GCSE Business and Economics

1.5 Understanding the economic context

This topic considers the economic factors that affect businesses. How does the interaction of demand and supply affect the price charged and the quantity sold? How do changes in interest rates affect a business? How do changes in exchange rates affect exports and imports? What is the business cycle and how are businesses affected at different stages in the cycle? How are stakeholders affected by these factors?

Learning outcomes for this unit:

1. Know how the prices of commodity markets are determined

2. Know the difference between commodity markets and normal markets

3. Be able to describe the effect on small firms of price changes in raw materials and energy costs

4. Be able to describe how changing interest rates affect small firms which rely on overdrafts and loans for

finance

5. Be able to calculate the impact of interest rates on a business

6. Know the main ways that changing interest rates impacts on consumer spending

7. