cannot work
and pay taxes, while health and social care costs rise
• Resistance to tax rises – policies to increase taxes are very unpopular
• Resistance to reducing public expenditure – especially if public spending is
concerned with merit goods such as healthcare an education
• Development of the economy – the government consciously increases
spending to invest in the economy
• Wage inflation – if wages rise public spending to healthcare and education
professionals will also rise
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A policy of fiscal surplus could lead to:
• A slowing of growth in the economy – injections < withdrawals
• Unemployment– if growth slows too much unemployment could rise
• Less investment – if the surplus is caused by reduced government spending this
could harm education, infrastructure, healthcare, etc.
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Why governments operate a fiscal surplus
Governments will operate a fiscal surplus to slow economic growth. They may also use
the funds gained in a fiscal surplus to pay back debt accrued during a fiscal deficit.
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A balanced budget occurs when:
• The government do not want to grow or slow growth of the economy
• The government is using monetary policy rather than fiscal to manage the economy
Supply-side policies
Governments have a budget, which is presented in a document (created by the minister in
charge of finance) that has been passed by law. It details revenue and expenditure.
Governments may choose to spend more or less to stimulate or slow growth in the economy.
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Definitions
Supply-side policy
Government spending designed to make the economy more efficient or productive
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Government spending supply-side policies:
• Spending on education – to create a more productive educated workforce
• Spending on the healthcare service – leading to a healthier workforce
• Spending on infrastructure – leading to increased efficiency in the economy
Other supply side policies involve encouraging competition and investment and
improving the effectiveness of labour.
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Policies to encourage competition
There is an accepted belief that competition increases efficiency. Supply-side policies
to encourage competition include:
• Privatisation – transferring state owned activities to the private sector to
encourage competition
• Deregulation – allowing private sector to compete with state owned
businesses
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Policies to encourage investment include:
• Decreasing business taxes – leading to increased profits which can be invested
• Providing tax relief and allowances – more funds are then available for investment
• Deregulating financial markets – allowing a greater provision of loans which can be
used for investment
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Policies to improve the effectiveness of labour
• Increase skills through provision of training
• Reduce the power of trade unions to avoid restrictive employment practices
and inflated wages
• Improve the incentive to hire by reducing the minimum wage and employment
protection
• Improve the incentive to work by reducing income tax
• Reduce the disincentives to work by reducing unemployment pay
• Provide childcare vouchers to encourage parents to work
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Other supply side policies include:
• Improving the transport and communications infrastructure
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• Encouraging research and development through government support programmes
• Reducing bureaucracy to encourage economic activity and new start ups, etc.
• Regional policies to overcome specific needs in certain areas of the country, e.g. to
support workers in a town where traditional industry has disappeared
Advantages and disadvantages of supply side policies:
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Advantages Disadvantages
Competitiveness increases leading to A long term solution which is unlikely to
improved overseas trade influence the economy in the short term
Less government influence leads to Some policies may be unpopular
greater choice
Less likely to cause inflation than Restriction of union rights may lead to
monetary or fiscal policy worker exploitation
Less likely to impact national debt Removal of minimum wages, social benefits
or employment protection leads to
uncertainty
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Government approaches to managing an economy
To summarise, the government has three approaches to managing an economy: monetary,
fiscal and supply side policy.
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There are several factors which affect the success of a government policy:
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And finally...
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Stop!
By this stage you should know:
• What fiscal and supply side policies are and how they can be implemented
• The different types of tax and whether they are regressive, progressive or
proportional
• What the different fiscal policy positions are
• The advantages and disadvantages of various fiscal policies
• Why supply side polices are implemented and what their downsides are
Got it?
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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BA1 11 The Trade Cycle
Circular flow review
The circular flow diagram so far:
• Money flows form households to businesses
• The more money that flows, the greater the size of the economy
• Money removed from the circular flow is a withdrawal, e.g. savings or imports
• Money added to the circular flow is an injection, e.g. borrowing or exports
• Governments manage the economy by controlling withdrawals and injections
• Monetary policy controls the economy using interest and exchange rates
• Fiscal policy controls the economy using government spending and tax
• Supply-side policy increases the efficiency of the economy itself
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Circular flow equilibrium
An economy is said to be in equilibrium when its injections equal its withdrawals. At this
point it is neither growing or declining.
Injections Withdrawals
Investment I Savings S
Government expenditure G = Taxation T
Exports X Imports M
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Formula
Circular flow equilibrium
I + G + X = S + T + M
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Example
Calculating the equilibrium
What is the value of taxation if the economy is in equilibrium and injections and
withdrawals were at the levels listed below?
Investment $10bn Exports $20bn
Government Expenditure $130bn Imports $30bn
Savings $60bn
Step 1: Find the total level of injections
I + G + X = Total injections
$10bn + $130bn + $20bn = $160bn
Step 2: Find the level of withdrawals already known
S + M = Withdrawals - Tax
$60bn + $30bn = $90bn
Step 3: Balance the withdrawals and injections
Total injections = Withdrawals - Tax
$160bn = $90bn - Tax
Tax = $70bn
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The accelerator
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Injections grow an economy by increasing demand. However, to be effective this increased
demand must be met by increased supply. If supply does not increase then excess demand
will cause inflation.
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Definitions
Inflation
High prices caused by excess demand forcing prices up.
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Ideally increasing demand will incentivise suppliers to invest to meet demand, leading to
increased supply. As an injection, investment also increases national income, stimulating
growth. Therefore growth stimulates growth.
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The accelerator
Investment creates a continuous stimulus for economic growth where the faster the
economy grows the faster growth becomes.
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The multiplier
An injection into the economy will likely increase growth in the economy by more than its
original value.
£20bn was originally injected into the economy, but £50bn (20bn + £15bn + £10bn +£5bn)
has been spent. This is what’s knows as the multiplier effect.
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Definitions
The multiplier effect
Injections into the economy increase growth by more than the value of the original
injection by all the subsequent times it is re-spent and re-spent.
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The multiplier effect can be accurately calculated using the marginal propensity to
consume (MPC).
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Definitions
The marginal propensity to consume (MPC)
The percentage of income earned that is typically re-spent.
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Formula
The multiplier
1
K =
1 - MPC
K = The multiplier
MPC = Marginal Propensity to Consume
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Example
Calculating the multiplier
On average people save 30% of their income, spending the rest. The government
spends £10m on a new road. What is the total increase in national income?
Step 1: Calculate the MPC
30% of income is saved, so 70% of income is spent.
MPC = (1 – 0.3)
MPC = 0.7
Step 2: Calculate the multiplier
1
K = = 3.33
1 – 0.7
Step 3: Multiply the multiplier by the original injection
£10m x 3.33 = £33.3m
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Governments use the multiplier to correctly design a policy to have the correct level of
stimulus for the economy and protect it from growing too quickly, which could lead to
inflation.
Trade cycle
The trade cycle is also known as the business cycle.
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Definitions
The trade cycle
Explains the sequence of growth and decline in national income in a given economy
when there is no government intervention.
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The trade cycle is made up of four periods following on from each other:
• Boom – period of rapid growth
• Recession – a slow-down in growth and then a decline
• Depression – growth reaches its lowest point
• Recovery – growth slowly increases
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Governments aim to reduce the size of the fluctuations in the trade cycle, speed up recovery
and avoid recession and depressions using monetary, fiscal and supply side policies, which
help keep the economy stable.
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The boom phase
During the phase:
• Capacity and labour are fully utilised
• Unemployment is very low
• Companies are profitable and optimistic about the future, fuelling investment
• Governments experience a budget surplus as tax revenues are high
At the end of the phase:
• Significant growth means supply cannot meet demand
• Excess demand leads to bottlenecks, shortages and inflation
• Imports rise as excess demand is satisfied with foreign goods
• Increasing imports means money leaves the circular flow
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Government policy at the end of the boom phase is to reduce aggregate demand.
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How aggregate demand is reduced
Raising taxation Resulting in lower disposable incomes, leading to a decrease
in spending.
Reducing public spending Thereby reducing an injection into the economy.
Raising interest rates Resulting in limited and expensive credit, leading to a
decrease in investment.
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NOTE: economies may experience the economic growth of a boom period without high
inflation if aggregate supply increases in line with aggregate demand.
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The recession and depression phases
• Demand begins to fall
• Revenues and profits start to fall
• Investors lose confidence and investment falls
• Low profits may mean unemployment rises
• Inflation begins to fall
• Governments may experience a budget deficit as tax revenues are low
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Government policy during recession and depression phases is to boost aggregate demand
How aggregate demand is boosted
Lowering taxation Resulting in higher disposable incomes, leading to an
increase in spending.
Increasing public spending Thereby increasing an injection into the economy.
Lowering interest rates Resulting in cheap and readily available credit, leading to an
increase in investment.
The government may also use suitable supply side policy in order to increase efficiency in the
economy.
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The recovery phase
• Demand begins to stabilise
• Investors gain confidence and investment rises
• Production and profits rise
• Increasing profits may mean employment rises
• Prices remain constant before rising slowly
• Governments may see budget deficits shrinking
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Government policy during the recovery phase is to boost aggregate demand. Governments
will encourage development, boosting aggregate demand and stimulating growth using
fiscal and monetary policies.
The trade cycle will effect some goods differently to others:
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Capital goods Will see large falls in demand during downturns as investment stalls,
but will see large rises in demand during upturns.
Necessities Will have a limited affect from the trade cycle, as people limit
spending elsewhere to continue to purchase these goods.
Non-essentials Will see large falls in demand during downturns as consumers
choose to delay purchases until economic conditions improve.
Goods sold to the May see a fall in demand if public spending is reduced, but will see a
public sector rise in demand if government expenditure increases.
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Employment
Governments often develop policies to increase employment.
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Definitions
Employment
The amount of people in work.
Full employment
Occurs when everyone that is willing and able to work is in work.
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Unemployment is measured as a percentage of the total workforce.
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Formula
Unemployment rate
Number unemployed
x 100%
Total workforce
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Why is unemployment a problem?
Unemployment can lead to the following issues:
• Output is below full capacity – a country is not maximising its potential
• Long term loss of labour – if skills are lost/forgotten during periods of
unemployment
• Increased welfare costs – those unemployed claim benefits
• Fall in tax revenue – those unemployed cannot pay taxes
• Potentially increased crime and civil unrest – as the gap between rich and poor
widens and poverty increases
• Falling national income – wages fall due to the excess supply in the workforce
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Types of unemployment
Cyclical Dependent on the position in the trade cycle – unemployment
rises during a recession.
Structural Changing industries in a country lead to rising unemployment.
Frictional Those currently in-between jobs.
Seasonal Employment in some industries increases or decreases depending
on the season.
Voluntary Workers choose not to work at the current wage rate.
Classical/ Real Wages are too high so businesses don’t employ more staff.
wage
Technological Workers are displaced by technology, e.g. banking automation.
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Inflation
Inflation is the general rising of prices over time. It can also be considered as a decline in the
purchasing value of money.
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Definitions
Purchasing value of money
The amount of goods which can be bought for one item of currency
e.g. When bread is 25p £1 buys 4 loaves. If the price of bread rises to 50p £1 buys 2
loaves. The purchasing value of money has halved.
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In the UK inflation is measured using RPI and CPI (though all countries have similar
measures):
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RPI Retail Prices Index Both based on the average Includes the direct and
prices of a typical basket of associated costs of housing
(pre-agreed) goods
CPI Consumer Price Does not include costs of
Index housing
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Why is inflation a problem?
Inflation can be a problem because:
• Standards of living fall – people can buy less with their money and the gap
between rich and poor widens
• Investment tends to stall – high prices lead to falling demand and decreasing
investment
• Affect on savings – the purchasing power of savings falls
• Affect on a country’s trading performance – e.g. high prices on domestic goods
will not sell well abroad
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Types of inflation
Demand-pull Demand is too high and so people put up prices, e.g. an
inflationary gap.
Cost-push Rising costs of raw materials push prices up. Costs may rise due to
increased taxes, movements in the exchange rate making imported
goods more expensive and shortages.
Wage-price Increasing wages leading to increased costs leading to increased
spiral prices, etc.
Stagflation A combination of a recession with high inflation.
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Example
1970s oil crisis
In the 1970’s a rise in the price of oil triggered a recession. Normally a recession sees
low inflation as aggregate demand is also low. However, rising oil prices caused
inflation to be high despite low aggregate demand.
This combination of a recession with high inflation is termed stagflation.
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Definitions
Inflationary gap
When aggregate demand exceeds aggregate supply leading to an increase in prices.
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Governments aim to keep economic growth stable at a relatively limited rate so inflation is
low too.
And finally...
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Stop!
By this stage you should know:
• What it means when an economy is at equilibrium
• How the accelerator works
• What the multiplier effect is and how it can be calculated
• The four stages of a trade cycle and government response to each phase
• The types of unemployment and inflation and why they can be a problem
Got it?
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If not, go back and re-read the study text before moving on.
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Question Time
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The Aggregate Supply and
BA1 12
Demand Model
Aggregate demand
Demand refers to the extent to which consumers are willing and able to purchase a good or
service over a set time period. Aggregate demand is simply the total of this.
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Definitions
Aggregate demand
The total demand of goods and services that consumers are willing and able to
purchase in a national economy during a specific time period
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Aggregate demand is inversely related to price: as price rises, demand falls, and vice versa.
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Elements of aggregate demand
Aggregate demand is made up of:
• Consumption (C) – the amount of goods and services required
• Investment (I) – amounts spent from banks and other intermediaries
• Government expenditure (G) – amounts spent by the government
• Exports (X) – the amount demanded by foreign countries
However, aggregate demand also takes in to account spending leaving the economy:
• Imports (M) – the amount demanded from foreign countries
Therefore:
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BA1 Fundamentals of business economics
AD = C + I + G + (X-M)
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Shifts along the demand curve
Shift along right If price falls from P1 to P the national income will fall from Y to Y1
Shift along left If prices rise from P to P1 the national income will fall from Y1 to Y
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Shifts of the demand curve
Shifts to the right A shift from aggregate demand to aggregate demand 1 means that
although national income increases there is no change in price
Shifts to the left A shift from aggregate demand 1 to aggregate demand means that
although national income decreases there is no change in price
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Factors affecting aggregate demand
• Economic conditions in other countries – increasing or decreasing exports
• Expectations about the future – fears for the future lead to increased savings
• Competitiveness in the export market – amounts spent by the government
• Government policy – the amount demanded by foreign countries
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Aggregate supply
Supply refers to the extent to which companies are willing and able to supply a good or
service at any given price over a set time period. Aggregate supply is the total of this.
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Definitions
Aggregate supply
The total supply of goods and services that firms in a national economy plan on selling
during a specific time period.
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Aggregate supply is positively related to price: as price rises, supply increases and vice versa.
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Shifts along the demand curve happen when there is a change in price or quantity.
The demand curve itself shifts when:
• There is a change in factors of production – e.g. lack of availability of staff pushing
the curve left, or the discovery of a new resource pushing the supply curve right
• There are changing costs – rising costs diminish profitability of the product, so
suppliers are incentivised to supply less and the supply curve shifts left
Limited by spare capacity and resources
In the long run aggregate supply is limited by spare capacity and resources. Once everyone in
the economy who is willing and able to work is employed or there is no more capital
available for investment supply will be at a maximum.
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Long run aggregate supply
The economy has reached full capacity at Yf.. All resources in the economy are fully
utilised and everyone who is willing and able to work is in employment.
At this point the supply curve becomes vertical, because any increase in price will not
result in a greater quantity supplied.
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Equilibrium
Equilibrium is reached where aggregate demand equals aggregate supply. This is often just
below full capacity.
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At the equilibrium point, aggregate demand = aggregate supply = national income (often
appears on the axis of aggregate demand and supply curves.
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Definitions
National income
The total amount of goods and services produced over the course of a year, which is
equal to the total amount earned by all people and businesses.
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When demand increases but the economy is already at full capacity an inflationary gap can
occur.
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Definitions
Inflationary gap
Aggregate demand exceeds aggregate supply leading to an increase in prices.
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• At P1 the level of demand Y1 is above that output achievable with full employment
• At Yf output cannot be increased so high demand causes prices to rise until P 2
• The rise in prices from P1 to P2 is known as the inflationary gap
The opposite of an inflationary gap is known as a deflationary gap.
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Definitions
Deflation
A general falling of prices over time.
Deflationary gap
Spare resources result in costs (e.g. unemployment benefit) and prices being low.
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• At P2 the level of demand Y1 is below the full employment output level
• At Y1 there are spare resources which result in the deflationary gap
• At Y1 governments may stimulate demand using fiscal and monetary policy
• Aggregate demand increases to aggregate demand 1 leading to increased prices
from P2 to P1
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• The government will decide if this inflation is offset by the growth in national income
and the reduction in unemployment
The aggregate supply curve can also shift right and left.
• A fall in costs pushes aggregate supply to aggregate supply 1
• In order to sell this increased level of supply (Y2) prices will need to fall from P1 to P2
• A shift of aggregate supply to the right in the long term increases national income
from Y1 to Y2, deflation and low unemployment
The opposite will also happen if costs rise, pushing aggregate supply 1 left to aggregate
supply.
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Economic growth
There are two main ways of measuring economic growth: GDP and GNP.
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Definitions
Gross Domestic Product – GDP
The value of the goods and services being produced within a country.
Gross National Product – GNP
Gross Domestic Product plus the net income received by residents from their overseas
investments.
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If GDP or GNP is rising over time the economy is growing. The opposite is also true.
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Growing an economy
The two main drivers of economic growth are:
• Increasing aggregate demand
• Increasing aggregate supply
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Factors driving economic growth include fiscal, monetary and supply side policy:
Fiscal policy Monetary policy Supply side policy
Lower taxes increase Lower interest rates to Reduce bureaucracy
disposable income and encourage borrowing and
encourage spending discourage saving Encourage competition
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Increase government Lower exchange rates to Enable research and
spending encourage sales of exports development to allow
and discourage purchase of innovation and technological
imports progress
Ensuring the supply of inputs
such as skilled labour and
natural resources
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Costs of economic growth
• Growth could be in ‘demerit’ goods or environmental damage
• There may be an unequal distribution of the gains from the economic growth,
leading to a widening gap between rich and poor
• Economic growth which does not match increasing population size will result
in excess demand and inflation, so economic growth may not be enjoyed by
whole population
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And finally...
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Stop!
By this stage you should know:
• How aggregate demand and supply differ from demand and supply
• The factors affecting aggregate demand and supply
• How aggregate supply changes over the short and long term
• What an inflationary or deflationary gap is and when it occurs
• The measures and costs of economic growth
Got it?
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If not, go back and re-read the study text before moving on.
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Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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BA1 13 Global trade
Globalisation and internationalisation
Globalisation and internationalisation covers different aspect of trade between countries.
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Definition
Internationalisation
The increasing activity within the international market by businesses
e.g. international trade or firms opening up new production facilities in other
countries.
Globalisation
This is similar to internationalisation, but also involves the uniformity of markets, tastes
and products sold across the world.
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Globalisation
This is similar to internationalisation, but also involves the following:
• Creation of a global single market through harmonising laws
• Homogenisation of tastes, e.g. regional foods being sold in the global market
• Same product sold globally
Benefits of international trade
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Benefits of international trade can be derived from companies, economies and consumers.
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International trade benefits
Greater choice of Consumers can buy products not readily available in their home
products markets, e.g. bananas sold in the UK.
Increased Competition will result in lower prices for consumers.
competition
Economies of scale Increased supply to cover international trade allows producers
(firms) to strike deals with suppliers, lowering production costs.
Economies of scale Lower production costs means firms can be passed on as lower
(consumers) prices, increasing consumers’ disposable income and, hence
standard of living.
Increased quality of In order to maintain market share, firms will have to maintain
goods and services the quality of their products.
Increased Producing more goods requires businesses to hire more people
employment to produce them.
Correct market Monopolies in one market will have to compete with
failures businesses in other markets, thereby correcting inefficiencies,
increasing choice reducing prices and improving quality.
Specialisation Countries can exploit unique natural resources and factors of
production, achieving a comparative advantage over other
countries, e.g. large volumes of low cost land in Canada.
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The drivers of international trade and globalisation
The drivers of international trade can be separated into four major areas:
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Disadvantages of international trade
Whilst international trade has its advantages, it also has its downsides.
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Disadvantages of international trade
Environmental damage Resulting from increased production and transportation.
May result in governmental restrictions.
Depletion of non- If international trade is high, non-renewable resources will
renewable resources quickly become depleted, e.g. oil and natural gas.
Distribution costs Advantages of specialisation may be outweighed by costs
of distributing goods to other markets.
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Unfair competition For example, ‘dumping’, where producers sell goods at an
unsustainably low price in order to price out the
competition.
Strategic industries Governments may want to protect key domestic industries,
e.g. water, food and energy.
Over-specialisation Over-reliance on specialisation could cause problems, e.g.
products become redundant or tastes change.
Sunrise industries are New industries in a country are sometimes unable to make
unprotected themselves competitive in the international market.
Sunset industries are Industries in decline may lose market share as a result of
unprotected competition. Failure of these industries can be significant if
they represent a major part of the economy.
Unemployment Can arise where one country has significant advantages
over another which makes their imports highly competitive,
e.g. through specialisation.
Over-dependence on This can result in difficulties arising from changes of
international trade political and economic circumstances.
Balance of payments If the value of goods imported exceeds goods
deficit exported the resulting outflow of money will lead to
a declining economy.
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These disadvantages may result in countries choosing to restrict trade.
Protectionism
Restricting trade is known as protectionism.
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Definition
Protectionism
The way that a country restricts trade with other countries, e.g. the US under the
presidency of Donald Trump.
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Types of protectionism
Tariffs Taxes charged on imports, e.g. a fixed charge on products or
an ad valorem tax based on the value of a product.
Quota Limits on the volume or value of imports of goods or services
over a given time.
VER (Voluntary Export Set by the exporting country at the request of the importing
Restraints) VERA or Export country to protect certain industries in the latter. Usually
Visas implemented due to a preference over tariffs or quotas.
Administrative costs/red Governments may choose to impose special certification
tape requirements, e.g. traceability documentation, that must be
reached by imports. May act as a barrier to trade.
Embargoes A total ban on a good being imported to a country, e.g. for
dangerous substances.
Subsidies Governments can provide subsidies to the domestic export
industry to aid competition in international market.
Public procurement Governments can choose to buy goods they require from
domestic markets in order to support domestic industries.
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Arguments against protectionism
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Trade agreements and trading blocs
Trade agreements enable the creation of a regional trade bloc where, at minimum, trade is
free between the entities involved. There are a number of different options:
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Let’s take each type of trading agreement in turn:
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Types of trading agreement
• Free trade areas – multi-lateral agreements which permit the free trade of
goods, services, capital and investment and do not have a common tariff
applied to countries outside the agreement
• Customs unions – similar to free trade areas, but impose a common external
tariff to imports from outside the union
• Single markets – a trade bloc where physical, technical and fiscal barriers have
been removed and that permits free movement of factors of production,
enterprise and services
• Economic union – a combination of a single market and a customs union,
allowing free trade within the bloc, but also applies a common external tariff. It
can have a common currency, which would make it a monetary union.
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There are multiple pros and cons to operating within a regional trading bloc:
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Pros
• Advantages of international trade – e.g. specialisation
• Support for countries in bloc – the level of trade between members states will
increase
• Low cost of imports – consumers benefit from low cost imports from within the
group
• Efficient for negotiations – negotiating trade agreements can be done as a single
bloc, rather than as individual countries
Cons
• Inefficiency – barriers to trade will protect less efficient producers within the bloc,
creating market distortions
• Retaliation – other country may form their own trade blocs to protect themselves
• Unsuitable trading policies – policies may not be suitable for all member states
Major institutions promoting global trade
Global institutions like the WTO create rules and a framework to guide and steer the
developments of globalisation.
General Agreement on Tariffs and Trade (GATT)
The GATT was formed in response to the Second World War, with the first talks being held in
1947. The agreement was signed by 23 countries in 1948. Its aims were:
• To reduce tariffs, quotas and subsidies which formed barriers to free trade
• To keep in place useful regulations on international trade
The GATT was replaced by the World Trade Organisation as a result of the Marrakesh
Agreement of April 1994.
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World Trade Organisation (WTO)
• Sets out global rules of trade between nations
• Ensures trade flows as smoothly, predictably and freely as possible
• Ensures implementation, administration and operation of relevant trade
agreements
• Provides forum for negotiation to enable settling of disputes
• Co-operates with the International Monetary Fund (IMF) and the International
Bank for Reconciliation and Development
• Reviews members’ trading policies – the biggest four (the EU, US, Japan and
Canada) are reviewed every two years
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The European Union (EU)
The EU was created via the Maastricht treaty in 1993 from its predecessor the European
Economic Community (EEC), which itself was established by the Treaty of Rome in 1957. The
original aims of the EEC were to:
• Reduce customs duties and create a customs union
• Create a single market for goods, labour, services and capital across the EEC’s
member states
• Implement a customs tariffs and commercial policy towards non-member states
• Common transport and agricultural policies
• Establishment of a European Social Fund focusing on improving employment
opportunities and promoting social inclusion
• Setting up the European Commission, a group overseeing policies and legislation in
the member countries
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Challenges faced by the EU since 2010
• The 2008 banking crisis put pressure on certain Eurozone countries, resulting
in economic uncertainty and high unemployment
• The UK’s vote to leave the EU in June 2016 causes need for a change in the
constitution
• Issues regarding the Influx of refugees and economic migrants into certain EU
countries
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There are two main features to the economic operations of the EU:
• Single currency zone – the euro is used by most countries in the EU with the aim of
encouraging free trade between member states
• European Central Bank – the central bank of the Eurozone which sets its monetary
policy, keeps inflation rates under control and designs and produces the notes and
coins of the single currency
The G8
A forum including Canada, Russia (suspended since 2014), Germany, Italy, the UK, Japan and
France. Its functions include:
• Each country taking it in turns to host the forum
• Using the forum as an opportunity to discuss issues relating to health, law
enforcement, the environment and trade
The G20
The G20 was established in 1999. It is similar to the G8, but:
• Comprises the 20 countries with the largest economies
• Has the aim of discussing, reviewing and promoting high-level discussions on policy
issues relating to international financial stability
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The impact of globalisation
The overall impact of globalisation will depend on the balance of positive and negative
outcomes at any one time.
Effect of IT
IT has had a particularly strong impact on global trade:
• Trade and communications between businesses have been made easier as a result of
the Internet
• Technology has allowed businesses to control global supply chains
• IT ultimately only benefits those businesses which have access to it, arguably leading
to a greater divide between richer and poorer countries
Off-shoring
Some businesses may choose to relocate to another country (off-shoring) in order to
compete in international markets.
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Benefits of off-shoring
• Avoid quotas and tariffs
• Cheaper production costs, e.g. lower labour costs or local natural resources
• Relocate to where a particular industry is concentrated and benefit from
economies of scale
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Off-shoring outcomes:
• Benefits of increased employment and wages in areas that attract business, with
possibly the opposite in other areas
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• Production can be allocated to areas where specific resources are abundant, although
this may lead to a depletion of the resource in the country
New markets
New markets become available when trade agreements are forged and as political
circumstances change. This can lead to:
• Businesses having the opportunity to sell their products and services in different
markets
• A reduction in the need to adapt products to a specific market
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Increased competition
Increased competition can lead to:
• Lower prices for consumers
• Greater choice for consumers
• Some domestic industries not being able to compete with international
businesses, meaning these industries decline causing greater unemployment
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Liberalisation of markets
The liberalisation of markets leads to:
• The removal of trade barriers
• The deregulation of worker and consumer rights, e.g. minimum wage requirements
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And finally...
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Stop!
By this stage you should know:
• What the difference is between internationalisation and globalisation
• The drivers of international trade
• How international trade works, its advantages and its disadvantages
• The different organisations involved in international trade
• The impact of globalisation
Got it?
If not, go back and re-read the study text before moving on.
business
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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Foreign Exchange Markets and
BA1 14
the Exchange Rate
The exchange rate
The international money market allows the trading of different currencies and operates using
the exchange rate.
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Definition
Exchange rate
Sets the amount of one currency needed to buy a unit of another.
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£1 : $1 In order to buy one £ you would need one $ and vice versa
£1 : $2 In order to buy one £ you would need two $s. In order to buy one $ you would need $
£0.50
Floating exchange rates
Exchange rates don’t always stay the same due to the effects of demand and supply.
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Definition
Floating exchange rate
A system where exchange rates are free to fluctuate.
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In these systems, any changes in demand or supply of the currency will result in a change in
the exchange rate.
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Changes in currency demand
Demand for currencies may increase or decrease:
An increase in demand for currency
• There has been an increase in demand from Demand 1 to Demand 2
• The increase in demand has caused price to rise from P1 to P2
A decrease in demand for currency
• There has been a decrease in demand from Demand 2 to Demand 1
• The increase in demand has caused price to fall from P2 to P1
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Activities affecting currency demand
Importing Importers need the currency of the country the imports are from
to pay for their orders.
Investing Investors need the currency of the country they are investing in.
Inflation Inflation may cause domestic goods to appear more expensive
and therefore less competitive internationally, so exports fall.
Speculation An expectation that the exchange rate is going to change leads to
increased demand for currencies whose value is rising.
Government Governments may buy and sell their own currency to manipulate
spending the exchange rate, also known as dirty floating.
Interest rates In the short run, high interest rates increase the demand for
currency as investors are drawn to take advantage of these rates.
These funds are also known as hot money. In the long term high
interest rates mean expensive borrowing and falling investment.
Internationally Some currencies are globally accepted, e.g. US$. Large companies
recognised may keep a supply of it in order to complete certain deals.
currencies
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Definition
Dirty floating
Where governments manipulate the exchange rate by buying or selling large
quantities of currency, or altering interest rates so the exchange rate is not allowed
to freely react to market conditions.
Hot money
Funds from investors which move as quickly as possible to take advantage of the
highest short-term interest rates.
