Business organisations and their stakeholders

Organisations develop out of the need to coordinate work (Section 1) but this can be achieved
in different ways. In this chapter we will also look
at the different types of organisation (
Section 2).
The objectives, policies, procedures and
management/leadership style of an organisation will
all be influenced in part by its stakeholders.
Different stakeholder groups have different degrees
of power and interest, and management must
respond to each in a different way (
Section 3).

Study Guide Intellectual level  



                              A1 The purpose and types of business organisation

(a) Define ‘business organisations’ and explain why they are formed.



                               (b) Describe common features of business organisations. K
                             (c) Outline how business organisations differ. K
                             (d) List the industrial and commercial sectors in which business organisations operate. K
                             (e) Identify the different types of business organisation and their main characteristics: K
(i)                Commercial

(ii)              Not-for-profit

(iii)             Public sector

(iv)             Non-governmental organisations

(v)              Co-operatives

                             A2 Stakeholders in business organisations

(a) Define stakeholders and explain the agency relationship in

business and how it may vary in different types of business organisation.















(b) Define internal, connected and external stakeholders and

explain their impact on the organisation.

(c) Identify the main stakeholder groups and the objectives of


each group.

(d) Explain how the different stakeholder groups interact and how

their objectives may conflict with one another.

(e) Compare the power and influence of various stakeholder


groups and how their needs should be accounted for, such as under the Mendelow framework.



  1   Purpose of business organisations

1.1 What all organisations have in common

An organisation is: ‘a social arrangement which pursues collective goals, which controls its own performance and which has a boundary separating it from its environment’.


Here are some examples of organisations.

  • A multinational car manufacturer (eg Ford)              A local authority
  • An accountancy firm (eg Ernst & Young)              A trade union (eg Unison)
  • A charity (eg Oxfam)              An army

The common characteristics of organisations are as follows.

  • Organisations are preoccupied with performance, and meeting or improving their standards.
  • Organisations contain formal, documented systems and procedures which enable them to control what they do.
  • Different people do different things, or specialise in one activity.
  • They pursue a variety of objectives and goals.
  • Most organisations obtain inputs (eg materials), and process them into outputs (eg for others to buy).

Why do organisations exist?


Organisations can achieve results which individuals cannot achieve by themselves.
  • Organisations overcome people’s individual limitations, whether physical or intellectual.
  • Organisations enable people to specialise in what they do best.
  • Organisations save time, because people can work together or do two aspects of a different task at the same time.
  • Organisations accumulate and share knowledge.
  • Organisations enable synergy: by bringing together two individuals their combined output will exceed their output if they continued working separately.

In brief, organisations enable people to be more productive.

1.3 How organisations differ

The common elements of organisations were described earlier, but organisations also differ in many ways. Here are some possible differences.

  • Ownership

Some organisations are owned by private owners or shareholders. These are private sector organisations. Public sector organisations are owned by the government.

  • Control

Some organisations are controlled by the owners themselves but many are controlled by people working on their behalf. Some are indirectly controlled by government-sponsored regulators.

  • Activity

What organisations actually do can vary enormously. They could be manufacturing organisations, for example, or they could be a healthcare service.

  • Profit or non-profit orientation

Some businesses exist to make a profit. Others, for example the army, are not profit orientated.

  • Legal status

Organisations may be limited companies or partnerships.

  • Size

The business may be a small family business or a multinational corporation.

  • Sources of finance

Businesses can raise finance by borrowing from banks or government funding or issuing shares.

  • Technology

Businesses have varying degrees of technology use. For example, computer firms will have high use of technology but a corner shop will have very low use.

1.4 What the organisation does

Organisations do many different types of work. Here are some examples.

Industry Activity
Agriculture Producing and processing food
Manufacturing Acquiring raw materials and, by the application of labour and technology, turning them into a product (eg a car)
Extractive/raw materials Extracting and refining raw materials (eg mining)
Energy Converting one resource (eg coal) into another (eg electricity)
Retailing/distribution Delivering goods to the end consumer
Intellectual production Producing intellectual property (eg software, publishing, films, music)
Service industries Including retailing, distribution, transport, banking, various business services (eg accountancy, advertising) and public services such as education, medicine
  2   Types of business organisation 

2.1 Profit vs not-for-profit orientation


An important difference in the list above is between profit orientated (‘commercial’) and not for profit orientated (‘non-profit’) organisations.

The basic difference in outlook is expressed in the diagram below. Note the distinction between primary and secondary goals. A primary goal is the most important: the other goals support it.

  • Private sector. Organisations not owned or run by central or local government, or government agencies
  • Public sector. Organisations owned or run by central or local government or government agencies


2.3 Private sector commercial business organisations 

A commercial business organisation exists to make a profit. In other words, the costs of its activities should be less than the revenues it earns from providing goods or services. Profits are not incidental to its activities but the driving factor.

Business organisations come in all different shapes and sizes, and there is a choice of legal structure.

2.3.1 Legal status

Someone setting up a business can choose to go into business alone, take on one or more partners who also share the profits of the business, or set up a limited company.

2.3.2 Limited companies

A limited company has a separate legal personality from its owners (shareholders). The shareholders cannot normally be sued for the debts of the business unless they have given some personal guarantee. Their risk is generally restricted to the amount that they have invested in the company when buying the shares. This is called limited liability.


Whereas sole traderships and partnerships are normally small or medium-sized businesses, limited company status is used for businesses of any size.

The ownership and control of a limited company are legally separate even though they may be vested in the same individual or individuals.

  • Shareholders are the owners but have limited rights, as shareholders, over the day to day running of the company. They provide capital and receive a return. Shareholders could be large institutional investors (such as insurance companies and pension funds), private individuals, or employees.
  • Directors are appointed by shareholders to run the company. In the UK, the board of directors controls management and staff, and is accountable to the shareholders, but it has responsibilities towards both groups – owners and employees alike.
    • Executive directors participate in the daily operations of the organisation.
    • Non-executive directors are invited to join in an advisory capacity, usually to bring their particular skills or experience to the discussions of the board to exercise some overall guidance.
  • Operational management usually consists of career managers who are recruited to operate the business, and are accountable to the board.

2.3.3 Types of limited company

In the UK, limited companies come in two types: private limited companies (eg X Limited) and public limited companies (eg X plc). They differ as follows.

  • Number of shareholders. Most private companies are owned by only a small number of shareholders. Public companies generally are owned by a wider proportion of the investing public.
  • Transferability of shares. Shares in public companies can be offered to the general public. In practice this means that they can be traded on a stock exchange. Shares in private companies, on the other hand, are rarely transferable without the consent of the shareholders.
  • Directors as shareholders. The directors of a private limited company are more likely to hold a substantial portion of the company’s shares than the directors of a public company.
  • Source of capital
    • A private company’s share capital will normally be provided from three sources.
      • The founder or promoter
      • Business associates of the founder or employer
      • Venture capitalists
    • A public company’s share capital, in addition, can be raised from the public directly, or through institutional investors, using recognised markets.

Many companies start in a small way, often as family businesses which operate as private companies, then grow to the point where they become public companies and can invite investors to subscribe for shares. The new capital thus made available enables the firm to expand its activities and achieve the advantages of large scale operation.

2.3.4 Advantages and disadvantages of limited companies


  • More money is available for investment.
  • Risk is reduced for investors thanks to limited liability.
  • They have a separate legal personality. A company can own property, make contracts etc.
  • Ownership is legally separate from control. Investors need not get involved in operations.
  • No restrictions on size Some companies have millions of shareholders.  They offer flexibility. Capital and enterprise can be brought together.


  • Legal compliance costs. Because of limited liability, the financial statements of most limited companies have to be audited, and then published for shareholders.
  • Shareholders have little practical power, other than to sell their shares to a new group of managers, although they can vote to sack the directors.

2.4 The public sector

The public sector comprises all organisations owned and run by the government and local government. Here are some examples.

  • The armed forces              Government departments
  • Most schools and universities

Public sector organisations have a variety of objectives.

  • The UK Pensions Service administers part of the social security system relating to pensions, benefits and retirement information.
  • The Post Office makes a profit from mail services, although it does have a social function

2.4.1 Key characteristics of the public sector

  • Accountability, ultimately, to Parliament
  • Funding. The public sector can obtain funds in three main ways.
    • Raising taxes
    • Making charges (eg for prescriptions)
    • Borrowing
  • Demand for services. There is a relationship between the price charged for something and the ‘demand’. In the public sector demand for many services is practically limitless.
  • Limited resources. Despite the potentially huge demand for public services, constraints on government expenditure mean that resources are limited and that demand cannot always be met.

2.4.2 Advantages

  • Fairness. The public sector can ensure that everyone has access to health services.
  • Filling the gaps left by the private sector. This can be done by providing public goods, such as street lighting.
  • Public interest. Governments once believed the public interest was best served if the state ran certain services.
  • Economies of scale. Costs can be spread if everything is centralised.
  • Cheaper finance. Taxes or borrowing backed by government guarantees might be cheaper than borrowing at commercial rates.
  • Efficiency. The public sector is sometimes more efficient than the private sector. The UK’s National Health Service, despite its well-publicised problems, has lower administration costs and serves more of the population than the private sector does in the US.

2.4.3 Disadvantages

  • Accountability. Inefficiency may be ignored as taxpayers bear losses.
  • Interference. Politicians may not be familiar with the operation of a business and yet political pressures and indecision may influence adversely the decision-making process. Pressures to get elected may lead to the deferral of necessary but unpopular decisions.
  • Cost. There can be conflict between economy of operation and adequacy of service. The public will demand as perfect a service as possible but will not wish to bear the cost involved.

2.5 Non-governmental organisations


A non-governmental organisation (NGO) is a legally constituted organisation of people acting together independently from any form of government.

Non-governmental organisations (NGOs) are bodies which are not directly linked with national government. The description ‘NGO’ generally applies to groups whose primary aim is not a commercial one, but within this the term is applied to a diverse range of activities, aimed at promoting social, political or environmental change. However, NGOs are not necessarily charities and, although they may have political aims, they are not political parties.

NGOs need to engage in fund raising and mobilisation of resources in order to ensure that they are operating effectively and efficiently (for example in terms of donations received, volunteer labour or materials). This process may require quite complex levels of organisation. The following are some organisational features of NGOs.

  • Staffing by volunteers as well as full-time paid employees
  • Finance from grants or contracts
  • Skills in advertising and media relations
  • Some kind of national ‘headquarters’  Planning and budgeting expertise

It can be seen, therefore, that NGOs may need to possess an efficient level of organisation structure, much in the same way as a traditional commercial undertaking.


The United Nations (UN) has various NGOs, such as UNESCO (UN Educational, Scientific and Cultural Organisation) and UNICEF (UN Children’s Fund).


2.6 Co-operative societies and mutual associations

Co-operatives are businesses owned by their workers or customers, who share the profits. Here are some of the features they have in common.

  • Open membership
  • Democratic control (one member, one vote)
  • Distribution of the surplus in proportion to purchases  Promotion of education

Although limited companies also have some measure of democratic control, this is on the basis of one share, one vote. So one shareholder could dominate a company if they hold a majority of shares. This would not happen in a co-operative.


A major example of a co-operative in the UK is the Co-operative Retail Store network. In addition there is the Co-operative Wholesale Society and the Co-operative Bank.


Mutual associations are similar to co-operatives in that they are ‘owned’ by their members rather than outside investors.

  • Some financial companies used to be mutual associations. However, building societies in the UK such as the Halifax converted from being mutual associations to being banks. The Nationwide Building Society has held out against this, so far citing the lower interest rates it can offer to borrowers.
  • Credit unions are examples of mutual associations. They are financial institutions owned and controlled by their members.

              QUESTION                                                                                             Legal form

Florence Nightingale runs a successful and growing small business as a sole trader. She wishes to expand the business and has her eyes on Scutari Ltd, a small private limited company in the same line. After the acquisition, she runs the two businesses as if they were one operation making no distinction between them. What is the legal form of the business she is running?


This is quite a tricky question. For example, if suppliers have contracts with Scutari Ltd, the contract is with the company, and Florence is not legally liable for the company’s debts. If their contracts are with Florence, then they are dealing with her personally. Florence has to make a choice.

  • She can run the entire business as a sole trader, in which case Scutari Ltd’s assets must be transferred to her.
  • She can run her entire business as a limited company, in which case she would contribute the assets of her business as capital to the company.
  • She can ensure that the two business are legally distinct in their assets, liabilities, income and expenditure.


  3   Stakeholder goals and objectives

Managers are not completely free to set objectives: they have different groups of stakeholders to consider. The managers act as agents for the stakeholders, whose influence varies from organisation to organisation.

The agency relationship in business therefore refers to the separation between an organisation’s owners (the shareholders) as the ‘principal’, and those managing the organisation on their behalf (the company directors) as their ‘agents’.

Those running the company should do so in a way that best serves the interests of shareholders (rather than pursuing their own interests). It is important that management interests are aligned with the organisation’s goals, so that they act in a way that benefits shareholders and other stakeholders.

The concept of agency is particularly relevant for large organisations, where there is a large separation between company ownership and its management.


Stakeholders are those individuals or groups that, potentially, have an interest in what the organisation does. These stakeholders can be within the organisation, connected to the organisation or external to the organisation.

There are three broad types of stakeholder in an organisation, as follows.

  • Internal stakeholders (employees, management)
  • Connected stakeholders (shareholders, customers, suppliers, financiers)
  • External stakeholders (the community, government, pressure groups)

3.1 Internal stakeholders: employees and management

Because employees and management are so intimately connected with the company, their objectives are likely to have a strong influence on how it is run. They are interested in the following issues.

  • The organisation’s continuation and growth. Management and employees have a special interest in the organisation’s continued existence.
  • Individual interests and goals. Managers and employees have individual interests and goals which can be harnessed to the goals of the organisation.
Internal stakeholder Interests to defend Response risk
Managers and employees •      Jobs/careers

•      Money

•      Promotion

•      Benefits

•      Satisfaction

•       Pursuit of ‘systems goals’ rather than shareholder interests

•       Industrial action

•       Negative power to impede implementation

•       Refusal to relocate

•       Resignation

  • Connected stakeholders

If management performance is measured and rewarded by reference to changes in shareholder value then shareholders will be happy, because managers are likely to encourage long-term share price growth.

Connected stakeholder Interests to defend Response risk
Shareholders (corporate strategy) •      Increase in shareholder wealth, measured by profitability, P/E ratios, market capitalisation, dividends and yield

•      Risk

 Sell shares (eg to predator) or boot out management
Bankers (cash flows) •      Security of loan

•      Adherence to loan agreements

•      Denial of credit

•      Higher interest charges

•      Receivership

Suppliers (purchase strategy) •      Profitable sales

•      Payment for goods

•      Long-term relationship

•      Refusal of credit

•      Court action

•      Wind down relationships

Customers (product market strategy) •      Goods as promised

•      Future benefits

•      Buy elsewhere

•      Sue

  • External stakeholders

External stakeholder groups – the government, local authorities, pressure groups, the community at large, professional bodies – are likely to have quite diverse objectives.

External stakeholder Interests to defend Response risk
Government •      Jobs

•      Training

•      Tax

•      Tax increases

•      Regulation

•      Legal action

Interest/pressure groups •       Pollution

•       Rights

•       Other

•      Publicity

•      Direct action

•      Sabotage

•      Pressure on government

Professional bodies     Members’ ethics  Imposition of ethical standards
  • Another approach

Stakeholders may also be analysed by reference to whether they have a contractual relationship with the organisation. Stakeholders who have such a relationship are called primary stakeholders, while those who do not are known as secondary stakeholders. The primary stakeholder category thus includes internal and connected stakeholders, while the secondary stakeholder category equates to external stakeholder status.

  • Stakeholder conflict

Since their interests may be widely different, conflict between stakeholders can be quite common. Managers must take the potential for such conflict into account when setting policy and be prepared to deal with it if it arises in a form that affects the organisation.

A relationship in which conflict between stakeholders is vividly characterised is that between managers and shareholders. The relationship can run into trouble when the managers’ decisions focus on maintaining the corporation as a vehicle for their managerial skills while the shareholders wish to see radical changes so as to enhance their dividend stream and increase the value of their shares. The shareholders may feel that the business is a managerial corporation run for the benefit of managers and employees without regard for the objectives of the owners. The conflict in this case can be seriously detrimental to the company’s stability.

  • Shareholders may force resignations and divestments of businesses, while managers may seek to preserve their empire and provide growth at the same time by undertaking risky policies.
  • In most cases, however, managers cannot but acknowledge that the shareholders have the major stake as owners of the company and its assets. Most companies therefore focus on making profits and increasing the market value of the company’s shares, sometimes at the expense of the long-term benefit of the company. Hence long-term strategic plans may be ‘hijacked’ by the need to make a sizeable profit in one particular year; planning horizons are reduced and investment in long-term business prospects may be shelved.

Clearly, each stakeholder group considers itself in some way a client of the organisation, thus broadening the debate about organisation effectiveness.

3.6 Stakeholder mapping: power and interest

Mendelow (1991) suggests that stakeholders may be positioned on a matrix whose axes are power held and likelihood of showing an interest in the organisation’s activities. These factors will help define the type of relationship the organisation should seek with its stakeholders. Level of interest

Low                              High

  • Key players are found in segment D: strategy must be acceptable to them, at least. An example would be a major customer. These stakeholders may even participate in decision-making.
  • Stakeholders in segment C must be treated with care. While often passive, they are capable of moving to segment D. They should therefore be kept satisfied. Large institutional shareholders might fall into segment C.
  • Stakeholders in segment B do not have great ability to influence strategy, but their views can be important in influencing more powerful stakeholders, perhaps by lobbying. They should therefore be kept informed. Community representatives and charities might fall into segment B.
  • Minimal effort is expended on segment A.

A single stakeholder map is unlikely to be appropriate for all circumstances. In particular, stakeholders may move from quadrant to quadrant when different potential future strategies are considered.

Stakeholder mapping is used to assess the significance of stakeholder groups. This in turn has implications for the organisation.

  • The framework of corporate governance should recognise stakeholders’ levels of interest and power.
  • It may be appropriate to seek to reposition certain stakeholders and discourage others from repositioning themselves, depending on their attitudes.
  • Key blockers and facilitators of change must be identified.

Each of these groups has three basic choices.

  • Loyalty. They can do as they are told.
  • Exit. For example by selling their shares, or getting a new job.
  • Voice. They can stay and try to change the system. Those who choose voice are those who can, to varying degrees, influence the organisation. Influence implies a degree of power and willingness to exercise it.

Existing structures and systems can channel stakeholder influence.

  • They are the location of power, giving groups of people varying degrees of influence over strategic choices.
  • They are conduits of information, which shape strategic decisions.
  • They limit choices or give some options priority over others. These may be physical or ethical constraints over what is possible.
  • They embody culture.
  • They determine the successful implementation of strategy.
  • The firm has different degrees of dependency on various stakeholder groups. A company with a cash flow crisis will be more beholden to its bankers than one with regular cash surpluses.

So, different stakeholders will have their own views as to strategy. As some stakeholders have negative power, in other words power to impede or disrupt the decision, their likely response might be considered.

3.7 The strategic value of stakeholders

The firm can make strategic gains from managing stakeholder relationships. Over the years various theories and studies have revealed the following correlations.

  • A correlation between employee and customer loyalty (eg reduced staff turnover in service firms generally results in more repeat business).
  • Continuity and stability in relationships with employees, customers and suppliers is important in enabling organisations to respond to certain types of change, necessary for business as a sustained activity.

Responsibilities towards customers are mainly those of providing a product or service of a quality that customers expect, and of dealing honestly and fairly with customers.

Responsibilities towards suppliers are expressed mainly in terms of trading relationships.

  • The organisation’s size could give it considerable power as a buyer. One ethical guideline might be that the organisation should not use its power unscrupulously.
  • Suppliers might rely on getting prompt payment in accordance with the terms of trade negotiated with its customers.
  • All information obtained from suppliers and potential suppliers should be kept confidential.

3.8 Measuring stakeholder satisfaction

We have already considered ways in which stakeholders may be classified and given some instances of their probable interests. Measuring the success the organisation achieves in satisfying stakeholder interests is likely to be difficult, since many of their expectations relate to qualitative rather than quantitative matters. It is, for example, difficult to measure good corporate citizenship. On the other hand, some of the more important stakeholder groups do have fairly specific interests, the satisfaction of which should be fairly amenable to measurement. Here are some examples of possible measures.

Stakeholder group Measure
Employees Staff turnover; pay and benefits relative to market rate; job vacancies
Government Pollution measures; promptness of filing annual returns; accident rate; energy efficiency
Distributors Share of joint promotions paid for; rate of running out of inventory


PER performance objectives PO2 requires you to be able to demonstrate your skills in stakeholder relationship management. This could cover communications with internal and external colleagues, maintaining good business relationships, drafting reports, making presentations, using technology

effectively and even addressing complaints. It all requires an understanding of stakeholder needs, as covered in this chapter.


N Organisations can achieve results which individuals cannot achieve by themselves.
N An important difference in the list above is between profit orientated (‘commercial’) and non profit orientated organisations.
N A non-governmental organisation (NGO) is a legally constituted organisation of people acting together independently from any form of government.
N Stakeholders are those individuals or groups that, potentially, have an interest in what the organisation does. These stakeholders can be within the organisation, connected to the organisation or external to the organisation.


  • Which of the following defines an organisation?
  • A private sector organisation is one owned or run by:
    A social arrangement which pursues collective goals, which controls its own performance and which has a boundary separating it from its environment
  • A social arrangement which exists to make a profit, controls its own performance and which operates within certain boundaries
    • Central government
    • Local government
    • Government agencies D None of the above
  • Businesses owned by their workers or customers who share the profits are called
    • Limited companies C Co-operatives B Private limited companies D Partnerships
  • Which one of the following are examples of internal stakeholders?
    • Shareholders C             Suppliers
    • Employees D             Financiers
  • According to Mendelow’s matrix, stakeholders in segment C (low interest, high power) should be kept informed. Is this true or false?


  • A This is the definition of an organisation. Not all organisations exist to make a profit.
  • D None of the above. A public sector organisation is owned or run by central or local government.
  • C Co-operatives are owned by their workers or customers.
  • B The others are all connected stakeholders.
  • Stakeholders in this segment should be kept satisfied.








Now try …
Attempt the questions below from the Practice Question Bank






02The business environment

The aim of environmental analysis (Section 1) is to review
the environment for
opportunities and threats, and to
secure environmental fit. An organisation has many
interchanges with its environment. It draws inputs from it
and outputs goods and services to it. The environment is
a major source of uncertainty.

An organisation is affected by
general environmental
, usefully summarised in the PEST model (Section
). The PEST model is drawn out into its component
elements in
Sections 2 to 10, which cover legal aspects
(employment legislation, data protection and health and
safety), social and cultural trends, the impact of
technology on organisations and environmental factors.
External competitive forces, as identified by Michael
Porter, are covered in
Sections 11 and 13.
The internal capabilities of the organisation are analysed
in the value chain framework (
Section 12). While the
value chain has an internal rather than an external focus,
it is included in this chapter as a method of improving a
company’s competitive position in the wider market.

Study Guide Intellectual level  



                              A3 Political and legal factors affecting business

(a) Explain how the political system and government policy affect the organisation.



               (b) Describe the sources of legal authority, including supranational bodies, national and regional governments. K
                             (c) Explain how the law protects the employee and the implications of employment legislation for the manager and the organisation. K
                               (d) Identify the principles of data protection and security. K
                             (e) Explain how the law promotes and protects health and safety in the workplace. K
                             (f) Recognise the responsibility of the individual and organisation for compliance with laws on data protection, security and health and safety. K
                             (g) Outline principles of consumer protection, such as sale of goods and simple contract. K
                           A6 Social and demographic factors

(a) Explain the medium- and long-term effects of social and demographic trends on business outcomes and the economy.





                             (b) Describe the impact of changes in social structure, values, attitudes and tastes on the organisation. K
                             (c) Identify and explain the measures that governments may take in response to the medium and long-term impact of demographic change. K
                         A7 Technological factors

(a) Explain the potential effects of technological change on the organisation structure and strategy:





(i)        Downsizing

(ii)      Delayering

(iii)     Outsourcing

(b) Describe the impact of information technology and information systems development on business processes and the changing role of the accountant in business as a result of technological advances..









                         A8 Environmental factors

(a) List ways in which the business can affect or be affected by its physical environment.





                             (b) Describe ways in which businesses can operate more efficiently and effectively to limit damage to the environment. K
                             (c) Identify the benefits of economic sustainability to stakeholders. K
                         A9 Competitive factors

(a) Identify a business’s strengths, weaknesses, opportunities and threats (SWOT) in a market and the main sources of competitive advantage.




                             (b) Identify the main elements within Porter’s value chain and explain the meaning of a value network. K
                             (c) Explain the factors or forces that influence the level of competitiveness in an industry or sector using Porter’s five forces model. K
Study Guide Intellectual level  






                             (d) Describe the activities of an organisation that affect its competitiveness:

(i)        Purchasing

(ii)      Production

(iii)     Marketing

(iv)     Service






  1   Analysing the business environment
Whatever the overall strategic management method used, no organisation is likely to achieve its aims if it fails to take into account the characteristics of the environment in which it operates.

The environment is everything that surrounds an organisation, physically and socially.


Step 1 Assess the nature of the environment (eg is it changing?).
Step 2 Identify those influences which have affected the organisation in the past or which are likely to do so in future.
Step 3 Prepare a structural analysis identifying the ‘key forces at work in the immediate or competitive environment’.

Environmental analysis is one of the inputs to the strategy-making process. Johnson and Scholes suggest the following procedure:


These steps should identify important developments. Then the following questions should be asked.


Step 4 What is the organisation’s position in relation to other organisations?
Step 5 What threats and/or opportunities are posed by the environment?

An organisation’s environment may be examined in a number of ways.

  • Global/local. Some organisations operate worldwide. However, they still have to be sensitive to the local requirements of the countries or markets they operate in or export to. Some companies are much more exposed to global competition than others.
  • General/task: this is the method we will use.
    • The general (or macro) environment covers all those factors influencing all organisations indirectly, for example: general economic trends, population growth, new technology. These factors are abbreviated to PEST (political-legal, economic, social-cultural, technological) factors.
    • The task (or micro) environment includes those areas which have a direct impact on the organisation, such as its ability to acquire raw materials, its competitors and its customers. Porter (1980) analyses the task environment into five competitive forces, which are discussed in Section 13.

The distinction is not hard and fast, and is drawn for convenience only.

The environment is a source of uncertainty. In other words, decision-makers do not have sufficient information about environmental factors, and many things are out of their control. The overall degree of uncertainty may be assessed along two axes: simplicity/complexity and stability/dynamism.

  • Simplicity/complexity
    • The variety of influences faced by an organisation. The more open an organisation is, the greater the variety of influences. The greater the number of markets the organisation operates in, the greater the number of influences to which it is subject.
    • The amount of knowledge necessary. Some environments, to be handled successfully, require knowledge. All businesses need to have knowledge of the tax system, for example, but only pharmaceuticals businesses need to know about mandatory testing procedures for new drugs.
    • The interconnectedness of environmental influences causes complexity. Importing and exporting companies are sensitive to exchange rates, which themselves are sensitive to interest rates. Interest rates then influence a company’s borrowing costs. Scenario-building and modelling are ways of dealing with complexities to develop an understanding of environmental conditions.
  • Stability/dynamism
    • An area of the environment is stable if it remains the same. (For example, investors get nervous about a change in government.) Firms which can predict demand face a stable environment.
    • An unstable environment changes often. The environment of many fashion goods is unstable.

As a rule of thumb, use the following checklist for uncertainty.

  • Simple (few environmental influences to worry about) and stable: low uncertainty
  • Complex and stable: low to moderate uncertainty
  • Simple and unstable: moderate to high uncertainty
  • Complex and unstable: high uncertainty

1.1 The changing environment

Changes in the business environment have been driven by a number of developments. Here are some of the changes that have happened.

  • Globalisation of business – increased competition and global customers as domestic markets become saturated, with companies able to compete easily anywhere in the world
  • Science and technology developments, especially in communications (the internet) and transport (particularly air travel)
  • Mergers, acquisitions and strategic alliances
  • Changing customer values and behaviour
  • Increased scrutiny of business decisions by government and the public
  • Increased liberalisation of trade, and deregulation and co-operation between business and government easing access to foreign markets
  • Changes in business practices – downsizing, outsourcing and re-engineering
  • Changes in the social and business relationships between companies and their employees, customers and other stakeholders

As companies have become exposed to more international competition, at the same time as having greater access to international markets, their preferred choice of organisational structure has been affected. This has been evident, as discussed earlier, in the shift away from mechanistic and bureaucratic organisations towards flatter structures with more flexible operating arrangements. Network forms of organisation and ‘virtual’ organisations are another manifestation of this trend. The need for strategic international alliances has increased with the need to understand and access foreign markets. The development of communications technology (email, the internet) is the key factor that has made such relationships possible.

Some firms have been changing the structure of their workforces for the sake of greater flexibility in responding to competitor activity or customer needs. This so-called ‘flexible firm‘ comprises a core of full-time permanent staff who possess the key skills, and peripheral part-timers and temporary or contract workers. This workforce can be flexed in a number of ways to meet changes in the market.

  2   The political and legal environment
Government policy influences the economic environment, the framework of laws, industry structure and certain operational issues. Political instability is a cause of risk. Different approaches to the political environment apply in different countries. International trade is subject to a further layer of international law and regulation.

The political environment affects the firm in a number of ways.

  • A basic legal framework generally exists.
  • The Government can take a particular stance on an issue of direct relevance to a business or industry.
  • The Government’s overall conduct of its economic policy is relevant to business.

2.1 The political and legal environment

Laws come from common law, parliamentary legislation and government regulations derived from it, and obligations under treaties such as those establishing the European Union.


Factor Example
General legal framework:

contract, tort, agency

Basic ways of doing business, negligence proceedings
Criminal law Theft, insider dealing, bribery, deception
Company law Directors and their duties, reporting requirements, takeover proceedings, shareholders’ rights, insolvency
Employment law Trade Union recognition, Social Chapter provisions, minimum wage, unfair dismissal, redundancy, maternity, Equal Opportunities
Health and safety Fire precautions, safety procedures
Data protection Use of information about employees and customers
Marketing and sales Laws to protect consumers (eg refunds and replacement, ‘cooling off’ period after credit agreements), what is or isn’t allowed in advertising
Environment Pollution control, waste disposal
Tax law Corporation tax payment, collection of income tax (PAYE) and National

Insurance contributions, sales tax (VAT)

Legal factors affecting all companies

Some legal and regulatory factors affect particular industries, if the public interest is served. For example, in the UK, electricity and gas, telecommunications, water and rail transport are subject to regulators who have influence over market access, competition and pricing policy (can restrict price increase). These UK bodies are called Ofgem, Ofcom, Ofwat and ORR respectively. Other countries will have similar regulators.

This is because:

  • The industries are, effectively, monopolies
  • Large sums of public money are involved (eg in subsidies to rail companies)

2.2 The impact of government

Porter notes several ways whereby the Government can directly affect the economic structure of an industry. They are explained below.

Capacity expansion Government policy can encourage firms to increase or cut their capacity.

(a)     The UK tax system offers ‘capital allowances’ to encourage investment in equipment.

(b)     A variety of incentives, funded by the EU and national governments, exist for locating capacity in a particular area.

(c)      Incentives are used to encourage investment by overseas firms.

Demand •         The Government is a major customer.

•         Government can also influence demand by legislation, tax reliefs or subsidies.

Divestment and rationalisation In some European countries, the state takes many decisions regarding the selling off or closure of businesses, especially in sensitive areas such as defence.
Emerging industries Can be promoted by the Government or damaged by it.
Entry barriers Government policy can discourage firms from entering an industry, by restricting investment or competition or by making it harder, by use of quotas and tariffs, for overseas firms to compete in the domestic market.
Competition (a)    The Government’s purchasing decisions will have a strong influence on the strength of one firm relative to another in the market (eg armaments).

(b)   Regulations and controls in an industry will affect the growth and profits of the industry – eg minimum product quality standards.

(c)    As a supplier of infrastructure (eg roads), the Government is also in a position to influence competition in an industry.

(d)   Governments and supra-national institutions such as the EU might impose policies which keep an industry fragmented, and prevent the concentration of too much market share in the hands of one or two producers.

In some industries, governments regulate the adoption of new products. This is well illustrated by the pharmaceuticals industry, where new drugs or medicines must in many countries undergo stringent testing and obtain government approval before they can be marketed.

National and EU institutions also affect the operating activities of some organisations, for example:

  • Anti-discrimination legislation
  • Health and safety legislation
  • Product safety and standardisation (especially EU standards)
  • Workers’ rights (eg unfair dismissal, maternity leave)
  • Training and education policies (which can determine the ‘standard’ of recruits)

QUESTION                                                                                           Government impact

How do you think government policy affects the pharmaceutical industry in your country?


Using the example of the UK.

  • The Government must authorise most new drugs (eg for safety before they can be sold).
  • The UK Government is a major purchaser of pharmaceuticals for the national health service, and so has significant buying power.
  • Health education policies affect consumer demand.
  • Funding of universities affects the science base for recruitment. (e) Employment practices, such as working hours, are influenced by EU employment directives.


2.3 Influencing government

Businesses are able to influence government policies in a number of ways.

  • They can employ lobbyists to put their case to individual ministers or civil servants.
  • They can give MPs non-executive directorships, in the hope that the MP will take an interest in all legislation that affects them.
  • They can try to influence public opinion, and hence the legislative agenda, by advertising.

Of particular importance is the need to influence the decision-making processes of the European Commission. EU regulations, for practical purposes, take priority over national law. They are arrived at after a great deal of negotiation, and for this reason alone, are difficult to change. It is therefore much better to influence the drafting process of new regulations than to try to get them changed once they have been implemented.

The EU will have an increasing role in the conduct of European businesses in:

  • Product standards
  • Environmental protection
  • Monetary policy (a European Central Bank might set interest rates)
  • Research and development
  • Regional policy
  • Labour costs (wages, pensions)

In addition, an EU-Africa Business Forum has been set up to improve investment and the business climate in Africa.

2.4 Political risk and political change

Changes in UK law are often predictable. A government will publish a green paper discussing a proposed change in the law, before issuing a white paper and passing a bill through Parliament. Plans should be formulated about what to do if the change takes place.

However, it is political change which complicates the planning activities of many firms. Many economic forecasts ignore the implications of a change in government policy.

  • At national level, political influence is significant and includes legislation on trading, pricing, dividends, tax and employment as well as health and safety (to list but a few).
  • Politics at international level also has a direct bearing on organisations. EU directives affect all countries in the EU.

The political risk in a decision is the risk that political factors will invalidate the strategy and perhaps severely damage the firm. Examples are wars, political chaos, corruption and nationalisation.

  • International trade

The political environment is of particular importance in international trade. Such trade is governed by an extra layer of legislation contained in treaties and agreements and is potentially subject to a higher level of political risk. This may be manifested in a variety of ways, such as taxation law, labour regulation and economic policy on such matters as ownership. At worst, there is a threat of expropriation or nationalisation. Failure to repress lawlessness and corruption are further complicating factors, as is open or covert refusal to consider international bidders for government contracts.

  • The European Union

The European Union operates a single European market, allowing for the free movement of labour, goods and services, and free competition.

The EU single market programme has involved areas as diverse as harmonising technical standards, opening up areas such as telecommunications to competition, consumer protection, mutual recognition of professional qualifications, and so on.

  • International trade liberalisation: the World Trade Organisation (WTO)

The World Trade Organisation was set up to promote free trade and resolve disputes between trading partners.


  3   Employment protection
Much legislation has been aimed at the idea of ’employment protection’. As a result, all forms of termination of employment must be treated with great care.

The theory of comparative advantage suggests that free trade is the best way to promote global economic growth and, by implication, domestic prosperity. In other words, people should be free to buy and sell goods and services anywhere in the world.

3.1 Retirement

In the UK, many employees are taking early retirement perhaps as a result of corporate downsizing, but many people still search for work at an older age and there are pressure groups seeking to ban ageism in recruitment. Retirement ages for men and women are being equalised.

Organisations encourage retirement for a variety of reasons.

  • Promotion opportunities are created for younger workers.
  • Early retirement is an alternative to redundancy.
  • The age structure of an organisation may become unbalanced.
  • The cost of providing pensions rises with age.
    • Resignation

People resign for many reasons, personal and occupational. Employees who are particularly valuable should be encouraged to stay. Particular problems the employee has been experiencing (eg salary) may be solvable, though not always in the short term.

In any case, an exit interview, when the leaver explains the decision to go, is a valuable source of information.

The period of notice required for the employee to leave should be set out in the contract of employment, but some leeway may be negotiated on this.


  • Dismissal

There are three forms of termination that constitute dismissal under UK law (Employment Rights Act 1996, (TSO, 1996)).

  • The termination of an employee’s contract by the employer
  • The ending of a fixed-term contract without renewal on the same terms: in effect, there is no such thing as a fixed-term contract of employment
  • Resignation by the employee where the employer’s conduct breaches the contract of employment: this is constructive dismissal

The statutory minimum period of notice to be given is determined by the employee’s length of continuous service with the employer. Longer periods may be written into the contract, at the employer’s discretion, and by agreement. Either party may waive their right to notice, or accept payment in lieu of notice. An employee is entitled to a written statement of the reasons for dismissal.

  • Wrongful dismissal

Wrongful dismissal is dismissal that breaches the contract of employment. An example would be failure to give the contractual period of notice (assuming the circumstances did not justify summary dismissal). Wrongful dismissal relates to the method of dismissal.

  • Unfair dismissal

The legal concept of unfair dismissal gives protection to the employee against arbitrary dismissal; that is, dismissal without good reason. A dismissal need not be wrongful to be unfair. The basic principle is that any dismissal is potentially unfair. Under employment protection legislation, the employee has to prove that they have been dismissed. The onus is then on the employer to prove that the dismissal was fair. Examples of dismissals that would be unfair would be dismissing an employee who has legitimately ‘whistleblown’ on unethical practices or dismissal as a result of an employee joining a trade union.

  • Disciplinary procedures

The use of a disciplinary system can be evidence in certain situations that an employee has not been dismissed unfairly.

  • Redundancy

Redundancy is dismissal under two circumstances.

  • The employer has ceased to carry on the business at all or in the place where the employee was employed.
  • The requirements of the business for employees to carry out work of a particular kind have ceased or diminished or are expected to.

Compensation is a legal entitlement, and encourages employees to accept redundancy without damage to industrial relations.

The employee is not entitled to compensation in three circumstances.

  • The employer has made an offer of suitable alternative employment and the employee has unreasonably rejected it.
  • The employee is of pensionable age or over, or has less than two years’ continuous employment.
  • The employee’s conduct merits dismissal without notice.

There are certain legal minima for compensation offered, based on age and length of service.

3.7.1 Procedure for handling redundancies

From a purely humane point of view, it is obviously desirable to consult with employees or their representatives. Notice of impending redundancies is a legal duty for redundancies over a certain number.

The impact of a redundancy programme can be reduced in several ways.

  • Retirement of staff over the normal retirement age
  • Early retirement of staff approaching normal retirement age
  • Restrictions on recruitment to reduce the workforce over time by natural wastage
  • Dismissal of part-time or short-term contract staff
  • Offering retraining and/or redeployment within the organisation  Seeking voluntary redundancies

Where management have to choose between individuals doing the same work, they may dismiss the less competent or require people to re-apply for the job. The LIFO principle may be applied, so that newcomers are dismissed before long-serving employees.

Many large organisations provide benefits in excess of the statutory minimum with regard to consultation periods, terms, notice periods, counselling and aid with job search, training in job-search skills, and so on.

Many firms provide advice and outplacement counselling to help redundant employees find work elsewhere.

3.8 Equal opportunities

Some groups are discriminated against with little or no justification. This applies particularly in employment matters. There are laws and regulations to help prevent this and to redress the balance.

The subject of equal opportunities is covered, in detail, in Chapter 13.

  4   Data protection and security


  • Why is privacy an important issue?

In recent years, there has been a growing fear that the ever-increasing amount of information about individuals held by organisations could be misused.

In particular, it was felt that an individual could easily be harmed by the existence of computerised data about them which was inaccurate or misleading and which could be transferred to unauthorised third parties at high speed and little cost.

In the UK the current legislation covering this area is the Data Protection Act 2018.

  • The Data Protection Act 2018
The (UK) Data Protection Act 2018 protects individuals about whom data is held. Both manual and computerised information must comply with the Act.

The Data Protection Act 2018 (TSO, 2018) is an attempt to protect the individual. The terms of the Act cover data about individuals – not data about corporate bodies. (Remember that you will not be examined on the details of the UK’s Data Protection Act but the syllabus states that you must be able to identify the principles of data protection and security). The Act embodies the main aspects of the EU’s General Data Protection Regulation (GDPR) but extends the protection by establishing a wider  framework of regulations.

  • Definitions of terms used in the Act

In order to understand the Act it is necessary to know some of the technical terms used in it.

  • Personal data is information about a living individual, including expressions of opinion about them. Data about organisations is not personal data.
  • Data users are organisations or individuals who control or process personal data and the use of personal data.
  • Data controllers determine the purpose and means of processing personal data.
  • Data processors are responsible for processing personal data on behalf of a controller.
  • Data subjects are individuals who are the subject of personal data.



The UK Data Protection Act includes six Data Protection Principles with which data users must comply.
Principle Description
Lawfulness, fairness and transparency Data can only be held if there are valid grounds to do so. Data can only be used fairly and with clarity, openness and honesty in how the data is used from the start.
Purpose limitation Data subjects must be made aware of the purpose for recording the data from the time it is first collected. This purpose must be specified, explicit and legitimate.  Should data need to be used for a different purpose in future then consent from the data subject must be obtained unless there are legal grounds to do so otherwise.
Data minimisation Data held must be adequate (sufficient to fulfil the purpose), relevant (connected to the purpose for holding it) and not excessive (the minimum needed to fulfil the purpose).
Accuracy Data held must be accurate and not misleading. Reasonable steps should be taken to ensure there are no inaccuracies. Any data that is found to be inaccurate or misleading must be corrected.
Storage limitation Data must not be held for longer than is needed for the purpose it was collected and processed. There should be a justifiable data retention policy that can be justified. Data that is not needed must be deleted or anonymised.
Integrity and

confidentiality (security)

Appropriate security measures regarding the risks that might arise in connection with the data must be taken.

4.4 The data protection principles

The Act has two main aims:

  • To protect individual privacy. Previous UK law only applied to computer-based The 2018 Act applies to all personal data, in any form.
  • To harmonise data protection legislation so that, in the interests of improving the operation of the single European market, there can be a free flow of personal data between the member states of the EU.

4.4.1 The rights of data subjects The Act establishes the following rights for data subjects.

Right Description
To be informed Data subjects must be informed about how their personal data is collected and used. Information that must be shared includes (for example) the purposes that their data is used for, what the retention period is and who the information is shared with. Individuals must be given this information at the time that their personal data is collected or within a month if the data was collected from another source.
Access Individuals have the right to request information held about them either verbally or in writing. The requested information must be supplied within one month, and (in most circumstances) there should be no charge for it.
Rectification Data subjects can request inaccurate or misleading information held about them to be rectified. Incomplete information must be made complete. The request can be made verbally or in writing and it must be completed within one month. Only in limited circumstances can the request be refused.
Erasure This is known as the right ‘to be forgotten’. Data subjects may request information held about them be destroyed. This request can be made verbally or in writing. This right only applies in certain circumstances and a reply must be sent to the data subject within one month.
Restrict processing Data subjects can have restrictions placed on the processing of their data or have it suppressed altogether. The data can still be held, but it must not be processed. They can request the restriction verbally or in writing. The right only applies in certain circumstances and the individual must be given a response within one month.
Data portability Data subjects can request to be sent the data held about them so they can reuse it in a different service. For example, data held by an online banking app can be requested and transferred to another app that can make use of it (such as a money manager type app).
To object Data subjects can object to the processing of their data. Where the data is used in connection with direct marketing there is an absolute right to object. Where the data is used for other purposes, this right can be refused if there is a compelling reason to do so. The objection can be made verbally or in writing and a reply must be sent to the data subjection within one month.
Automated decision making and profiling Other data protection rights are granted to data subjects where data held about them is used to make automated decisions about them, or where data evaluation about them is automated. For example where decisions are made by bank computer systems as to whether or not to lend money to an individual. The uses of data in this way is limited and the individual must be given information about the processing. They also have the right to request human intervention or to challenge decisions made following such processing.

 QUESTION                                                     Data protection

Your managing director has asked you to recommend measures that your company, which is based in the UK, could take to ensure compliance with data protection legislation. Suggest what measures should be taken.


Measures could include the following.

  • Obtain consent from individuals to hold any sensitive personal data you need.
  • Supply individuals with a copy of any personal data you hold about them if so requested.
  • Consider if you may need to obtain consent to process personal data.  Ensure you do not pass on personal data to unauthorised parties.


  5   Health and safety 
People should be able to be confident that they will not be exposed to excessive risk when they are at work. This means that risk and danger must be actively managed.

5.1 Importance of maintaining health and safety at work

  • An employer has legal obligations under UK and EU law.
  • Accidents and illness cost the employer money.
  • The company’s image in the marketplace and society may suffer.

The major legislation in the UK covers a number of Acts of Parliament. EU law will become more important in the future. The most important piece of legislation in this area in the UK is the Health and Safety at Work Act 1974 (HMSO, 1974). Remember that UK law will not feature in the exam but you do need to be aware of health and safety best practices.

5.2 Employers’ duties

A senior manager must be specified as responsible for ensuring that problems are solved and rules observed.

  • All work practices must be safe.
  • The work environment must be safe and healthy.
  • All plant and equipment must be maintained to the necessary standard.
  • Information, instruction, training and supervision should encourage safe working practices. Employers must provide training and information to all staff.
  • The safety policy should be clearly communicated to all staff.
  • Employers must carry out risk assessments, generally in writing, of all work hazards. Assessment should be continuous. They must assess the risks to anyone else affected by their work activities.
  • They must share hazard and risk information with other employers, including those on adjoining premises, other site occupiers and all subcontractors coming onto the premises.
  • They must introduce controls to reduce risks.
  • They should revise safety policies in the light of the above, or initiate safety policies if none were in place previously.
  • They must identify employees who are especially at risk.
  • They must employ competent safety and health advisers.

The Safety Representative Regulations provide that a safety representative may be appointed by a recognised trade union, and for safety committees to be set up at the request of employee representatives. Safety representatives are entitled to paid time off work to carry out their duties.

5.3 Employee duties

  • Take reasonable care of themselves and others
  • Allow the employer to carry out their duties (including enforcing safety rules)
  • Not interfere intentionally or recklessly with any machinery or equipment
  • Inform the employer of any situation which may be a danger (this does not reduce the employer’s responsibilities in any way) (e) Use all equipment properly

QUESTION                                                                                            Work environment

What aspects of your own work environment (if any) do you think are:

            A hindrance to your work?                A hazard to your health or safety?                 A source of dissatisfaction?


5.4 Accident and safety policies

Accidents are expensive.

  • Time is lost by the injured employee and other staff.
  • Costs caused by disruption to operations, for example repair costs and production ‘downtime’ following damage to equipment.
  • Compensation payments or fines resulting from legal action and increased insurance premiums.
  • Output from the injured employee on return to work is often reduced.
  • Recruiting and training a replacement for the injured worker will have its own cost.

An employee who is injured as a result of either the employer’s failure to take reasonable care or a breach of statutory duty can sue.

  • An employee is not deemed to consent to the risk of injury because they are aware of the risk. It is the employer’s duty to provide a safe working system.
  • Employees can become inattentive or careless in doing work which is monotonous or imposes stress. This factor too must be allowed for in the employer’s safety precautions.
  • The employer should encourage and insist on proper use of safety equipment.
  • Many dangers can be caused by carelessness or other fault of an otherwise competent employee, possibly by their mere thoughtlessness. Reducing the frequency and severity of accidents
  • Develop safety consciousness among staff.
  • Develop effective consultative participation.
  • Give adequate instruction in safety rules and measures.
  • Materials handling should be minimised.
  • Good maintenance pays dividends.
  • Implement in full the code of practice for the industry. (g) Safety inspections should be carried out regularly.

Accident reporting systems

  • Accidents should be reported on an accident report form and records kept.
  • Statistical trends should be monitored to reveal areas where recurring accidents suggest the need for special investigation, but only more serious incidents will have to be followed-up in depth.
  • Follow-up should be clearly aimed at preventing recurrence – not placing blame.
  • Risk audit or sampling should be carried out regularly to prevent accidents.
  • There should be a procedure for reporting ‘near-misses’, anonymously if necessary, to encourage openness.

5.5 Health and safety policy

In order to enhance safety awareness, promote good practice and comply with legal obligations, many employers have a health and safety policy for their staff. Such a policy will have a number of features.

(a)        Statement of principles (d)           Detailed instructions on how to use equipment
(b)        Detail of safety procedures (e)        Training requirements

(c)         Compliance with the law

Senior managers must set a good example.

  • Visibly reacting to breaches of the policy (eg if the fire doors are blocked open, remove the blockage).
  • Ensuring that the policy is communicated to staff (eg memoranda, newsletters).
  • Setting priorities for operations.
      6   Consumer protection 

    Involving staff in the health and safety process.

We will now look at those aspects of law and regulation which apply to consumer protection, including contract law and the sale of goods. All countries have their own legislation dealing with these topics. These are the general principles.

6.1 What is a contract?

A contract is a legally binding agreement.

A contract is a legally binding agreement. In all areas of life we make contracts. If you buy or sell a house, a contract is made and ‘exchanged’. When you start a job, you will probably have a contract of employment. When you go into a shop and buy something, you have entered into an agreement with the shopkeeper – you agree that the shopkeeper will give you the goods and you will give them the money.

