Chapter 1 The Foundations of Business

Business Participants and Activities

Let’s begin our discussion of business by identifying the main participants of business and the functions that most businesses perform. Then we’ll finish this section by discussing the external factors that influence a business’s activities.

Functional Areas of Business

Figure 1.1

Hospitals specialize in an intangible product—health care.

© 2010 Jupiterimages Corporation

The activities needed to operate a business can be divided into a number of functional areas: management, operations, marketing, accounting, and finance. Let’s briefly explore each of these areas.

Finance

FinanceActivities involved in planning for, obtaining, and managing a company’s funds. involves planning for, obtaining, and managing a company’s funds. Finance managers address such questions as the following: How much money does the company need? How and where will it get the necessary money? How and when will it pay the money back? What should it do with its funds? What investments should be made in plant and equipment? How much should be spent on research and development? How should excess funds be invested? Good financial management is particularly important when a company is first formed, because new business owners usually need to borrow money to get started.

Figure 1.2 Business and Its Environment

External Forces that Influence Business Activities

Apple and other businesses don’t operate in a vacuum: they’re influenced by a number of external factors. These include the economy, government, consumer trends, and public pressure to act as good corporate citizens. Figure 1.2 "Business and Its Environment" sums up the relationship among the participants in a business, its functional areas, and the external forces that influence its activities. One industry that’s clearly affected by all these factors is the fast-food industry. A strong economy means people have more money to eat out at places where food standards are monitored by a government agency, the Food and Drug Administration. Preferences for certain types of foods are influenced by consumer trends (eating fried foods might be OK one year and out the next). Finally, a number of decisions made by the industry result from its desire to be a good corporate citizen. For example, several fast-food chains have responded to environmental concerns by eliminating Styrofoam containers.David Baron, “Facing-Off in Public,” Stanford Business, April 15, 2006, http://www.gsb.stanford.edu/news/bmag/sbsm0308/feature_face_off.shtml (accessed January 21, 2012). As you move through this text, you’ll learn more about these external influences on business. (Section 1.3 "What Is Economics?" will introduce in detail one of these external factors—the economy.)

Resources: Inputs and Outputs

EconomicsStudy of how scarce resources are used to produce outputs—goods and services—that are distributed among people. is the study of the production, distribution, and consumption of goods and services. ResourcesInputs used to produce outputs. are the inputs used to produce outputs. Resources may include any or all of the following:

• Land and other natural resources
• Labor (physical and mental)
• Capital, including buildings and equipment
• Entrepreneurship

Resources are combined to produce goods and services. Land and natural resources provide the needed raw materials. Labor transforms raw materials into goods and services. Capital (equipment, buildings, vehicles, cash, and so forth) are needed for the production process. Entrepreneurship provides the skill and creativity needed to bring the other resources together to produce a good or service to be sold to the marketplace.

Because a business uses resources to produce things, we also call these resources factors of productionResources consisting of land, labor, capital (money, buildings, equipment), and entrepreneurial skills combined to produce goods and services.. The factors of production used to produce a shirt would include the following:

• The land that the shirt factory sits on, the electricity used to run the plant, and the raw cotton from which the shirts are made
• The laborers who make the shirts
• The factory and equipment used in the manufacturing process, as well as the money needed to operate the factory
• The entrepreneurship skill used to coordinate the other resources to initiate the production process and the distribution of the goods or services to the marketplace

Input and Output Markets

Many of the factors of production (or resources) are provided to businesses by households. For example, households provide businesses with labor (as workers), land and buildings (as landlords), and capital (as investors). In turn, businesses pay households for these resources by providing them with income, such as wages, rent, and interest. The resources obtained from households are then used by businesses to produce goods and services, which are sold to the same households that provide businesses with revenue. The revenue obtained by businesses is then used to buy additional resources, and the cycle continues. This circular flow is described in Figure 1.3 "The Circular Flow of Inputs and Outputs", which illustrates the dual roles of households and businesses:

• Households not only provide factors of production (or resources) but also consume goods and services.
• Businesses not only buy resources but also produce and sell both goods and services.