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In order to demand one currency, another needs to be supplied. When a currency is sold, its
supply increases and vice versa:
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An increase in supply of currency
• There has been an increase in supply from Supply 1 to Supply 2
• The increase in supply has caused price to fall from P1 to P2
A decrease in supply of currency
• There has been a decrease in supply from Supply 2 to Supply 1
• The increase in supply has caused price to rise from P2 to P1
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Factors affecting currency supply
Trade In order to buy imports, supply of the domestic currency will be
high as currency is sold to buy from overseas
Government Governments may sell their own currency in order to lower the
Policy exchange rate to make their goods seems more competitive. This
is also known as dirty floating.
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The international currency market
International money markets allows the buying and selling of all things financial. These fall
into two categories, capital and currency, and are catered for by two different markets.
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Definition
International capital market
A market through which funds are provided for a variety of business and investor
needs
e.g. to borrow funds for buying new machinery.
International foreign exchange (Forex)
Central banks, banks, companies, investment companies etc. can buy and sell
currencies.
Central bank
The bank responsible for keeping inflation in control and designing and printing
money.
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The international capital market covers the Eurocurrency, Eurocredit and Eurobond
markets.
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Definition
Eurocurrency
Any currency held in banks outside of the country where it is legal tender, which is
borrowed and lent (the banks that undergo this activity make up the Eurocurrency
market).
Eurocredit market
Made up of the same banks that operate in the Eurocurrency market, but offering
longer-term loans than the Eurocurrency market.
Eurobond market
A group of financial institutions, large companies, government and supranational
institutions that issue Eurobonds.
Eurobond
Long term finance that typically covers a duration of 5-30 years (not necessarily based
in Europe or issued in Euros).
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The foreign exchange market sees around $4 trillion traded daily.
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Uses of the foreign exchange market
• To facilitate international trade
• Investment for which another currency is required due to the location or nature
of the investment
• Speculation, e.g. institutions making money out of the movements in the
exchange rate
• Financial institutions making investments on behalf of their clients in foreign
currencies
• Managing exchange rate risk, e.g. buying currency in advance of when it may
be needed when the exchange rate is favourable
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Government policy and the balance of payments
International trade impacts the balance of payments, often resulting in a balance of payments
surplus or deficit.
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Definition
Balance of payments surplus
When the value of exports is higher than the value of imports.
Balance of payments deficit
When the value of imports is higher than the value of exports.
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The government control the balance of payments using a number of methods:
• Do nothing
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• Devaluation
• Import controls
• Deflation
• Supply – side policies
Doing nothing:
Doing nothing can take a long time and is not guaranteed to correct a surplus in the balance
of payments so governments often intervene.
Devaluation
Governments will often intervene to correct an imbalance.
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Devaluation
Governments use two methods to devalue a currency:
• Selling domestic currency – increasing the supply reduces the value of the
currency
• Reducing short term interest rates – this decreases the demand, therefore
reducing the value of the currency
A devalued currency results in exports appearing cheaper abroad and imports
appearing more expensive, thus helping to correct a balance of payments deficit.
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Import controls
Governments may choose to reduce the amount of imports by introducing tariffs and
quotas.
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Definition
Tariffs
Taxes on imports and which raise the prices of imports and make them less attractive
hence reducing their demand.
Quotas
Set amounts restricting the amount of specific imports which can be bought, henc
reducing their demand.
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Deflation
With the help of the central bank, governments reduce the domestic demand for products by
reducing public spending or increasing interest rates to prompt deflation.
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Definition
Deflation
The general falling of prices over time.
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Lower prices encourage imports as overseas buyers can buy cheaply in the country and
discourage exports as domestic buyers can buy more cheaply at home than abroad.
Supply side policies
Supply side policies stimulate the economy so that production becomes more cost effective.
As competitiveness of exports and domestic products increases, the balance of payments
deficit decreases.
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Supply side policies
Supply-side policies include:
• Freeing up the markets
• Improving the flow, quality and availability of resources
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Problems with government policies
There are some major problems with both devaluing and deflating the economy.
Issues with devaluing a currency
Short term:
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• It often takes a while for purchasers and sellers to change their habits, so in in the
short term devaluation will have little impact
• Producers may not pass on benefits from the devaluation to customers
Long term:
• If the deficit occurs during a global recession devaluing the currency will not increase
demand for exports as demand is low globally
• If demand for imports or exports is inelastic they will not be affected by movements in
the exchange rate
• It does not promote efficiency as the increased competitiveness is created purely via
the exchange rate
• It does not stimulate investment by domestic producers, as the increased
competitiveness is created purely via the exchange rate
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Problems with deflation
• Reduced demand may lead to increased unemployment
• Increased unemployment – spare capacity due to falling demand and reduced
business confidence will result in lower investment
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Types of foreign exchange risk
There are three types of foreign exchange risk. The first is economic risk.
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Definition
Economic Risk
Refers to movements in the exchange rate which may result in increased or decreased
competitiveness of a company’s products in the long term.
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Example
English Company SE are trading with American Company RW.
In 20X1 the exchange rate was $1:£2.
Company SE purchased $1,000 worth of goods, spending £2,000 to purchase $1,000.
However, in 20X2 the exchange rate was $1:£2.5
Company SE must now spend £2,500 to purchase $1,000. This is too expensive, so
Company SE decides to move to another supplier.
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The second type of foreign exchange risk is translation risk.
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Definition
Translation Risk
An accounting concept relating to the value of assets held in foreign currencies.
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Changes in the exchange rate over time will change the value of assets when converted back
into the business’ home currency when reporting in the financial statements.
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Translation risks are usually mitigated by netting assets in that currency with borrowings in
that currency, hence reducing the net value to be translated back into the home currency.
The third type of foreign exchange risk is transaction risk.
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Definition
Transaction Risk
The risk that an exchange rate will change unfavourably over time.
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Transaction risk is associated with the time delay between entering into a contract and
settling it and then having to pay more than originally expected because rates have moved
unfavourably.
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Example
English company Carol’s Buns buys an oven from American company Phil’s ovens for
$15,000.
When the contract was signed the exchange rate was £1:$2 so Carol expected to pay
£7,500.
However, when the payment was required 2 months later the exchange rate was £1:$1.
Carol must now pay £15,000.
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It is possible to manage transaction risks using hedging techniques.
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Definition
Hedging
An investment which reduces or manages foreign exchange risk.
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There are two types of hedging: internal hedging and external hedging.
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Definition
Internal hedging
An investment which reduces or manages foreign exchange risk which can be done
within the company.
External hedging
An investment which reduces or manages foreign exchange risk using a range of
financial products from outside the organisation.
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Internal hedging techniques
Matching Receipts in one foreign currency are matched against
payments made in the same currency, reducing the
total amount that needs to be converted back into the
home currency. This reduces foreign exchange risk.
Lagging Paying amounts due later to match against funds to
be received in that currency, or in anticipation of
favourable exchange rate movements.
Leading Paying amounts due early using funds already
received in that currency or in anticipation of
unfavourable exchange rate movements.
Invoicing or paying in home Avoiding all currency risk by avoiding the need for
currency foreign exchange. This passes the risk on to customers
(or suppliers), who may see this unfavourably,
however.
Counter trading Where customers are also suppliers pay can be made
in goods and services.
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Netting inter-company A centralised treasury department can offset
transactions payments made between divisions or subsidiaries in
different countries (and hence use different currencies)
to keep the total amounts exchanged to a minimum.
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External hedging techniques
External hedging techniques fall into forwards and futures. We will firstly focus on forward
exchange contracts.
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Definition
Forward exchange contracts
A non-standardised contract between two parties to buy or sell a fixed amount of
foreign currency at a specified future time at a price agreed upon today.
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Other features of forward exchange contracts include:
• They are legally binding
• Any date can be set for exercising the contract but once agreed upon the date cannot
be changed
• Flexible in terms of amounts (any amount can be agreed)
• They are offered by banks
The forward price of a forward exchange contract is commonly contrasted with the spot
price.
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Definition
Spot price
The current exchange rate.
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The difference between the spot and the forward price is the forward premium or forward
discount.
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Example
Non currency example of forwards
Mr B decides to buy a house in 1 years time. Mr A wants to sell a house for $100,000 in
1 years time. Mr A and Mr B enter into a forward contract, agreeing to the sale price
of £104,000 in 1 year.
Currency example of forwards
Mr B lives in the USA but is buying a house in the UK. To mitigate the risk of paying
more than the agreed £104,000 in 1 year’s time (caused by fluctuations in the
exchange rate), he agrees the rate he will pay to convert from Mars Pennies to Jupiter
dollars now. He has entered into a forward foreign currency exchange transaction.
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Currency futures are another technique to manage foreign exchange risk.
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Definition
Currency future
A futures contract to exchange one currency for another at a specified date in the
future at a price (exchange rate) that is fixed on the purchase date.
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Futures and forwards differ in that future contracts are standardised amounts (e.g. €125,000)
which are traded on currency exchanges.
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How futures work
If a futures contract is held at the end of the last trading day, actual payments are
made in each currency. However this is rare, because investors tend to close out the
contract prior to the delivery date by selling it on the market.
Investors use futures contracts to hedge against foreign exchange risk. If an investor
will receive a cash flow denominated in a foreign currency on some future date, that
investor can lock in the current exchange rate by entering into an offsetting currency
futures position that expires on the date of the cash flow.
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Further notes on how futures work:
• They are controlled by an exchange (in US) which gives security that the other party
will abide by the contract
• There is a deposit required by exchange from both parties in the margin account
• Profits and losses in the margin account are adjusted daily
• Futures are always a standard size
• Maturity dates are fixed at end of March, June, September and December
PESTEL
PESTEL is a model which helps a business consider its threats and opportunities.
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These are six key areas in which to consider how current and future changes will affect the
business.
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Political How and to what degree a E.g. tax policy, labour law,
government intervenes in the environmental law, trade
economy. restrictions, tariffs, and political
stability.
Economic How economic factors may E.g. economic growth, interest
impact how a business operates rates, exchange rates and the
and makes decisions. inflation rate.
Social How the cultural and E.g. health, population growth
demographic aspects in the rate, age distribution, career
population may impact the attitudes and a society's
business. emphasis on safety.
Technological How changes in key E.g. IT, the internet, social
technologies in their industry can media, computer security,
be managed and adapted to. automation, and the rate of
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BA1 Fundamentals of business economics
technological change.
Environmental How environmental factors may E.g. weather and climate, the
especially affect industries such potential impacts of climate
as tourism, farming, and change, long term
insurance. environmental risks and short
term risks such as a natural
disaster.
Legal How legal factors may affect how E.g. discrimination law,
a company operates, its costs, consumer law, employment law,
and the demand for its products. and health and safety law.
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Example
A car manufacturer based in the UK:
Political
• As a major corporation the UK government will be interested in taxes being
paid and their role as a major employer
• Government subsidies may be available
Economic
• Worldwide economic position: the car market will reduce if there is a global
downturn
• Exchange rates will impact the value of currencies against the £
Social
• Social trends towards buying specific models of car, e.g. smaller models
• Changing needs in different countries
Technological
• New technologies which will be key to product development
• Investment in research and development will be important
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Environmental
• Environmental sustainability of models will become more and more important
• Increasing customer awareness and focus on sustainability and environmental
issues
Legal
• New laws on relevant issues such as safety and new technology
• International business that must adapt to different laws in different countries
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And finally...
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Stop!
By this stage you should know:
• How the exchange rate operates and enables international trade
• The key features on the international currency market
• Strategies used by governments to manage the balance of payments
• What the different types of foreign exchange risk are and how they can be
dealt with
• What PESTEL is and how it can be applied
Got it?
If not, go back and re-read the study text before moving on.
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Question Time
It's now time to practise questions.
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BA1 Fundamentals of business economics
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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BA1 Fundamentals of Business Economics
BA1 15 The Financial System
Fund requirements
There are a number of different sources of funds for businesses and organisations to use if
they need to borrow money.
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Factors affecting the sources used to borrow money
• The nature of the business, e.g. sole-trader, corporation or government
• The amount of money required
• The time period the money is need over
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Some businesses can rely on their own income, yet this is not possible for always possible
due to the unsynchronised nature of receipts and payments made.
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Business fund requirements
Businesses may need to seek additional, different types of funds at different times if the flow
and needs of the business don’t match.
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Types of fund available to businesses
Short term funds For example, an overdraft to cover the gap between a
payment and a receipt.
Medium term funds For example, hire purchase or leasing of assets, which
provides business with fixed amount paid at a specific time.
Long term funds For example, bank loans or share capital for capital
purchases and investments.
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The types of funding a business requires depends on the situation a business is in. There are
three ways to categorise the money needs of business:
• Working capital – day to day money needs, e.g. wages and raw materials
• Investment capital – money used to invest in things like machinery or acquisitions
and mergers
• Asset management function – creating a portfolio of long-term assets to include
any long term investment with any surpluses that arise
The financial system
The financial system covers all organisations and procedures that facilitate transactions
between investors, lenders and borrowers. It includes markets, institutions and products.
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Financial markets
Financial markets include:
• Money markets – for short-term borrowing, between overnight and a year in
duration. Used for liquidity needs relating to operation costs, e.g. employees’ wages
• Capital markets – where longer-term instruments like shares, bonds and other
investments are traded. These are split into primary and secondary markets
• Primary markets – where new financial instruments are sold, e.g. new shares and
bonds
• Secondary markets – where shares and bonds are subsequently traded, e.g. stock
markets like the London Stock Exchange
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• Foreign exchange markets – for buying and selling of foreign currency for payments
abroad.
• Commodity markets – for trading commodities, e.g. sugar, coffee and oil
• Insurance markets – sell policies protecting the purchaser against risk, e.g.
destruction of property by fire
Alongside these is the derivatives market, where derivatives are bought and sold.
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Definition
Derivative
An arrangement or product with a value derived from or dependent on the value of an
underlying asset, e.g. a commodity, currency or security.
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Financial institutions (financial intermediaries)
Financial institutions/intermediaries use one business or individual’s surplus funds which have
been deposited into it to fund another’s borrowing or deficit requirements, e.g. banks (retail
and investment), pension funds, building societies and insurance companies.
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Example
Company A is a small delivery company that wants to borrow some money to buy a
new delivery car. They might just be in luck, as Fred, who lives nearby, has just had a
big win betting on horses.
With more money than he knows what to do with, Fred decides to deposit it in the
local bank. The bank can now lend this money to Company A in the form of a loan,
which Company A quickly spends on a new delivery car!
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Financial instruments
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Financial intermediaries offer contracts to their clients through which they can offer funds.
These are known as financial instruments. A number of factors affect the type that is chosen.
Each financial market has different financial instruments available within it:
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Financial instruments available in money markets
Overdrafts Short-term funds provided by banks to cover a shortfall
between receipts and payments. Can be an expensive
form of credit.
Short-term bank loans Provided at a fixed value with the repayment period and
amounts agreed in advance, and carrying a rate of
interest.
Credit agreements Short-term, high-interest funding agreements where
something is held as collateral.
Leasing Long-term alternative to buying items outright with a
fixed sum monthly repayment.
Hire purchase Similar to leasing but ownership of item transfers to
buyer on last repayment.
Trade credit Delay of credit repayment which is effective in the short-
term but could have long-term repercussions, e.g.
customer confidence in business.
Commercial paper Unsecured short-term issued by large corporations for
significant sums, e.g. £100,000.
Bills of Exchange Issued between three and six months with varying risk
depending on the buyer. They are usually used in
international trade agreements.
Certificates of deposit Issued for a given deposit and for duration of between
three and six months at low risk with a specified date of
maturity and fixed interest rate. Access prior to the date
incurs a fine.
Businesstime
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Financial instruments in capital markets
Ordinary shares (equity) Companies issue these directly to investors or sold onto the
stock market to raise funds, e.g. Ltd companies in the UK can
sell shares direct to an investor.
Bonds Have a nominal value or a face value of an amount, a coupon
rate or rate of return and redemption terms or the value at
which it can be redeemed.
Mortgages A loan used to fund the purchase of property. Tend to have a
duration between 10 to 35 years and considered to be low
risk.
Mezzanine financing A hybrid of debt and equity finance. For example, debt is
taken out and the lender is entitled to an amount of share
capital equal to the debt if the borrower defaults. Considered
risk and high return.
Businesstime
businesstime
Bonds come in various forms
• Debentures – sold on money markets with a fixed interest rate by companies
instead of taking out a loan at a bank
• Loan stock – similar to debentures but shares are used as collateral, i.e. lender
can keep same value of shares if loan is not repaid
• Treasury Bills – issued by governments at a discount from the face value
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Instruments for smaller and newer businesses
Smaller and newer business face a disadvantage in money and capital markets, as not all
options for raising funds are available to them.
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Disadvantages of small/new businesses in money and capital markets
• Lack of business history – financial institutions may not feel confident in
lending money to them
• Lack of access to stock/bond markets – as a result of the rules governing
access to these markets
businesstime
However, governments are aware of this, so often to create specific instruments in response
to the issue.
businesstime
Example
The Alternative Investment Market in the UK is used by small businesses to make
shares available to the public.
Businesstime
And finally...
Stop!
By this stage you should know:
• What businesses consider when looking to acquire funds
• The different components of the financial system
• How financial institutions, markets and intermediaries operate
• The disadvantages faced by smaller businesses in financial markets
Got it?
If not, go back and re-read the study text before moving on.
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businesstime
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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Business
BA1 16 Financial intermediaries
Business
Types of intermediaries
Business
There are many financial intermediaries, one way to categorise them is based on whether
they take deposits from customers or not.
Business
Taking these in turn:
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Banks
Involved with accepting deposits from customers, lending funds and selling a variety of
financial services, e.g. mortgage and travel insurance. They are closely regulated in many
countries.
However, not all banks are the same:
Business
Business
Business
Looking more closely at the above options:
Investment banks
Banks involved in large and complicated transactions such as mergers, reorganisations or
providing financial advice to companies issuing shares or bonds. e.g. Warburgs and Goldman
Sachs
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BA1 Fundamentals of Business Economics
Retail banks
“High street” banks involved in taking deposits from customers and lending out funds.
Products offered include:
• Current accounts
• Savings accounts
• Mortgages
• Personal loans
• Participation in loan guarantee schemes
• Overdrafts
• Certificates of deposit
• Accepting Bills of Exchange
• Providing financial advice and market information
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Wholesale banks
Banks dealing primarily with financial institutions and large businesses. The products that
they provide include:
• Currency conversion
• Working capital financing
• Underwriting a new shares issue
• Supervising a take over through the stock market
• Large trade transactions
• Negotiating Bills of Exchange
• Borrowing and lending money between banks
• Helping clients to manage their money
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However, not all banks fit into these categories. There are also other examples of financial
intermediaries:
Business
Other types of financial intermediary
Discount houses/bill These are not banks and are specific to the UK. They are
brokers dedicated to buying, selling, discounting, or negotiating
bills of exchange or promissory notes
Building societies Similar to banks, but are owned by the customers who
deposit funds
Investment/unit Used to invest deposits in a range of company shares
trusts/mutual funds
Pension funds Enable contributions to a scheme that allows individuals
to withdraw money in the form of a pension at some
point in the future
Insurance A fixed sum is paid by the customer for an insurance
companies policy against a specific event occurring e.g. a burglary or
a car accident. Should the event happen, an agreed
amount is paid out
Leasing companies Provide capital equipment to businesses over a
prearranged term in return for a fixed regular payment
Factoring companies Companies that buy accounts receivable from a business
at a discount on the face value
businesstime
However, all these different types of bank need to make money themselves.
Business Business
Credit creation
Business
Banks make money through lending money however, they need to take into account the cash
ratio; the ratio of cash or liquid assets to deposits held by a bank.
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businesstime
Definition
111
Cash ratio
The ratio of cash or liquid assets to the deposits held by the bank. Maybe set down as
part of the regulatory system for the banks in any particular country.
businesstime
The amount to be retained by the bank is calculated by using this formula:
businesstime
Formula
Cash ratio amount to be retained by banks
Cash ratio amount = Amount deposited x 10%
retained by banks
businesstime
The amount that can be lent out is calculated using this formula:
businesstime
Formula
Cash able to be lent out by banks
Cash to be lent = Amount deposited - Retained cash ratio amount
out by banks
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Business
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Example
£2000 is deposited into a bank account. The cash ratio operated by the bank was 10%.
This would be written in the formula above as follows:
1 x £2000 = £200
10
This £200 is then subtracted from the deposit to give the amount the bank can lend
out, i.e.£1800.
businesstime s s
The maximum amount of money that could be created from an initial loan can be calculated
using this formula:
businesstime
Formula
Change in total deposits
1
Change in total deposits = x The initial cash deposit
Cash ratio
businesstime
The increase in the amount of cash seen in this example shows the credit multiplier effect in
action.
businesstime
Definition
Credit multiplier effect
The increase in credit, and therefore money supply, occurring from an original deposit
as a result of the cash ratio.
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BA1 Fundamentals of Business Economics
businesstime
The two factors which determine the credit multiplier effect are:
• The value of the deposits into the banks
• The cash ratio required to be held
The Government can encourage more money in the economy, and hence economic growth,
by loosening the rules they have on credit creation. They can tighten those rules to limit
growth.
Business
Government funds and the central bank
Business
Governments, like business, require funds to operate.
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As the receipts may not necessarily match the payments, governments may need financial
intermediaries to assist with the surpluses and deficits which arise. They will tend to use a
central bank. The central bank acts as the bank for both other banks and the government.
The banks’ bank
Usually, all banks must keep an account at the central bank for these reasons:
• Clearing – to allow for the transfers which have to be made from one bank to another
• Cash reserve – banks use the central bank as a reserve in an emergency, “Lender of
the last resort” i.e. if the bank gets into financial difficulties
The government’s bank
The central bank also acts as the Government’s bank:
• Account holder – holds the accounts of various government departments
• Debt management – organises the redemption of old debt, e.g. treasury bills and the
issuing of new debt
• Foreign currency reserves – holds reserves of foreign currency to facilitate global
activity and also buys and sells domestic currency to reduce fluctuations in the
exchange rate
• Supervisor for the banking system – the central bank enforces regulations on other
banks within a country
• Notes and coins – issues notes and coins
• Lender of the last resort – lends money to banks unable to fulfil their obligations
• Monetary policy – responsible for controlling the key instruments of monetary policy
Monetary policy concerns affecting the size of the money supply in the economy. The central
bank can do this in several ways:
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BA1 Fundamentals of Business Economics
The central bank and monetary policy
Options for affecting the money supply are:
• Buying and selling treasury bills – buying bills increases the money supply,
selling them decreases it
• Changing market interest rates – e.g. the central bank can offer to buy
bonds from other banks at a higher interest rate, this is then passed on
through an increased rate on their own loans to their customers
• Changing the capital adequacy ratio – this is the ratio of capital that a bank
has to have and is linked to the risk related to the assets that it holds. A higher
ratio means less funds available to lend
• Quantitative easing – when interest rates are low the central bank ‘creates’
money electronically which it uses to buy bonds
Supervisor for the banking system
Central banks regulate other banks through their liquidity and their capital adequacy.
businesstime
Definition
Liquidity
The speed at which a bank can turn something into cash to meet customer demand
businesstimebusinesstime
The central bank ensures that other banks are keeping enough cash in order to meet
customer demand, while also keeping enough in reserve through the capital adequacy ratio if
losses are made or debts go bad.
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And finally...
businesstime
Stop!
By this stage you should know:
• The different types of financial intermediaries
• The different types of banks
• How credit is created by banks
• The role and functions of central banks
Got it?
If not, go back and re-read the study text before moving on.
businesstime
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
Business
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BA1 Fundamentals of Business Economics
Financial Markets and
BA1 17
Instruments
Business
Types of financial markets
Business
Firms often choose to raise equity finance to support their business goals.
businesstime
Definition
Equity finance
The process of raising capital through the sale of shares in an enterprise. Equity
financing essentially refers to the sale of an ownership interest to raise funds for
business purposes.
businesstime
Capital markets are where shares, bonds and other investments are traded. These can be
further categorised as primary and secondary markets.
businesstime
Definitions
Primary market
Deals with the issuing of new shares and bonds.
Secondary market
Buys and sells previously owned shares.
businesstime
Business
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Ways of issuing shares in the primary market
• Private placing – shares issued only to financial institutions, or private clients
of banks
• Offers for sale – the business sells its shares to a bank who then take on the
risks involved with selling them to investors
• Public issue – where an invitation to purchase shares is issued to the public
using prospectuses
• Rights issue – where existing shareholders are given the right to buy
additional shares, usually at a price below the stock market to encourage
investors
businesstime
A firm is valued according to the total market price of all their shares, which is termed the
market capitalisation of a firm. The current price of shares will also determine how
successful a future sale will be e.g. high price attracts buyers.
There are three main financial instruments traded in the capital markets:
• Ordinary shares – also known as equities, allow shareholders to ‘own’ part of the
company, granting them voting rights at board meetings and a share of the profits
called dividends
• Preference shares – pay a set dividend prior to consideration of the ordinary share
dividend, but do not include voting rights
• Company bond/debenture holders – a type of loan in which the shareholder does
not own any part of the company
Other places where companies can raise funds are money markets.
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Definition
Money markets
Where short-term borrowing and lending occur (usually under 12-months). They are
designed for large transactions between financial institutions and companies or
governments.
businesstime
Calculating the return on financial instruments
BusiBusinessness
Shareholders receive returns in the form of dividends. When this return is expressed as a
percentage it is known as dividend yield and calculated as:
BusinesBusinesss
Formula
Returns on equity
Dividend paid per share
Dividend yield = x 100%
Market price of the share
Note that both the numerator and denominator should be expressed in the same
units
BusineBusinessss
This is the only formula for working out equity returns, but bond returns require three
formulas:
• The bill rate
• The running rate or interest yield
• The gross redemption yield
Taking these in turn:
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BA1 Fundamentals of Business Economics
Bill rate
The bill rate is the equivalent of the coupon rate. Using this the yield will be:
businesstime
Formula
Yield using the bill rate
Yield = Bond value x Coupon rate
businesstime
However, using the bill rate does not take into account the market price of bonds.
Running yield
This method takes into account the market value of a bond:
businesstime
Formula
Running yield
Interest (Coupon rate)
Running yield = x 100%
Market value
businesstime
The issue with this method is that it fails to take into account the gain in market value.
Gross redemption yield
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BA1 Fundamentals of Business Economics
The gross redemption yield is the best estimate as it takes into account both the market price
and any gains in value before the bond is sold.
businesstime
Gross redemption yield
The investor can compare the result of this calculation to their required yield, the
interest rate and the level of risk being undertaken to make their decision whether to
invest.
businesstime
Risk
This affects the rate of return and market price of bonds. Any investor will have a certain rate
of return in mind based on the perceived level of risk they are taking on. This is therefore the
required value of their net dividend yield:
businesstime
Formula
Net dividend yield
Annual dividend
Net dividend yield = x 100%
Market value
businesstime
Rearranging the formula, means the required market value, given this required return, can be
calculated:
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BA1 Fundamentals of Business Economics
Formula
Market value
Annual x 100%
Market dividend
=
value Net dividend yield
businesstime
Through this formula, the effects of risk can be seen as:
• The higher the perceived risk, the lower the market price will fall so as to maintain the
yield
• The lower the perceived risk, the higher the market price will be
Business
Business
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BA1 Fundamentals of Business Economics
Therefore, yields are important to investors. As time passes, investors increasingly want a
higher return.
Graphically this relationship is shown as:
Business
Business
This kind of relationship can also be seen to hold for loans and interest rates. A loan over a
long period will have a higher interest rate than one over a shorter period.
businesstime
Example
A company wanting to borrow £100,000 over a 20 year period would pay a higher
interest rate on a loan over the whole period, than if they took out two consecutive
loans covering 10 years each.
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However, companies offering loans may not always follow this rule:
Loans and their relationship with interest rates
Loans with high fixed
Guarantees return, used when market price is falling
interest rates
Loans with arrangement Size of arrangement fees could mean any savings due to low
fees interest rates are offset
Mitigating risk
Risk is significant in determining the market price of a company, so businesses use credit
rating agencies.
businesstime Business
Definition
Credit rating agencies
Organisations which provide some indication of how likely a company will default on
their debt.
businesstime Business
The rating is calculated taking into account:
• The ratio of debts to assets
• The size and strength of a company’s cash flow
• The stability of a company’s asset value (the more stable, the lower the risk)
• How long a debt is scheduled to be outstanding (the longer the duration, the higher
the risk)
Business
The rating can be used to determine the level of return the businesses will need as
compensation.
Companies can also charge a credit ‘spread’ as a method of mitigating risk.
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businesstime
Definition
Credit spread
An amount charged over and above the rate of a government bond; the no risk rate.
This amount acts as compensation for the unknown risk an investor is taking.
No-risk rate
The rate charged on bonds is considered to be the ‘no risk’ rate as governments
always pay back their debts.
businesstime
Companies with low risk, e.g. with high assets, high profits and in a stable condition, will
have a low spread, while high risk companies will have a high spread.
The final yield on a corporate bond can therefore be calculated by using this formula:
BusiBusinessness
Formula
Yield on a corporate bond
Yield on corporate = Yield on + spread
bond government
bond
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Interest rates
Business Business
Interest rates grant some yield to a company without the risk of investing in shares.
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Definition
Base rate
The rate around which all interest rates are set and used by central banks to determine
the rates at which they lend money to companies.
businesstime
The interest rate given by banks does not always take into account inflation.
businesstime
Definition
Nominal return rate
Rates often advertised by banks which do not factor in inflation.
businesstime
However, the nominal return rate does not always accurately reflect the real returns from
interest as it does not take into account the inflation rate.
businesstime
Definition
Inflation rate
The general rise in prices over the course of the year.
businesstime
Taking the inflation rate into account gives the real interest rate.
businesstime
Example
A 5% interest rate during a period when inflation is running at 4% would give a 1%
real interest rate.