Under contract law, the money that you give in exchange for the goods is referred to as the

consideration‘. For a contract to take place, there must be agreement between the parties. This requires an offer made by one party, acceptance by the other party and, in England and Wales (but not Scotland), some consideration passing between them.

An important point about contracts is that they do not have to be written. They do not even have to be spoken. A customer picking up something in a supermarket and walking to the checkout is making an offer to the shop, and that offer is implied by their behaviour.

Any business buying and selling goods is continually making and discharging (completing) contracts. Probably none of the parties involved give much thought to the legal aspect of what they are doing until something goes wrong.

When one party to a contract fails to carry out his part of the agreement, the other party can take legal action against them for breach of contract. So if a business has a customer who is failing to pay, they can take them to court.

Where one party makes a misrepresentation to the other, the contract is considered void. For example, A sells goods to B, who sells them on to C. B then fails to pay A for the goods and disappears without trace. If A can demonstrate that they were genuinely mistaken as to the identity of B and would not have dealt with them had they known who B really was, then A can recover the goods which were subject to the original contract from C. This is because the law takes the view in such a situation that the original contract between A and B was no contract at all. Therefore C, who was an innocent third party acting in good faith, has to return the goods to A and either bear the loss or find and sue B.

6.2 Sale of goods and services

An important area of contract law is the law concerning the sale of goods. UK legislation also covers contracts where the supply of services is the major part of the contract. For example, contracts of repair, where the supply of goods may be incidental to the provision of a service.

Imagine that you are about to enter into a contract for the purchase of some goods. What might you be concerned about?

  • You may want the goods delivered for a particular occasion or date.
  • Are the goods stolen, ie does the seller have a right to sell the goods?
  • You would expect the goods to be the same type and quality as the description or any sample.     The goods should be of reasonable quality and suitable for their purpose.

The UK’s Consumer Rights Act 2015 (TSO, 2015) legislation covers these matters and a number of other important issues. We will use UK legislation as an example in the following sections. Its provisions are regarded as implied terms of most contracts for the sale of goods.

6.2.1 Implied terms

A sale of goods is subject to the following provisions.

  • Title, or the seller’s right to sell the goods
  • Description of the goods
  • Quality of the goods
  • Fitness of the goods for the purpose for which they are supplied

6.2.2 Time of performance

If goods arrive too late, they may be useless.

The terms of the contract will determine whether a particular timescale is a condition of performance. If it is, a breach of such terms entitles the injured party to treat the contract as discharged.

In commercial contracts for the supply of goods for business or industrial use, it will be assumed that time is of the essence, even where there is no express term to that effect.

6.2.3 Seller’s title

You cannot sell something that is not yours to sell. It is an implied condition that the seller has a right to sell the goods, or will have, at the time of sale.

If the seller delivers goods without having the right to sell, the buyer does not get to own the goods, which is the essential basis of the contract. If the buyer subsequently has to return the goods to the real owner, they may recover the entire price from the seller.

6.2.4 Example: Seller’s title

R bought a car from D, which D had unknowingly bought from a thief. When this was discovered, the car was returned to the true owner. R sued D for the return of the full purchase price (as damages). The court decided that, although R had used the car for several months, they had not had ownership of it, which is what they had paid for. D therefore had to repay the full amount.

6.2.5 Goods to correspond with contract description

If you have agreed to buy certain goods on the basis of the description (whether the buyer’s or the seller’s), you expect the goods to correspond to the description.

This is implied, under the Act, in any contract for sale of goods ‘by description’. The description may be of ingredients, components, age, date of shipment, packing, quantity etc.

6.2.6 Example: Sale by description

A seller advertised a secondhand reaping machine, describing it as new the previous year. The buyer bought it without seeing it. When it arrived they found that it was much more than a year old and rejected it. The seller sued for the price. It was held that this was a sale by description, the goods had not corresponded to the description, and the buyer was therefore entitled to reject the goods.

6.2.7 Satisfactory quality

All goods supplied under a contract for the sale of goods in the course of a business must be of ‘satisfactory quality’. They should meet the standard that a reasonable person would regard as satisfactory, taking account of any description of the goods, the price and other relevant circumstances.

In deciding whether goods are of satisfactory quality, the following should be taken into account.

  • Fitness for all the purposes for which goods of the kind in question are commonly supplied. A hot water bottle that deteriorated when filled with hot water, for example, would not be of satisfactory quality. A bucket needs to hold a variety of substances, and be handled in a variety of ways, without leakage, damage, immediate deterioration, and so on.
  • Appearance and finish. Previous to 1994, goods with superficial damage, but which operated properly in the main, could be of merchantable quality. Satisfactory quality includes freedom from dents, marks, scratches, and so on – unless they have clearly been allowed for in the description and price.
  • Freedom from minor defects.
  • Safety.
  • Durability. They have to remain of satisfactory quality for a period which could be expected by a reasonable person.

QUESTION                                                                                                            Refund

Peter buys an electronic keyboard from his local catalogue store. He pays $199 for it. He returns to the store the next day complaining that, although the main keys work, none of the pre-set rhythm buttons seem to function. He demands an immediate refund. The sales assistant refuses to given him a refund or take back the goods, and instead gives him a card with the name and address of the manufacturer, suggesting that Peter contacts them to obtain a refund or a replacement.

(a)           Was the sales assistant legally justified in refusing to give a refund?                Yes/No (b)             Give briefly a reason for your answer.


  • No
  • Contracts of sale are between the buyer and the seller, not between the buyer and the manufacturer.


6.2.8 Fitness of goods for a disclosed purpose

If you tell a seller (explicitly or by implication) that you intend to use goods for a particular purpose, you expect the goods supplied to be reasonably fit for that purpose.

This is an implied term, under the Act, unless it can be shown that the seller may not have known whether the goods were suitable for a purpose which was not familiar to them and the buyer may have been in a better position to tell.

Like ‘satisfactory quality’, this condition only applies to goods sold in the course of a business.

  7   Social and demographic trends

7.1 Population and the labour market

Population affects an organisation’s supply of labour and hence its policies towards recruiting and managing human resources.

This section uses the example of the UK.

Growing populations offer a larger labour market.

  • Increasing birth rates mean more young people.
  • Falling death rates mean more elderly people – some of these will continue working.

The changing age structure of the labour force. Fewer young people might mean that young people will become more expensive. The number of 16 year olds entering the labour force peaked in the late 1970s, but has been falling ever since.

Women are increasing their participation in the labour force.

The increasing participation of women occurs for four reasons.

  • More part-time jobs
  • Rising male unemployment as many industries which employed men have declined
  • The growth of the service sector

7.2 Implications for employers
An increase in the average age at which women have children

How organisations can cope with these demographic and educational trends

  • Establish the labour market the organisation is in (eg young people, part-time workers). In other words, ‘Who do we want to recruit?’
  • Discover the organisation’s catchment areas (ie location of potential recruits).
  • Discern the supply side trends in the catchment area labour force (eg how many school leavers are expected? What is the rate of growth/decline of the local population?).
  • Examine education trends in the area.
  • Assess the demand from other employers for the skills you need (eg if there is a large concentration of, say, electronics companies in the region, then they will be interested in hiring people with similar skills).
  • Assess whether some of your demand can be satisfied by a supply from other sources.

Organisations will need proper resourcing strategies to make sure their demand for labour is properly met.

7.3 Family life cycle

An example of a use of demography by marketing people is family life cycle (FLC). This is a summary of demographic variables.

  • It combines the effects of age, marital status, career status (income) and the presence or absence of children.
  • It is able to identify the various stages through which households progress. It is clear that particular products and services can be marketed to people at specific stages of the life cycle.
    • Social structures and class

Social class: Society can be divided into broad groups, whose members share common features, such as occupation, income level and education background. These groups are known as social classes.


In sociological terms, a class is more than a group of people with various things in common, however. Classes fit into a social structure, in which some classes have advantage over others.

          Access to power             Inherited wealth
•              Educational attainment

•              Income

           Status or esteem

It is possible to infer shared values, attitudes and behaviour within a social class as distinct from those of a higher or lower class: some research has been able to relate consumption behaviour to class standing. (This makes social class an attractive proposition for market segmentation.)

  • Socio-economic position, income and wealth

While there are some real differences between the groups, ‘social class’ for marketing or planning purposes should be used with caution. Sometimes people’s lifestyles are a reflection of their economic condition in society, not the reason for their position.

  • Socio-economic status

QUESTION                                                                                        Socio-economic status

‘Comparing people’s income is a simple matter. All you need to do is compare income after direct tax and social security contributions to see how well off people are.’ Do you agree with this statement?


Unfortunately the issue is not that simple. Firstly, there is indirect taxation (for example, sales tax). Households on different incomes are more or less exposed to this. Secondly, there is the issue of mortgage interest relief which is available in some countries. It is not available to people renting their accommodation. Thirdly, there are additional social benefits such as education. It is difficult to combine these factors.


7.7 Buying patterns

Buying behaviour is an important aspect of marketing. Many factors influence the buying decisions of individuals and households. Demography and the class structure are relevant in that they can be both behavioural determinants and inhibitors.

  • Behavioural determinants encourage people to buy a product or service. They include the individual’s personality, culture, social class, and the importance of the purchase decision (eg a necessity such as food or water, or a luxury).
  • Inhibitors are factors that make the person less likely to purchase something (eg low income).

Socio-economic status can be related to buying patterns in a number of ways, both in the amount people have to spend and what they spend it on. It affects both the quantity of goods and services supplied and the proportion of their income that households spend on goods and services.


  8   Cultural trends
Organisations are part of the wider social environment.

Examples of how cultural trends can change organisations are given in this section.

  • Health and diet issues

There have been significant changes in some countries in attitudes to diet and health.

Some people are slowly moving to a healthier diet. In addition, there has been an increase in vegetarianism, and ‘green consumerism’. This includes a concern with ‘organic food’ now found in many supermarkets.

  • Impact of health and diet on businesses

Growing market. There is a growing market for sports-related goods (even though, as is the case with running shoes, sporting goods might be purchased as fashion accessories).

Employee health. Employers are concerned with the effect of ill-health on productivity. Some employers provide gyms and physical recreation facilities. Others offer counselling programmes to employees who may be struggling with stress or health problems.

New foods. The health food and supplement market has grown significantly over the past decade. Some foods and supplements claim health benefits including improved mental focus and concentration.

Convenience food. There is a market for new sorts of convenience food.

Organic foods. Organic foods (grown without artificial pesticides, hormones etc) are more popular. This could lead to a healthier workforce, or on the other hand may increase days lost to issues of food health (eg food poisoning).

8.3 Women in work

There was once widespread discrimination against women.
Over the past few decades, in most countries the number of women in the workforce has increased significantly. A related trend is an increase in part-time working and flexible working. In the UK, more than five times as many women as men are part-timers.

  • Overt discrimination is where one group is treated less favourably than another.
  • Indirect discrimination makes it harder for somebody of a particular group to fulfil requirements.


Furthermore, the principle of equal pay for equal work and for equal value is enshrined in legislation. This is covered in more detail in Chapter 13.

  • Environmentalism

Issues relating to the effect of an organisation’s activities on the physical environment have come to the fore in recent years. This will be dealt with in detail later in this chapter.

  • The business response
  • ‘Green products’. Companies like The Body Shop have cleverly exploited ecological friendliness as a marketing tool. Supermarkets now stock cleaning products which are supposed to be kind to nature.
  • Changed practices. Bad publicity has led to improvements. A consumer campaign to boycott tuna from companies whose methods of fishing endangered the lives of dolphins has led to changed fishing techniques.

  • Limits. There may be a limit to how much consumers are prepared to alter their lifestyles, or pay, for the sake of ecological correctness.
  • Education and confusion. Consumers may be imperfectly educated about environmental issues. For example, much recycled paper has simply replaced paper produced from trees from properly managed (ie sustainably developed) forests. There is widespread confusion as to green labelling.
  • Environmental impact assessments. Companies review not just the finished product but their production processes too.

As far as pollution goes, it is likely that government will take an increased interest in this area. Companies might have to face a variety of measures designed to deal with pollution.

  9   The impact of technology on organisations and accountants

9.1 Organisation structure 

Information systems and information technology have played a significant role in the development of the modern business environment, including encouraging the flattening of organisation hierarchies and widening spans of control.

Information systems and information technology have played a significant role in the development of the modern business environment. For example, modern communications technology makes decentralised organisations possible, allowing decision-making to be passed down to ’empowered’ workers or outsourced to external companies.

There is a trend towards smaller, more agile companies. Flexibility and speed are increasingly seen as the key to competitive advantage. Advances in IT have allowed complex operating processes to be accelerated and made feedback information available almost immediately.

Span of control, or ‘span of management’, refers to the number of subordinates responsible to a superior. If a manager has five subordinates, the span of control is five.
9.1.1 Span of control

Business automation and rationalisation, and improved management information systems, have often resulted in reduced staffing levels. In particular, layers of middle management have been removed in many organisations. This has been termed ‘delayering’. Managers or staff ‘lower down’ the hierarchy have been empowered to make decisions previously made by middle managers. Information technology has therefore had the effect of flattening organisation hierarchies and widening spans of control.

There is no universally ‘correct’ size for the span of control. The appropriate span of control will depend on:

  • The ability of the manager. A good organiser and communicator will be able to control a larger number. The manager’s workload is also relevant.
  • The ability of subordinates. The more experienced, able, trustworthy and well-trained subordinates are, the easier it is to control larger numbers.
  • The nature of the task. It is easier for a supervisor to control a large number of people if they are all doing routine, repetitive or similar tasks.
  • The geographical dispersal of subordinates. A manager may be able to manage a larger group (wider span of control) more easily if subordinates are located together, for example in the same building as the manager.
  • The availability of good quality information. Relevant, timely information reduces uncertainty and may enable a manager to manage a larger group.

9.1.2 Tall and flat organisations

An information system, such as an intranet, can help provide organisation unity and coherency in flat, decentralised organisations.

The trend towards flatter structures is evidenced by talk of an ‘e-lance economy’, characterised by shifting coalitions of small firms collaborating on particular projects.

9.1.3 Organisation structure and information systems

The structure of an organisation and the way in which the organisation’s information system is arranged are related issues.

Centralised systems means holding and processing data in a central place, such as a computer centre at head office. Data will be collected at ‘remote’ (ie geographically separate) offices and other locations and sent in to the central location.

Decentralised systems have the data/information processing carried out at several different locations, away from the ‘centre’ or ‘head office’.

9.2 Effects of technological advances on the role of the accountant and on organisations

Some effects of technological advances on the role of the accountant and on organisations include:

•              Routine processing (bigger volumes, greater speed, greater accuracy)

•              Digital information and record keeping

•              New skills required and new ways of working

•              Reliance on IT

•              New methods of communication and of providing customer service

•              Interoperability (encourages collaboration across organisation boundaries) and open systems

•              The view of information as a valuable resource

•              The view of information as a commodity which can be bought, sold or exchanged (‘information market’)

9.2.1 Routine processing

Information technology enables business to process larger volumes of data, at greater speed and with greater accuracy. It allows an accountant to process more transactions in a shorter space of time, freeing their time up to work on value-adding services such as providing business advice, rather than information processing.

9.2.2 Digital information and recordkeeping

In most businesses, information storage and transmission is digital rather than paper-based. This means that there is greater focus on accountants backing up information on networks as opposed to information sitting in filing cabinets However, some people continue to prefer ‘hard copies’ and print out information as required.

The nature and quality of management information has also changed.

  • Managers have access to more information – for example from an Executive Support System. Information is also likely to be more timely, accurate, reliable and up to date.
  • More detailed planning is possible through the use of models (eg spreadsheets).
  • Information for control should be more readily available.
  • Decision-making should improve as a consequence of better quality information.


The role of accountants is developing and there is an increased need for IT literacy and flexibility in working methods to meet the needs of the client and employer. They are increasingly required to have IT skills (such as in data science and computer coding) as well as traditional accounting skills.

Later in our studies we shall see in detail how digital information has affected the role of the accountant, however, some examples of the impact that technological advances are having on the role of accountants include:

  • Cloud accounting – allows accountants to work more collaboratively together and with their clients.
  • Automation and artificial intelligence – supports the automatic and intelligent processing of transactional data to free the accountant to work on value-adding services.
  • Big data and data analytics – allow predictive analytics to assist the auditor in targeting key business risks to improve their audit work.
  • Distributed ledger technology – allows asset ownership to be easily verified, reducing the need for auditors to audit all transactions.

9.2.3 Employment issues

The infiltration of IT into almost every area of business means that the vast majority of employees (including accountants) are now expected to utilise information technology. As we saw above, IT skills are required and new ways of working have emerged.

9.2.4 Technological change

A reliance on information technology commits an organisation to continual change. Systems are likely to be superseded after a few years. Accountants must continually update their knowledge and expertise to keep pace with this change.

9.2.5 Customer service

Information technology has enabled organisations to provide better customer service. Customer databases, EDI, extranets, websites and data mining can all be applied to improving service levels. As the role of the accountants moves away from data processing and verification, they will focus their time on providing advice and support to their customer. For example, an accountant in practice could help clients by providing greater insight into the effectiveness of an organisation’s strategy.

9.2.6 Information markets

The term ‘information market’ reflects the growing view that information is a commodity which can be bought, sold or exchanged.

There has been a growing realisation that information is a resource and that it has many of the characteristics of any other resource. A key theme of this syllabus is the benefits which information, properly managed and used, can bring to an organisation.

9.2.7 Developments in communications

Communications technology is probably having a greater impact on organisational life than computers are at present. Email provides a quick and efficient means of communicating worldwide.

Mobile and WiFi technology allow flexibility in communication. Short Message Service (SMS) messages, often referred to as ‘text messages’, provide another option for short, concise, instant communication. Computer Telephony Integration (CTI) systems can route incoming calls (they can be frustrating, particularly for callers with non-standard enquiries). CTI also enables information about callers to be gathered and stored, allowing personalised communication.

Computer conferencing systems and organisation-wide intranets and bulletin boards encourage communication – both formal and informal.

Video-calls (for example Skype) and videoconferencing facilitate virtual face-to-face contact between people who are spread widely across the world. Together with cloud accounting, the accountant is not always required to work on-site with their client or employer.

9.3 IT and the employee/employer relationship

The widespread use of information technology in the workplace has affected the relationship between employers and employees.

  • Reduced need to follow the chain-of-command
  • Information overload
  • Nature of work
  • Close business relationships regardless of geographical location
  • More flexible working arrangements  Greater monitoring and control

Delayering has gone hand in hand with a trend towards downsizing whereby large numbers of managers and staff have been made redundant.

9.4 Homeworking and supervision

Advances in communications technology have, for some tasks, reduced the need for the actual presence of an individual in the office. This is particularly true of tasks involving computers.

  • The employee can, for example, do tasks involving data entry at home.
  • The keyed-in data can be sent over a telecommunications link to head office.
  • Some firms see benefits in employing the services of a pool of freelance workers, when there is a demand. This approach is being adopted in publishing and journalism.

This is sometimes known as homeworking (or, occasionally, telecommuting if it involves IT). The practice is not new in itself, but it is relatively new to the management of the office.

9.5 Outsourcing

Outsourcing is the contracting out of specified operations or services to an external vendor. There are various outsourcing options available, with different levels of control maintained ‘in-house’. Outsourcing has advantages (eg use of highly skilled people) and disadvantages (eg lack of control).


Outsourcing is the contracting out of specified operations or services to an external vendor.

9.5.1 Types of outsourcing

There are four broad classifications of outsourcing, as described in the following table.

Classification Comment
Ad hoc The organisation has a short-term requirement for increased IS/IT skills. An example would be employing programmers on a short-term contract to help with the programming of bespoke software.


The development and installation of a particular IS/IT project is outsourced; for example, a new accounting system.
Partial Some IT/IS services are outsourced. Examples include hardware maintenance, network management or ongoing website management.
Total An external supplier provides the vast majority of an organisation’s IS/IT services, eg third party owns or is responsible for IT equipment, software and staff.

9.5.2 The advantages and disadvantages of outsourcing

Advantages of outsourcing

The advantages of outsourcing are as follows.

  • Outsourcing can remove uncertainty about cost, as there is often a long-term contract where services are specified in advance for a fixed price. If computing services are inefficient, the costs will be borne by the FM company. This is also an incentive to the third party to provide a high quality service.
  • Long-term contracts (maybe up to ten years) encourage planning for the future.
  • Outsourcing can bring the benefits of economies of scale. For example, a FM company may conduct research into new technologies that benefits a number of their clients.
  • A specialist organisation is able to retain skills and knowledge. Many organisations would not have a sufficiently well-developed IT department to offer IT staff opportunities for career development. Talented staff would leave to pursue their careers elsewhere.
  • New skills and knowledge become available. A specialist company can share staff with specific expertise between several clients. This allows the outsourcing company to take advantage of new developments without the need to recruit new people or retrain existing staff, and without the cost.
  • Flexibility (contract permitting). Resources may be able to be scaled up or down depending on demand. For instance, during a major changeover from one system to another the number of IT staff needed may be twice as large as it will be once the new system is working satisfactorily. An outsourcing organisation is more able to arrange its work on a project basis, whereby some staff will expect to be moved periodically from one project to the next.

Disadvantages of outsourcing

Some possible drawbacks are outlined below.


  10   Environmental factors
There is increasing concern about businesses’ relationship with the natural environment. Businesses may suffer significant costs and a loss of reputation if problems arise.

It is arguable that information and its provision is an inherent part of the business and of management. Unlike office cleaning, or catering, an organisation’s IT services may be too important to be contracted out. Information is at the heart of management.

  • A company may have highly confidential information and to let outsiders handle it could be seen as risky in commercial and/or legal terms.
  • If a third party is handling IS/IT services there is no onus on internal management to keep up with new developments or to suggest new ideas. Consequently, opportunities to gain competitive advantage may be missed. Any new technology or application devised by the third party is likely to be available to competitors.
  • An organisation may find itself locked in to an unsatisfactory contract. The decision may be very difficult to reverse. If the service provider supplies unsatisfactory levels of service, the effort and expense the organisation would incur to rebuild its own computing function or to move to another provider could be substantial.
  • The use of an outside organisation does not encourage awareness of the potential costs and benefits of IS/IT within the organisation. If managers cannot manage in-house IS/IT resources effectively, then it could be argued that they will not be able to manage an arrangement to outsource effectively either.


10.1 Significance of environmental effects

There is a general issue for society of whether environmental problems, such as climate change, actually exist. There are some who believe that environmental changes are just natural events in the lifecycle of the planet. If environmental problems do exist, the issue is how serious are they? There is an additional issue of whether business activities have contributed to environmental change. Clearly there are concerns which need to be closely examined.

10.2 Impact on environment of economic activities 

Environmental footprint is the impact that a business’s activities have on the environment, including its resource environment and pollution emissions.


At an individual firm or business level, environmental impact can be measured in terms of environmental costs in various areas. Much business activity takes place at some cost to the environment. Examples of impacts on the environment include:

  • Depletion of natural resources
  • Noise and aesthetic impacts
  • Residual air and water emissions
  • Long-term waste disposal (exacerbated by excessive product packaging)
  • Uncompensated health effects
  • Change in the local quality of life (through for example the impact of tourism)


Plastic shopping bags are widely recognised as a blight on the environment. Supermarkets now charge customers for plastic bags, in an attempt to:

  • Encourage customers to reduce their bag usage by changing from single use carrier bags to reusable bags
  • Raise monies for environmental projects to counterbalance the adverse impact of the bags and other aspects of supermarket operations


10.3 Impact on organisation of environmental costs

In addition, an IFAC report listed a large number of costs that a business might suffer internally.

Direct or indirect environmental costs

  • Waste management
  • Remediation costs or expenses
  • Compliance costs
  • Permit fees
  • Environmental training
  • Environmentally driven research and development
  • Environmentally related maintenance
  • Legal costs and fines
  • Environmental assurance bonds
  • Environmental certification and labelling
  • Natural resource inputs
  • Record keeping and reporting

Contingent or intangible environmental costs

  • Uncertain future remediation or compensation costs
  • Risk posed by future regulatory changes  Product quality

  • Employee health and safety
  • Environmental knowledge assets
  • Sustainability of raw material inputs
  • Risk of impaired assets
  • Public/customer perception

Clearly failing to take sufficient account of environmental impact can have a significant impact on the business’s accounts as well as the outside world.

10.4 Social impacts of activities 

Partly because of the publicity generated by reports, there is now significant focus on the environmental impact of businesses’ activities. However, corporate social responsibility does not start and end with the environment. Organisations need to consider other aspects of corporate social responsibilities such has how people in developing countries are treated.

10.4.1 Stakeholder expectations

Pressures on organisations to widen the scope of their corporate public accountability come from increasing expectations of stakeholders and knowledge about the consequences of ignoring such pressures.

Stakeholders in this respect include communities (particularly where operations are based), customers (product safety issues), suppliers and supply chain participants and competitors. Issues such as plant closures, pollution, job creation, sourcing, etc can have powerful social effects for good or ill on these stakeholders.