Figure 1.3 The Circular Flow of Inputs and Outputs

The Questions Economists Ask

Economists study the interactions between households and businesses and look at the ways in which the factors of production are combined to produce the goods and services that people need. Basically, economists try to answer three sets of questions:

1. What goods and services should be produced to meet consumers’ needs? In what quantity? When should they be produced?
2. How should goods and services be produced? Who should produce them, and what resources, including technology, should be combined to produce them?
3. Who should receive the goods and services produced? How should they be allocated among consumers?

Economic Systems

The answers to these questions depend on a country’s economic systemMeans by which a society makes decisions about allocating resources to produce and distribute products.—the means by which a society (households, businesses, and government) makes decisions about allocating resources to produce products and about distributing those products. The degree to which individuals and business owners, as opposed to the government, enjoy freedom in making these decisions varies according to the type of economic system. Generally speaking, economic systems can be divided into two systems: planned systems and free market systems.

How Economic Systems Compare

In comparing economic systems, it’s helpful to think of a continuum with communism at one end and pure capitalism at the other, as in Figure 1.4 "The Spectrum of Economic Systems". As you move from left to right, the amount of government control over business diminishes. So, too, does the level of social services, such as health care, child-care services, social security, and unemployment benefits.

Figure 1.4 The Spectrum of Economic Systems

Perfect Competition

Figure 1.5

Produce, like these apples, is a standardized product available from numerous businesses.

© 2010 Jupiterimages Corporation

Perfect competitionMarket in which many consumers buy standardized products from numerous small businesses. exists when there are many consumers buying a standardized product from numerous small businesses. Because no seller is big enough or influential enough to affect price, sellers and buyers accept the going price. For example, when a commercial fisher brings his fish to the local market, he has little control over the price he gets and must accept the going market price.

The Basics of Supply and Demand

To appreciate how perfect competition works, we need to understand how buyers and sellers interact in a market to set prices. In a market characterized by perfect competition, price is determined through the mechanisms of supply and demand. Prices are influenced both by the supply of products from sellers and by the demand for products by buyers.

To illustrate this concept, let’s create a supply and demand schedule for one particular good sold at one point in time. Then we’ll define demand and create a demand curve and define supply and create a supply curve. Finally, we’ll see how supply and demand interact to create an equilibrium price—the price at which buyers are willing to purchase the amount that sellers are willing to sell.

Demand and the Demand Curve

DemandQuantity of a product that buyers are willing to purchase at various prices. is the quantity of a product that buyers are willing to purchase at various prices. The quantity of a product that people are willing to buy depends on its price. You’re typically willing to buy less of a product when prices rise and more of a product when prices fall. Generally speaking, we find products more attractive at lower prices, and we buy more at lower prices because our income goes further.

Figure 1.6 The Demand Curve

Using this logic, we can construct a demand curveGraph showing the quantity of a product that will be bought at certain prices. that shows the quantity of a product that will be demanded at different prices. Let’s assume that the diagram in Figure 1.6 "The Demand Curve" represents the daily price and quantity of apples sold by farmers at a local market. Note that as the price of apples goes down, buyers’ demand goes up. Thus, if a pound of apples sells for $0.80, buyers will be willing to purchase only fifteen hundred pounds per day. But if apples cost only $0.60 a pound, buyers will be willing to purchase two thousand pounds. At $0.40 a pound, buyers will be willing to purchase twenty-five hundred pounds.

Supply and the Supply Curve

SupplyQuantity of a product that sellers are willing to sell at various prices. is the quantity of a product that sellers are willing to sell at various prices. The quantity of a product that a business is willing to sell depends on its price. Businesses are more willing to sell a product when the price rises and less willing to sell it when prices fall. Again, this fact makes sense: businesses are set up to make profits, and there are larger profits to be made when prices are high.

Figure 1.7 The Supply Curve

Now we can construct a supply curveGraph showing the quantity of a product that will be offered for sale at certain prices. that shows the quantity of apples that farmers would be willing to sell at different prices, regardless of demand. As you can see in Figure 1.7 "The Supply Curve", the supply curve goes in the opposite direction from the demand curve: as prices rise, the quantity of apples that farmers are willing to sell also goes up. The supply curve shows that farmers are willing to sell only a thousand pounds of apples when the price is $0.40 a pound, two thousand pounds when the price is $0.60, and three thousand pounds when the price is $0.80.