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Interest rate risk
BusinBusinessess
When borrowing money, companies can hedge the risk posed by a rise in interest rates
between now and when they need it.
BusinesBusinesss
Definition
Hedging
When companies take action to reduce risk.
BuBusinesssiness
There are four types of interest rate hedge:
• Forward rate agreement – a contract between two parties that determines the rate
of interest paid or received on an obligation beginning in the future
• Interest rate guarantees – an option on a forward rate agreement or FRA that allows
a company to have the option of taking out an FRA in the future for an up-front fee
• Interest rate futures – similar to an FRA as it fixes a future rate of interest, but unlike
an FRA it is an exchange traded agreement, i.e. traded on an exchange
• Interest rate options – grants the buyer the right, but not the obligation, to deal in
interest rate futures, is exchange-traded, and a premium is payable
Business
And finally...
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Stop!
By this stage you should know:
• The different types of financial markets
• How to calculate the return on financial instruments
• The way interest rates work
• How companies can mitigate the risk on their interest
Got it?
If not, go back and re-read the study text before moving on.
businesstime
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
234
BA1 Fundamentals of Business Economics
Discounting and Investment
BA1 18
Appraisal
Choosing how to invest
Investment decisions can be made using three techniques: NPV, IRR and ROCE.
businesstime
Definition
Net Present Value – NPV
Gives a return in terms of cashflows generated by a project.
Internal Rate of Return – IRR
Provides a percentage return figure.
Return on Capital Employed – ROCE
Compares a company's capital with its earnings.
businesstime
This chapter only focusses on IRR and NPV.
The time value of money
Money in the present has a greater value than money in the future:
• In one year not as much can be purchased with the same funds due to inflation
• In one year funds could have earned interest
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• Returns due to be received earlier are more certain and less risky than returns in the
future
businesstime
Definition
Inflation
The general rising of prices over time.
businesstime
There are two ways we can calculate interest: as simple interest and compound interest.
businesstime
Definition
Simple interest
Considers how much was earned on the original amount (known as the principal).
Compound interest
Considers how much is earned, taking in to consideration each addition of the simple
interest to the principal.
businesstime
There is a formula which can be used to quickly calculate simple interest.
businesstime
Formula
Simple interest
V = P +(r x P x n)
V = The value of the investment at the end of the particular time period in question
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P = The amount invested
r = The rate of interest
n = The amount of years it is invested for
businesstime
Example
Simple interest
What is the simple interest be on a £300 investment after 5 years if the interest rate is
10%?
V = £300 + (0.1 x 300 x 5)
V = £450
businesstime
Compound interest can also be also be calculated using a formula.
businesstime
Formula
Compound interest
V = P (1 + r) n
V = The value of the investment at the end of the particular time period in question
P = The amount invested
r = The rate of interest
n = The amount of years it is invested for
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BA1 Fundamentals of Business Economics
Example
Compound interest
What is the compound interest be on a £300 investment after 5 years if the interest
rate is 10%?
V = £300 (1 + 0.1)5
V = £300 x 1.61051
V = £483.15
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Annualised interest rates
It is possible you may be given an interest rate which is given over a time period of less than
a year. It is important that these rates are annualised or the calculations made will be
incorrect.
businesstime
Formula
Annualised interest rates
x
Annualised interest rate = (1 + Period rate)
X = The number of periods in a year
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BA1 Fundamentals of Business Economics
Example
Annualised interest rate
What is the interest be on a £300 investment after one year if the interest rate is 10%,
paid in two 5% instalments after every 6 months?
Annualised interest rate = (1 + 0.05)2
Annualised interest rate = 1.1025
Therefore, the interest after 1 year is:
£300 x 1.1025 = £330.75
businesstime
To avoid confusion for the consumer interest rates are usually quoted as APR (Annual
Percentage Rate).
Terminal values
Sometimes money is invested more than once into a bank account. We must then calculate
the terminal value, considering the time for which each different deposit has been earning
interest.
businesstime
Example
Terminal values
Start of year 1: £300 End of year 1: £200
End of year 2: £200 End of year 3: £100
If the interest rate is 10%, what is the value of the investment at the end of the fourth
year?
We must think of each deposited amount separately.
Step 1: Calculate the interest earned on the initial deposit
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BA1 Fundamentals of Business Economics
V = P (1 + r) n
V = 300 (1 + 0.1)4
V = £439.23
Step 2: Calculate the interest earned on the deposit at the end of year 1
V = 200 (1 + 0.1)3
V = £266.20
Step 3: Calculate the interest earned on the deposit at the end of year 2
V = 200 (1 + 0.1)2
V = £242
Step 4: Calculate the interest earned on the deposit at the end of year 3
V = 100 (1 + 0.1)
V = £110
Step 5: Add it all together
£439.23 + £266.20 + £242 + £110 = £1,057.43
businesstime
Another type of investment which involves adding to the deposit is called a sinking fund.
businesstime
Definition
Sinking fund
Investments where a given amount is put in every year, usually used to pay off a debt
or replace a specific asset.
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Example
Sinking funds
Machine J costs £60,000 and must be replaced in 5 years time. If the interest rate is 6%
and the deposits every year must be equal, how much must be invested?
V = P (1 + r) n
Step 1: Find the calculation needed
We are looking for P, the amount invested. Our calculation will therefore be:
£60,000 = P (1 + 0.06)5 + P (1 + 0.06)4 + P (1 + 0.06)3 + P (1 + 0.06)2+ P (1 + 0.06)1
Step 2: Take P outside the brackets and simplify
£60,000 = P (1.065 + 1.064 + 1.063 + 1.062 + 1.061)
Step 3: Calculate the brackets
£60,000 = P (5.975)
Step 4: Divide the target amount by P
£60,000
=P
5.975
Answer:
£10,041.84 = P
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Discounting
Deciding which investment opportunity is difficult when the investments operate on different
time schemes. To accurately calculate the returns on an investment we must use discounting.
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Definition
Discounting
Converting all future values of an investment opportunity into their current values so
that they can be easily compared.
businesstime
Discounting involves calculating how much the future returns would be worth now.
businesstime
Example
Discounting
Investment A promises a return of $300 in 3 years time.
Investment B promises to pay $350 in 4 years time.
If Ms J wants to make a 6% return on her investments (called a discount rate) which
investment is best?
Investment A
V = P (1 + r) n
$300 = P (1 + 0.06)3
$300 = 1.191P
$252 = P
So $300 in 3 years time is worth $252 in the present.
Investment B
$350 = P (1 + 0.06)4
$350 = 1.262P
$277 = P
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So $350 in 4 years time is worth $277 in the present. Therefore investment B is the
best.
businesstime
This method of calculating present and future values can become confusing, however.
Therefore, the present value is usually calculated using a different formula.
businesstime
Formula
Present value
F
P = F x (1+r) -n or P=
(1 + r) n
P = Present Values
F = Future Values
r = the rate of interest
n = the amount of years it is invested for
businesstime
Note: the discount factor in the above formula is represented by (1 + r) -n
The exam
Discount factor tables will be given to you in the exam. For example, the discount rates at 6%
has been highlighted below.
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Net Present Value
The net present value of a project shows whether the project is worth doing or not using the
cashflows generated by a project.
businesstime
Definition
Net Present Value (NPV)
Calculates an organisation’s change in wealth if it undertakes a particular project.
Positive NPV
An increase in the total value of the company from doing the project.
Negative NPV
A decrease in total value of the company from doing the project.
businesstime
If there are two projects with positive NPVs, the one with the highest NPV should be chosen
Assumptions which are made when using NPV:
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BA1 Fundamentals of Business Economics
• Cash outflows or inflows that occur during any particular year are all treated as if they
occurred at the end of that financial year
• If you are specifically told that a cash outflow or inflow occurs at the start of a year,
include it as the end of the previous year
businesstime
Example
NPV
ABC Ltd have an opportunity to buy Machine D for £8,000. Machine D would produce
a positive annual return to profits of £1,500 for 4 years, when it would be scrapped for
£600.
What is the NPV of the machine if the discount rate is 6%?
Step 1: Calculate the cash flow for Year 0
There is a negative cash flow in year 0 as the Machine A as it costs £8,000.
As year 0 is in the present the present value of Machine A is £8,000.
Time period Cash flow Discount factor Present value
£ @ 6% £
0 (8,000) 1.000 (8,000)
Step 2: Calculate the cash flow for Year 1
Machine D creates a positive cash flow of £1,500 for four years. However, £1,500 in
one year is not worth the same value in the present, so the discount factor is required.
(1+r) -n
(1 + 0.06) -1 = 0.943
To find the present value the formula is :
P = F x (1+r) -n
P = £1,500 x 0.943
P = £1,415
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BA1 Fundamentals of Business Economics
Time period Cash flow Discount factor Present value
£ @ 6% £
0 (8,000) 1.000 (8,000)
1 1,500 0.943 1,415
Step 3: Calculate the cash flows for Years 2 – 4
Time period Cash flow Discount factor Present value
£ @ 6% £
0 (8,000) 1.000 (8,000)
1 1,500 0.943 1,415
2 1,500 0.890 1,335
3 1,500 0.840 1,260
4 1,500 0.792 1,188
Step 4: Find the final positive cash flow from Machine D
After 4 years the new mixer will be sold for scrap at £600 so the present value of £600
in 4 years time must also be considered.
Time period Cash flow Discount factor Present value
£ @ 6% £
0 (8,000) 1.000 (8,000)
1 1,500 0.943 1,415
2 1,500 0.890 1,335
3 1,500 0.840 1,260
4 1,500 0.792 1,188
4 600 0.792 485
Step 5: Add all the present values together to find the net present value
NPV = -£8,000 + £1,415 + £1,335 + £1,260 + £1,188 + £485 = -£2,317
As the NPV is negative ABC Ltd should not go ahead with this project.
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Benefits of NPV Negative of NPV
It takes into account the time value of money. The discount rate cannot be guaranteed
as future rates may change, hence NPV is
The final result gives the increased worth of just an estimate.
the business.
The assumption that all cash inflow and
outflows occur at the end of a period adds
some inaccuracies.
The returns may not be accurately
predictable.
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Annuity
Investors may also choose to invest in an annuity.
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Definition
Annuity
A financial instrument purchased for an initial sum which then pays out the same
amount each and every year
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An annuity will continue to pay out until:
• The owner of the policy dies
• The specified fixed period of time comes to an end
• An even related to the policy occurs (like the holder retiring)
The value of annuities can be calculated using the cumulative discount factor formula.
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Formula
Cumulative discount factor formula
1 1
r ( 1-
(1+r)n )
r = The rate of interest
n = The amount of years it is invested for
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Example
Annuities
Annuity A will pay out £4,000 each year for 12 years.
Annuity B will pay out £3,200 each year for 20 years.
The initial purchase price of both annuities is is the same and both will continue even
in the case of death. If the rate of interest is 7% which annuity is best?
Annuity A
1 1
=
r ( 1-
(1+r)n )
1 1
=
0.07 ( 1-
(1+0.07)12 )
1
= 14.29
( 1-
2.252 )
= 14.29 (1 -0.556)
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= 7.945
We multiply this 'cumulative discount rate’ by the amount paid to find the NPV of
annuity A:
= £4,000 x 7.945
= £31,780
Annuity B
1 1
=
0.07 ( 1-
(1+0.07)20 )
1
= 14.29
( 1-
3.870 )
= 14.29 (1 -0.258)
= 10.59
We multiply this 'cumulative discount rate’ by the amount paid to find the NPV of
annuity B:
= £3,200 x 10.59
= £33,888
Therefore, as £33,888 is larger than £31,780, Annuity B is the best option.
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Perpetuities
A perpetuity is similar to an annuity, but it is much simpler to calculate its value.
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Definition
Perpetuity
A financial instrument purchased for an initial sum which then pays out the same
amount each and every year, with no end date.
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Formula
The discount rate for a perpetuity
1
r
r = the rate of interest
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Example
Perpetuity
A perpetuity pays out $4,000 per year. Assuming an interest rate of 7%, what is the
present value of the perpetuity?
1
= 14.286
0.07
Therefore the NPV is:
$4,000 x 14.286 = $57,144
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Internal rate of return
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One final method for analysing the value of a project is using the internal rate of return.
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Definition
Internal rate of return
Provides the discount rate at which the net present value of all cash flows from a
project is 0.
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The discount rate is otherwise known as the cost of capital; it reflects the returns demanded
by shareholders on a project.
If the IRR is above the current cost of capital then returns are higher than those required by
shareholders.
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Formula
Internal Rate of Return
NVPa
IRR = A + X (B - A)
NVPa - NVPb
A = The NPV for the project at a chosen cost of capital
B = A chosen NPV, higher or lower than A
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Although the formula for calculating NVP may look confusing the procedure is quite simple:
• Calculate an NPV for the project at a cost of capital that you choose (often 10% is a
good starting point)
• Calculate a second NPV value using a different cost of capital
• Complete the calculation using the formula
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Example
Internal rate of return
ABC Ltd are considering opening a second shop. The shop will cost £600,000.
Revenue projections for this project show the following positive net cashflows over 5
years
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
£000 £000 £000 £000 £000 £000
Net Cash Flow 105 117 120 150 180
It is forecast that the second shop could be sold for £525,000 after 5 years. The current
estimated cost of capital for the project is 12%.
What is the IRR?
Step 1: Calculate the NVP for this project (NVPa)
Firstly add the cost of the initial investment and estimate resale value to the table:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
£000 £000 £000 £000 £000 £000
Capital Expenditure (600)
Net Cash Flow 105 117 120 150 180
Sale of Business 525
Next find the discount factors for years 0 – 5 using the formula:
(1 +r) -n
For year one the discount factor is
(1 +0.12) -1 = 0.893
We can now add the discount factors to the table:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
£000 £000 £000 £000 £000 £000
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BA1 Fundamentals of Business Economics
Capital Expenditure (600)
Revenue 105 117 120 150 180
Sale of Business 525
Net Cash Flow (600) 105 117 120 150 705
Discount Factor (12%) 1.000 0.893 0.797 0.712 0.636 0.567
Multiply the cash flows by the discount rate to find the present value. Then add all the
present values together to find the net present value.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
£000 £000 £000 £000 £000 £000
Capital Expenditure (600)
Revenue 105 117 120 150 180
Sale of Business 525
Net Cash Flow (600) 105 117 120 150 705
Discount Factor (12%) 1.000 0.893 0.797 0.712 0.636 0.567
Present Value (600.00) 93.77 93.25 85.44 95.40 399.74
Net Present Value 167.60
Step 2: Calculate the NVP using a different cost of capital (NVPb
As the NPV at 12% was positive, we should now choose a second cost of capital that is
higher than 12%. Let's choose 20%.