10.4.2 Reputation risk

Increasingly a business must have the reputation of being a responsible business that enhances longterm shareholder value by addressing the needs of its stakeholders – employees, customers, suppliers, the community and the environment.

10.5 Corporate social responsibility and risk management 

Corporate social responsibility (CSR) can be described as an organisation monitoring its activities to ensure its active compliance with the spirit of the law, ethical standards and international norms. The goal of CSR is to get the organisation to take responsibility for its actions and to encourage a positive impact on the environment, consumers and stakeholders generally.

CSR can provide value to an organisation through risk management by encouraging the organisation to ‘do the right thing’. CSR can also help a business to think about sustainability; for example in its use of resources. Raw materials may be purchased from renewable sources, or the business may decide to switch to ‘green’ energy, such as wind or solar power.

In order to publicise its CSR policies, the organisation may include a customised report on CSR with its financial statements eg as part of the directors’ report or as a separate statement.

  11   Competitive forces 

11.1 SWOT analysis 

A method of environmental analysis which looks at an organisation’s internal strengths and weaknesses as well as external opportunities and threats is known as SWOT analysis.

11.1.1 Internal appraisal: strengths and weaknesses

An internal appraisal will identify:

(a)           The areas of the organisation that have strengths that should be exploited by suitable strategies  (b)        The areas of the organisation that have weaknesses which need strategies to improve them

The strengths and weaknesses analysis is intended to shape the organisation’s approach to the external world. For instance, the identification of shortcomings in products could lead to a programme of product development.

11.1.2 External appraisal: opportunities and threats

The external appraisal identifies opportunities that can be exploited by the organisation’s strengths and also to anticipate environmental threats against which the company must protect itself.


  • What opportunities exist in the business environment?
  • What is their inherent profit-making potential?
  • Can the organisation exploit the worthwhile opportunities?
  • What is the comparative capability profile of competitors?


  • Threats
    What is the company’s comparative performance potential in this field of opportunity?
  • What threats might arise to the company or its business environment?
  • How will competitors be affected?
  • How will the company be affected?

11.2 Using a SWOT analysis

The SWOT analysis can be used in one of two ways.

  • The organisation can develop resource-based strategies which enable the organisation to extend the use of its strengths. This is common in retailing, for example, as supermarket chains extend their own brands from food to other areas.
  • The business can develop positioning-based strategies. In other words, identifying what opportunities are available and what the firm has to do exploit them.
  12   Converting resources: the value chain
The value chain describes those activities of the organisation that add value to purchased inputs. Primary activities are involved in the production of goods and services. Support activities provide necessary assistance. Linkages are the relationships between activities. Managing the value chain, which includes relationships with outside suppliers, can be a source of strategic advantage.

The value chain model of corporate activities offers a bird’s eye view of the firm and what it does.

Competitive advantage arises out of the way in which firms organise and perform activities to add value.

  • Value activities


Activities incur costs and, in combination with other activities, provide a product or service which earns revenue.

  • Example

Let us explain this point by using the example of a restaurant. A restaurant’s activities can be divided into buying food, cooking it, and serving it (to customers). There is no reason, in theory, why the customers should not do all these things themselves, at home. The customer, however, is not only prepared to pay for someone else to do all this but also pays more than the cost of the resources (food, wages, and so on). The ultimate value a firm creates is measured by the amount customers are willing to pay for its products or services above the cost of carrying out value activities. A firm is profitable if the realised value to customers exceeds the collective cost of performing the activities.

  • Customers purchase value, which they measure by comparing a firm’s products and services with similar offerings by competitors.
  • The business creates value by carrying out its activities either more efficiently than other businesses, or by combining them in such a way as to provide a unique product or service.

QUESTION                                                                                                 Value activities

Outline different ways in which the restaurant can create value.


Here are some ideas. Each of these options is a way of organising the activities of buying, cooking and serving food in a way that customers will value.

  • It can become more efficient, by automating the production of food, as in a fast food chain.
  • The chef can develop commercial relationships with growers, so he or she can obtain the best quality fresh produce.
  • The chef can specialise in a particular type of cuisine (eg Nepalese, Korean).
  • The restaurant can be sumptuously decorated for those customers who value atmosphere and a sense of occasion, in addition to a restaurant’s purely gastronomic pleasures. (e) The restaurant can serve a particular type of customer (eg celebrities).


12.3 The value chain

Porter’s Value Chain (Porter, 1985) groups the various activities of an organisation into a value chain. Here is a diagram.

The margin is the excess the customer is prepared to pay over the cost to the firm of obtaining resource inputs and providing value activities. It represents the value created by the value activities themselves and by the management of the linkages between them.

Primary activities are directly related to production, sales, marketing, delivery and service.

Activity Comment
Inbound logistics Receiving, handling and storing inputs to the production system: warehousing, transport, inventory control, and so on


Convert resource inputs into a final product. Resource inputs are not only materials. People are a resource, especially in service industries
Outbound logistics Storing the product and its distribution to customers: packaging, testing, delivery, and so on
Marketing and sales Informing customers about the product, persuading them to buy it, and enabling them to do so: advertising, promotion, and so on
Service Installing products and \ or the act of performing the service for the client or customer. Includes all aspects of post-sales service delivery

Support activities provide purchased inputs, human resources, technology and infrastructural functions to support the primary activities.

Activity Comment
Procurement (purchasing) Acquire the resource inputs to the primary activities (eg purchase of materials, subcomponents equipment)
Technology development Product design, improving processes and/or resource utilisation
Human resource management Recruiting, training, developing and rewarding people
Firm infrastructure Planning, finance, quality control: Porter believes they are crucially important to an organisation’s strategic capability in all primary activities

Linkages connect the activities of the value chain.

  • Activities in the value chain affect one another. For example, more costly product design or better quality production might reduce the need for after-sales service.
  • Linkages require co-ordination. For example, Just In Time requires smooth functioning of operations, outbound logistics and service activities such as installation.

12.4 Value network

Activities and linkages that add value do not stop at the organisation’s boundaries. For example, when a restaurant serves a meal, the quality of the ingredients – although they are chosen by the cook – is determined by the grower. The grower has added value, and the grower’s success in growing produce of good quality is as important to the customer’s ultimate satisfaction as the skills of the chef.

According to Johnson et al, (2005), an organisation’s value chain is connected to the value chains of suppliers, distributors and customers in what may be referred to as a value network.

A value network generates value through exchanges between two or more organisations. Exchanges may include both tangible (for example goods) and intangible (for example knowledge such as collaborative design).

QUESTION                                                                                                 Primary activity

BCD Co is a large trading company. Steve is the administration manager and is also responsible for legal and compliance functions. Sheila is responsible for after-sales service and has responsibility for ensuring that customers who have purchased goods from BCD Co are fully satisfied. Sunny deals with suppliers and negotiates on the price and quality of inventory. He is also responsible for identifying the most appropriate suppliers of plant and machinery for the factory. Sam is the information technology manager and is responsible for all information systems within the company.

According to Porter’s value chain, which of the managers is involved in a primary activity as opposed to a support activity?

A          Steve C            Sunny
B          Sheila D          Sam


B          The word ‘administration’ indicates that Steve is in a support role and that ‘information technology’ indicates that Sam is in a support role. Sunny’s responsibilities describe procurement which is also a support role.


  13   Competitive advantage – Porter’s five forces model
The competitive environment is structured by five forces: barriers to entry; substitute products; the bargaining power of customers; the bargaining power of suppliers; competitive rivalry.

In discussing competition, Porter (Porter, 1980) distinguishes between factors which characterise the nature of competition.

  • In one industry compared with another (eg the chemicals industry compared with the clothing retail industry), some factors make one industry as a whole potentially more profitable than another (ie yielding a bigger return on investment).
  • Factors within a particular industry lead to the competitive strategies that individual firms might select.

Five competitive forces influence the state of competition in an industry, which collectively determine the profit (ie long-run return on capital) potential of the industry as a whole. Learn them.

  • The threat of new entrants to the industry
  • The threat of substitute products or services
  • The bargaining power of customers
  • The bargaining power of suppliers
  • The rivalry amongst current competitors in the industry

The threat of new entrants (and barriers to entry to keep them out)

A new entrant into an industry will bring extra capacity and more competition. The strength of this threat is likely to vary from industry to industry and depends on two things.

  • The strength of the barriers to entry. Barriers to entry discourage new entrants.
  • The likely response of existing competitors to the new entrant.

13.2 The threat from substitute products

A substitute product is a good or service produced by another industry which satisfies the same customer needs.



The Channel Tunnel

Passengers have several ways of getting from London to Paris, and the pricing policies of the various industries transporting them there reflects this.

  • ‘Le Shuttle’ carries cars in the Channel Tunnel. Its main competitors come from the ferry companies, offering a substitute service. Therefore, you will find that Le Shuttle sets its prices with reference to ferry company prices, and vice versa.
  • Eurostar is the rail service from London to Paris/Brussels. Its main competitors are not the ferry companies but the airlines.


13.3 The bargaining power of customers

Customers want better quality products and services at a lower price. Satisfying this want might force down the profitability of suppliers in the industry. Just how strong the position of customers will be depends on a number of factors including:

  • How much the customer buys
  • How critical the product is to the customer’s own business
  • Switching costs (ie the cost of switching supplier)
  • Whether the products are standard items (hence easily copied) or specialised
  • The customer’s own profitability: a customer who makes low profits will be forced to insist on low prices from suppliers
  • Customer’s ability to bypass the supplier (or take over the supplier)
  • The skills of the customer purchasing staff, or the price awareness of consumers

When product quality is important to the customer, the customer is less likely to be price-sensitive, and so the industry might be more profitable as a consequence.

13.4 The bargaining power of suppliers

Suppliers can exert pressure for higher prices. The ability of suppliers to get higher prices depends on several factors.

  • Whether there are just one or two dominant suppliers to the industry, able to charge monopoly or oligopoly prices
  • The threat of new entrants or substitute products to the supplier’s industry
  • Whether the suppliers have other customers outside the industry, and do not rely on the industry for the majority of their sales
  • The importance of the supplier’s product to the customer’s business
  • Whether the supplier has a differentiated product which buyers need to obtain
  • Whether switching costs for customers would be high

13.5 The rivalry amongst current competitors in the industry

The intensity of competitive rivalry within an industry will affect the profitability of the industry as a whole. Competitive actions might take the form of price competition, advertising battles, sales promotion campaigns, introducing new products for the market, improving after-sales service or providing guarantees or warranties. Competition can stimulate demand, expanding the market, or it can leave demand unchanged, in which case individual competitors will make less money, unless they are able to cut costs.     

PER performance objective PO3 requires you to demonstrate practical experience of strategy and innovation. This would mean that you need to be familiar with your employer’s business, the sector in which it operates and the wider business environment, as covered in this chapter.

N Whatever the overall strategic management method used, no organisation is likely to achieve its aims if it fails to take into account the characteristics of the environment in which it operates.
N Government policy influences the economic environment, the framework of laws, industry structure and certain operational issues. Political instability is a cause of risk. Different approaches to the political environment apply in different countries. International trade is subject to a further layer of international law and regulation.
N Much legislation (and not enough economic knowledge) has been aimed at the idea of ’employment protection’. As a result, all forms of termination of employment must be treated with great care.
N Privacy is the right of the individual not to suffer unauthorised disclosure of information.
N The (UK) Data Protection Act 2018 protects individuals about whom data is held. Both manual and computerised information must comply with the Act.
N The UK Data Protection Act includes six Data Protection Principles with which data users must comply.
N People should be able to be confident that they will not be exposed to excessive risk when they are at work. This means that risk and danger must be actively managed.
N A contract is a legally binding agreement.
N Population affects an organisation’s supply of labour and hence its policies towards recruiting and managing human resources.
N Organisations are part of the wider social environment
N Information systems and information technology have played a significant role in the development of the modern business environment, including encouraging the flattening of organisation hierarchies and widening spans of control.









Some effects of technological advances on organisations and accountants include:

–             Routine processing (bigger volumes, greater speed, greater accuracy)

–             Digital information and record keeping

–             New skills required and new ways of working

–             Reliance on IT

–             New methods of communication and of providing customer service

–             Interoperability (encourages collaboration across organisation boundaries) and open systems

–             The view of information as a valuable resource

–             The view of information as a commodity which can be bought, sold or exchanged (‘information market’)

N There is increasing concern about businesses’ relationship with the natural environment. Businesses may suffer significant costs and a loss of reputation if problems arise.
N A method of environmental analysis which looks at an organisation’s internal strengths and weaknesses as well as external opportunities and threats is known as SWOT analysis
N The value chain describes those activities of the organisation that add value to purchased inputs. Primary activities are involved in the production of goods and services. Support activities provide necessary assistance. Linkages are the relationships between activities. Managing the value chain, which includes relationships with outside suppliers, can be a source of strategic advantage.
N The competitive environment is structured by five forces: barriers to entry; substitute products; the bargaining power of customers; the bargaining power of suppliers; competitive rivalry.


  • Environmental analysis is relevant when undertaking the strategy-making process. Is this true or false?
  • Give four types of legal factor affecting a company.
  • How can businesses influence government policy?
  • Which of the following types of dismissal relates to the method of dismissal?
    • Unfair dismissal
    • Wrongful dismissal C Forced dismissal
  • An individual who is the subject of personal data is a data ……………. .
  • How can senior managers promote health and safety awareness?
  • Information technology has encouraged which three of the following?
    • Flattening of organisation hierarchies
    • Widening spans of control
    • Smaller volumes of routine processing D More flexible working arrangements 8 Downsizing can reduce capacity. Is this true or false?
  • What are the five competitive forces?
  • Which one of the following is a primary activity in the value chain?
    • Technology department
    • Procurement
    • Human resources management D Marketing and sales
  • The purpose of value chain analysis is to understand customer price and quality preferences. True or false?

  • The environment is everything that surrounds an organisation and so understanding it is one of the key inputs to the strategy-making process.
  • Four from:

General legal framework (eg contract)          Data protection

Criminal                                                          Marketing and sales

Company                                                        Environment

Employment                                                  Taxation

Health and safety

  • Employ lobbyists; hand out non-executive directorships; try to influence public opinion.
  • B               Wrongful dismissal relates to the method of dismissal. Unfair dismissal is dismissal without good reason.
  • An individual who is the subject of personal data is a data subject.
  • Visibly reacting to policy breaches Setting priorities

Ensuring that the policy is communicated  Involving staff in the health and safety process

  • A, B, D. Information technology means that greater volumes of data can be processed more quickly and with greater accuracy.
  • It can make organisations leaner and more flexible, but also can reduce capacity.
  •  Threat of new entrants   Bargaining power of suppliers

Threat of substitute products    Rivalry amongst current competition  Bargaining power of customers

  • D  Marketing and sales
  • The main purpose is to understand how the company creates value from its various activities.










Now try …
Attempt the questions below from the Practice Question Bank










03 In this chapter we present an overview of the goals of macroeconomic  policy concentrating on fiscal policy and monetary policy.

In this chapter we present an overview of the goals of macroeconomic
policy concentrating on fiscal policy and monetary policy.
Section 1 considers the circular flow of income in the economy and
this leads us on to the explanation of supply and demand in
Section 2.
In macroeconomics we are concerned with spending, investment,
price levels, employment and output in the economy as a whole
Section 3).
Broadly speaking, macroeconomists divide into the two camps of the
Keynesians and the monetarists. These two camps have had differing
ideas about how national income can be made to grow, how full
employment can be achieved and how booms and slumps of trade
cycles can be smoothed out (
Section 4).
There are also different views about the causes of inflation and the
effectiveness of government measures to stimulate the economy
Sections 5-7).
We consider the Government’s policies (
Section 8) for managing the
economy and the role of fiscal policy (
Section 9) in affecting demand
and examine the types of taxation and the role of taxation in creating
incentives. This is followed by a discussion of the conduct of
monetary policy (
Section 10).
The balance of payments (
Section 11) is a statistical ‘accounting’
record of a country’s international trade transactions (the purchase and
sale of goods and services) and capital transactions (the acquisition and
disposal of assets and liabilities) with other countries during a period of

Study Guide Intellectual level  



                          A4 Macro-economic factors

(a) Define macroeconomic policy and explain its objectives.



(b) Explain the main determinants of the level of business activity


in the economy and how variations in the level of business activity affect individuals, households and businesses.

(c) Explain the impact of economic issues on the individual, the


household and the business:

(i)        Inflation

(ii)      Unemployment

(iii)     Stagnation

(iv)     International payments disequilibrium

(d) Describe the main types of economic policy that may be


implemented by government and supra-national bodies to maximise economic welfare.











(e) Recognise the impact of fiscal and monetary policy measures


on the individual, the household and businesses.



  1   The structure and objectives of the economy

Macroeconomics is the study of the aggregated effects of the decisions of individual economic units (such as households or businesses). It looks at a complete national economy, or the international economic system as a whole.

Macroeconomic policy describes the policies and actions a government takes to control economic issues, including economic growth, inflation, employment and trade performance.


We look in detail at macroeconomic policy and objectives later in this chapter (in Section 8). We now turn our attention to the flow of income and expenditure in an economy.

1.1 Income and expenditure flows


There is a circular flow of income in an economy, which means that expenditure, output and income will all have the same total value.

Firms must pay households for the factors of production (this generally means that firms pay wages to members of households) and households must pay firms for goods and services. The income of firms is the sales revenue from the sales of goods and services.

This creates a circular flow of income and expenditure, as illustrated in Figure 1. This is a basic closed economy, without foreign trade. It assumes the economy has only two sectors (firms and households), with no government intervention and no imports or exports. In this model, we assume that households spend all that they earn (in economics this spending is known as consumption), and all the firms’ goods and services are sold to the households.

Households earn income because they have provided labour which enables firms to provide goods and services. The income earned is used as expenditure on these goods and services that are made.

  • The total sales value of goods produced should equal the total expenditure on goods, assuming that all goods that are produced are also sold.
  • The amount of expenditure should also equal the total income of households, because it is households that consume the goods and they must have income to afford to pay for them.

At this stage we are assuming there are no withdrawals from, or injections into, the circular flow of income.

1.2 Withdrawals and injections into the circular flow of income

Now we assume that there are withdrawals from the circular flow of income (savings, taxation, import expenditure) and injections into the circular flow (investment, government spending, export income).

Our simplified diagram of the circular flow of income in Figure 1 needs to be amended to allow for these two things.

Be aware that saving is different from investment. Saving simply means withdrawing money from circulation. Think of it as cash kept in a money box rather than being put into a bank to earn interest. Whereas investment covers expenditure on capital items, such as plant, machinery, roads and houses.

The important point to note is that changes in behaviour of one of the components of the circular flow (for example, investment) can lead to significant changes in economic performance as a whole.

  2   Factors which affect the economy

The economy is rarely in a stable state because of the various changing factors which influence it. These include investment levels, the multiplier effect, inflation, savings, confidence, interest rates and exchange rates.

The economy is explained by the various factors that influence it, such as investment levels, the multiplier effect, inflation, savings, confidence, interest rates and exchange rates. These factors are subject to change which means that the economy is rarely in a stable state. Economists use the business cycle (explained later in the chapter) to describe the fluctuating level of activity in the economy.

2.1 The multiplier in the national economy

The multiplier involves the process of circulation of income in the national economy, whereby an injection of a certain size leads to a much larger increase in national income. An initial increase in expenditure will have a snowball effect, leading to further and further expenditures in the economy. Since total expenditure in the economy is one way of measuring national income, it follows that an initial increase in expenditure will cause an even larger increase in national income. The increase in national income will be a multiple of the initial increase in spending, with the size of the multiple depending on such factors as what proportion of any new investment is spent or what proportion is saved.

If you find this hard to visualise, think of an increase in government spending on the construction of roads. The government would spend money paying firms of road contractors, who in turn will purchase raw materials from suppliers, and subcontract other work. All these firms employ workers who will receive wages that they can spend on goods and services of other firms. The new roads in turn might stimulate new economic activity, for example amongst road hauliers, house builders and estate agents.

Depending on the size of the multiplier, an increase in investment would therefore have repercussions throughout the economy, increasing the size of the national income by a multiple of the size of the original increase in investment.

2.2 Aggregate supply and demand

Two of the main problems in the economy are inflation and unemployment. In order to understand how these problems arise, it is first necessary to understand aggregate demand, aggregate supply and how these combine to determine the level of national income and prices in the economy.

2.2.1 Aggregate demand

The total demand in the economy for goods and services is called the aggregate demand and it is made up of several components of the circular flow. These components include consumption, investment, government spending and exports minus imports. Put simply, the aggregate demand curve represents the sum of all the demand curves for individuals and businesses in a country.

Figure 3 The aggregate supply and demand model

Figure 3 shows that the aggregate demand curve slopes from left to right (ie demand will rise as prices fall because people can afford more) but may shift as shown. A shift may be due to a factor such as an increase or decrease in consumer confidence. This is explained below.

2.2.2 Aggregate supply

The aggregate supply refers to the ability of the economy to produce goods and services. Aggregate supply is positively related to the price level. This is because a price rise will make more profitable sales and encourage organisations to increase their output. The aggregate supply curve slopes upwards from left to right and does not shift in the short term, as shown in Figure 3.

Where the aggregate demand curve intersects with the aggregate supply curve, the total demand for goods and services in the economy is equal to the total supply of goods and services in the economy. (This is known as the equilibrium level of national income.)

Note that the graph highlights the fact that a change in either the aggregate supply or demand will have an effect on the price level and the national income. Assuming that employment levels are related to national income levels, the model shows how unemployment and inflation (a change in price level) could arise.

2.2.3 A shift in aggregate demand

Say, for example, that the equilibrium level is currently where national income = Yand price = P0 .

Then suppose there is a drop in consumer confidence so consumers stop spending (ie demand falls). The new equilibrium would be where national income = Y1 and where price = P1. If, on the other hand, consumer confidence increased (for example due to more access to affordable credit), consumers would buy more (an increase in demand) and so the new equilibrium would be where national income = Y2 and price = P2.

  3   The determination of national income

Equilibrium national income is determined using aggregate supply and aggregate demand analysis.

3.1 Aggregate demand and supply equilibrium

Aggregate demand (AD) is total planned or desired consumption demand in the economy for consumer goods and services and also for capital goods, no matter whether the buyers are households, firms or government.

3.2 Full-employment national income

If one aim of a country’s economic policy is full employment, then the ideal equilibrium level of national income will be where AD and AS are in balance at the full employment level of national income, without any inflationary gap – in other words, where aggregate demand at current price levels is exactly sufficient to encourage firms to produce at an output capacity where the country’s resources are fully employed.  

3.3 Inflationary gaps 

In a situation where resources are already fully employed, there may be an inflationary gap since increases in demand will cause price changes, but no variations in real output.

A shift in demand or supply will not only change the national income, it will also change price levels.

3.4 Example

If you are not sure about this point, a simple numerical example might help to explain it better. Suppose that in Ruritania there is full employment and all other economic resources are fully employed. The country produces 1,000 units of output with these resources. Total expenditure (that is, aggregate demand) in the economy is 100,000 Ruritanian dollars, or 100 dollars per unit. The country does not have any external trade, and so it cannot obtain extra goods by importing them. Because of pay rises and easier credit terms for consumers, total expenditure now rises to 120,000 Ruritanian dollars. The economy is fully employed, and cannot produce more than 1,000 units. If expenditure rises by 20%, to buy the same number of units, it follows that prices must rise by 20% too. In other words, when an economy is at full employment, any increase in aggregate demand will result in price inflation.

3.5 Deflationary gap

In a situation where there is unemployment of resources there is said to be a deflationary gap. Prices are fairly constant and real output changes as aggregate demand varies. A deflationary gap can be described as the extent to which the aggregate demand function will have to shift upward to produce the full employment level of national income.

3.6 Stagflation

In the 1970s there was a problem with stagflation: a combination of unacceptably high unemployment, unacceptably high inflation and low/negative economic growth. One of the causes was diagnosed as the major rises in the price of crude oil that took place. The cost of energy rose and this had the effect of rendering some production unprofitable.

National income fell, and both prices and unemployment rose. Any long-term major increase in costs (a price shock) is likely to have this effect.

3.7 Summary

An equilibrium national income will be reached where aggregate demand equals aggregate supply. There are two possible equilibria.

  • One is at a level of demand which exceeds the productive capabilities of the economy at full employment, and there is insufficient output capacity in the economy to meet demand at current prices. There is then an inflationary gap.
  • The other is at a level of employment which is below the full employment level of national income. The difference between actual national income and full employment national income is called a deflationary gap. To create full employment, the total national income (expenditure) must be increased by the amount of the deflationary gap.
  4   The business cycle

Business cycles or trade cycles are the continual sequence of rapid growth in national income, followed by a slowdown in growth and then a fall in national income (recession). After this recession comes growth again, and when this has reached a peak, the cycle turns into recession once more.

4.1 Phases in the business cycle

Four main phases of the business cycle can be distinguished.

                Recession                  Recovery             Depression                 Boom

Recession tends to occur quickly, while recovery is typically a slower process.