Equilibrium Price

We can now see how the market mechanism works under perfect competition. We do this by plotting both the supply curve and the demand curve on one graph, as we’ve done in Figure 1.8 "The Equilibrium Price". The point at which the two curves intersect is the equilibrium pricePrice at which buyers are willing to buy exactly the amount that sellers are willing to sell.. At this point, buyers’ demand for apples and sellers’ supply of apples is in equilibrium.

Figure 1.8 The Equilibrium Price

You can see in Figure 1.8 "The Equilibrium Price" that the supply and demand curves intersect at the price of $0.60 and quantity of two thousand pounds. Thus, $0.60 is the equilibrium price: at this price, the quantity of apples demanded by buyers equals the quantity of apples that farmers are willing to supply. If a farmer tries to charge more than $0.60 for a pound of apples, he won’t sell very many and his profits will go down. If, on the other hand, a farmer tries to charge less than the equilibrium price of $0.60 a pound, he will sell more apples but his profit per pound will be less than at the equilibrium price.

What have we learned in this discussion? We’ve learned that without outside influences, markets in an environment of perfect competition will arrive at an equilibrium point at which both buyers and sellers are satisfied. But we must be aware that this is a very simplistic example. Things are much more complex in the real world. For one thing, markets rarely operate without outside influences. Sometimes, sellers supply more of a product than buyers are willing to purchase; in that case, there’s a surplus. Sometimes, they don’t produce enough of a product to satisfy demand; then we have a shortage.

Circumstances also have a habit of changing. What would happen, for example, if income rose and buyers were willing to pay more for apples? The demand curve would change, resulting in an increase in equilibrium price. This outcome makes intuitive sense: as demand increases, prices will go up. What would happen if apple crops were larger than expected because of favorable weather conditions? Farmers might be willing to sell apples at lower prices. If so, the supply curve would shift, resulting in another change in equilibrium price: the increase in supply would bring down prices.

Key Takeaways

• In a free market system, buyers and sellers interact in a market to set prices.
• When the market is characterized by perfect competition, many small companies sell identical products. Because no company is large enough to control price, each simply accepts the market price. The price is determined by supply and demand.
• Supply is the quantity of a product that sellers are willing to sell at various prices.
• Demand is the quantity of a product that buyers are willing to purchase at various prices.
• The quantity of a product that people will buy depends on its price: they’ll buy more when the price is low and less when it’s high.
• Price also influences the quantity of a product that producers are willing to supply: they’ll sell more of a product when prices are high and less when they’re low.
• In a competitive market, the decisions of buyers and sellers interact until the market reaches an equilibrium price—the price at which buyers are willing to buy the same amount that sellers are willing to sell.

Exercise

(AACSB) Analysis

You just ran across three interesting statistics: (1) the world’s current supply of oil is estimated to be 1.3 trillion barrels; (2) the worldwide use of oil is thirty billion barrels a year; and (3) at this rate of consumption, we’ll run out of oil in forty-three years. Overcoming an initial sense of impending catastrophe, you remember the discussion of supply and demand in this chapter and realize that things aren’t as simple as they seem. After all, many factors affect both the supply of oil and the demand for products made from it, such as gasoline. These factors will influence when (and if) the world runs out of oil. Answer the following questions, and provide explanations for your answers:

1. What’s the major factor that affects the supply of oil? (Hint: It’s the same major factor affecting the demand for oil.)
2. If producers find additional oil reserves, what will happen to the price of oil?
3. If producers must extract oil from more-costly wells, what will happen to the price that you pay to fill up your gas tank?
4. If China’s economy continues to expand rapidly, what will happen to the price of oil?
5. If drivers in the United States start favoring fuel-efficient cars over SUVs, will gas be cheaper or more expensive?
6. In your opinion, will oil producers be able to supply enough oil to meet the increasing demand for oil-related products, such as gasoline?

Monopolistic Competition

In monopolistic competitionMarket in which many sellers supply differentiated products., we still have many sellers (as we had under perfect competition). Now, however, they don’t sell identical products. Instead, they sell differentiated products—products that differ somewhat, or are perceived to differ, even though they serve a similar purpose. Products can be differentiated in a number of ways, including quality, style, convenience, location, and brand name. Some people prefer Coke over Pepsi, even though the two products are quite similar. But what if there was a substantial price difference between the two? In that case, buyers could be persuaded to switch from one to the other. Thus, if Coke has a big promotional sale at a supermarket chain, some Pepsi drinkers might switch (at least temporarily).

How is product differentiation accomplished? Sometimes, it’s simply geographical; you probably buy gasoline at the station closest to your home regardless of the brand. At other times, perceived differences between products are promoted by advertising designed to convince consumers that one product is different from another—and better than it. Regardless of customer loyalty to a product, however, if its price goes too high, the seller will lose business to a competitor. Under monopolistic competition, therefore, companies have only limited control over price.

Oligopoly

OligopolyMarket in which a few sellers supply a large portion of all the products sold in the marketplace. means few sellers. In an oligopolistic market, each seller supplies a large portion of all the products sold in the marketplace. In addition, because the cost of starting a business in an oligopolistic industry is usually high, the number of firms entering it is low.

Companies in oligopolistic industries include such large-scale enterprises as automobile companies and airlines. As large firms supplying a sizable portion of a market, these companies have some control over the prices they charge. But there’s a catch: because products are fairly similar, when one company lowers prices, others are often forced to follow suit to remain competitive. You see this practice all the time in the airline industry: When American Airlines announces a fare decrease, Continental, United Airlines, and others do likewise. When one automaker offers a special deal, its competitors usually come up with similar promotions.

Monopoly

In terms of the number of sellers and degree of competition, monopolies lie at the opposite end of the spectrum from perfect competition. In perfect competition, there are many small companies, none of which can control prices; they simply accept the market price determined by supply and demand. In a monopolyMarket in which there is only one seller supplying products at regulated prices., however, there’s only one seller in the market. The market could be a geographical area, such as a city or a regional area, and doesn’t necessarily have to be an entire country.

There are few monopolies in the United States because the government limits them. Most fall into one of two categories: natural and legal. Natural monopoliesMonopoly in which, because of the industry’s importance to society, one seller is permitted to supply products without competition. include public utilities, such as electricity and gas suppliers. Such enterprises require huge investments, and it would be inefficient to duplicate the products that they provide. They inhibit competition, but they’re legal because they’re important to society. In exchange for the right to conduct business without competition, they’re regulated. For instance, they can’t charge whatever prices they want, but they must adhere to government-controlled prices. As a rule, they’re required to serve all customers, even if doing so isn’t cost efficient.

A legal monopolyMonopoly in which one seller supplies a product or technology to which it holds a patent. arises when a company receives a patent giving it exclusive use of an invented product or process. Patents are issued for a limited time, generally twenty years.United States Patent and Trademark Office, General Information Concerning Patents, April 15, 2006, http://www.uspto.gov/web/offices/pac/doc/general/index.html#laws (accessed January 21, 2012). During this period, other companies can’t use the invented product or process without permission from the patent holder. Patents allow companies a certain period to recover the heavy costs of researching and developing products and technologies. A classic example of a company that enjoyed a patent-based legal monopoly is Polaroid, which for years held exclusive ownership of instant-film technology.Mary Bellis, “Inventors-Edwin Land-Polaroid Photography-Instant Photography/Patents,” April 15, 2006, http://inventors.about.com/library/inventors/blpolaroid.htm (accessed January 21, 2012). Polaroid priced the product high enough to recoup, over time, the high cost of bringing it to market. Without competition, in other words, it enjoyed a monopolistic position in regard to pricing.

Economic Goals

All the world’s economies share three main goals:

1. Growth
2. High employment
3. Price stability

Let’s take a closer look at each of these goals, both to find out what they mean and to show how we determine whether they’re being met.

Economic Growth

One purpose of an economy is to provide people with goods and services—cars, computers, video games, houses, rock concerts, fast food, amusement parks. One way in which economists measure the performance of an economy is by looking at a widely used measure of total output called gross domestic product (GDP)Measure of the market value of all goods and services produced by a nation’s economy in a given year.. GDP is defined as the market value of all goods and services produced by the economy in a given year. In the United States, it’s calculated by the Department of Commerce. GDP includes only those goods and services produced domestically; goods produced outside the country are excluded. GDP also includes only those goods and services that are produced for the final user; intermediate products are excluded. For example, the silicon chip that goes into a computer (an intermediate product) would not count, even though the finished computer would.

By itself, GDP doesn’t necessarily tell us much about the state of the economy. But change in GDP does. If GDP (after adjusting for inflation) goes up, the economy is growing. If it goes down, the economy is contracting.

The Business Cycle

The economic ups and downs resulting from expansion and contraction constitute the business cyclePattern of expansion and contraction in an economy.. A typical cycle runs from three to five years but could last much longer. Though typically irregular, a cycle can be divided into four general phases of prosperity, recession, depression (which the cycle generally skips), and recovery:

• During prosperity, the economy expands, unemployment is low, incomes rise, and consumers buy more products. Businesses respond by increasing production and offering new and better products.
• Eventually, however, things slow down. GDP decreases, unemployment rises, and because people have less money to spend, business revenues decline. This slowdown in economic activity is called a recessionEconomic slowdown measured by a decline in gross domestic productivity.. Economists often say that we’re entering a recession when GDP goes down for two consecutive quarters.

Figure 1.9

© Thinkstock

• Generally, a recession is followed by a recovery in which the economy starts growing again.
• If, however, a recession lasts a long time (perhaps a decade or so), while unemployment remains very high and production is severely curtailed, the economy could sink into a depressionSevere, long-lasting recession.. Though not impossible, it’s unlikely that the United States will experience another severe depression like that of the 1930s. The federal government has a number of economic tools (some of which we’ll discuss shortly) with which to fight any threat of a depression.

Full Employment

To keep the economy going strong, people must spend money on goods and services. A reduction in personal expenditures for things like food, clothing, appliances, automobiles, housing, and medical care could severely reduce GDP and weaken the economy. Because most people earn their spending money by working, an important goal of all economies is making jobs available to everyone who wants one. In principle, full employmentCondition under which about 95 percent of those who want to work are employed. occurs when everyone who wants to work has a job. In practice, we say that we have “full employment” when about 95 percent of those wanting to work are employed.

The Unemployment Rate

The U.S. Department of Labor tracks unemployment and reports the unemployment ratePercentage of the total labor force that’s currently unemployed and actively seeking work.: the percentage of the labor force that’s unemployed and actively seeking work. The unemployment rate is an important measure of economic health. It goes up during recessionary periods because companies are reluctant to hire workers when demand for goods and services is low. Conversely, it goes down when the economy is expanding and there is high demand for products and workers to supply them.

Figure 1.10 "The U.S. Unemployment Rate, 1970–2010" traces the U.S. unemployment rate between 1970 and 2010. If you want to know the current unemployment rate, go to the CNNMoney Web site (CNNMoney.com) and click on “Economy” and then on “Job Growth.”

Figure 1.10 The U.S. Unemployment Rate, 1970–2010

Price Stability

A third major goal of all economies is maintaining price stabilityConditions under which the prices for products remain fairly constant.. Price stability occurs when the average of the prices for goods and services either doesn’t change or changes very little. Rising prices are troublesome for both individuals and businesses. For individuals, rising prices mean you have to pay more for the things you need. For businesses, rising prices mean higher costs, and, at least in the short run, businesses might have trouble passing on higher costs to consumers. When the overall price level goes up, we have inflationRise in the overall price level.. Figure 1.11 "The U.S. Inflation Rate, 1960–2010" shows inflationary trends in the U.S. economy since 1960. When the price level goes down (which rarely happens), we have deflationDecrease in overall price level..

Figure 1.11 The U.S. Inflation Rate, 1960–2010

The Consumer Price Index

The most widely publicized measure of inflation is the consumer price index (CPI)Index that measures inflation by measuring the prices of goods purchased by a typical consumer., which is reported monthly by the Bureau of Labor Statistics. The CPI measures the rate of inflation by determining price changes of a hypothetical basket of goods, such as food, housing, clothing, medical care, appliances, automobiles, and so forth, bought by a typical household.

The CPI base period is 1982 to 1984, which has been given an average value of 100. Table 1.1 "Selected CPI Values, 1950–2010" gives CPI values computed for selected years. The CPI value for 1950, for instance, is 24. This means that $1 of typical purchases in 1982 through 1984 would have cost $0.24 in 1950. Conversely, you would have needed $2.18 to purchase the same $1 worth of typical goods in 2010. The difference registers the effect of inflation. In fact, that’s what an inflation rate is—the percentage change in a price index.

