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Introduction to Business and
Economics
Introduction to the Enterprise (Universitat de
les Illes Balears)
1. 10 Principles of Economics
The word "economy" comes from a Greek word meaning "one who manages a household." Both a household and an economy face many decisions, such as who will work, what goods and how many of them should be produced, what resources should be used in production, and at what price the goods should be sold.
The fundamental problem of economics is the scarcity of resources. Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Economics is the study of how society manages its scarce resources.
The study of economics involves the distribution of resources for the production of goods and services within a social system. These resources include:
Natural Resources Human Resources (Labor) Financial Resources (Capital) Intangible Resources (know-how, patents, absorptive capacity)
How People Make Decisions
People face trade-offs. To get one thing, we usually have to give up another thing (opportunity cost). Making decisions requires trading off one goal against another, such as high grades versus entertainment or high quality versus new market. The cost of something is what you give up to get it. The opportunity cost of an item is what you give up to obtain that item. Decisions require comparing costs and benefits of alternatives. Marginal changes are small, incremental adjustments to an existing plan of action. People make decisions by comparing costs and benefits at the margin. People respond to incentives. Marginal changes in costs or benefits motivate people to respond. The decision to choose one alternative over another occurs when that alternative's marginal benefits exceed its marginal costs.
How People Interact with Each Other
People gain from their ability to trade with one another, as trade allows people to specialize in what they do best. A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Households decide what to buy and who to work for, while firms decide who to hire and what to produce. Adam Smith made the observation that households and firms interacting in markets act as if guided by an "invisible hand," where prices guide decision-makers to reach outcomes that tend to maximize the welfare of society as a whole. Governments can (sometimes) improve market outcomes. Market failure occurs when the market fails to allocate resources efficiently, and the government can intervene to promote efficiency and equity. Market failures may be caused by externalities or market power.
The Forces and Trends that Affect How the Economy as a
Whole Works
A country's standard of living depends on its production. This can be measured by comparing personal incomes or the total market value of the nation's production. Almost all variations in living standards are explained by differences in country productivity, which is the amount of goods and services produced from each hour of a worker's time. Prices rise when the government prints too much money. Inflation is an increase in the overall level of prices in the economy, and one cause of inflation is the growth in the quantity of money. When the government creates large quantities of money, the value of money falls, leading to higher prices. Society faces a short-run trade-off between inflation and unemployment. The Phillips Curve illustrates this trade-off, where in the short-term, the same wage with higher inflation leads to a decrease in real wages and lower unemployment, while the same wage with lower inflation leads to an increase in real wages and higher unemployment. In the long-term, as workers demand higher wages to match the inflation, the real wage remains the same, and the firm will not hire more people.
Economic Systems
Economic systems address three fundamental questions:
What goods and services, and how much of each, will satisfy consumers' needs? How will goods and services be produced, who will produce them, and with what resources will they be produced? How are the goods and services to be distributed to consumers?
Measuring the Economy
Gross Domestic Product (GDP) is a measure of the income and expenditures of an economy, representing the total market value of all final goods and services produced within a country in a given period. GDP can be measured in nominal terms (using current prices) or real terms (using a base year's prices to adjust for inflation). The labor force includes both the employed and unemployed, and the unemployment rate is calculated as the percentage of the labor force that is unemployed. Other economic measures include inflation, budget deficits, trade balances, per capita income, and the Consumer Price Index. Economic expansion occurs when an economy is growing, while economic contraction is a slowdown characterized by declining spending, production, and employment, which may lead to a depression.
Business
A business is a set of individuals trying to earn profits by providing products that satisfy people's needs, which can be goods or services with tangible and intangible characteristics. Earning profits contributes to society by providing employment and reinvesting in the economy, but profits must be earned responsibly. Businesses require management skills, marketing expertise, financial resources, products, personnel, ethical behavior, adaptability, and compliance with the law. Stakeholders in a business include customers, employees, investors, government regulators, the community, and society.
Entrepreneurship
An entrepreneur is a person who risks their wealth, time, and effort to develop an innovative product or way of doing something for profit. Entrepreneurship involves risk-taking, innovation, creativity, reward, intuition, and persistence. Starting a new business requires developing a business plan, securing financial resources (equity or debt financing), and making decisions about the form of ownership and market entry strategy. Existing businesses can also be acquired, which provides the advantage of a built-in network of customers, suppliers, and distributors, but also any existing problems. Firms are created to achieve efficiency gains through economies of scale and scope, as well as to reduce transaction costs associated with participating in markets.
Externalities as Examples of Market Failure
and the Coase Theorem
Transaction Cost Theory
The transaction cost theory suggests that firms are created to reduce transaction costs. Firms aim to minimize both the costs of exchanging resources with the environment and the bureaucratic costs of exchanges within the company. For example, setting up a travel agency that organizes trips each week can reduce transaction costs for tourists who want to book tickets, hotels, and other arrangements.
Firms can decrease transaction costs in the following ways:
Assigning tasks to individuals to gain from specialization. Pooling employee skills to benefit from specialization. Monitoring work to ensure cooperation among self-interested people and alignment with the common goal.
The transaction cost reduction allows customers to quickly find and purchase what they need, without wasting time searching for the best offer in different places.
Goals and Conflict within the Firm
While firms reduce transaction costs, they can also generate some problems:
Less flexibility: Firms may not be able to get "the best" deal at a specific moment. Agency problems and conflicts of interest: As the business grows, entrepreneurs need to delegate decision-making authority to other people, leading to the agency problem. Individual goals might conflict with the organization's goals.