4.2 Diagrammatic explanation

At point A in the diagram below, the economy is entering a recession. In the recession phase, consumer demand falls and many investment projects already undertaken begin to look unprofitable. Orders will be cut, inventory levels will be reduced and business failures will occur as firms find themselves unable to sell their goods. Production and employment will fall. The general price level will begin to fall. Business and consumer confidence are diminished and investment remains low, while the economic outlook appears to be poor. Eventually, in the absence of any stimulus to aggregate demand, a period of full depression sets in and the economy will reach point B.

At point C the economy has reached the recovery phase of the cycle. Once begun, the phase of recovery is likely to quicken as confidence returns. Output, employment and income will all begin to rise. Rising production, sales and profit levels will lead to optimistic business expectations, and new investment will be more readily undertaken. The rising level of demand can be met through increased production by bringing existing capacity into use and by hiring unemployed labour. The average price level will remain constant or begin to rise slowly.

In the recovery phase, decisions to purchase new materials and machinery may lead to benefits in efficiency from new technology. This can enhance the relative rate of economic growth in the recovery phase once it is underway.

As recovery proceeds, the output level climbs above its trend path, reaching point D, in the boom phase of the cycle. During the boom, capacity and labour will become fully utilised. This may cause bottlenecks in some industries which are unable to meet increases in demand, for example because they have no spare capacity or they lack certain categories of skilled labour, or they face shortages of key material inputs. Further rises in demand will, therefore, tend to be met by increases in prices rather than by increases in production. In general, business will be profitable, with few firms facing losses. Expectations of the future may be very optimistic and the level of investment expenditure high.

It can be argued that wide fluctuations in levels of economic activity are damaging to the overall economic well-being of society. The inflation and speculation which accompanies boom periods may be inequitable in their impact on different sections of the population, while the bottom of the trade cycle may bring high unemployment. Governments generally seek to stabilise the economic system, trying to avoid the distortions of a widely fluctuating trade cycle.

  5   Inflation and its consequences

High rates of inflation are harmful to an economy. Inflation redistributes income and wealth. Uncertainty about the value of money makes business planning more difficult. Constantly changing prices impose extra costs.

5.1 Inflation


Historically, there have been very few periods when inflation has not been present. We discuss below why high rates of inflation are considered to be harmful. However, it is important to remember that deflation (falling prices) is normally associated with low rates of growth and even recession. It would seem that a healthy economy may require some inflation. Certainly, if an economy is to grow, the money supply must expand, and the presence of a low level of inflation will ensure that growth is not hampered by a shortage of liquid funds. (Liquidity is the ease with which assets can be converted into cash.)

5.2 Why is inflation a problem?

An economic policy objective which now has a central place in the policy approaches of the governments of many developed countries is that of stable prices. Why is a high rate of price inflation harmful and undesirable?

5.2.1 Redistribution of income and wealth

Inflation leads to a redistribution of income and wealth in ways which may be undesirable.

Redistribution of wealth might take place from accounts payable to accounts receivable. This is because debts lose ‘real’ value with inflation. For example, if you owed $1,000, and prices then doubled, you would still owe $1,000, but the real value of your debt would have been halved. In general, in times of inflation those with economic power tend to gain at the expense of the weak, particularly those on fixed incomes.

5.2.2 Balance of payments effects

If a country has a higher rate of inflation than its major trading partners, its exports will become relatively expensive and imports relatively cheap. As a result, the balance of trade will suffer, affecting employment in exporting industries and in industries producing import-substitutes. Eventually, the exchange rate will be affected.

5.2.3 Uncertainty of the value of money and prices

If the rate of inflation is imperfectly anticipated, no one has certain knowledge of the true rate of inflation. As a result, no one has certain knowledge of the value of money or of the real meaning of prices. If the rate of inflation becomes excessive, and there is ‘hyperinflation’, this problem becomes so exaggerated that money becomes worthless, so that people are unwilling to use it and are forced to resort to barter. In less extreme circumstances, the results are less dramatic, but the same problem exists. As prices convey less information, the process of resource allocation is less efficient and rational decision-making is almost impossible.

5.2.4 Resource costs of changing prices

A fourth reason to aim for stable prices is the resource cost of frequently changing prices. In times of high inflation, substantial labour time is spent on planning and implementing price changes. Customers may also have to spend more time making price comparisons if they seek to buy from the lowest cost source.

5.2.5 Economic growth and investment

It is sometimes claimed that inflation is harmful to a country’s economic growth and level of investment.. Although some studies have indicated that the adverse influence of inflation on economic growth and investment appears to be small in the short term, it could affect a country’s standard of living fairly significantly over the long term.

5.3 Consumer price indices

We have already referred to the way in which inflation erodes the real value of money. In order to measure changes in the real value of money as a single figure, we need to group all goods and services into a single price index.

A consumer price index is based on a chosen ‘basket’ of items which consumers purchase. A weighting is decided for each item according to the average spending on the item by consumers.

Consumer price indices may be used for several purposes, for example as an indicator of inflationary pressures in the economy, as a benchmark for wage negotiations and to determine annual increases in government benefits payments. Countries commonly have more than one consumer price index because one composite index may be considered too wide a grouping for different purposes.

5.3.1 The RPI and the CPI

One important measure of the general rate of inflation in the UK used over many years has been the Retail Prices Index (RPI). The RPI measures the percentage changes month by month in the average level of prices of the commodities and services, including housing costs, purchased by the great majority of households in the UK. The items of expenditure within the RPI are intended to be a representative list of items, current prices for which are collected at regular intervals.

Since 2003, the Harmonised Index of Consumer Prices (HICP) has been used as the basis for the UK’s inflation target. The UK HICP is called the Consumer Prices Index (CPI). The CPI excludes most housing costs.

5.3.2 The underlying rate of inflation

The term underlying rate of inflation is usually used to refer to the RPI adjusted to exclude mortgage costs and sometimes other elements as well (such as the local council tax). The effects of interest rate changes on mortgage costs help to make the RPI fluctuate more widely than the underlying rate of inflation.

RPIX is the underlying rate of inflation measured as the increase in the RPI excluding mortgage interest payments. Another measure, called RPIY, goes further and excludes the effects of sales tax (VAT) changes as well.

5.4 Causes of inflation

The following can cause inflation:

  • Demand pull factors              Expectations
  • Cost push factors              Excessive growth in the money supply        Import cost factors

5.4.1 Demand pull inflation


Demand pull inflation arises from an excess of aggregate demand over the productive capacity of the economy.

Demand pull inflation occurs when the economy is buoyant and there is a high aggregate demand, in excess of the economy’s ability to supply.

  • Because aggregate demand exceeds supply, prices rise.
  • Since supply needs to be raised to meet the higher demand, there will be an increase in demand for factors of production, and so factor rewards (wages, interest rates, and so on) will also rise.
  • Since aggregate demand exceeds the output capability of the economy, it should follow that demand pull inflation can only exist when unemployment is low. A feature of inflation in the UK in the 1970s and early 1980s, however, was high inflation coupled with high unemployment.

Demand pull inflation: inflation resulting from a persistent excess of aggregate demand over aggregate supply. Supply reaches a limit on capacity at the full employment level.


5.4.2 Cost push inflation


Cost push inflation arises from increases in the costs of production.

Cost push inflation occurs where the costs of factors of production rise regardless of whether or not they are in short supply. This appears to be particularly the case with wages.

Cost push inflation: inflation resulting from an increase in the costs of production of goods and services, eg through escalating prices of imported raw materials or from wage increases.


5.4.3 Import cost factors

Import cost push inflation occurs when the cost of essential imports rise regardless of whether or not they are in short supply. This has occurred in the past with the oil price rises of the 1970s. Additionally, a fall in the value of a country’s currency will have import cost push effects since a weakening currency increases the price of imports.

5.4.4 Expectations and inflation

A further problem is that once the rate of inflation has begun to increase, a serious danger of expectational inflation will occur. This means, regardless of whether the factors that have caused inflation are still persistent or not, there will arise a generally held view of what inflation is likely to be, and so to protect future income, wages and prices will be raised now by the expected amount of future inflation. This can lead to the vicious circle known as the wage-price spiral, in which inflation becomes a relatively permanent feature because of people’s expectations that it will occur.

5.4.5 Money supply growth

Monetarists have argued that inflation is caused by increases in the supply of money. There is a considerable debate as to whether increases in the money supply are a cause of inflation or whether increases in the money supply are a symptom of inflation. Monetarists have argued that since inflation is caused by an increase in the money supply, inflation can be brought under control by reducing the rate of growth of the money supply.

  6   Unemployment

6.1 The rate of unemployment

The rate of unemployment in an economy can be calculated as:

If the flow of workers through unemployment is constant then the size of the unemployed labour force will also be constant.

Flows into unemployment are:

  • Members of the working labour force becoming unemployed
    • Redundancies  Voluntarily quitting a job
    • Lay-offs
  • People out of the labour force joining the unemployed
    • School leavers without a job
    • Others (for example, carers) rejoining the workforce but having no job yet Flows out of unemployment are:
    • Unemployed people finding jobs
    • Laid-off workers being re-employed
    • Unemployed people stopping the search for work

In the UK, the monthly unemployment statistics published by the Office for National Statistics (ONS) count only the jobless who receive benefits.

The ONS also produce figures based on a quarterly survey of the labour force known as the International Labour organisation measure (ILO measure) that provides seasonally adjusted monthly data. This figure is considered to be more useful because it is also an internationally comparable measure.

6.2 Consequences of unemployment

Unemployment results in the following problems.

  • Loss of output. If labour is unemployed, the economy is not producing as much output as it could. Thus, total national income is less than it could be.
  • Loss of human capital. If there is unemployment, the unemployed labour will gradually lose its skills, because skills can only be maintained by working.
  • Increasing inequalities in the distribution of income. Unemployed people earn less than employed people, and so when unemployment is increasing, the poor get poorer.
  • Social costs. Unemployment brings social problems of personal suffering and distress, and possibly also increases in crime, such as theft and vandalism.
  • Increased burden of welfare payments. This can have a major impact on government fiscal policy.
    • Causes of unemployment

Unemployment may be classified into several categories depending on the underlying causes.

Category Comments
Real wage unemployment This type of unemployment is caused when the supply of labour exceeds the demand for labour, but real wages do not fall for the labour market to clear. This type of unemployment is normally caused by strong trade unions which resist a fall in their wages. Another cause of this type of unemployment is the minimum wage rate, when it is set above the market clearing level.
Frictional It is inevitable that some unemployment is caused not so much because there are not enough jobs to go round, but because of the friction in the labour market (difficulty in matching quickly workers with jobs), caused perhaps by a lack of knowledge about job opportunities. In general, it takes time to match prospective employees with employers, and individuals will be unemployed during the search period for a new job. Frictional unemployment is temporary, lasting for the period of transition from one job to the next.
Seasonal This occurs in certain industries, for example building, tourism and farming, where the demand for labour fluctuates in seasonal patterns throughout the year.
Structural This occurs where long-term changes occur in the conditions of an industry. A feature of structural unemployment is high regional unemployment in the location of the industry affected. The primary cause is a significant reduction in the level of demand.
Technological This is a form of structural unemployment, which occurs when new technologies are introduced.

(a)   Old skills are no longer required.

(b)   There is likely to be a labour saving aspect, with machines doing the job that people used to do.

With automation, employment levels in an industry can fall sharply, even when the industry’s total output is increasing.

Cyclical or demand-


It has been the experience of the past that domestic and foreign trade go through cycles of boom, decline, recession, recovery, then boom again, and so on.

(a)   During recovery and boom years, the demand for output and jobs is high, and unemployment is low.

(b)   During decline and recession years, the demand for output and jobs falls, and unemployment rises to a high level.

Cyclical unemployment can be long term, and a government might try to reduce it by doing what it can to minimise a recession or to encourage faster economic growth.

Seasonal employment and frictional unemployment will be short term. Structural unemployment, technological unemployment and cyclical unemployment are all longer term, and more serious.

  • Government employment policies

Job creation and reducing unemployment should often mean the same thing, but it is possible to create more jobs without reducing unemployment.

  • This can happen when there is a greater number of people entering the jobs market than there are new jobs being created. For example, if 500,000 new jobs are created during the course of one year, but 750,000 extra school leavers are looking for jobs, there will be an increase in unemployment of 250,000.
  • It is also possible to reduce the official unemployment figures without creating jobs. For example, individuals who enrol for a government-financed training scheme are taken off the unemployment register, even though they do not have full-time jobs.

A government can try several options to create jobs or reduce unemployment.

  • Spending more money directly on jobs (for example hiring more civil servants)
  • Encouraging growth in the private sector of the economy; when aggregate demand is growing, firms will probably want to increase output to meet demand, and so will hire more labour
  • Encouraging training in job skills, as there might be a high level of unemployment amongst unskilled workers, and at the same time a shortage of skilled workers – a government can help to finance training schemes, in order to provide a ‘pool’ of workers who have the skills that firms need and will pay for
  • Offering grant assistance to employers in key regional areas
  • Encouraging labour mobility by offering individuals financial assistance with relocation expenses, and improving the flow of information on vacancies

Other policies may be directed at reducing real wages to market clearing levels.

  • Abolishing closed shop agreements, which restrict certain jobs to trade union members
  • Abolishing minimum wage regulations, where such regulations exist

              QUESTION                                                                          Types of unemployment

Match the terms (a), (b) and (c) below with definitions A, B and C.

(a) Structural unemployment (c) Frictional unemployment (b) Cyclical unemployment

  • Unemployment arising from a difficulty in matching unemployed workers with available jobs
  • Unemployment occurring in the downswing of an economy in between two booms C Unemployment arising from a long-term decline in a particular industry


The pairings are (a) C, (b) B and (c) A.


  7   The objective of economic growth

7.1 Economic growth 


Economic growth may be measured by increases in the real gross national product (GNP) per head of the population.

It is not unusual to find economic growth measured simply as increases in total GNP, regardless of inflation and changes in population size. Over periods in which the population changes relatively little, this approach will be satisfactory.

Economic growth may be balanced, when all sectors of the economy expand together, or unbalanced. Less developed countries in particular find it difficult to achieve economic growth, because many of the factors necessary for growth are absent in these countries.

Actual economic growth is the annual percentage increase in national output, which typically fluctuates in accordance with the trade cycle. Potential economic growth is the rate at which the economy would grow if all resources (eg people and machinery) were utilised.

7.2 Actual growth

Actual growth in the long run is determined by two factors.

                The growth in potential output (in other words the aggregate supply)                 The growth in aggregate demand (AD)

These factors should move in step with one another as we explained in Section 2.2 and Figure 3.

7.3 Potential growth

The causes of growth in potential output are the determinants of the capacity of the economy (the supply side) rather than actual spending (the demand side), and are as follows.

  • There may be increases in the amount of resources
    • Land and raw materials. Land is virtually in fixed supply, but new natural resources are continually being discovered.
    • Labour (the size of the working population). The output per head will be affected by the proportion of the population which is non-working.
    • Capital (eg machinery).
  • Increases in the productivity of resources may result from technological progress or changed labour practices, for example.
    • Factors needed for sustained economic growth

Sustained economic growth depends heavily on an adequate level of new investment, which will be undertaken if there are expectations of future growth in demand. After investment has taken place on the basis of expectations, the level of income will increase, by the operation of the multiplier. But there is no reason why the actual level of income should end up increasing as much as the investing business people thought it would. It follows that investment, a factor in growth, is dependent on business confidence in the future, which is reflected in expectations of growth in consumption.

  • Natural resources

The rate of extraction of natural resources will impose a limit on the rate of growth. Production which uses up a country’s natural resources, such as oil, coal and other minerals, depletes the stock of available resources; it is therefore, in a sense, disinvestment.

  • Technological progress

Technological progress is a very important source of faster economic growth.

                The same amounts of the factors of production can produce a higher output.        New products will be developed, thus adding to output growth.

There can be technical progress in the labour force. If workers are better educated and better trained they will be able to produce more. For example, if there is a fault in the production process, a skilled worker will be able to deal with it quickly, whereas an unskilled worker might have to call for a superior instead.

Technological progress can be divided into three types.

  • Capital saving: technical advances that use less capital and the same amount of labour per unit of output
  • Neutral: technical advances that require labour and capital in the same proportions as before, using less of each per unit of output
  • Labour-saving: technical advances that uses less labour and the same amount of capital per unit of output

If technological progress is of type (c) and the new technology seems to be labour-saving, then unemployment will rise unless there is either a simultaneous expansion of demand or a reduction in hours worked by each person. In the latter case there is no productivity increase associated with the technological progress.

Technological progress may therefore stimulate growth but at the same time conflict with the goal of full employment. A further consequence of this could be that those people in work would benefit from economic growth in the form of higher wages, but those people put out of work by the new technology would be left with a lower income. There is thus a danger that the rich will get richer and the poor will get poorer in spite of economic growth, and this would be regarded by many people as an undesirable development.

  • External trade influences on economic growth

An improvement in the terms of trade (the quantity of imports that can be bought in exchange for a given quantity of exports) means that more imports can be bought or alternatively a given volume of exports will earn higher profits. This will boost investment and hence growth. The rate of growth of the rest of the world is important for an economy that has a large foreign trade sector. If trading partners have slow growth, the amount of exports a country can sell to them will grow only slowly, and this limits the country’s own opportunities for investment and growth.

  • Advantages and disadvantages of economic growth

Economic growth should lead to a higher income per head which can in turn lead to higher levels of consumption and a better standard of living.

A country with economic growth is more easily able to provide welfare services without creating intolerable tax burdens on the community.

There are possible disadvantages to growth, however.

  • Growth implies faster use of natural resources. Without growth, these resources would last longer.
  • Much economic activity tends to create pollution, such as acid rain and nuclear waste. It leads to emissions which threaten to produce disruptive climatic changes through an increase in the ‘greenhouse effect’. It results in more roads, new and larger towns, and less unspoilt countryside.
  • There is a danger that some sections of the population, unable to adapt to the demands for new skills and more training, will not find jobs in the developing economy. This structural unemployment might create a large section of the community which gains no benefit from the increase in national income.
  • In order to achieve growth, firms need to invest more and this requires financing. This finance can only come from higher savings which in turn require the population to consume less. In the short run, therefore, higher growth requires a cut in consumption.
  8   Government policies for managing the economy

Macroeconomic policy objectives relate to economic growth, inflation, unemployment and the balance of payments.

All modern governments are expected to manage their national economies to some extent. Electorates generally suppose that government action can support or hinder the growth of prosperity and look to them for serviceable macroeconomic policies.

There are four main objectives of economic policy, though debate continues about their relative priority.

  • To achieve economic growth, and growth in national income per head of the population. Growth implies an increase in national income in real terms. Increases caused by price inflation are not real increases at all.
  • To control price inflation (to achieve stable prices). This has become a central objective of UK economic policy in recent years.
  • To achieve full employment. Full employment does not mean that everyone who wants a job has one all the time, but it does mean that unemployment levels are low, and involuntary unemployment is short term.
  • To achieve a balance between exports and imports (on the country’s balance of payments accounts) over a period of years. The wealth of a country relative to others, a country’s creditworthiness as a borrower, and the goodwill between countries in international relations might all depend on the achievement of an external balance over time.

The problem with trying to satisfy these objectives is that when any are satisfied, they invariably cause a problem with the others. For example, creating full employment may lead to increased inflation rates. As explained later in the chapter, governments use ‘fiscal’ or ‘monetary’ policies to manage these objectives.

8.1 Government spending

Governments spend money. Expenditure must be allocated between departments and functions such as health, social services, education, transport, defence, grants to industry, and so on.

  • Wages and salaries to employees
  • Materials, supplies and services
  • Capital equipment
  • Interest on borrowings and repayments of capital
  • Benefits and pensions to those entitled to such

8.2 Significance of government tax and spending decisions to companies

  • Expenditure decisions by government affect suppliers to the Government, such as producers of defence equipment, medicines and medical equipment, and school text books.
  • There is a ‘knock-on’ effect throughout the economy of government spending; that is, companies might supply companies which in turn supply the Government.
  • Taxation affects consumers’ purchasing power.
  • Taxes on company profits and tax allowances affect the after-tax return on investment that companies achieve.
  • Investment by the public sector will tend to be directed towards activities in which the public sector is involved or on fulfilling social needs. Hence industries in these fields will benefit.
  • Public sector investment might have a longer time scale (eg health) or have less quantifiable economic benefits (eg education) than the private sector is able to cope with.

8.3 Economic planning

At one time, many people believed the Government should plan economic activity in detail. This is now out of favour, perhaps as a result of the failure of communism in the eastern bloc. In this model, government is a director of economic activity.

Economic planning on a lesser scale, with the Government as an enabler of private sector activity and as corrector of market imperfections, is now seen by many as more appropriate.

  • Government’s most important economic role is the legal system relating to business. Law relating to property, contracts in corporation, competition, employment, and so on provides a framework which enables businesses to be done with confidence.
  • Government also has a responsibility for macroeconomic management. Such management, like the legal framework, should provide stable conditions in which business can operate with confidence.
  • Governments can raise trade barriers to protect domestic industry, although the trend has been to lower such barriers.
  • Governments can subsidise exports, or promote them in other ways (eg by trade missions, export credit insurance and so forth).
  • Governments can also encourage inward investment by foreign countries..
  • Regional policy is an example of small scale economic planning.
    • Tax incentives or grants for investing in certain areas
    • Relaxing or enforcing town and county planning restrictions
    • Developing new towns to reduce population pressure in major conurbations, although this policy is perhaps a thing of the past
    • Promotion of infrastructure developments (eg roads, rail, airports)

The Government also attempts to influence businesses by persuasion and encouraging certain actions.

  • State influences over organisations

Government influences are outlined in the diagram below.

  • Government influence over commercial decisions
Decision Comment
Output capacity Grants or tax incentives to invest
Competition Forbid or allow takeovers/mergers

Outlaw anti-competitive practices

Opening markets to new entrants (eg gas)

Monopolies Break them up; regulate them
Sales demand Government policy affects demand
  • Government influence over operational decisions
Decision Comment
Health and safety Legislation, regulations
Employment Equal opportunities legislation
Consumers Product safety standards
Tax Sales tax procedures, income tax, accounting control

As well as State influences, there are other influences which affect groups of nations rather than a single nation, for example the EU. These are known as supra-national bodies. We looked at these in Chapter 2.

  9   Fiscal policy 


9.1 Fiscal policy and the Budget

A feature of fiscal policy is that a government must plan what it wants to spend, and so how much it needs to raise in income or by borrowing. It needs to make a plan in order to establish how much taxation there should be, what form the taxes should take and so which sectors of the economy (firms or households, high income earners or low income earners) the money should come from. This formal planning of fiscal policy is usually done once a year and is set out in the Budget.

The two components of the budget which the Government determines and through which it exercises its fiscal policy are:

  • Expenditure. The Government, at a national and local level, spends money to provide goods and services, such as a health service, public education, a police force, roads and public buildings, and to pay its administrative workforce. It may also, perhaps, provide finance to encourage investment by private industry, for example by means of grants.
  • Revenues. Expenditure must be financed, and the government must have income. Most government income comes from taxation, although some income is obtained from direct charges to users of government services, such as National Health Service charges.

A third element of the fiscal policy is:

(c)        Borrowing. To the extent that a government’s expenditure exceeds its income it must borrow to make up the difference. The amount that the Government must borrow each year is now known as the Public Sector Net Cash Requirement (PSNCR) in the UK. Its former name was Public Sector Borrowing Requirement (PSBR). Where the Government borrows from has an impact on the effectiveness of fiscal policy.

9.2 Budget surplus and budget deficit


If a government decides to use fiscal policy to influence demand in the economy, it can choose either expenditure changes or tax changes as its policy instrument.

Suppose, for example, that the Government wants to stimulate demand in the economy.

If the Government kept its own spending at the same level, but reduced levels of taxation, it would stimulate demand in the economy because firms and households would have more of their own money after tax for consumption or saving/investing.

  • It can increase demand directly by spending more itselfeg on the health service or education, and by employing more people itself.
    • This extra spending could be financed by higher taxes, but this would reduce spending by the private sector of the economy because the private sector’s after-tax income would be lower.
    • The extra government spending could also be financed by extra government borrowing. Just as individuals can borrow money for spending, so too can a government.
  • It can increase demand indirectly by reducing taxation and so allowing firms and individuals more after-tax income to spend (or save).
    • Cuts in taxation can be matched by cuts in government spending, in which case total demand in the economy will not be stimulated significantly, if at all.
    • Alternatively, tax cuts can be financed by more government borrowing.

Just as aggregate demand in the economy can be boosted by either more government spending or by tax cuts, financed in either case by a higher PSNCR, so too can demand in the economy be reduced by cutting government spending or by raising taxes, and using the savings or higher income to cut government borrowing.

Expenditure changes and tax changes are not mutually exclusive options, of course. A government has several options.