You can find out the current CPI by going to the CNNMoney Web site (CNNMoney.com) and click on “Economy” and then on “Inflation (CPI).”

Table 1.1 Selected CPI Values, 1950–2010

Year	1950	1960	1970	1980	1990	2000	2001	2002
CPI	24.1	29.1	38.8	82.4	130.7	172.2	177.1	179.9
Year	2003	2004	2005	2006	2007	2008	2009	2010
CPI	184.0	188.9	195.3	201.6	207.3	215.3	214.15	218.1

Economic Forecasting

In the previous section, we introduced several measures that economists use to assess the performance of the economy at a given time. By looking at changes in GDP, for instance, we can see whether the economy is growing. The CPI allows us to gauge inflation. These measures help us understand where the economy stands today. But what if we want to get a sense of where it’s headed in the future? To a certain extent, we can forecast future economic trends by analyzing several leading economic indicators.

Monetary Policy

Monetary policy is exercised by the Federal Reserve System (“the Fed”), which is empowered to take various actions that decrease or increase the money supply and raise or lower short-term interest rates, making it harder or easier to borrow money. When the Fed believes that inflation is a problem, it will use contractionary policy to decrease the money supply and raise interest rates. When rates are higher, borrowers have to pay more for the money they borrow, and banks are more selective in making loans. Because money is “tighter”—more expensive to borrow—demand for goods and services will go down, and so will prices. In any case, that’s the theory.

Figure 1.12

The Fed will typically tighten or decrease the money supply during inflationary periods, making it harder to borrow money.

© 2010 Jupiterimages Corporation

To counter a recession, the Fed uses expansionary policy to increase the money supply and reduce interest rates. With lower interest rates, it’s cheaper to borrow money, and banks are more willing to lend it. We then say that money is “easy.” Attractive interest rates encourage businesses to borrow money to expand production and encourage consumers to buy more goods and services. In theory, both sets of actions will help the economy escape or come out of a recession.

Fiscal Policy

Fiscal policy relies on the government’s powers of spending and taxation. Both taxation and government spending can be used to reduce or increase the total supply of money in the economy—the total amount, in other words, that businesses and consumers have to spend. When the country is in a recession, the appropriate policy is to increase spending, reduce taxes, or both. Such expansionary actions will put more money in the hands of businesses and consumers, encouraging businesses to expand and consumers to buy more goods and services. When the economy is experiencing inflation, the opposite policy is adopted: the government will decrease spending or increase taxes, or both. Because such contractionary measures reduce spending by businesses and consumers, prices come down and inflation eases.

The National Debt

If, in any given year, the government takes in more money (through taxes) than it spends on goods and services (for things such as defense, transportation, and social services), the result is a budget surplus. If, on the other hand, the government spends more than it takes in, we have a budget deficit (which the government pays off by borrowing through the issuance of Treasury bonds). Historically, deficits have occurred much more often than surpluses; typically, the government spends more than it takes in. Consequently, the U.S. government now has a total national debtTotal amount of money owed by the federal government. of more than $14 trillion.

As you can see in Figure 1.13 "The U.S. National Debt, 1940–2010", this number has risen dramatically in the last sixty-five years. The significant jump that starts in the 1980s reflects several factors: a big increase in government spending (especially on defense), a substantial rise in interest payments on the debt, and lower tax rates. As of this writing, your share is $46,146.21. If you want to see what the national debt is today—and what your current share is—go on the Web to the U.S. National Debt Clock (http://www.brillig.com/debt_clock).

Figure 1.13 The U.S. National Debt, 1940–2010

Macroeconomics and Microeconomics

In the preceding discussion, we’ve touched on two main areas in the field of economics: (1) macroeconomics, or the study of the economy as a whole, and (2) microeconomics, or the study of the economic choices made by individual consumers or businesses. Macroeconomics examines the economy-wide effect of inflation, while microeconomics considers such decisions as the price you’re willing to pay to go to college. Macroeconomics investigates overall trends in imports and exports, while microeconomics explains the price that teenagers are willing to pay for concert tickets. Though they are often regarded as separate branches of economics, we can gain a richer understanding of the economy by studying issues from both perspectives. As we’ve seen in this chapter, for instance, you can better understand the overall level of activity in an economy (a macro issue) through an understanding of supply and demand (a micro issue).