Calculate NPV at 20% in the same way as before:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
£000 £000 £000 £000 £000 £000
Capital Expenditure (600)
Revenue 105 117 120 150 180
Sale of Business 525
Net Cash Flow (600) 105 117 120 150 705
Discount Factor (20%) 1.00 0.83 0.69 0.58 0.48 0.40
Present Value (600) 87.47 81.20 69.48 72.30 283.41
Net Present Value (6.15)
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BA1 Fundamentals of Business Economics
Step 3: Put the results into the IRR calculation
NPVa
IRR = A+ x (B-A)
NPVa - NPVb
A: 12% NPVa: 167.5
B: 20% NPVb: -6.15
167.6
IRR = 0.12 + x (0.20 – 0.12)
167.6 + 6.15
167.6
IRR = 0.12 + x 0.08
173.75
IRR = 0.12 + 0.96 x 0.08
IRR = 0.12 + 0.0768
IRR = 0.1968
The IRR on this project is therefore 0.1968 or 19.68%
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Advantages of the IRR Disadvantages of the IRR
It takes into account of the time value of As it is a % measure, it is not suitable for
money. choosing between projects of different
sizes.
It gives a percentage measure that is easily
understandable to both financial and non- NPV is considered the superior tool for
financial managers. project assessment as it relates directly to
the increasing (or reducing) wealth of the
There is no need to know an exact cost of business.
capital.
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BA1 Fundamentals of Business Economics
And finally...
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Stop!
By this stage you should know:
• What the time value of money is and how it affects values in the future
• How to calculate simple and compound interest
• What a sinking fund is and how to calculate deposits
• Why discounting is useful and how to use it
• How to calculate NPV and IRR
• What the various advantages and disadvantages are for using NPV and IRR
Got it?
If not, go back and re-read the study text before moving on.
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Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
Business
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BA1 Fundamentals of Business Economics
BA1 19 Data and information
Business
Data and information
Business
Data is an important for businesses in decision-making and communications and helps them
to plan for the future.
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Definition
Data
The initial input of raw facts and figures.
Information
Data which has been processed and converted into meaningful output.
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Information can either be internal or external:
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Definition
Internal information
Information that can be found within the business itself, e.g. profits/losses figures and
staff availability information.
External information
Contextual information that concerns the business, e.g. the disposable income of
those living in the area where a business operates and customer lifestyle or preference
information.
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BA1 Fundamentals of Business Economics
External information can be unreliable as the processing or collection of data by outside
reporters may not always be of a good standard.
Business
Types of data
Business
Data can be both quantitative and qualitative.
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Definition
Quantitative data
Data that is measurable numerically and is objective, hence more reliable, e.g. sales.
Qualitative information
Data that is based on experiences and opinions and is subjective, hence potentially
less reliable, e.g. customer feedback.
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Most companies operate a combined approach using quantitative and qualitative data. Data
can also be categorised as either primary or secondary data:
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Definition
Primary data
Data obtained for a specific purpose through original research conducted by the
business itself.
Secondary data
Data obtained by a business from external sources.
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BA1 Fundamentals of Business Economics
Using each type of data has its own pros and cons:
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Pros and cons of primary and secondary data
Pros Cons
Primary Collected for specific Reliability depends on staff skills
data purpose
Expensive to produce
Secondary Cost-effective Information too generic
data
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There are also other ways to classify data:
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Definition
Adhoc data
Data required for a specific issue, e.g. whether to stock a particular product.
Continuous data
Collected and analysed continuously by a business, e.g. weekly sales.
Business
Despite all these different types of data, it is important that businesses source good data and
information in order for it to be worthwhile.
What makes good data/good information?
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BA1 Fundamentals of Business Economics
It is important for businesses to receive good quality information.
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Characteristics of good quality information
Reliable Facts and statistics derived from a trusted source.
Relevant Information directly related to the industry/business and its
decisions.
Clear Information can be easily read and is well-presented.
Accurate Statistics that are correct, but also expressed in the most
appropriate way.
Targeted Information that is delivered to the right person at the right
time.
Cost-efficient Usefulness of information in changing business processes
should outweigh monetary cost of sourcing it.
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A key part of what makes good quality information and data is where it comes from.
Sources
Business
There are a variety of sources of both internal and external information:
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Sources of internal information
Financial information Information used on an accounting system, e.g. cash books
and sales ledgers
Management information Gathered from internal sources, e.g. production reports
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BA1 Fundamentals of Business Economics
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Sources of external information
Business contacts Information obtained through customers and suppliers e.g.
product availability, competitor information and feedback
Trade associations Information obtained through trade journals, e.g. regarding
technological changes, new materials or legal information
News media Information obtained through media sources e.g. economic
forecasts and social trends
Government Information obtained through Government sources, e.g. current
gross national product or unemployment rates
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Big data
Business
Businesses are often required to use big data.
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Definition
Big data
Information which is too large to analyse or interpret using standard reporting
facilities.
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The value of big data is that it:
• Allows information to be drawn from large amounts of different data as opposed to
separate sets
• Big data has the potential for almost universal application
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BA1 Fundamentals of Business Economics
Example
Hospitals use big data to monitor patient details and determine potential re-
admission rates. If this is likely to be high they can take action to resolve issues, saving
time and money further down the line.
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The size of big data means businesses must take issues such as cost of storage and
protection of privacy into account.
In 2001, Gartner developed the Three Vs outlining the challenges of using big data:
• Volume – the increasing amount of data being processed means it is harder to
extract key information
• Velocity – the increasing speed of data in and out means it can quickly change.
Analysis therefore need to be quick to spot and react to the latest change
• Variety – the range of types and sources of data makes analysis difficult, e.g. data on
different IT systems in an organisation cannot be easily brought together to analyse
linkages
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Definition
Gartner’s formal definition of big data
High volume, high velocity, and/or high variety information that requires new forms of
processing which enable advanced decision-making, insight discovery, and process
optimisation.
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There are seven stages to the big data process:
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BA1 Fundamentals of Business Economics
Business
Using Big data can provide a competitive advantage through:
• Production of improved products
• Ensuring stock levels are correct
• Better targetting of marketing campaigns
• Effective pricing strategies
It also has the advantage of being able to be collected from sources such as social media.
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BA1 Fundamentals of Business Economics
Graphs
Data can be converted into graphs to make information more accessible. One such graph is
the bar chart which comes in three distinct types; single, multiple and component.
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Example
A shop selling apple pies, steak pies and chicken pies wants to record its sales revenue
over the course of three months. It uses a single bar chart, a multiple bar chart and a
component bar chart to express its results.
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Single bar chart
10000
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
Month 1 Month 2 Month 3
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BA1 Fundamentals of Business Economics
Pros:
• Simplest, e.g. all that is needed are values for the x and y axes
• Clear overview of subject being measured, e.g. value of sales per month
Cons:
• Lacks detail, e.g. in above which products did well or badly?
Multiple bar chart
##
Pros:
• Separate bar for each product – highlights areas of success and concern allowing the
latter to be investigated and corrective action undertaken
• Can be rearranged to show performance of one item over the total period –
highlights patterns or consistencies
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BA1 Fundamentals of Business Economics
Cons:
• No overall total - to get total sales each month the total for each column above
would need to be added together
Component bar chart (or compound bar chart)
Pros:
• Can see the total value and the breakdown per component e.g. total pie sales and
sales per type of pie per month
• Can represent the Y axis value as a percentage providing better insight as to
composition e.g. percentage component chart
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Percentage component chart
Business
Pie charts
Pie charts present information as a circle which represents 100% of the overall quantity. They
are split proportionally into segments representing each component’s value.
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Pros:
• Can see the extent to which an element has contributed to the total
• Provides a clear overview
Cons:
• Doesn’t show trends e.g. can see total sales for each pie for a three month period but
not the up or down trend
• Information will require further analysis to be useful
Scatter diagrams
Scatter diagrams are useful in showing the connection between two pieces of data.
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Example
A shop manager creates a scatter graph to show the correlation or connection
between the number of rainy days and umbrella sales. The scatter graph shows there
was an increase in umbrella sales when the number of rainy days was over 60.
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The correlation between pieces of data expressed on a scatter diagram is found by drawing a
line of best fit:
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The more points are on or near the line of best fit, the better the correlation. This correlation
can be either positive or negative:
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Definitions
Positive correlation
When both variables are increasing together.
Negative correlation
When one variable is increasing while the other decreases.
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Histograms
Histograms look similar to bar charts as they both represent data using bars:
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BA1 Fundamentals of Business Economics
Business
The height of each bar of the histogram is proportional to the frequency, i.e. the variable on
the y axis while the width of each bar is proportional to the class interval, i.e. the variable on
the x axis.
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Example
The histogram above shows that 6 children in a class were between 113 and 116cm
tall.
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Ogives
Ogive graphs plot the cumulative frequency of data on the y axis and interval or group size
on the x axis. They record the running total of a data set, e.g. the number of children in a
class and their heights.
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BA1 Fundamentals of Business Economics
Business
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Example
The ogive above shows that 25 children in the class had a height of 125cm or less.
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BA1 Fundamentals of Business Economics
And Finally…
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Stop!
By this stage you should know:
• The role of data and information in a business
• The different sources of data/information and how effective they are
• The role of ‘big data’ and its strengths and weaknesses
• How data/information is expressed through graphs
Got it?
If not, go back and re-read the study text before moving on.
businesstime
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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BA1 Fundamentals of Business Economics
BA1 20 Data Coefficients
Correlation coefficient
The line of best fit shows how strong a correlation is between variables.
It is possible to accurately calculate how close a correlation is using a correlation coefficient,
sometimes known as Pearson’s correlation coefficient.
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Definition
Pearson’s correlation coefficient
Calculates how close a correlation is between two variables.
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Formula
Pearson’s correlation coefficient
(n∑xy) - (∑x∑y)
r=
√(n∑x - (∑x)2) (n∑y2 - (∑y)2)
2
x = Variable 1
y = Variable 2
∑ = The sum of
n = The number of data entries of each variable
r = The correlation coefficient
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BA1 Fundamentals of Business Economics
Example
Pearson’s correlation coefficient
Find Pearson’s correlation coefficient for the following data:
X Y
No of units Total costs
(000s) (000s)
2 21
1.5 19.5
3 24
2.5 23.2
3.5 25.5
2.2 22.2
14.7 135.4
Step 1: Calculate all the required numbers for Pearson’s correlation coefficient
X Y XY X2 Y2
No of units Total costs (000s) (000s) (000s)
(000s) (000s)
2 21 42,000 4,000 441,000
1.5 19.5 29,250 2,250 380,250
3 24 72,000 9,000 576,000
2.5 23.2 58,000 6,250 538,240
3.5 25.5 89,250 12,250 650,250
2.2 22.2 48,840 4,840 492,840
14.7 135.4 339,340 38,590 3,078,580
Step 2: Put these numbers into the correlation coefficient formula
(6 x 339,340) – (14.7 x 135.4)
r=
√(6 x 38,590) – (14.7)2) (6 x 3,078,580 – (135.4)2)
2,036,040 – 1,990.38
r=
√(231,540 – 216.09) (18,471,480 – 18,333.16)
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BA1 Fundamentals of Business Economics
2,034,049.62
r=
√(231,323.91) (18,453,146.84)
2,034,049.62
r=
√4,268,654,079,000
2,034,049.62
r=
2,066,072.138
r= 0.985
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Understanding the correlation coefficient
Value of r Meaning Looks like
1 Perfect positive correlation All points on the line of best fit. Line slopes up from
bottom left to top right.
-1 Perfect negative correlation All points on the line of best fit. Line slopes down from
top let to bottom right.
0 No correlation Points all over the place and no best fit line is possible.
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The correlation coefficient can only ever be between -1 and 1. In these instances, we need to
look at how close it is to these figures to decide how close or not the correlation is.
Coefficient of determination
The coefficient of determination is an additional calculation that takes the minus out of the
correlation coefficient.
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BA1 Fundamentals of Business Economics
Definition
Coefficient of determination
Calculates the proportion to which a change in Y is determined by a change in X.
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Understanding the coefficient of determination
Value Description Meaning
1 Perfect correlation The change in Y value was solely down to the change
in the X value.
0 No correlation The change of the X value had nothing to do with the
change in Y value.
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Formula
Coefficient of determination
r2
r = The correlation coefficient
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BA1 Fundamentals of Business Economics
Example
Coefficient of determination
Find the coefficient of determination if the correlation coefficient is 0.987
Coefficient of determination = r2
r = 0.987
r2 = 0.974
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Rank correlation coefficient
The rank correlation coefficient may also be known as Spearman's rank correlation
coefficient.
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Definition
Spearman's rank correlation coefficient
Determines the correlation (if any) between the rankings of two distributions.
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BA1 Fundamentals of Business Economics
Formula
Spearman's rank correlation coefficient
6∑d2
RS = 1 -
n(n2 - 1)
RS = Spearman's rank correlation coefficient
n = The number of points in the data
d = The difference between rankings
∑ = The sum of
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Example
Spearman's rank correlation coefficient
Calculate Spearman's rank correlation coefficient for the following data:
Employee Productivity Happiness
ranking ranking
Jane 2nd 5th
Mary 10th 8th
Luke 3rd 4th
James 7th 6th
Sophie 1st 3rd
Tim 5th 1st
Martin 8th 9th
Susan 4th 2nd
Becky 6th 10th
Ben 9th 7th
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BA1 Fundamentals of Business Economics
Step 1: Find the difference between rankings (d), d2 and the sum of d2
Employee Productivity Happiness Difference d2
ranking ranking between
rankings
Jane 2nd 5th 3 9
Mary 10th 8th 2 4
Luke 3rd 4th 1 1
James 7th 6th 1 1
Sophie 1st 3rd 2 4
Tim 5th 1st 4 16
Martin 8th 9th 1 1
th nd
Susan 4 2 2 4
th th
Becky 6 10 4 16
th th
Ben 9 7 2 4
Total = 78
Step 2: Insert numbers into the formula
6 x 78
RS = 1 -
10 (100 - 1)
468
RS = 1 -
990
RS = 1 - 0.473
RS = 0.527
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The closer to 1 the Spearman's rank correlation coefficient is the better the correlation.
Correlation and relationship
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BA1 Fundamentals of Business Economics
Correlation does not always signify relationship; correlation could be due to a third hidden
factor.
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Example
Hidden factors
The following assumptions have been made:
• Intelligent parents will tend to produce intelligent children
• Intelligent parents tend to provide their children with music lessons
If music lesson provision was plotted against intelligence in children there may be a
strong correlation.
However, there is no direct link here: the music lessons are not causing the
intelligence. The strong correlation is between intelligent parents choosing to provide
music lessons. This is the hidden factor.
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Of course, unrelated variables may correlate by chance, known as spurious correlation.
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Definition
Spurious correlation
Where two unrelated variables coincidentally have the same trend pattern, e.g.
marmalade consumption and which country wins the Eurovision Song contest having
the same trend pattern.
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When using correlation calculations it is important to verify the connection, as taking a very
small narrow or otherwise skewed sample of data can result in inaccurate results:
• What is the likelihood that the variables are influencing each other?
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BA1 Fundamentals of Business Economics
• Was the data sample used skewed or narrow?
You must also beware of extrapolating, as this may also result in inaccuracies.
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Definition
Extrapolating
Making assumptions about results outside of the set of data.
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And finally...
Stop!
By this stage you should know:
• How to calculate the correlation coefficient, coefficient of determination and
rank correlation of coefficient
• The various uses for coefficients
• How to interpret the results of the correlation coefficient, coefficient of
determination and rank correlation of coefficient
• What the difference is between correlation and relationship
Got it?
If not, go back and re-read the study text before moving on.
Question Time
It's now time to practise questions.
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BA1 Fundamentals of Business Economics
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
284
BA1 Fundamentals of Business Economics
BA1 21 Trends, forecasts and patterns
Introduction
One of the challenges with forecasting is that variables rarely move in a perfectly uniform
manner over time. There are several causes of these variations over time.
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Business strategy issues
Long term trend – T The underlying direction and quantity of change over the
long term, e.g. house prices in the UK from 1995 – 2005
rose around 14% per annum.
Seasonal variations – S Short term trends and fluctuations, e.g. sales of surfboards
are higher in the summer.
Cyclical variations – C Variations which happen over a much longer period than
seasonal variations – often over many years, e.g. recurring
periods of recession in the US every 10 years or so.
Random variations – R Random and impossible to forecast fluctuations and
trends, e.g. a natural disaster which has a heavy impact on
profits.
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BA1 Fundamentals of Business Economics
Example
Causes of variation
Riya has been asked to predict the 20X6 results using the figures for the last few years:
Time Period £m
20X3 Winter 14
20X3 Spring 23
20X3 Summer 36
20X3 Autumn 25
20X4 Winter 18
20X4 Spring 27
20X4 Summer 40
20X4 Autumn 29
20X5 Winter 22
20X5 Spring 31
20X5 Summer 44
20X5 Autumn 33
Although there is no obvious pattern, patterns do start to emerge when considering
the different variations over time:
• There is an overall long term trend of increasing £m
• There is a seasonal variation of steadily increasing £m between seasons
Note: Riya can largely ignore cyclical variations as they occur over too long a period.
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Time series analysis
Data may have both long term trends and seasonal variations. Time series analysis can be
used to forecast a variable in the future.
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Definition
Time series analysis
Involves the analysis of past observations in order to forecast a variable into a future
period.
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Time series analysis can be used to forecast a seasonal variation into the future.
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The steps of time series analysis
• Find the trend
• Calculate the seasonal variation
• Forecast the next year of numbers
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The simplest way to find the trend is to plot observations on a graph and draw a “line of best
fit”:
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The seasonal variation may be calculated using the either the additive model or
multiplicative model.
Model Use cases How does it look
Additive model Used when seasonal variations The gap above and below the
are fixed amounts. trendline remains constant over
time. See above.
Multiplicative Used when seasonal variations The gap above and below the
model are a percentage amount. trendline is always getting bigger
and bigger over time. See below.
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Forecasting on a graph
To forecast using graph simply extend the graph, using the same patterns found in
previous periods, as shown below.
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Adjusting the trend line
Time series analysis begins with finding a trend (T) and then adjusting that trend line for the
seasonal (S), cyclical (C) and random (R) variations using the additive model or the
multiplicative model.
The additive model assumes variations to be a constant amount.
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Formula
Additive model
Y=T+S+C+R
Y = Income
T = Long term trend
S = Seasonal variation
C = Cyclical variation
R = Random variation
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Example
Additive model
A sales revenue of £690,000 may be contributed to by:
Trend (T) £600,000
Cyclical variation (C) (£70,000)
Seasonal variation (S) £130,000
Random variation (R) £30,000
Y = 600,000 -70,000 + 130,000 + 30,000
Y = £690,000
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The multiplicative model assumes the seasonal variation to be a constant proportion.
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Formula
Multiplicative model
Y=TxSxCxR
Y = Income
T = Long term trend
S = Seasonal variation
C = Cyclical variation
R = Random variation
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Example
Multiplicative model
A sales revenue of £690,000 may be contributed to by:
Trend (T) £600,000
Cyclical variation (C) 0.975
Seasonal variation (S) 1.126
Random variation (R) 1.047
Y = 600,000 x 0.975 x 1.126 x 1.047
Y = £690,000 (approximately)
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The multiplicative and additive models also require different methods to calculate the
adjusted value.
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Formula
Calculating the adjusted value using the multiplicative model
Actual value
Adjusted value =
Seasonal component
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Example
Calculating the seasonal component using the multiplicative model
The sales figure is £600,000. The revised figures after a seasonal adjustment using the
multiplicative model is £540,000. What is the seasonal component?
Actual value
Adjusted value =
Seasonal component
Rearranged:
Actual value
Seasonal component =
Adjusted value
600,000
Seasonal component =
540,000
Seasonal component = 1.111
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However, when using the additive model adjusted value is calculated differently.
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Formula
Calculating the adjusted value using the additive model
Adjusted Value = Trend + Seasonal component
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Example
Calculating the seasonal component using the additive model
The sales figure is £600,000. The revised figures after a seasonal adjustment using the
additive model is £550,000. What is the seasonal component?
Adjusted Value = Trend + Seasonal component
540,000 = 600,000 + Seasonal component
- 60,000 = Seasonal component
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Sales may also follow a trend represented by an equation, which can be used to forecast
future sales figures.
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Example
Forecasting future sales figures using a sales equation
Sales follow a trend represented by the equation y = 100 + 25x
Where y = sales and x = the quarter number
The actual unit sales for the period are as follows:
Period Units sold
Quarter 1 135
Quarter 2 165
Quarter 3 150
Quarter 4 190
Forecast the future sales figures for both an additive and multiplicative variation.
Step 1: Calculate the trend
Quarter 1 sales:
y = 100 + 25x
y = 100 + 25 x 1
y = 125
Period Units sold Trend
Q1 135 125
Q2 165 150
Q3 150 175
Q4 190 200
Step 2: Calculate the seasonal variations using an additive variation
Additive variations are expressed in a lump sum figure. They are calculated by finding
the difference between the trend and the actual sales.
e.g. the additive variation for Q1 is 135 - 125 = 10
Period Units sold Trend Additive variation
Q1 135 125 10
Q2 165 150 15
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Q3 150 175 (25)
Q4 190 200 (10)
Step 3: Forecast sales using an additive variation
The trend for quarters 5 to 8 is forecast using the equation y = 100 + 25x
Quarter 5 sales:
y = 100 + 25x
y = 100 + 25 x 5
y = 225
Period Trend
Q5 225
Q6 250
Q7 275
Q8 300
Adjust the trend for the seasonal variations by adding on the variation amounts
Period Trend Additive variation Forecast sales
Q5 225 10 235
Q6 250 15 265
Q7 275 (25) 250
Q8 300 (10) 290
Step 4: Calculate the seasonal variations using a multiplicative variation
Multiplicative variations are expressed as a percentage They are calculated as a
percentage difference between the trend and the actual figures.
e.g. the multiplicative variation for Q1 is 8%.
The difference between the trend and the actual sales in quarter 1 is +10 units
By dividing 10 by the expected sales of 125, we find a percentage difference of +8%.
Period Units sold Trend Multiplicative variation
Q1 135 125 8.00%
Q2 165 150 10.00%
Q3 150 175 (14.29%)
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Q4 190 200 (5.00%)
Step 5: Forecast sales using a multiplicative variation
The trend for quarters 5 to 8 is forecast using the equation y = 100 + 25x, as before.
The forecast figures are calculated by taking the trending sales figures and adding a
percentage of sales as a seasonal variation.
e.g. The multiplicative seasonal variation for quarter 5 is 8%, so forecast sales are
calculated as 225 + (8% x 225), which amounts to 243 units.
Period Trend Multiplicative variation Forecast sales
Q5 225 8.00% 243
Q6 250 10.00% 275
Q7 275 (14.29%) 236
Q8 300 (5.00%) 285
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Generally the multiplicative model is seen to be the superior option as seasonal variations
tend to increase or decrease in line with the movement of the trend:
• It is unlikely that sales will increase by exactly 10 units during the Q1 every single year
as suggested by the additive model
• It is likely that the increase in first quarter sales will go up as sales increase as
suggested by the multiplicative model
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Example
Calculating the trend given the actual sales and the seasonal variation
Using the data given below, what is the trend?
Period Actual units sold Multiplicative seasonal variation
Q1 135 8.00%
Q2 165 10.00%
Q3 150 -14.29%
Q4 190 -5.00%
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Step 1: Express the multiplicative seasonal variation as a decimal
Actual units Multiplicative Seasonal variation
Period sold seasonal variation as a decimal
Q1 135 8.00% 1.08
Q2 165 10.00% 1.10
Q3 150 -14.29% 0.8571
Q4 190 -5.00% 0.95
Step 2: Use the additive model formula to calculate the trend
Y = T x S
Rearranged:
Y
T =
S
So the trend figures are:
135
Q1 T = = 125
1.08
165
Q2 T = = 150
1.10
150
Q3 T = = 175
0.8571
190
Q4 T = = 200
0.95
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Forecasting a trend line using linear regression
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The line of best fit is incredibly important when making forecasts, as it shows the trend of
data over time. Considering the data below, it would be much easier to read and understand
the correlation if there were a trendline.
The most accurate method to find the trend line is to use the least square method.
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Formula
Finding the linear trendline using the least squares method
T = a +bt
T = trend
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a = where the trend line cuts the vertical axis at time 0
b = increase (or decrease) in one time period
t = time period
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It is possible to calculate the increase (or decrease) in one time period (b) using a formula.
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Formula
The increase (or decrease) in one time period in a linear trend
N∑ xy - ∑x ∑y
b=
n∑x2 - (∑x)2
b = Increase (or decrease) in one time period
x = The quarter number
y = The actual data
n = The number of items of data,
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It is possible to calculate where the trend line cuts the vertical axis at time 0 (a) using a
formula.
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Formula
Where the trend line cuts the vertical axis at time 0
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b = Increase (or decrease) in one time period
= Average of x
= Average of x
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Example
Forecasting a trend line using linear regression
Forecast the sales for 20X4 using linear regression using the data provided
underneath.
Time £m
20X0 Q1 24.6
20X0 Q2 38.4
20X0 Q3 36.9
20X0 Q4 48.0
20X1 Q1 32.3
20X1 Q2 44.8
20X1 Q3 42.0
20X1 Q4 60.3
20X2 Q1 39.8
20X2 Q2 47.6
20X2 Q3 54.9
20X2 Q4 72.8
20X3 Q1 56.9
20X3 Q2 59.1
20X3 Q3 59.9
20X3 Q4 72.0
Step 1: Find the trend line using the least squares method
We need to find T = a +bt. Firstly we must find b. b can be found by using:
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N∑ xy - ∑x ∑y
b=
n∑x2 - (∑x)2
To find b we need to know xy, x2 and their totals.
Period (x) Time £m xy x2
1 20X0 Q1 24.6 24.6 1
2 20X0 Q2 38.4 76.8 4
3 20X0 Q3 36.9 110.7 9
4 20X0 Q4 48.0 192.0 16
5 20X1 Q1 32.3 161.5 25
6 20X1 Q2 44.8 268.8 36
7 20X1 Q3 42.0 294.0 49
8 20X1 Q4 60.3 482.4 64
9 20X2 Q1 39.8 358.2 81
10 20X2 Q2 47.6 476.0 100
11 20X2 Q3 54.9 603.9 121
12 20X2 Q4 72.8 873.6 144
13 20X3 Q1 56.9 739.7 169
14 20X3 Q2 59.1 827.4 196
15 20X3 Q3 59.9 898.5 225
16 20X3 Q4 72.0 1,152.0 256
136 Totals 790.3 7540.1 1496
∑x ∑y ∑xy ∑x2
So b is:
(16 x 7,540.1) – (136 x 790)
b=
(16 x 1,496) - 1362
120,642 -107,481
b=
23,936 -18,496
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13,161
b=
5,440
b= 2.42
a must then be calculated:
136 790.3
= = 8.5 = = 49.39
16 16
a = 49.39 – (2.42 x 8.5)
a = 28.82
T = 28.82 + 2.42t
Step 2: Trend line forecasts
e.g. 20X4’s second quarter is Q18
T = 28.82 + (2.42 x 18)
T = 72.38
Period Time Trend
1 20X0 Q1 31.24
2 20X0 Q2 33.66
3 20X0 Q3 36.08
4 20X0 Q4 38.50
5 20X1 Q1 40.92
6 20X1 Q2 43.34
7 20X1 Q3 45.76
8 20X1 Q4 48.18
9 20X2 Q1 50.60
10 20X2 Q2 53.02
11 20X2 Q3 55.44
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12 20X2 Q4 57.86
13 20X3 Q1 60.28
14 20X3 Q2 62.70
15 20X3 Q3 65.12
16 20X3 Q4 67.54
17 20X4 Q1 69.96
18 20X4 Q2 72.38
19 20X4 Q3 74.80
20 20X4 Q4 77.22
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Variances around the trend line
The calculation of variances around the trendline involves finding average variations.
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Formula
Seasonal variation
Actual value
Trend
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Finding the average variations can be done in three steps.
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Example
Calculating variances around the trendline
Using the data given above, calculate variances around the trend line.
Step 1: Work out the trend for previous periods
We know this to be T = 28.82 + 2.42t
Step 2: Calculate the seasonal variations:
31.24
E.g. for Q1: = 0.79
24.6
Time Trend £m (y) Variation (S)
20X0 Q1 31.24 24.6 0.79
20X0 Q2 33.66 38.4 1.14
20X0 Q3 36.08 36.9 1.02
20X0 Q4 38.50 48.0 1.25
20X1 Q1 40.92 32.3 0.79
20X1 Q2 43.34 44.8 1.03
20X1 Q3 45.76 42.0 0.92
20X1 Q4 48.18 60.3 1.25
20X2 Q1 50.60 39.8 0.79
20X2 Q2 53.02 47.6 0.90
20X2 Q3 55.44 54.9 0.99
20X2 Q4 57.86 72.8 1.26
20X3 Q1 60.28 56.9 0.94
20X3 Q2 62.70 59.1 0.94
20X3 Q3 65.12 59.9 0.92
20X3 Q4 67.54 72.0 1.07
Step 3: Work out the average (mean) seasonal variation
E.g. for Q1:
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0.79 + 0.79 + 0.79 + 0.94
=0.83
4
Step 4: Make a prediction taking into account seasonal variations
Multiply the trend for future periods calculated in a previous example by the average
variation for the period.
Period Trend Av. Variation Forecast (£m)
20X4 Q1 69.96 0.83 57.84
20X4 Q2 72.38 1.00 72.65
20X4 Q3 74.80 0.96 72.01
20X4 Q4 77.22 1.21 93.10
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And finally...
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Stop!
By this stage you should know:
• What the different types of variation are
• How to adjust a trend line using the additive and multiplicative models
• What a seasonal trend is and how to calculate variations using both the
additive and multiplicative models
• How to forecast a trend line using linear regression
• How to calculate variances around the trendline
Got it?
If not, go back and re-read the study text before moving on.
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Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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BA1 22 Moving Averages
Introduction
Moving averages ensure long term data can stand out clearly by reducing irregularities.
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Definition
Moving averages
A method to reduce irregularities and smooth out the dispersion caused by variations.
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A moving average is perfect for use on a set of data that may have correlation but is very
irregular:
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Moving averages can include any number of points, from two upwards. One of the most
common is the three point moving average.
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Example
Three point moving average
Find the three point moving average for the following data.