  • Increase expenditure and reduce taxes, with these changes financed by a higher PSNCR
  • Reduce expenditure and increase taxes, with these changes reducing the size of the PSNCR
  • Increase expenditure and partly or wholly finance this extra spending with higher taxes (d) Reduce expenditure and use these savings to reduce taxes

When a government’s income exceeds its expenditure, and there is a negative PSNCR or Public Sector Debt Repayment (PSDR), we say that the Government is running a budget surplus. This may be a deliberate policy (known as contractionary policy) to reduce the size of the money supply by taking money out of the economy. When a government’s expenditure exceeds its income, so that it must borrow to make up the difference, there is a PSNCR and we say that the Government is running a budget deficit. When the government is injecting money into the economy, this is known as expansionary policy.

9.3 Functions of taxation

Taxation has several functions. Some of these include the following.

  • To raise revenues for the Government as well as for local authorities and similar public bodies (eg the European Union).
  • To cause certain products to be priced to take into account their social costs. (For example, smoking entails certain social costs, such as hospital care.) (c)           To redistribute income and wealth.

(d)        To protect industries from foreign competition. If the Government levies a duty on all imported goods, much of the duty will be passed on to the consumer in the form of higher prices, making imported goods more expensive.

9.4 Direct and indirect taxes


A government must decide how it intends to raise tax revenues, from direct or indirect taxes, and in what proportions tax revenues will be raised from each source.

A direct tax is paid direct by a person to the Revenue authority. Examples of direct taxes in the UK are income tax, corporation tax, capital gains tax and inheritance tax. A direct tax can be levied on income and profits, or on wealth. Direct taxes tend to be progressive or proportional taxes. They are also usually unavoidable, which means that they must be paid by everyone.

An indirect tax is collected by the Revenue authority from an intermediary (a supplier) who then attempts to pass on the tax to consumers in the price of goods they sell. Indirect taxes are of two types.

A specific tax is charged as a fixed sum per unit sold.

An ad valorem tax is charged as a fixed percentage of the price of the good.


9.5 Tax and income levels

Note the following distinctions.

  • A regressive tax takes a higher proportion of a poor person’s salary than of a rich person’s. Television licences and road tax are examples of regressive taxes since they are the same for all people.
  • A proportional tax takes the same proportion of income in tax from all levels of income.
  • A progressive tax takes a higher proportion of income in tax as income rises. Income tax as a whole is progressive, since the first part of an individual’s income is tax free due to personal allowances and the rate of tax increases in steps in the UK from 20p in £1 to 45p in £1 as taxable income rises.

Direct taxes tend to be progressive or proportional. Income tax is usually progressive, with high rates of tax charged on higher bands of taxable income. Indirect taxes can be regressive, when the taxes are placed on essential commodities or commodities consumed by poorer people in greater quantities.
  10   Monetary policy
Monetary policy uses money supply, interest rates or credit controls to influence aggregate demand.

Monetary policy: government policy on the money supply, the monetary system, interest rates, exchange rates and the availability of credit.

Monetary and fiscal policies attempt to attain the macroeconomic policy objectives by influencing aggregate demand.


QUESTION                                                                                      Effects of policy

How are businesses affected by fiscal and monetary policy?


Businesses are affected by a government’s tax policy (eg corporation tax rates) and monetary policy (high interest rates increase the cost of investment, and depress consumer demand).


10.1 Objectives of monetary policy

Monetary policy can be used as a means towards achieving ultimate economic objectives for inflation, the balance of trade, full employment and real economic growth. To achieve these ultimate objectives, the authorities will set intermediate objectives for monetary policy.

In the UK, the ultimate objective of monetary policy in recent years has been principally to reduce the rate of inflation to a sustainable low level. The intermediate objectives of monetary policy have related to the level of interest rates, growth in the money supply, the exchange rate for sterling, the expansion of credit and the growth of national income.

10.2 The money supply as a target of monetary policy

To monetarist economists, the money supply is an obvious intermediate target of economic policy. This is because they claim that an increase in the money supply will raise prices and incomes and this in turn will raise the demand for money to spend. The current trend is to call this quantitative easing, a policy whereby a government prints more money in order to stimulate the economy.

When such a policy is first introduced, the short-term effect would be unpredictable for three reasons.

  • The effect on interest rates might be erratic.
  • There might be a time lag before anything can be done. For example, it takes time to cut government spending and hence to use reduction in government borrowing as an instrument of monetary policy.
  • There might be a time lag before control of the money supply alters expectations about inflation and wage demands.

Growth in the money supply, if it is a monetary policy target, should therefore be a medium-term target.

10.3 Interest rates as a target for monetary policy

The authorities might decide that interest rates – the price of money – should be a target of monetary policy. This would be appropriate if it is considered that there is a direct relationship between interest rates and the level of expenditure in the economy, or between interest rates and the rate of inflation.

A rise in interest rates will raise the price of borrowing in the internal economy for both companies and individuals. If companies see the rise as relatively permanent, rates of return on investments will become less attractive and investment plans may be curtailed. Corporate profits will fall as a result of higher interest payments. Companies will reduce inventory levels as the cost of having money tied up in inventory rises. Individuals should be expected to reduce or postpone consumption in order to reduce borrowings, and should become less willing to borrow for house purchase.

Although it is generally accepted that there is likely to be a connection between interest rates and investment (by companies) and consumer expenditure, the connection is not a stable and predictable one, and interest rate changes are only likely to affect the level of expenditure after a considerable time lag.

Other effects of raising interest rates

  • High interest rates will keep the value of sterling higher than it would otherwise be. This will keep the cost of exports high, and so discourage the purchase of exports. This may be necessary to protect the balance of payments and to prevent ‘import-cost-push’ inflation. UK manufacturers have complained bitterly about this effect and BMW cited it as one of the reasons for disposing of Rover.
  • High interest rates will attract foreign investors into sterling investments, and so provide capital inflows which help to finance the large UK balance of payments deficit.

An important reason for pursuing an interest rate policy is that the authorities are able to influence interest rates much more effectively and rapidly than they can influence other policy targets, such as the money supply or the volume of credit.

10.4 The exchange rate as a target of monetary policy

Why the exchange rate is a target

  • If the exchange rate falls, exports become cheaper to overseas buyers and so more competitive in export markets. Imports will become more expensive and so less competitive against goods produced by manufacturers at home. A fall in the exchange rate might therefore be good for a domestic economy, by giving a stimulus to exports and reducing demand for imports.
  • An increase in the exchange rate will have the opposite effect, with dearer exports and cheaper imports. If the exchange rate rises and imports become cheaper, there should be a reduction in the rate of domestic inflation. A fall in the exchange rate, on the other hand, tends to increase the cost of imports and adds to the rate of domestic inflation.

When a country’s economy is heavily dependent on overseas trade, as the UK economy is, it might be appropriate for government policy to establish a target exchange value for the domestic currency. However, the exchange rate is dependent on both the domestic rate of inflation and the level of interest rates. Targets for the exchange rate cannot be achieved unless the rate of inflation at home is first brought under control.

10.5 Targets and indicators

An economic indicator provides information about economic conditions and might be used as a way of judging the performance of government.

  • A leading indicator is one which gives an advance indication of what will happen to the economy in the future. It can therefore be used to predict future conditions. For example, a fall in the value of sterling by, say, 2% might be used to predict what will happen to the balance of payments and to the rate of inflation.
  • A coincident indicator is one which gives an indication of changes in economic conditions at the same time that these changes are occurring. For example, if the narrow money supply rises by 5%, this might ‘confirm’ that the rate of increase in GDP over the same period of time has been about the same, 5% in ‘money’ terms.
  • A lagging indicator, you will have guessed, is one which ‘lags behind’ the economic cycle. Unemployment, to take an example, often continues to rise until after a recession has ended and only starts to fall again after recovery has begun.

There are a number of monetary indicators.

  • The size of the money stock
  • Interest rates such as the banks’ base rate of interest, the Treasury bill rate and the yield on longdated government securities
  • The exchange rate against another currency, for example the US dollar, or the trade-weighted exchange rate index
  • The size of the Government’s borrowing
  • Government borrowing as a percentage of Gross Domestic Product

10.6 Monetary policy and fiscal policy

Monetary policy can be made to act as a subsidiary support to fiscal policy and demand management. Since budgets are once-a-year events, a government must use non-fiscal measures in between budgets to make adjustments to its control of the economy.

  • A policy of low interest rates or the absence of any form of credit control might stimulate bank lending, which in turn would increase expenditure (demand) in the economy.
  • High interest rates might act as a deterrent to borrowing and so reduce spending in the economy.
  • Strict credit controls (for example restrictions on bank lending) might be introduced to reduce lending and so reduce demand in the economy.

Alternatively, monetary policy might be given prominence over fiscal policy as the most effective approach by a government to achieving its main economic policy objectives. This might not, however, be possible: from 1990 to 1992, for example, monetary policy in the UK was heavily constrained by the need to set interest rates at levels which maintained sterling’s position in the European exchange rate mechanism (ERM). From 1997, the Government has given the Bank of England the role of setting interest rates, although it is still the Government which sets an inflation target. If the UK joined a single European currency, interest rates would largely be determined at the European level.

10.7 Monetary policy, inflation control and economic growth

Monetarists argue that monetary control will put the brake on inflation, but how does this help the economy? We might argue like this.

  • High inflation increases economic uncertainty. Bringing inflation under control will restore business confidence and help international trade by stabilising the exchange rate.
  • A resurgence of business confidence through lower interest rates (due to less uncertainty and lower inflation) will stimulate investment and real output.
  • A controlled growth in the money supply will provide higher incomes for individuals to purchase the higher output.
  11   The balance of payments

The balance of payments accounts consist of a current account with visibles and invisibles sections and transactions in capital (external assets and liabilities including official financing).

11.1 The nature of the balance of payments 

Under the current method of presentation of the UK balance of payments statistics, current account transactions are subdivided into four parts.

  • Trade in goods              Income
  • Trade in services              Transfers

Before 1996, the term visibles was used in official statistics for trade in goods and the term invisibles was used for the rest. These terms have now been dropped in order to give more emphasis to the balances for trade in goods and services, although you may still find them mentioned.

Income is divided into two parts.

  • Income from employment of UK residents by overseas firms
  • Income from capital investment overseas Transfers are also divided into two parts.
  • Public sector payments to and receipts from overseas bodies, such as the EU. Typically these are interest payments
  • Non-government sector payments to and receipts from bodies, such as the EU

The capital account balance is made up of public sector flows of capital into and out of the country, such as government loans to other countries.

The balance on the financial account is made up of flows of capital to and from the non-government sector, such as direct investment in overseas facilities; portfolio investment (in shares, bonds, and so on); and speculative flows of currency. Movements on government foreign currency reserves are also included under this heading.

When journalists or economists speak of the balance of payments they are usually referring to the deficit or surplus on the current account, or possibly to the surplus or deficit on trade in goods only (this is also known as the balance of trade).

11.2 Equilibrium in the balance of payments

A balance of payments is in equilibrium if, over a period of years, the exchange rate remains stable and autonomous credits and debits are equal in value (the annual trade in goods and services is in overall balance). However, equilibrium will not exist if these things require the government to introduce measures which create unemployment or higher prices, sacrifice economic growth or impose trade barriers (eg import tariffs and import quotas).

11.3 Surplus or deficit in the current account


A surplus or deficit on the balance of payments usually means a surplus or deficit on the current account.

A problem arises for a country’s balance of payments when the country has a deficit on current account year after year, although there can be problems too for a country which enjoys a continual current account surplus.

The problems of a deficit on the current account are probably the more obvious. When a country is continually in deficit, it is importing more goods and services that it is exporting. This leads to two possible consequences.

  • It may borrow more and more from abroad, to build up external liabilities which match the deficit on the current account, for example encouraging foreign investors to lend more by purchasing the government’s gilt-edged securities.
  • It may sell more and more of its assets. This has been happening recently in the US, for example, where a large deficit on the US current account has resulted in large purchases of shares in US companies by foreign firms.

Even so, the demand to buy the country’s currency in the foreign exchange markets will be weaker than the supply of the country’s currency for sale. As a consequence, there will be pressure on the exchange rate to depreciate in value.

If a country has a surplus on the current account year after year, it might invest the surplus abroad or add it to official reserves. The balance of payments position would be strong. There is the problem, however, that if one country which is a major trading nation (such as Japan) has a continuous surplus on its balance of payments current account, other countries must be in continual deficit. These other countries can run down their official reserves, perhaps to nothing, and borrow as much as they can to meet the payments overseas, but eventually they will run out of money entirely and be unable even to pay their debts. Political pressure might therefore build up within the importing countries to impose tariffs or import quotas.

11.4 How can a government rectify a current account deficit?

The government of a country with a balance of payments deficit will usually be expected to take measures to reduce or eliminate the deficit. A current account deficit may be rectified by one or more of the following measures.

  • A depreciation of the currency (called devaluation when deliberately instigated by the government, for example by changing the value of the currency within a controlled exchange rate system)
  • Direct measures to restrict imports, such as tariffs or import quotas or exchange control regulations
  • Domestic deflation to reduce aggregate demand in the domestic economy

The first two are expenditure switching policies, which transfer resources and expenditure away from imports and towards domestic products, while the last is an expenditure reducing policy.

N Macroeconomics is the study of the aggregated effects of the decisions of individual economic units (such as households or businesses). It looks at a complete national economy, or the international economic system as a whole
N There is a circular flow of income in an economy, which means that expenditure, output and income will all have the same total value.
N The economy is rarely in a stable state because of the various changing factors which influence it. These include investment levels, the multiplier effect, inflation, savings, confidence, interest rates and exchange rates.
N Equilibrium national income is determined using aggregate supply and aggregate demand analysis.
N Business cycles or trade cycles are the continual sequence of rapid growth in national income, followed by a slowdown in growth and then a fall in national income. After this recession comes growth again, and when this has reached a peak, the cycle turns into recession once more.
N High rates of inflation are harmful to an economy. Inflation redistributes income and wealth. Uncertainty about the value of money makes business planning more difficult. Constantly changing prices impose extra costs.
N Demand pull inflation arises from an excess of aggregate demand over the productive capacity of the economy.
N Cost push inflation arises from increases in the costs of production.
N The number of unemployed at any time is measured by government statistics.
N Economic growth may be measured by increases in the real gross national product (GNP) per head of the population.
N Macroeconomic policy objectives relate to economic growth, inflation, unemployment and the balance of payments.
N Fiscal policy provides a method of managing aggregate demand in the economy.
N If a government decides to use fiscal policy to influence demand in the economy, it can choose either expenditure changes or tax changes as its policy instrument.
N A government must decide how it intends to raise tax revenues, from direct or indirect taxes, and in what proportions tax revenues will be raised from each source.
N Direct taxes have the quality of being progressive or proportional. Income tax is usually progressive, with high rates of tax charged on higher bands of taxable income. Indirect taxes can be regressive, when the taxes are placed on essential commodities or commodities consumed by poorer people in greater quantities.
N Monetary policy uses money supply, interest rates or credit controls to influence aggregate demand.
N The balance of payments accounts consist of a current account with visibles and invisibles sections and transactions in capital (external assets and liabilities, including official financing).
N A surplus or deficit on the balance of payments usually means a surplus or deficit on the current account.


  • Government policy on taxation, public borrowing and public spending is:
    • Monetary policy B             Fiscal policy
  • A government can increase demand by using fiscal policy.

True           False

  • A tax which takes a higher proportion of a poor person’s salary than of a rich person’s is:
    • Proportional tax C Progressive tax B Regressive tax D Indirect tax
  • High rates of personal income tax are thought to have a disincentive effect. This refers to the likelihood that the high rates of tax will:
    • Encourage illegal tax evasion by individuals
    • Lead to a reduction in the supply of labour
    • Lead to a reduction in savings by individuals D Discourage company investment
  • The government of a certain country decides to introduce a poll tax, which will involve a flat rate levy of $200 on every adult member of the population. This new tax could be described as:
    • Regressive C             Progressive
    • Proportional D Ad valorem
  • Which of the following will not be the immediate purpose of a tax measure by the Government?
    • To discourage an activity regarded as socially undesirable
    • To influence interest rates
    • To protect a domestic industry from foreign competition
    • To price certain products so as to take into account their social cost
  • Which of the following government aims might be achieved by means of fiscal policy? 1. A redistribution of income between firms and households. 2. A reduction in aggregate monetary demand. 3. A change in the pattern of consumer demand.
    • Objectives 1 and 2 only C             Objectives 2 and 3 only B     Objectives 1 and 3 only               D             Objectives 1, 2 and 3
  • Other things remaining the same, an increase in the money supply will tend to reduce:
    • Interest rates C             The volume of bank overdrafts B        Liquidity preference       D             Prices and incomes
  • Injections into the economy are:
    • Consumption and Investment
    • Investment and Government Expenditure
    • Investment, Government Expenditure and Export Demand
    • Consumption, Investment, Government Expenditure and Export Demand 10 A deflationary gap occurs when:
    • Aggregate demand is insufficient to buy up all the goods and services the company is capable of producing.
    • Aggregate demand is more than sufficient to buy up all the goods and services produced by an economy.
    • A government attempts to spend its way out of recession.
    • A government is cutting its level of expenditure.



  • B Monetary policy is policy on the money supply, monetary system, interest rates, exchange rates and the availability of credit.
  • A government can increase demand by spending more itself or by reducing taxation so that firms and households have more after-tax income to spend.
  • B This is the definition of regressive tax.
  • B The disincentive effect refers specifically to the disincentive of individuals to work.
  • A A flat-rate poll tax, with no concession for the lower paid, would take a higher proportion of the

income of lower-income earners than of higher-income earners. This is a regressive tax system.

  • B The main purpose of taxation will be to raise revenue for the government. Other aims might be to redistribute wealth or affect demand in the economy. Changes in rate of tax do not have a direct influence on interest rates, which can be influenced by a government’s monetary
  • D Objective 1 could be achieved by raising (or lowering) taxes on firms and lowering (or raising) taxes on households. Objective 2 could be achieved by raising taxation in order to reduce consumers’ disposable income and so to reduce aggregate expenditure in the economy: these consequences should lead to a fall in the demand for money. Objective 3 can be achieved either by taxing income or by means of selective indirect taxes on certain goods.
  • A Lower interest rates should be a consequence of an increase in the money supply, with a movement along the liquidity preference curve rather than a shift in the liquidity preference curve.
  • C
  • A






Now try …
Attempt the questions below from the Practice Question Bank






04 Microeconomic factors

We start by looking at the definition of the micro environment (Section 1) and the differences between the Microeconomic factors
micro and macro environments (Section 2).
Next we shall examine the concept of a market which, in
economics, goes beyond the idea of a single geographical
place where people meet to buy and sell goods (
We will then look in more depth at the microeconomic
level of the individual firm, individual markets and
consumers (or households). This means looking at what
influences the amount of a product which is demanded or
supplied and analysing how price and output are
determined through the interaction of
demand and supply
(Sections 4 to 8).

Study Guide Intellectual level  



                          A5 Microeconomic factors

(a) Define the concept of demand and supply for goods and





(b) Explain elasticity of demand and the impact of substitute and


complementary goods.

(c) Explain the economic behaviour of costs in the short and long



(d) Define perfect competition, oligopoly, monopolistic competition


and monopoly.



  1   The micro environment

The micro environment refers to the immediate operational environment, including suppliers, competitors, customers, stakeholders and intermediaries.

The micro environment includes all factors which impact directly on a firm and its activities in relation to a particular market in which it operates, and also any internal aspects of the organisation which influence the development of a marketing strategy.

The micro environment includes the groups and organisations that have a two-way operation relationship with the business, and which the business can control and influence to some degree.

1.1 Supply and demand

An organisation’s micro environment consists of itself and its current and potential customers, suppliers and intermediaries. The competition also has a key influence on the micro environment.

The organisation is an open system, with boundaries to its immediate environment. The organisation must establish relationships across these boundaries to obtain supplies and credit. It also must have linkages to the marketplace, either directly to end customers or indirectly through intermediaries.

Competitors also form part of the micro environment and senior management must understand the relationships that exist between competitors in the micro environment of the organisation. This was covered in more detail in Chapter 1 where we took a closer look at the stakeholders of an organisation.

We might need to remind ourselves of some of the underlying relationships between an organisation and the other organisations in its environment.

The market economy based on capitalism contrasts with the centrally planned economy in which the state controls production. A feature of market economies is that many firms compete with each other to create a customer. This is a spur to innovation and marketing activities which are the distinguishing characteristics of business organisation.

The micro environment comprises not just those firms that an organisation actually does business with. It also includes those firms and individuals that an organisation could potentially do business with.

Therefore it includes not just current customers, but potential customers who may currently be served by another organisation. Thus, an important element in understanding the micro environment is competition between organisations in order to:

  • Win customers
  • Obtain supplies
  • Get access to the best intermediaries

The micro environment is of general importance to the marketing process for several reasons. In general, the micro environment is the immediate or operational environment; it drives the tactical responses of management on a daily basis. The marketer can utilise the marketing mix to influence and affect the stakeholders of a business.

Remember that the micro environment contains both actual and potential customers – management can use the marketing mix to convert potential customers into actual customers; however, to do this requires an understanding of the needs and wants of those potential customers.

  2   Internal and external micro and macro environments

For the organisation as a system, we need to consider the various forces which have an impact internally and externally.

The diagram which follows highlights the organisation (which is a social system) taking inputs and transforming them into outputs for consumption. The process is cyclical in nature, those consuming the end output providing feedback which is used to adapt the inputs selected and the transformation process in the future. The purpose of this feedback is to better meet the needs of these consumers (customers, end-users etc). This process also happens within the context of the micro and macro environments, which have factors and forces that will have an impact on all elements within this process.

There are four main elements to the system: the inputs, the transformational process which occurs within the organisation, the output and then the final consumption of these outputs. The inputs can be remembered using a common abbreviation, the 5Ms.

The 5Ms refer to inputs that an organisation requires in order to function. They are:

  • Materials
  • Money
  • Men (ie human resource)
  • Machines
  • Management


Each of the 5Ms needs to be carefully employed, as each is a valuable resource in enabling the organisation to meet its goals.

The competence and skill employed within the organisation should be used in a way to enable the transformation of these inputs into something valuable or important to the customer. Mullins (2005) noted that organisations even within the same sector may have radically different goals, procedures, methods of operating, styles of management, systems, structure and behaviour of staff. Despite these differences, Mullins identified four factors that all organisations require in order to function:

  • People – behind every action, document written, presentation, decision made are human interactions
  • Objectives – which form the basis of an organisation and determine the nature of the outputs and the series of activities to achieve them
  • Structure – is needed by which to channel and co-ordinate efforts and interactions
  • Management – is required to direct and control efforts in order to pursue objectives


You are not expected to discuss different forms and methods of management. However, it is useful for you to appreciate that effective strategic management is at the core of the organisation’s ability to transform inputs and to be able to offer a competitive offering of value to customers.


The output and consumption elements of our diagram outline that the process is ongoing and that once something is created by the organisation (the product or service) it is passed on. Marketing as a discipline reminds us that, in order for this process to continue, the organisation needs to ensure that the output will meet the needs of specified customers and this must relate to the customer value proposition.

The customer value proposition consists of the sum total of benefits which a vendor promises that a customer will receive in return for the customer’s associated payment (or other value-transfer).


In simple words: value proposition = what the customer gets for what the customer pays.

Accordingly, a customer can evaluate a company’s value proposition on two broad dimensions with multiple subsets:

  • Relative performance: what the customer gets from the vendor relative to a competitor’s offering
  • Price: which consists of the payment the customer makes to acquire the product or service; plus the access cost

The vendor-company’s marketing and sales efforts offer a customer value proposition; the vendorcompany’s delivery and customer-service processes then fulfil that value proposition.

When faced with their next purchase decision, whose product or service is a customer most likely to buy? Will it be yours or will it be that of a key competitor? This is the most important question most business managers will have to answer. Most of the time, customers will make that decision based on the benefits that are most valuable to them, and the price they must pay to receive those benefits. In other words, most purchase decisions are based upon perceived value – the trade-off between the quality of the most desirable benefits and the price paid for those benefits.


Imagine the following scenario for a hypothetical organisation called Premier Motors which produces high-performance sports cars.

If, for example, Premier Motors has used the very best input resources available to them and has the ultimate management and organisational workings to produce the most exceptional cars ever designed, you might think that this would be highly lucrative. If, however, they were based in Mongolia, which has one of the lowest levels of car ownership, they would not have a significant local customer base. Equally, they would find that to transport the product to other parts of the world would be very expensive. For some exceptionally wealthy consumers the opportunity to purchase the best car in the world regardless of cost would mean that there is a market for the cars; however, the potential size of this market is highly limited and not necessarily cost effective in the long term.

We now need to add in the additional environmental elements to our example. In the micro environment, the lack of many customers is clearly a disadvantage. Also, within the high-performance sports car market Premier Motors may well have a number of competitors who may not produce such exceptional cars but are more affordable and therefore have a larger market. At the macro level, in times of economic prosperity there may be a larger global number of ‘high worth’ individuals, while in turbulent economic times there may be a reduced propensity to purchase such ostentatious cars not only for financial reasons but also possibly due to a change in social and cultural expectations.

Although this is a completely fictitious and extreme example, it at least demonstrates how the whole process is embedded in a complex picture to be assessed and anticipated by the marketer.


  3   The concept of a market 

In a free market, the price mechanism signals demand and supply conditions to producers and consumers. It therefore determines the activities of both producers and consumers, influencing the levels of demand for and the supply of goods.

3.1 What is a market?

A market involves the buyers and sellers of a good who influence its price. Markets can be worldwide, as in the case of oil, wheat, cotton and copper for example. Others are more localised, such as the housing market or the market for second-hand cars.

A market can be defined as a situation in which potential buyers and potential sellers (suppliers) of a good or service come together for the purpose of exchange.


Suppliers and potential suppliers are referred to in economics as firms. The potential purchasers of consumer goods are known as households.

However, some markets have buyers who are other firms or government authorities. For example, a manufacturing firm buys raw materials and components to go into the products that it makes. Service industries and government departments must similarly buy in supplies in order to do their own work. The demand for goods by firms and government authorities is a derived demand, in that it depends on the demand from households for the goods and services that they produce and provide.

Markets for different goods or commodities are often interrelated. All commodities compete for households’ income so that if more is spent in one market, there will be less to spend in other markets. Further, if markets for similar goods are separated geographically, there will be some price differential at which it will be worthwhile for the consumer to buy in the lower price market and pay shipping costs, rather than buy in a geographically nearer market.

3.2 Price theory and the market

Price theory is concerned with how market prices for goods are arrived at, through the interaction of demand and supply.

A good or service has a price if it is useful as well as scarce. Its usefulness is shown by the fact that consumers demand it. In a world populated entirely by vegetarians, meat would not command a price, no matter how few cows or sheep there were because no one would want to eat meat.

3.3 Utility

Utility is the word used to describe the pleasure or satisfaction or benefit derived by a person from the consumption of goods. Total utility is the total satisfaction that people derive from spending their income and consuming goods.

Marginal utility is the satisfaction gained from consuming one additional unit of a good or the satisfaction forgone by consuming one unit less. If someone eats six apples and then eats a seventh, total utility refers to the satisfaction they derive from all seven apples together, while marginal utility refers to the additional satisfaction from eating the seventh apple, having already eaten six.

3.4 Assumptions about consumer rationality

Economists assume that consumers act rationally. This means, in turn, that:

  • Generally the consumer prefers more goods to less.
  • Generally the consumer is willing to substitute one good for another, provided its price is right.
  • Choices are transitive. This means that if, at a given time, a commodity A is preferred to B and B is preferred to C then we can conclude that commodity A is preferred to commodity C.

Acting rationally means that the consumer attempts to maximise the total utility attainable with a limited income. When the consumer decides to buy another unit of a good they are deciding that its marginal utility exceeds the marginal utility that would be yielded by any alternative use of the price they pay.

If a person has maximised their total utility, it follows that they have allocated their expenditure in such a way that the utility gained from spending the last penny spent on each good will be equal.

We are now going to look at demand and supply in turn, before considering how they (demand and supply) interact through the price mechanism.

  4   The demand schedule

The position of the demand curve is determined by the demand conditions, which include consumers’ tastes and preferences, and consumers’ incomes.
  • The concept of demand

Demand for a good or service is the quantity of that good or service that potential purchasers would be willing and able to buy, or attempt to buy, at any possible price.


Demand might be satisfied, and so actual quantities bought would equal demand. On the other hand, some demand might be unsatisfied, with the number of would-be purchasers trying to buy a good being too great for the supply of that good. In which case, demand is said to exceed supply.

The phrase ‘willing and able to buy’ in the key term above is important. Demand does not mean the quantity that potential purchasers wish they could buy. For example, a million households might wish that they owned a luxury yacht, but there might only be actual attempts to buy 100 luxury yachts at a given price. Economic demand needs to be effective. That is, it must be supported by available money (ie willing and able to buy), rather than just being a general desire for goods or services.

  • The demand schedule and the demand curve

The relationship between demand and price can be shown graphically as a demand curve. The demand curve of a single consumer or household is derived by estimating how much of the good the consumer or household would demand at various hypothetical market prices. Suppose that the following demand schedule shows demand for biscuits by one household over a period of one month.

Notice that we show demand falling as price increases. This is what normally happens with most goods. This is because purchasers have a limited amount of money to spend and must choose between goods that compete for their attention. When the price of one good rises, it is likely that other goods will seem relatively more attractive and so demand will switch away from the more expensive good to the cheaper alternative. So the shape of the demand curve is determined by the consumer acting rationally; with demand tending to be higher at a low price, and lower at a high price for most goods and services.

We can show this schedule graphically, with price on the y axis and quantity demanded on the x axis. If we assume that there is complete divisibility, so that price and quantity can both change in infinitely small steps, we can draw a demand curve by joining the points represented in the schedule by a continuous line (Figure 1). This is the household’s demand curve for biscuits in the particular market we are looking at.

The area of each rectangle in Figure 1 represents consumers’ total money outlay at the price in question. For example, at a price of $6, demand would be 1 kilogram and total spending would be $6, represented by rectangle ABCO. Similarly, at a price of $2, demand would be 8 kilograms and the total spending of $16 is represented by rectangle GEFO.

In Figure 1, the demand curve happens to be a straight line. Straight line demand curves are often used as an illustration in economics because it is convenient to draw them this way. In reality, a demand curve is more likely to be a curved line convex to the origin. As you will be able to appreciate, such a demand curve means that there are progressively larger increases in quantity demanded as price falls (Figure 2). This happens because of the fall in marginal utility experienced as consumption of a good increases.

QUESTION Demand curve

Refer to Figure 2. The price of the commodity is currently $3 per kilo, and demand is approximately 4 kilograms at that price. What would be the (approximate) demand for the commodity if the price fell to $2 per kilo? And what would be the demand if the price rose to $4 per kilo?


Demand rises to (approximately) 6 kilos at the reduced price of $2 per kilo. If the price rises to $4 per kilo, demand falls to (approximately) 3 kilos.


Note that changes in demand caused by changes in price are represented by movements along the demand curve, from one point to another. These changes in quantity demanded in response to a change in price are called expansions or contractions in demand. The price has changed, and the quantity demanded changes (prompting a movement along the curve), but the demand curve itself remains the same.

4.3 The market demand curve            

In the example above, we have been looking at the demand schedule of a single household. A market demand curve is a similar curve, but it expresses the expected total quantity of the good that would be demanded by all consumers together, at any given price.

Market demand is the total quantity of a product that all purchasers would want to buy at each price level. A market demand schedule and a market demand curve are therefore simply the sum of all the individual demand schedules and demand curves put together. Market demand curves would be similar to those in Figures 1 and 2 – sloping downwards from left to right – but with quantities demanded (total market demand) being higher at each price level.

A demand curve generally slopes down from left to right.

  • As we saw earlier, the curve is downward sloping because progressively larger quantities are demanded as price falls.
  • A fall in the good’s price means that it becomes cheaper both in relation to the household’s income and also in relation to other (substitute) products. Therefore the overall size of the market for the good increases. The converse argument applies to an increase in prices; the size of the market will shrink as the good becomes more expensive.

Several factors influence the total market demand for a good. One of these factors is obviously its price, but there are other factors too, and to help you to appreciate some of these other factors, you need to recognise that households buy not just one good with their money but a whole range of goods and services.

Factors determining demand for a good

  • The price of the good
  • The size of households’ income (income effect)
  • The price of other substitute goods (substitution effect)
  • Tastes and fashion
  • Expectations of future price changes
  • The distribution of income among households

The income effect reflects the impact of a price change on consumers’ income. If the price of a good falls, all other things being equal, consumers become better off, as their real income has increased. Therefore they can afford to buy more of the good, following its fall in price.

The income effect can also be reinforced by the substitution effect. The substitution effect occurs when consumers buy more of one good and less of another good because of relative price changes between the two goods. For example, if two types of bread are considered substitutes, the price of bread 1 falls relative to the price of bread 2, then consumers will buy more of 1 than 2: they substitute bread 1 for bread 2.

A demand curve shows how the quantity demanded will change in response to a change in price provided that all other conditions affecting demand are unchangedthat is, provided that there is no change in the prices of other goods, tastes, expectations or the distribution of household income. (This assumption that ‘all other things remain equal’ is referred to as ceteris paribus.)

Make sure you remember this point about a movement along the demand curve reflecting a change in price when other factors are unchanged. We will return to it later to examine what happens to the demand curve when the other conditions affecting demand are changed.

4.4 Substitutes and complements

  • Substitute goods are goods that are alternatives to each other, so that an increase in the demand for one is likely to cause a decrease in the demand for another. Switching demand from one good to another ‘rival’ good is substitution.
  • Complements are goods that tend to be bought and used together, so that an increase in the demand for one is likely to cause an increase in the demand for the other.


A change in the price of one good will not necessarily change the demand for another good. For example, we would not expect an increase in the price of televisions to affect the demand for bread. However, there are goods for which the market demand is interconnected. These interrelated goods are referred to as either substitutes or complements.

Examples of substitute goods and services 

  • Rival brands of the same commodity, like Coca-Cola and Pepsi-Cola
  • Tea and coffee
  • Some different forms of entertainment

Substitution takes place when the price of one good rises relative to a substitute good.

By contrast, complements are connected in the sense that demand for one is likely to lead to demand for the other.

Examples of complements 

  • Cups and saucers
  • Bread and butter
  • Motor cars and the components and raw materials that go into their manufacture

                          QUESTION                                                         Substitutes and complements

What might be the effect of an increase in the ownership of domestic deep freezers on the demand for perishable food products?


  • Domestic deep freezers and perishable products are complements because people buy deep freezers to store perishable products.
  • Perishable products are supplied either as fresh produce (for example, fresh meat and fresh vegetables) or as frozen produce, which can be kept for a short time in a refrigerator but for longer in a freezer. The demand for frozen produce will rise, while the demand for fresh produce will fall.
  • Wider ownership of deep freezers is likely to increase bulk buying of perishable products. Suppliers can save some packaging costs, and can therefore offer lower prices for bulk purchases.


4.5 The price elasticity of demand

If prices went up by 10%, would the quantity demanded fall by the same percentage?

Price elasticity of demand (PED) is a measure of the extent of change in the market demand for a good in response to a change in its price. The demand for a good is said to be inelastic when changes in price have a relatively small effect on the quantity of the good demanded. The demand for a good is said to be elastic when changes in price have a relatively large effect on the quantity of a good demanded. ‘Relatively small’ and ‘relatively large’ here equate to ‘less than 1’ and ‘greater than 1’ respectively.


The coefficient of PED is measured as:

Percentage change in quantity demanded


Percentage change in price

Since demand usually increases when the price falls, and decreases when the price rises, elasticity has a negative value. However, it is usual to ignore the minus sign, and just describe the absolute value of the coefficient. Inelastic demand has a coefficient of less than 1, while elastic demand is greater than 1.

This can be expressed as:


100 Q


100 P

where              is the symbol for ‘change in’

Q       is the quantity demanded of the good

P        is the price of the good

If we are measuring the responsiveness of demand to a large change in price, we can measure elasticity between two points on the demand curve, and the resulting measure is called the arc elasticity of demand. We calculate the arc elasticity of demand from the percentage change in quantity relative to average quantity for the relevant range of output and from the percentage price change relative to the average of the corresponding price range.

If we wish to measure the responsiveness of demand at one particular point in the demand curve, we can calculate a point elasticity of demand, without averaging price and quantity over a range. In doing so, it is convenient to assume that the demand curve is a straight line unless told otherwise.

4.6 Example: arc elasticity of demand 

The price of a good is $1.20 per unit and annual demand is 800,000 units. Market research indicates that an increase in price of 10 cents per unit will result in a fall in annual demand of 70,000 units.

What is the price elasticity of demand measuring the responsiveness of demand over this range of price increase?


Annual demand at $1.20 per unit is 800,000 units.

Annual demand at $1.30 per unit is 730,000 units. Average quantity over the range is 765,000 units.

Average price is $1.25.

% change in demand 70,000

100% = 9.15% 765,000

% change in price 10c

100% = 8%  125c

Price elasticity of demand = 9.15

= –1.14 8

Ignoring the minus sign, the arc elasticity is 1.14.

The demand for this good, over the range of annual demand 730,000 to 800,000 units, is elastic because the price elasticity of demand is greater than 1. Now try the following exercise yourself.

                          QUESTION                                                         Arc price elasticity of demand

If the price per unit of X rises from $1.40 to $1.60, it is expected that monthly demand will fall from 220,000 units to 200,000 units.

What is the arc price elasticity of demand over these ranges of price and output?


Monthly demand at $1.40 per unit = 220,000 units

Monthly demand at $1.60 per unit = 200,000 units

Average quantity = 210,000 units

Average price = $1.50

% change in demand 20,000

× 100% = 9.52%  210,000

% change in price 20

× 100% = 13.33%  150


Arc price elasticity of demand =          =  –0.71%


Ignoring the minus sign, the arc elasticity is 0.71.

Demand is inelastic over the demand range considered, because the price elasticity of demand (ignoring the minus sign) is less than 1.


4.7 Example: point elasticity of demand

The price of a good is $1.20 per unit and annual demand is 800,000. Market research indicates that an increase in price of 10 cents per unit will result in a fall in annual demand for the good of 70,000 units.


Calculate the elasticity of demand at the current price of $1.20.


We are asked to calculate the elasticity at a particular price. We assume that the demand curve is a straight line.

At a price of $1.20, annual demand is 800,000 units. For a price rise:


% change in demand                                                       × 100% = 8.75% (fall)



% change in price                                                            × 100% = 8.33% (rise)



Price elasticity of demand at price $1.20 =                 = – 1.05


Ignoring the minus sign, the price elasticity at this point is 1.05. Demand is elastic at this point, because the elasticity is greater than 1.

                          QUESTION                                                       Point price elasticity of demand

If the price per unit of x rises from $1.40 to $1.60, it is expected that monthly demand will fall from 220,000 units to 200,000 units.

What is the point price elasticity of demand when the price is $1.40?


We assume that the demand curve is a straight line.

At a price of $1.40, demand is 220,000 units.

For a price rise of 20 cents to $1.60:

% change in demand                              × 100% = 9.09% (fall)

% change in price 20c

× 100% = 14.29% (rise)


Price elasticity of demand = 9.09

= – 0.64


or 0.64 ignoring the minus sign.

Demand is inelastic at this point, because it is less than 1.


                          QUESTION                                                                         Range of elasticity

A shop sells 100 shirts each month at a price of $20. When the price is increased to $24, the total sales revenue rises by 14%. Within which range does the price elasticity of demand lie?

  • Under 0.15
  • Greater than 0.15 and less than 0.5
  • Greater than 0.5 and less than 1.0 D Greater than 1.0


B                Total revenue of $20 = 100  $20 = $2,000

Total revenue at $24 = $2,000  1.14 = $2,280

Number sold at $24 = $2,280  24 = 95

Price elasticity of demand

4.8 Income elasticity of demand         


Income elasticity of demand measures the responsiveness of demand to changes in household income. Cross elasticity of demand is determined by the availability of substitute (competitors’) products.

It is possible to construct other measures of elasticity than price elasticity, and an important one which you need to know about is income elasticity of demand. The income elasticity of demand for a good indicates the responsiveness of demand to changes in household incomes.

When household income rises people will not only increase their demand for existing goods but also start to demand new goods which they could not previously afford.

% change in quantity demanded

Income elasticity of demand =

% change in income

  • Demand for a good is income elastic if income elasticity is greater than 1; in other words, if quantity demanded rises by a larger percentage than the rise in income. For example, if the demand for compact discs will rise by 10% if household income rises by 7%, we would say that the demand for compact discs is income elastic.
  • Demand for a good is income inelastic if income elasticity is between 0 and 1, and the quantity demanded rises less than the proportionate increase in income. For example, if the demand for books rises by 6% if household income rises by 10%, we would say that the demand for books is income inelastic.

The change in quantity demanded takes the form of a shift in the position of the demand curve, not a movement along it, since it is not stimulated by a change in price.

Goods whose income elasticity of demand is positive are said to be normal goods, meaning that demand for them will rise when household income rises. If income elasticity is negative, the commodity is called an inferior good since demand for it falls as income rises.

Inferiority in this sense is an observable fact about the consumer’s demand preferences, rather than a statement about the quality of the good itself.

Inter-city bus travel is an example of an inferior good. Bus travel is cheaper than air or rail travel, but takes longer. When consumers have limited income, they are prepared to forgo the increased time taken to travel in return for the cheaper cost. However, as their income increases, they will choose the more rapid modes of transport over the slower, albeit cheaper, bus travel. Therefore demand for bus travel will fall as income rises.

Income elasticity of demand can be summarised as follows.

Elasticity Value Type of good Example
Negative –ve Inferior Inter-city bus travel
Inelastic 0 – 1 Necessity Basic food stuffs
Elastic > 1 Luxury Yachts, sports cars

For most commodities, an increase in income will increase demand. The exact effect on demand will depend on the type of product. For example, the demand for some products like bread will not increase much as= income rises. Therefore, bread has a low income elasticity of demand. In contrast, the demand for luxuries increases rapidly as income rises and luxury goods therefore have a high income elasticity of demand.

QUESTION Elasticity of demand and supply

What will be the effect on price, quantity demanded and quantity supplied of luxury sports cars, given a significant reduction in income tax?


The demand curve for sports cars will shift to the right. Price, quantity demanded and quantity supplied will all go up.

The effect of a cut in income tax is to leave households with more to spend. Sports cars are a luxury good, so their income elasticity of demand is likely to be quite high. The percentage increase in demand for the cars is therefore likely to be greater than the percentage increase in after-tax household income.

We can illustrate the change diagrammatically:

Cross elasticity of demand 


% change in quantity demanded of good A *

Cross elasticity of demand =

% change in the price of good B

*(assuming no change in the price of A)

The cross elasticity of demand depends upon the degree to which goods are substitutes or complements.

  • If the two goods are substitutes, cross elasticity will be positive and a fall in the price of one will reduce the amount demanded of the other.
  • If the goods are complements, cross elasticity will be negative and a fall in the price of one will raise demand for the other.

For example, assume bread and butter are complements. If the price of bread increases, demand for bread and then, in turn, butter will decrease. So, as a fraction, we have a negative value (quantity of butter demanded) over a positive value (increase in price) meaning the cross elasticity of demand is negative.

Cross elasticity involves a comparison between two products. The concept is a useful one in the context of considering substitutes and complementary products.

The value of the cross-elasticity of demand shows the strength of the relationship between the two goods. Indices tending towards 1 or –1 indicate a strong relationship; statistics tending towards zero indicate a weak relationship.

Cross-elasticity Value Example
Perfect complements –1
Complements –ve Bread and butter
Unrelated products 0 Bread and cars
Substitutes +ve White bread and brown bread
Perfect substitutes +1

Remember that cross elasticity of demand (like other measures of elasticity) measures the percentage change in the quantity demanded for one good, in response to the percentage change in the price of another.

4.10 Market demand and the distribution of income 

Market demand for a good is influenced by the way in which the national income is shared among households.

In a country with many rich and many poor households and few middle income ones, we might expect a relatively large demand for luxury cars and yachts and also for bread and potatoes. In a country with many middle-income households, we might expect high demand for medium-sized cars and TV sets, and other middle income goods.

                          QUESTION                                                                       Income distribution

What do you think might be the demand for swimming pools amongst a population of five households enjoying total annual income of $1m, if the distribution of income is either as under assumption 1 or as under assumption 2?

Annual income
Assumption 1 Assumption 2
$ $
Household 1 950,000 200,000
Household 2 12,500 200,000
Household 3 12,500 200,000
Household 4 12,500 200,000
Household 5 12,500 200,000


Under assumption 1, the demand for swimming pools will be confined to household 1. Even if this household owns three or four properties, the demand for swimming pools is likely to be less than under assumption 2, where potentially all five households might want one.


4.11 Shifts of the demand curve 

So far, we have been looking at the way a change in price affects the quantity demanded, depicted as a movement along the demand curve. However, when there is a change in the conditions of demand, the quantity demanded will change even if price remains constant. In this case, there will be a different price/quantity demand schedule and so a different demand curve. We refer to such a change as a shift of the demand curve.

Figure 4 depicts a rise in demand at each price level, with the demand curve shifting to the right, from D0 to D1. For example, at price P1, demand for the good would rise from X to Y. This shift could be caused by any of the following conditions of demand.

  • A rise in household income (including a reduction in direct taxes)
  • A rise in the price of substitutes
  • A fall in the price of complements
  • A change in tastes towards this product
  • An expected rise in the price of the product
  • An increase in population

Figure 4 shows an outward shift in the demand curve, but conversely a fall in demand at each price level would be represented by a shift in the opposite direction: to the left of the demand curve. Such a shift may be caused by the opposite of the conditions of demand shown above.

4.12 Demand, fashion and expectations

A change in fashion or tastes will also alter the demand for a product. For example, if it becomes fashionable for middle-class households in the UK to drink wine with their meals, expenditure on wine will increase. There may be passing ‘crazes’, such as roller blades or skateboards. And tastes can be affected by advertisers and suppliers trying to ‘create’ demand for their products. However, the effect of a product becoming fashionable will be that demand for it rises without its price having to be reduced.

If consumers believe that prices will rise, or that shortages will occur, they may attempt to stock up on the product before these changes occur. Again, this could lead to increases in demand, despite the price of the good remaining unchanged.

In County X, a recent fall in the price of DVDs has seen demand for DVDs increase significantly. However, cinema operators have reported a decline in customer numbers, which they believe is due to people preferring to buy DVDs to watch rather than going to the cinema.

What effect is the fall in the price of DVDs likely to have on the demand curves for:

  • DVD players?
  • Cinema tickets?


  • There is likely to have been an outward shift in the demand curve for DVD players. DVD players are complements to the DVDs themselves because people will need to buy the DVD players in order to watch their DVDs. So, the increased demand for DVDs will lead to an increase in demand for DVD players even though their price may be unchanged. This results in an outward shift in their demand curve (an expansion of demand).
  • There is likely to be an inward shift in the demand curve for cinema tickets (a contraction of demand). Even though the price of cinema tickets has not changed, people are demanding less of them because they are choosing to watch DVDs instead. Cinema tickets are a substitute product to DVDs, and a fall in the price of a substitute leads to an inward shift of the demand curve for a product.


  5   The supply schedule

The supply curve shows the quantity of a good which would be supplied by producers at a given price.

5.1 The concept of supply


As with demand, supply relates to a period of time – for example, we might refer to an annual rate of supply or to a monthly rate.

The quantity of a good supplied to a market varies up or down for two reasons.

  • Existing suppliers may increase or reduce their output quantities.
  • Firms may stop production altogether and leave the market, or new firms may enter the market and start to produce the good.

If the quantity that firms want to produce at a given price exceeds the quantity that households (consumers) would demand, there will be an excess of supply, with firms competing to win what sales demand there is. Oversupply and competition would then be expected to result in price competitiveness and a fall in prices.

As with demand, a distinction needs to be made.

  • An individual firm’s supply schedule is the quantity of the good that the individual firm would want to supply to the market at any given price.
  • Market supply is the total quantity of the good that all firms in the market would want to supply at a given price.

5.2 The supply curve 

A supply schedule and supply curve can be created both for an individual supplier and for all firms which produce the good.

A supply curve is constructed in a similar manner to a demand curve (from a schedule of quantities supplied at different prices) but shows the quantity suppliers are willing to produce at different price levels. It is an upward sloping curve from left to right, because greater quantities will be supplied at higher prices.

We usually assume that suppliers aim to maximise their profits, and the upward slope of the supply curve reflects this desire to make profit (ie they are prepared to supply more of something, the higher the price that is being paid for it).

5.3 Short run supply curve

Following the assumption that suppliers are profit maximisers, they will produce at the point where marginal costs equals marginal revenue. For now, it is only necessary to note that producing at the level of output where marginal revenue equals marginal cost is the profit-maximising position for a firm.

Therefore, the amount a firm will supply will be affected by the costs of production (marginal and average costs).

We will look at supply in both the short run and the long run.

Short run supply curve

A firm’s short run average cost curve is U shaped, with marginal cost (MC) rising and falling more steeply than average cost (AC).

If we assume there is a single, constant selling price for all firms, then a firm’s average revenue (AR) and marginal revenue (MR) will be identical. We can show this as Price = Average Revenue = Marginal Revenue.

We know that the firm will supply where MC = MR in order to maximise profit. Consequently, the firm’s chosen levels of output (forming its supply curve) are as shown in Figure 5 below.

We can see that at price P1 the firm supplies Q1 output, because MC = MR1. When price rises to P2, the output increases to Q2 and so on, provided that the firm has the capacity to increase its sales output. In these conditions, the firm’s marginal cost curve becomes its supply curve.

However, remember there is a minimum price level below which a firm will not supply. In the short run, a firm will only continue to supply if the selling price covers all its variable costs.