Mechanisms to Solve Agency Problems
Incentive schemes: Top managers are provided with high financial rewards linked to the firm's performance. Stock options give managers the right to buy company stock at a fixed price in the future. Board of directors: Owners (shareholders) elect a board of directors to oversee the management of the corporation. The board includes both insiders (employees of the company) and outsiders (not affiliated with the company). The chairman is the highest-ranking director in the board. Management team: The group of individuals (employees of the company) who make decisions about resource allocation and implementation of the strategic lines established by the board.
Conglomerate merger: Firms in unrelated industries merge. Acquisitions: The purchase of one company by another, usually by buying its stock. Leveraged Buyout (LBO): The purchase of a company or division using borrowed money, with the assets of the purchased company used to guarantee repayment of the loan.
Firms' External Environment
General Environment: Economic climate: The overall health of the economic system, including factors like economic growth, per capita income, inflation, and consumer price index. Socio-cultural trends: Changes in a country's class structure, culture, customs, and beliefs. Demographic trends: The distribution of individuals in a society in terms of age, sex, and marital status. Legal and political conditions: Changes in a country's laws and regulations, based on changes in political and ethical attitudes. Technological change: Advancements in technology, such as the social media boom. Specific Environment: Porter's Five Forces Model Threat of entry: New entrants bring new capacity, the desire to gain market share, and substantial resources.
Barriers to Entry and Threat of Rivalry
Barriers to Entry
Barriers to entry refer to factors that make it difficult for new firms to enter an industry, thereby reducing the threat of entry. Some key barriers to entry include:
Economies of Scale : Firms that can produce at the minimum efficient scale will have a cost advantage over smaller firms, creating a barrier to entry.
Product Differentiation : Established firms have brand identification and customer loyalties, forcing new entrants to spend heavily on marketing to overcome these.
Capital Requirements : The need to invest large financial resources, such as for advertising or R&D, creates a barrier to entry.
Cost Advantages Independent of Scale : Established firms may have cost advantages, such as access to distribution channels or switching costs, that are not replicable by new entrants.
Government Policies : Regulations like licensing requirements or limits on raw materials can restrict entry into an industry.
Threat of Rivalry
The threat of rivalry refers to the intensity of competition among existing firms in an industry. Factors that facilitate high rivalry include:
Numerous or Equally Balanced Competitors : A large number of firms of similar size increases competition. Slow or Declining Industry Growth : Firms must compete for a shrinking pie, leading to more aggressive competition. High Fixed or Storage Costs : With high fixed costs, firms will compete vigorously to fill capacity and maintain profitability. Lack of Differentiation or Switching Costs : Undifferentiated products and low switching costs force firms to compete on price. Capacity Augmented in Large Increments : Excess capacity leads to price competition as firms try to fill their capacity. Diverse Competitors : Firms with different strategies, origins, and goals will find it harder to cooperate and more likely to compete aggressively.
Threat of Substitutes and Bargaining Power
Threat of Substitutes
Substitute products are those that can satisfy the same customer needs as the industry's products. The threat of substitutes is high when:
Substitute products are available that can perform the same function as the industry's products. Substitutes are priced attractively compared to the industry's products. Buyers face low switching costs in moving to substitute products.
Bargaining Power of Suppliers
Suppliers can exert bargaining power over an industry by raising prices or reducing quality of inputs. Supplier power is high when:
The supplier industry is more concentrated than the industry it sells to. Suppliers provide highly differentiated products. There are no close substitute inputs available. The focal firm is an insignificant customer of the supplier. Suppliers could integrate forward into the focal industry.
Bargaining Power of Buyers
Buyers can exert bargaining power over an industry by forcing down prices, demanding higher quality or more services, and playing competitors against each other. Buyer power is high when:
Buyers are concentrated or purchase large volumes relative to seller sales. The industry's products are standardized or undifferentiated.
World Trade Organization (WTO) North American Free Trade Agreement (NAFTA) International Monetary Fund (IMF) World Bank European Union (EU) European Central Bank (ECB)
These aim to promote free trade, economic stability, and cooperation among nations.
International Business Strategies
Global Strategy (Globalization)
A global strategy involves standardizing products, promotion, and distribution worldwide, treating the world as a single market. Example: Coca-Cola.
Multinational Strategy
A multinational strategy involves customizing products, promotion, and distribution to local cultural, technological, regional, and national differences. Example: McDonald's.
Other International Strategies
Trading Company: Firms that buy and sell goods internationally, handling all trade activities. Licensing: Allowing another firm to use one's intellectual property in exchange for a fee. Franchising: Granting the right to use a firm's business model, name, and support in exchange for fees. Contract Manufacturing: Hiring a foreign firm to produce one's products to specification. Outsourcing: Transferring business processes to other countries with lower costs. Offshoring: Relocating business processes to another country, while retaining control. Joint Venture: Sharing costs and operations with a local partner in a foreign market. Strategic Alliance: Partnering to create competitive advantage worldwide. Direct Investment: Owning overseas facilities to maintain greater control.
Multinational Corporations (MNCs)
MNCs are large corporations that operate on a global scale, often with greater assets than the countries they operate in. While MNCs can drive economic development, they have also faced criticism from anti-
globalization activists for issues like labor exploitation and environmental harm.