Time £m
20X0 Q1 24.6
20X0 Q2 38.4
20X0 Q3 36.9
20X0 Q4 48.0
20X1 Q1 32.3
20X1 Q2 44.8
20X1 Q3 42.0
20X1 Q4 60.3
20X2 Q1 39.8
20X2 Q3 54.9
20X2 Q4 72.8
20X3 Q1 56.9
20X3 Q2 59.1
20X3 Q3 59.9
20X3 Q4 72.0
Step 1: Calculate an average for the first three points of data
24.6 + 38.4 + 36.9
=33.3
3
Step 2: Continue to calculate three point moving averages and include on the
table
38.4 + 36.9 + 48.0
=41.1
3
Time £m Moving Av.
20X0 Q1 24.6
20X0 Q2 38.4 33.3
20X0 Q3 36.9 41.1
20X0 Q4 48.0 39.1
20X1 Q1 32.3 41.7
20X1 Q2 44.8 39.7
20X1 Q3 42.0 49.0
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20X1 Q4 60.3 47.4
20X2 Q1 39.8 49.2
20X2 Q2 47.6 47.4
20X2 Q3 54.9 58.4
20X2 Q4 72.8 61.5
20X3 Q1 56.9 62.9
20X3 Q2 59.1 58.6
20X3 Q3 59.9 63.7
20X3 Q4 72.0
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When plotted against the original data it is possible to see how the moving average smooths
out the distortions somewhat giving a straighter line.
It is possible to do a four point moving average, but these calculations are not then aligned
to a particular quarter. A moving average trend can solve this problem.
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Example
Moving average trend
Find the four point moving average using the same data as previously.
Step 1: Calculate the four point moving averages and add to the table of data
24.6 + 38.4 + 36.9 + 48.0
=37.0
4
Time £m Moving Av.
20X0 Q1 24.6
20X0 Q2 38.4
37.0
20X0 Q3 36.9
38.9
20X0 Q4 48.0
40.5
20X1 Q1 32.3
41.8
20X1 Q2 44.8
44.9
20X1 Q3 42.0
46.7
20X1 Q4 60.3
47.4
20X2 Q1 39.8
50.7
20X2 Q2 47.6
53.8
20X2 Q3 54.9
58.1
20X2 Q4 72.8
60.9
20X3 Q1 56.9
62.2
20X3 Q2 59.1
Step 2: Find the moving average trend
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If we take the average of 37.0 and 38.9, we'll get a figure we can associate with 20X0
Q3 (sometimes referred to as the centred eight quarterly total).
Time £m Moving Av. Moving Av. Trend
20X0 Q1 24.6
20X0 Q2 38.4
37.0
20X0 Q3 36.9 37.9
38.9
20X0 Q4 48.0 39.7
40.5
20X1 Q1 32.3 41.1
41.8
20X1 Q2 44.8 43.3
44.9
20X1 Q3 42.0 45.8
46.7
20X1 Q4 60.3 47.1
47.4
20X2 Q1 39.8 49.0
50.7
20X2 Q2 47.6 52.2
53.8
20X2 Q3 54.9 55.9
58.1
20X2 Q4 72.8 59.5
60.9
20X3 Q1 56.9 61.6
62.2
20X3 Q2 59.1 62.1
62.0
20X3 Q3 59.9
20X3 Q4 72.0
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The moving average over four periods is much smoother than that for three as sales tend to
vary over the period of a year than over three quarters:
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Seasonal Variation
Using the same method it is also possible to calculate the seasonal variation. Using an
additive model this will reduce irregularities in the data by calculating the difference between
the moving average and the actual figure.
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Example
Seasonal variation
Find the seasonal average using the same data as previously.
Step 1: Find the difference between the moving average and the actual figure
and add to the table of data
For 20X0 Q3: actual figure – moving average is 36.9 – 37.9 = -1
Moving Moving Av. Seasonal
Time £m Av. (Trend) Variation
20X0 Q1 24.6
20X0 Q2 38.4
37.0
20X0 Q3 36.9 37.9 -1.0
38.9
20X0 Q4 48.0 39.7 8.3
40.5
20X1 Q1 32.3 41.1 -8.8
41.8
20X1 Q2 44.8 43.3 1.5
44.9
20X1 Q3 42.0 45.8 -3.8
46.7
20X1 Q4 60.3 47.1 13.2
47.4
20X2 Q1 39.8 49.0 -9.2
50.7
20X2 Q2 47.6 52.2 -4.6
53.8
20X2 Q3 54.9 55.9 -1.0
58.1
20X2 Q4 72.8 59.5 13.3
60.9
20X3 Q1 56.9 61.6 -4.7
62.2
20X3 Q2 59.1 62.1
62.0
20X3 Q3 59.9
20X3 Q4 72.0
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Step 2: Calculate the average seasonal variations
E.g. in Q3:
-1.0 + -3.8 + -1.0
= -1.9
3
Q1 -7.6 Q2 -1.0 Q3 -1.9 Q4 11.6
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And finally...
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Stop!
By this stage you should know:
• How to find moving point averages of any size
• Why moving averages are useful
• Why the moving average trend is useful and how it is calculated
• How to calculate seasonal variations using the moving average
Got it?
If not, go back and re-read the study text before moving on.
businesstime
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
316
BA1 Fundamentals of Business Economics
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BA1 23 Index Numbers
Introduction
Indexes (or indices) help when considering the market as a whole.
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Definition
Index number
A standardised way of measuring changes in prices/output etc. over different periods.
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There are two main types of index: price and quantity.
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Definition
Price index
A standardised way of measuring changes in prices – the monetary value.
Quantity/volume index
A standardised way of measuring changes in non-monetary items.
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When discussing index numbers a base time is established. The base year usually equals 100.
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Formula
Index numbers
Value of given year
Index number = X 100
Value of base year
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Single product index
We use the single product index when comparing the growth of individual products over
time.
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Example
Creating a single product index
Represent the following values for bottles of wine as an index, with a base year of
20X0:
Year Price
20X0 £4.00
20X1 £4.20
20X2 £4.50
20X3 £4.75
20X4 £4.60
20X5 £5.00
20X6 £5.10
20X7 £5.80
20X8 £5.50
20X9 £6.05
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The base year, 20X0, will be represented as 100.
To calculate the index for 20X1 we will use the index number formula:
£4.20
Index number = X 100 = 105
£4.00
This step must then be repeated for all the following prices:
Year Price Price Index
20X0 £4.00 100
20X1 £4.20 105
20X2 £4.50 113
20X3 £4.75 119
20X4 £4.60 115
20X5 £5.00 125
20X6 £5.10 128
20X7 £5.80 145
20X8 £5.50 138
20X9 £6.05 151
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A complete price index can be used to calculate the difference between any given year’s
prices.
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Example
Calculating the difference between years using a price index
Using the above example, by what percentage did a bottle of wine increase in price
from 20X3 – 20X7?
Step 1: Find your numbers
20X13: 119 20X17: 145
Step 2: Subtract the 20X13 index from the 20X17 index
145 – 119 = 26
Step 3: Divide the remainder by the start point
26
X 100 = 21.8
119
There is a 21.8% increase in the price of wine between 20X3 and 20X7.
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If the indexes get really big they may be divided by 100. This division by 100 gives us a ratio
of the current value to the base year value.
Selecting a base year:
• A base year should be selected when, as far as prices are concerned, nothing unusual
is happening (such as high inflation)
• A base year should be fairly recent (up to ten years ago is acceptable)
Weighted index
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The weighted price index calculates the price index for multiple products at once by adding a
weighting factor to each product depending on its importance.
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Formula
Weighted average price index
P1
∑Wx
Weighted average price index = P0
∑W
Or
Q1
∑Wx
Weighted average quantity index = Q0
∑W
W = The weighting
P1 / Q1 = The year we are comparing
P0 / Q0 = The base year
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To find the weighting a weighting factor must be added.
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Definition
Weighting factor
Determined by the relative importance of each item, e.g. the average annual
purchases.
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Example
Calculating a weighted price index
Using the following information calculate the average weighted price increase for the
five items over the course of a year.
Product Price per unit Price per unit Average annual
20X4 20X5 purchases
Soap £3.20 £2.40 12
Butter £3.90 £4.00 26
Soda £3.50 £5.60 54
Pasta £1.90 £5.70 18
Hoover bags £12.00 £15.00 5
Step 1: Calculate the price relatives for each term
This should be done by dividing that year’s price by the base price.
P1
Product
P0
Soap 2.40 =0.75
3.20
Butter 4.00 =1.03
3.90
Soda 5.60 =1.6
3.50
Pasta 5.70 =3
1.90
Hooverbags 15.00 =1.25
12.00
Step 2: Add a weighting factor
In this case this is the average annual purchase.
Product P1 W
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P0
Soap 2.40 =0.75 12
3.20
Butter 4.00 =1.03 26
3.90
Soda 5.60 =1.6 54
3.50
Pasta 5.70 =3 18
1.90
Hooverbags 15.00 =1.25 5
12.00
Step 3: Calculate the relative weight by multiplying the price relative by the
weighting
P1 P1
Product W Wx
P0 P0
Soap 2.40 =0.75 12 9.00
3.20
Butter 4.00 =1.03 26 26.78
3.90
Soda 5.60 =1.6 54 86.40
3.50
Pasta 5.70 =3 18 54.00
1.90
Hooverbags 15.00 =1.25 5 6.25
12.00
Step 4: calculate the sum of the weighting and the sum of the relative weights
P1
∑ W= 115 ∑Wx = 182.43
P0
Step 5: Enter these into the weighted average price index formulae
182.43 x 100 = 159
324
BA1 Fundamentals of Business Economics
115
The average weighted price increase for the five items over the course of a year has
been 59%.
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Different decisions can be made on which weighting to use: base year quantities or prices can
be used or the current year’s prices.
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Current weighting pros and cons
Pros Cons
It’s the most up to date. Once a base weighting process has
been established future results can
easily be compared and conclusions
drawn.
It removes the effects of goods which may It may prove easier, quicker and
be subject to high price rises. cheaper to use base weightings if
companies do not have current year
data for quantities available.
Using base weighting for several years
allows for easy comparison.
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Index splicing
Most pricing indexes work off a fixed base. Although this is great for consistency it runs a risk
of becoming out of date. If the index becomes out of date, or the economy goes through a
period of political/economic instability, the index may need to be ‘spliced’.
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325
BA1 Fundamentals of Business Economics
Definition
Index splicing
The simple process of recalculating each index figure using the value of the new base.
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businesstime
Formula
Index splicing
Old index of considered year
New price index = X 100
Old index of new base year
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326
BA1 Fundamentals of Business Economics
Example
Splicing an index
Set the new base year at 20X6 for he following price index
Price index
Year
(Base 19X0= 100)
20X0 225
20X1 240
20X2 250
20X3 261
20X4 280
20X5 285
20X6 300
20X7 305
20X8 310
20X9 320
All we need to do is using the index splicing formula given above.
E.g. year 20X0:
225
x 100 = 75
300
This must be done for all the data.
Price index Price index
Year
(Base 19X0 = 100) (Base 20X6 = 100)
20X0 225 225 x 100= 75
300
20X1 240 240 x 100= 80
300
20X2 250 250 x 100= 83
300
327
BA1 Fundamentals of Business Economics
Price index Price index
Year
(Base 19X0 = 100) (Base 20X6 = 100)
20X3 261 261 x 100= 87
300
20X4 280 280 x 100= 93
300
20X5 285 285 x 100= 95
300
20X6 300 300 x 100= 100
300
20X7 305 305 x 100= 102
300
20X8 310 310 x 100= 103
300
20X9 320 320 x 100= 107
300
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The more figures that can be used, the more useful they are.
Quantity indices
Indices are not always in terms of price; there are also quantity indices. The formulas for
aggregate quantity or weighted/relative) indices are slightly different than those for price.
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328
BA1 Fundamentals of Business Economics
Formula
Aggregate quantity index
Σ W Q1
x 100
Σ W Q0
W = the weighting
Q1 = the year we are comparing
Q0 = the base year
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Formula
Relative quantity index
Σ [ ( ) ]
Q1
Wx
Q0
x 100
ΣW
W = The weighting
Q1 = The year we are comparing
Q0 = The base year
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329
BA1 Fundamentals of Business Economics
Example
Calculating a relative quantity index
Considering the information below and using 20X1 as the base year, find the index of
the amounts produced in 20X2 using the weights provided and the relatives method.
Product Quantity sold ‘000s Weights
20X1 20X2
Pencils 7 9 33
Sharpeners 11 15 72
Erasers 18 21 27
Ball point pens 24 27 62
Step 1: Calculate each section of the relative quantity index formula using a table
Q1 Q1
Product W Wx
Q0 Q0
Pencils 1.29 33 42.57
Sharpeners 1.36 72 97.92
Erasers 1.17 27 31.59
Ball point pens 1.13 62 70.06
Total 194 242.14
Step 2: enter these figures into the relative quantity index formulae
242.14
x 100 = 124.81
194
Therefore quantities have risen by 24.81% since the base year.
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Retail Price Index (RPI)
330
BA1 Fundamentals of Business Economics
The Retail Price Index (RPI) and the Consumer Price Index (CPI) has been used in the UK
to measure the prices of goods since 1987.
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Definition
Retail Price Index (RPI)
An index based on the average prices of a typical basket of goods, including the direct
and associated costs of housing.
Consumer Price Index (CPI)
An index based on the average prices of a typical basket of goods, excluding costs of
housing.
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The RPI typically includes items such as:
• Food
• Clothes
• Cars
• Alcohol
• Petrol
• Gas
Companies may use indices to adjust for inflation. By deflating the price companies
understand the genuine rise in trading income rather than that just caused by inflation. When
we use an index in this way we are effectively ‘deflating’ the figures or removing the effect of
inflation to show just the rise or fall in real terms.
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331
BA1 Fundamentals of Business Economics
Example
Calculating real terms
Using the table below, calculate what has happened to wages in real terms between
20X1 and 20X3.
Year 20X1 20X2 20X3
Inflation index 108 115 123
Wages index 100 108 113
Step 1: Rebase the index figures to the same year.
To change the base year we divide the current year’s index over the new base year’s
index and multiply by 100.
E.g. for 20X2 and the inflation index:
115
x 100 = 106.48
108
Year 20X1 20X2 20X3
Inflation index 100 106.48 113.89
Wages index 100 108 113
Step 2: Express the wages index in real terms
This is done by dividing the wages index by the inflation index.
E.g. for 20X2:
108
x 100 = 101.43
106.48
Year 20X1 20X2 20X3
Inflation index 100 106.48 113.89
Wages index 100 108 113
Wages “real” index 100 101.43 99.21
332
BA1 Fundamentals of Business Economics
Wages have therefore fallen in real terms by 0.79% from 20X1 – 20X3.
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And finally...
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Stop!
By this stage you should know:
• How to calculate and use a single product index
• How to calculate a weighted price indexation
• Why index splicing is necessary and how it can be achieved
• How to calculate a quantity index
• How to adjust for inflation using indices
Got it?
If not, go back and re-read the study text before moving on.
businesstime
Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
333
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