At P2 and Q4, the supplier’s AR will be less than its AC but greater than its average variable cost (AVC). Because AC > AR the firm makes a loss, but some of its fixed costs are still paid for, because AR > AVC.

If the firm had stopped producing altogether, it would still incur its fixed costs even though there will be no sales income to pay for any of these fixed costs. So it would have been financially worse off than it was by producing at a level where AR > AVC, even though it made a loss at this point.

Therefore, in the short run, the firm’s supply curve is represented by the part of its marginal cost curve

Cost-plus pricing

The idea of the marginal cost curve representing the supply curve is the traditional theory of a firm’s short run supply curve. However, more recent theories of the firm incorporate a cost-plus pricing approach.

Under a cost-plus pricing approach, a firm adds a profit margin to its average cost at any level of output in order to establish its selling price. This alternative theory produces a horizontal supply curve.

A rational (profit maximising, or loss minimising) firm will only supply where AR > AC. So the minimum and maximum levels of output occur at Q1 and Q2 respectively, at price P1; that is, where AR crosses the AC curve (AC = AR).

Changes in the market price will lead to changes in output. (Note, we are still assuming a single, constant selling price for all firms in the industry.) A higher price (P2) will lead to a new supply curve, between Q3 and Q4.

5.4 Long run supply curve

In traditional theory, the marginal cost curve remains the supply curve in the long run. However, it may no longer be upward sloping.

The supply curve was upward sloping in the short run because of the impact of diminishing returns on the marginal cost curve. However, this is only a short run phenomenon, because the constraint of one factor of production being fixed is only a short run condition.

In the long run, the supply curve could still be upward sloping (if the firm suffers from diseconomies of scale) but it could equally be downward sloping to the right if the firm benefits from economies of scale. The curve could even be horizontal if the firm’s marginal cost remained constant at all levels of output.

The full cost-plus pricing theory also retains a horizontal supply curve in the long run. The level of the curve relative to the short run will depend on whether the firm experiences any economies or diseconomies of scale. However, the maximum and minimum output levels will still be where AC = AR.

5.5 Factors influencing the supply quantity

The quantity supplied of a good depends, as you might expect, on prices and costs. More specifically, it depends on the following factors.

  • The costs of making the good. These include raw materials costs, which ultimately depend on the prices of factors of production (wages, interest rates, land rents and profit expectations).
  • The prices of other goods. When a supplier can switch readily from supplying one good to another, the goods concerned are called substitutes in supply. An increase in the price of one such good would make the supply of another good whose price does not rise less attractive to suppliers. When a production process has two or more distinct and separate outputs, the goods produced are known as goods in joint supply or complements in production. Goods in joint supply include, for example, meat and hides. If the price of beef rises, more will be supplied and there will be an accompanying increase in the supply of cow hide.
  • Expectations of price changes. If a supplier expects the price of a good to rise, they are likely to try to reduce supply while the price is lower so that they can supply more of their product or service once the price is higher.
  • Changes in technology. Technological developments which reduce costs of production (and increase productivity) will raise the quantity of supply of a good at a given price.
  • Other factors. These include changes in the weather (for example, in the case of agricultural goods), natural disasters or industrial disruption.

The supply curve shows how the quantity supplied will change in response to a change in price. If supply conditions alter, a different supply curve must be drawn. In other words, a change in price will cause a change in supply along the supply curve. A change in other supply conditions will cause a shift

5.6 Shifts of the market supply curve

The market supply curve is the aggregate of all the supply curves of individual firms in the market. A shift of the market supply curve occurs when supply conditions (other than the price of the good itself) change. Figure 7 shows a shift in the supply curve from S0 to S1. A rightward (or downward) shift of the curve shows an expansion of supply and may be caused by the factors below.

  • A fall in the cost of factors of production, for example a reduction in the cost of raw material inputs
  • A fall in the price of other goods; the production of other goods becomes relatively less attractive as their price falls and firms are therefore likely to shift resources away from the goods whose price is falling and into the production of higher priced goods that offer increased profits. We therefore expect that (ceteris paribus) the supply of one good will rise as the prices of other goods fall (and vice versa).
  • Technological progress, which reduces unit costs and also increases production capabilities
  • Improvements in productivity or more efficient use of existing factors of production, which again will reduce unit cost

A shift of the supply curve is the result of changes in costs, either in absolute terms or relative to the costs of other goods. If the price of the good is P1, suppliers would be willing to increase supply from Q0 to Q1 under the new supply conditions (Figure 7).

Conversely, we might see a leftward (or upward) shift in the supply curve if the cost of supply increases. This would mean that at the existing price, a firm’s output will decrease and less will be supplied.

This is also illustrated on Figure 7: at price P1, the quantity supplied now falls from Q0 to Q2, as the supply curve shifts from S0 to S2.

In order for the supplier to restore output levels to the original Q0, price would have to increase to P2.

An upward (leftward) shift (S0          S2) in supply could be caused by:

  • An increase in the cost of factors of production
  • A rise in the price of other goods which would make them relatively more attractive to the producer
  • An increase in indirect taxes, or a reduction in a subsidy, which would make supply at existing prices less profitable

We need to distinguish between short run and long run responses of both supply and demand. In the short run both supply and demand are relatively unresponsive to changes in price compared with the long run.

  • In the case of supply, changes in the quantity of a good supplied often require the laying off or hiring of new workers, or the installation of new machinery. All of these changes, brought about by management decisions, take some time to implement.
  • In the case of demand, it takes time for consumers to adjust their buying patterns, although demand will often respond more rapidly than supply to changes in price or other demand conditions.

In some markets, responses to changes in price are relatively rapid. In others, response times are much longer. In stock markets for example, the supply and demand for company shares respond very rapidly to price changes, whereas in the markets for fuel oils or agrichemicals response times are much longer.

                          QUESTION                                                                         Quantity supplied

What effect will higher grain prices have on the supply curve of a cereal manufacturer who makes cereals from grain?


The higher price of grain will cause the supply curve to shift leftwards (or upwards). The increase in grain prices increase the cereal manufacturer’s production costs, making supply at existing prices less profitable.


  6   The equilibrium price

The competitive market process results in an equilibrium price, which is the price at which market supply and market demand quantities are in balance. In any market, the equilibrium price will change if market demand or supply conditions change.

6.1 Functions of the price mechanism

People only have a limited income and they must decide what to buy with the money they have. The prices of the goods they want will affect their buying decisions.

Firms’ output decisions will be influenced by both demand and supply considerations.

  • Market demand conditions influence the price that a firm will get for its output. Prices act as signals to producers, and changes in prices should stimulate a response from a firm to change its production quantities.
  • Supply is influenced by production costs and profits. The objective of maximising profits provides the incentive for firms to respond to changes in price or cost by changing their production quantities.
  • When a firm operates efficiently, responding to changes in market prices and controlling its costs, it is rewarded with profit.

Decisions by firms about what industry to operate in and what markets to produce for will be influenced by the prices obtainable. Although some firms have been established in one industry for many years, others are continually opening up, closing down or switching to new industries and new markets. Over time, firms in an industry might also increase or reduce the volume of goods they sell.

Sometimes, however, price will not represent the economic cost of a good or service. For example, price may be higher than costs due to taxes imposed by government. The sales price of cigarettes and alcohol is much higher than the cost of producing them, due to the imposition of taxes and duty.

By contrast, a subsidy may bring about an artificially low price.

However, in the main, we will be looking at price as an indicator of the exchange value of goods and services, as determined by the market forces of supply and demand.

6.2 The price mechanism and the equilibrium price


The price mechanism brings demand and supply into equilibrium, and the equilibrium price for a good is the price at which the volume demanded by consumers and the volume that firms would be willing to supply is the same. This is also known as the market clearing price, since at this price there will be neither surplus nor shortage in the market.

The way demand and supply interact to come to the equilibrium price can be illustrated by drawing the market demand curve and the market supply curve on the same graph (Figure 8).

Figure 8 shows the planned (or ex ante) demand and planned supply at a set of prices.

At price P1 in Figure 8, suppliers want to produce a greater quantity than the market demands, meaning that there is excess supply, equal to the distance AB. Suppliers would react as the stock of unsold goods accumulates.

(a) They would cut down the current level of production in order to sell unwanted inventories. (b)            They would also reduce prices in order to encourage sales.

The opposite will happen at price P2 where there is an excess of demand over supply shown by the distance CD. Supply and price would increase. Faced with an excess of demand, manufacturers would be able to raise their prices. This would make supplying the good more profitable and supply would increase.

At price P the amount that sellers are willing and able to supply is equal to the amount that customers are willing and able to buy. Consumers will be willing to spend a total of (P × Q) on buying Q units of the product, and suppliers will be willing to supply Q units to earn revenue of (P × Q). P is the equilibrium price.

The forces of supply and demand push a market to its equilibrium price and quantity. Note carefully the following key points.

  • If there is no change in conditions of supply or demand, the equilibrium price will prevail in the market and will remain stable.
  • If price is not at the equilibrium, the market is in disequilibrium and supply and demand will push prices towards the equilibrium price.
  • In any market there will only be one equilibrium position where the market is cleared.
  • Shifts in the supply curve or demand curve will change the equilibrium price (and the quantity traded).

6.3 Consumer surplus and producer surplus

The marginal utility derived by different consumers from consumption of a unit quantity of a good will vary and so, therefore, will the price they would offer to buy that good. Because of this, consumers may be able to buy the good at a prevailing market price lower than the price they were prepared to pay. You will be familiar with this idea from your own experience, where you would have been prepared to pay a certain amount for a holiday or a specific item of clothing, for example, but you have been able to buy them at a lower price than you had anticipated. This situation (where the market price is lower than the price the consumer was prepared to pay) is called a consumer surplus, and it can be represented as shown in Figure 9.

In the same way that consumers may be able to buy a good for less than they would be prepared to pay, so producers may be able to sell a good at a higher price than they would have accepted.

In this case, there is a producer surplus. Figure 9 illustrates this. The area of producer surplus on the graph represents the suppliers in the market who would be prepared to sell quantities of the good at less than the market price.

  7   Demand and supply analysis
The effects of demand and supply conditions on markets can be analysed by studying the behaviour of both demand and supply curves.

7.1 Case example

In this section we look at a case example involving the analysis of demand and supply conditions.

We will examine the likely effects on the price and quantity sold of secondhand cars in the event of: 

  • A large increase in petrol prices


  • 7.2 Analysis        
    A big increase in the price of new cars (c) A massive investment in public transport

Petrol and cars are complementary products; hence, any change in the market for petrol (part (a) of this case example) would be expected to affect the market for second-hand cars. The demand for petrol, however, is likely to be relatively unresponsive to a change in price, so a change in price will only have a small impact on the quantity demanded. Consequently, a major change in its price will be necessary to affect the demand for any complementary product. Figure 10 assumes that there is a large increase in the price of fuel (petrol) as stated above.

In this instance, we have assumed that the rise in the price of fuel results from a change in the conditions of supply. This is the basis of the new supply curve S1 shifting to the left of the existing one (Figure 10 (i)). A rise in the price of fuel is a rise in the cost of owning and running a car. There will thus be a fall in the demand for second-hand cars and a fall in the price and quantity sold (Figure 10 (ii)).

Part (b) of this case example involves new vehicles and used vehicles as substitute products.



                                   (i) New vehicles market (ii) Used vehicles market

                    0                             q 1      q               Number of vehicles


Figure 11

It is assumed that the increase in the price of new cars is the result of a major increase in supply costs. The rise in price causes a switch of demand into second-hand vehicles, so pushing up their price and leading to an increase in the number sold (Figure 11(ii)).

The increased price of new vehicles could alternatively result from an increase in the demand for them.

Case example, part (c) involves another ‘product’ which is in competition with second-hand cars. If there is a reduction in the price of public transport services following the outward shift in supply, this could be the result (Figure 12).

In part (c) of our case example, the fall in public transport prices leads to an expansion in demand for public transport (Figure 12(i)) while the demand for second-hand cars falls (with a new demand line D1 in Figure 12(ii)) together with a fall in price. However, the relationship between public transport and the market for second-hand cars is likely to be a highly complex and indeterminate one. Thus, people might make greater use of public transport while the ownership of cars (including second-hand cars) could continue to increase.

7.3 Price as a signal

As well as acting as an information system for buyers and sellers in a market, price can also act as a stimulant.


  8   Maximum and minimum prices
Where maximum prices are imposed, there will be excess demand: rationing may be necessary, and black marketeers may seek to operate. Where minimum prices are imposed, producers will make excess supply.

Price information may prompt buyers and sellers to change their behaviour. For example, a price rise may encourage firms to divert resources towards producing a good whose price has risen, in order to obtain a better reward from their resources.

8.1 Price regulation

The regulation of prices provides an illustration of how demand and supply analysis can be applied. Governments might try to control prices in two ways.

  • They might set a maximum price (or price ceiling) for a good, perhaps as part of an anti-inflationary economic policy.
  • They might set a minimum price (or price floor) for a good. The EU Common Agricultural Policy (CAP) is an example of a price floor, aimed to ensure that farmers receive at least the minimum prices for their produce.


8.2 Maximum prices 

The Government may try to prevent prices of goods rising by establishing a price ceiling below the equilibrium price. (Note: the price ceiling has to be below the equilibrium price. If the price ceiling is higher than the equilibrium price, setting a price ceiling will have no effect at all on the operation of market forces. Make sure that you understand why this is so.)

If the maximum price M is lower than what the equilibrium price would be, there will be an excess of demand over supply (Figure 13). The low price attracts customers, but deters suppliers. Because the price ceiling M is below the equilibrium price P, producers will reduce the quantity of goods supplied to the marketplace from Q to A. However, the quantity demanded will increase from Q to B because of the fall in price. The excess quantity demanded is AB.

Because the market is now in disequilibrium, the limited supply has to be allocated by a means other than price.

To prevent an unfair allocation of the units of the good that are available, the Government might have to introduce rationing (as with petrol coupons) or a waiting list (as for local authority housing). Rationing and black marketeers tend to go together. In Figure 13 consumers demand quantity B but can only get A. However, for quantity A they are prepared to pay price Z, which is well above the official price M. The black marketeers step in to exploit the gap. The commodity may be sold on ration at the official price M, but black marketeers may sell illicit production at price Z.

Note also that maximum prices can lead to a misallocation of resources. Producers will reduce output of the products subject to price controls because they are now relatively less profitable than those products not subject to price controls.


D          The initial equilibrium quantity is E (where supply and demand curves intersect). Quantity demanded at the controlled price P will be H. However, only quantity G will be supplied and purchases will therefore be limited to this amount. Therefore, the quantity purchased will fall from E to G due to the shortage of supply available.


8.3 Minimum prices

Minimum price legislation aims to ensure that suppliers earn at least the minimum price (or floor price) for each unit of output they sell.

If the minimum price is set below the market equilibrium there is no effect. But if it is set above the market price, it will cause an excess supply (see surplus ‘AB’ in Figure 14). This has been a recurring problem in Europe, where minimum prices guaranteed by agricultural subsidies have resulted in the ‘butter mountains’ and ‘wine lakes’ of past years.

In Figure 14, the minimum price Z is set above the equilibrium price P. The quantity demanded falls from Q to A but the quantity supplied increases to B because the higher price encourages suppliers to supply more. There is excess supply equal to the quantity AB.

Figure 14 Minimum price above equilibrium price

The problem with floor prices is that more of the good will be produced than can be sold at the minimum price, and so surplus quantities will build up, which have to be either stored or destroyed. Either way, the floor prices lead to a misallocation of resources.

To try to prevent oversupply and ‘dumping’ of excess supply at low prices, a system of production quotas might be introduced whereby each supplier is only allowed to produce up to a maximum quantity and no more. For some types of produce, the EU tried to overcome the problem of excess supply by imposing quotas on farmers.

Where maximum prices are imposed, there will be excess demand: rationing may be necessary, and black marketeers may seek to operate. Where minimum prices are imposed, producers will make excess supply.

QUESTION                                                                                         Floor prices

What are the economic impacts of the Common Agricultural Policy (CAP) and other floor price schemes?


CAP guarantees a minimum price above the market equilibrium price. Therefore it encourages an excess of supply over demand, creating surplus production of agricultural goods. However, it provides price and income stability for the farmers producing the goods.


8.4 Minimum wages

A minimum wage is an application of floor pricing in the labour market.

The UK now has minimum wage legislation. The purpose of a minimum wage is to ensure that low-paid workers earn enough to have an acceptable standard of living. If a minimum wage is enforced by legislation (a statutory minimum wage), or negotiated nationally for an industry by a trade union, the minimum wage will probably be above the current wage level for the jobs concerned. This would have two consequences.

  • To raise wage levels for workers employed to a level above the ‘equilibrium’ wage rate

To reduce the demand for labour and so cause job losses

Without a minimum wage, Qw workers would be employed at wage rate W (Figure 15).

                 QUESTION                                                                                   Minimum wage

By reference to Figure 15, work out what happens when a minimum wage M, higher than the existing rate W, is imposed.


The supply curve for labour is now the line MXY.

Demand for labour from employers will fall to Qm, but Qm workers will at least earn a higher wage. However, ceteris paribus, the imposition of the minimum wage would create unemployment at Qw – Qm.


In practice, there may be a temptation for firms to ignore the floor price, for example by establishing informal arrangements with workers whereby they work for less than the minimum wage. However, while this would provide employment for the workers, it raises ethical issues about their treatment.

  9   Competition and restrictive practices

9.1 Types of competition


The way in which firms are structured in an industry and the way they compete with each other are often described using the – terms perfect competition, imperfect competition, monopoly, oligopoly or monopolistic competition.

The following table explains the various types of market and competition.

Type of market

/ competition

Perfect competition A perfectly competitive market has many firms producing the same (ie homogeneous) goods or services. The market is easy to enter and exit.

Under perfect competition producers and consumers have all the information they require – they have ‘perfect knowledge’ of the market. The price and level of output under perfect competition tends towards the equilibrium point. Producers attempting to sell at a higher price will not sell anything, and producers attempting to sell as a price below equilibrium would obtain 100% market share.

The demand ‘curve’ is horizontal – it is ‘perfectly elastic’. There are few, if any, truly perfectly competitive markets in the real world. Some financial markets in which information is freely available are probably as close as we get to a perfectly competitive market.

Imperfect competition The term ‘imperfect competition’ apples to any market that is not perfect. As we explained above, almost all markets are imperfect, although the degree to which they are imperfect can vary significantly.
Monopoly A monopoly describes the situation where a market has only one producer. That is the pure definition, although the term is often used to describe a firm that has a very high share of a market.

A monopoly may come about because the producer has a statutory right to be the only producer, perhaps a ‘state owned enterprise’.

If left uncontrolled, a monopoly can set its own price in the marketplace, which can result in what economists refer to as ‘super-normal profits’. For this reason, monopolies are usually subject to control by government or a government agency.

Oligopoly An oligopoly arises when a market has a few dominant producers. Each of the few producers has a high level of influence – and a high level of knowledge of their competitor strategies. If an oligopoly has only two firms, it is referred to as a duopoly.

Oligopolistic markets are often characterised by complex product differentiation, significant barriers to entry and a high level of influence on prices.

An example of an oligopoly is the retail petrol and diesel market – several large companies including Exxon Mobil, Shell and BP control the majority of the market (although fuel outlets linked to supermarkets are gaining market share). An example of a duopoly would be the two major cola producers, The Coca-Cola Company and Pepsi Co.

Type of market

/ competition

Monopolistic competition Monopolistic competition arises when the market comprises many producers who tend to use product differentiation to distinguish themselves from others.

Although their products may be very similar, because producers differentiate their products they are able to create a short-term ‘monopoly’, as customers see their product as unique. Therefore, for monopolistic competition to exist, consumers must perceive differences in the products offered by different firms.

Monopolistic competition tends to have fewer barriers to entry or exit than oligopolistic competition.

9.2 Restrictive practices

As well as ‘imperfections’ in the market, the market may also be subject to restrictive or anti-competitive activities; some examples follow.

  • Dumping – selling product at a loss
  • Exclusive dealing – being bound by contract to only buy from or sell to one business
  • Price fixing – two or more businesses agree to sell at the same price
  • Refusal to deal – businesses refusing to use a certain vendor
  • Limit pricing – effectively a monopoly which is intended to discourage entry into the market
  • Retail price maintenance – reseller cannot set independent price
  • Government subsidies – deemed to be unfair to competitors


The micro environment refers to the immediate operational environment, including suppliers, competitors, customers, stakeholders and intermediaries.
For the organisation as a system, we need to consider the various forces which have an impact internally and externally.
In a free market, the price mechanism signals demand and supply conditions to producers and consumers. It therefore determines the activities of both producers and consumers, influencing the levels of demand for and the supply of goods.
The position of the demand curve is determined by the demand conditions, which include consumers’ tastes and preferences, and consumers’ incomes.
Elasticity, in general, refers to the relationship between two variables. Price elasticity of demand explains the relationship between change in quantity demanded and changes in price.
Income elasticity of demand measures the responsiveness of demand to changes in household income. Cross elasticity of demand is determined by the availability of substitute (competitors’) products.
The supply curve shows the quantity of a good which would be supplied by producers at a given price.
The competitive market process results in an equilibrium price, which is the price at which market supply and market demand quantities are in balance. In any market, the equilibrium price will change if market demand or supply conditions change.
The price mechanism brings demand and supply into equilibrium, and the equilibrium price for a good is the price at which the volume demanded by consumers and the volume that firms would be willing to supply is the same. This is also known as the market clearing price, since at this price there will be neither surplus nor shortage in the market.
The effects of demand and supply conditions on markets can be analysed by studying the behaviour of both demand and supply curves.
Where maximum prices are imposed, there will be excess demand: rationing may be necessary, and black marketeers may seek to operate. Where minimum prices are imposed, producers will make excess supply.
The way in which firms are structured in an industry and the way they compete with each other are often described using terms perfect competition, imperfect competition, monopoly, oligopoly or monopolistic competition.



  • What factors influence demand for a good?
  • What are (a) substitutes and (b) complements?
  • What factors affect the supply quantity?
  • What is meant by equilibrium price?
  • A demand curve is drawn on all except which of the following assumptions?
    • Incomes do not change.
    • Prices of substitutes are fixed.
    • Price of the good is constant.
    • There are no changes in tastes and preferences.
  • The diagram shown relates to the demand for and supply of Scotch whiskey. The market is initially in equilibrium at point X. The government imposes a specific tax on Scotch while, at the same time, the price of Irish Whiskey (a substitute for Scotch Whisky) rises. Which point, A, B, C or D, represents the new market equilibrium?

  • A price ceiling set above the equilibrium market price will result in:
    • Market failure
    • Excess supply over demand C Market equilibrium

D           Excess demand over supply

  • Which one of the following would normally cause a rightward shift in the demand curve for a product?
    • A fall in the price of a substitute product
    • A reduction in direct taxation on incomes
    • A reduction in price of the product
    • An increase in the price of a complementary product 9 What is an inferior good?
    • A good of such poor quality that demand for it is very weak
    • A good of lesser quality than a substitute good, so that the price of the substitute is higher
    • A good for which the cross elasticity of demand with a substitute product is greater than 1 D A good for which demand will fall as household income rises

10              In traditional theory, which of the following best describes a firm’s short run supply curve:

  • Its marginal cost curve where price is less than average variable costs
  • Its marginal cost curve where price is greater than average variable costs
  • Its average cost curve where price is less than marginal cost
  • Its average cost curve where price is greater than marginal cost



  • The price of the good

The price of other goods

Household income

Taste and fashion

  • Substitutes are goods that are alternatives to each other (for example, Coke and Pepsi)

Complements are goods which are bought and used together (for example, cars and petrol)

  • The price obtainable for the good

The prices obtainable for other goods, particularly goods in joint supply

The costs of making the good

Disruptions such as bad weather and strikes

  • The price at which the volume of demand and the volume of supply are equal; there is neither surplus nor shortage.
  • C Demand curves express the quantity demanded at each given market price. Non-price determinants such as income must be held constant when looking at the effect of price movements in isolation.
  • A Supply shifts from S0 to S1, reflecting the per-unit tax. Demand shifts from D0 to D1 as the price of a substitute (Irish whiskey) rises.
  • C If the price ceiling is above the equilibrium market price, it will not interfere with the working of the price mechanism. The market will not be forced from its current equilibrium. A price ceiling only affects the workings of the price mechanism if it is set below the equilibrium price.
  • B A reduction in income tax will increase ‘real’ household income, and so demand for normal products will shift to the right, ie quantity demanded will be greater at any given price.

A fall in the price of a substitute good would entice consumers away from the original good. This would cause a leftward shift in the demand curve.

A change in the price of the good itself does not cause a shift in the curve but a movement along it.

Complementary products tend to be bought and used together, so an increase in the price of one

will lead to a reduction in demand for the other, reflected in a leftward shift in the demand curve.

  • D Inferior goods are defined in terms of the relationship between quantity demanded and income. The issue of substitutes is not relevant.
  • B The marginal cost curve represents the firm’s supply curve, but a firm will only continue to supply in the short run provided that the selling price covers its variable costs and therefore allows it to make a contribution to covering fixed costs.








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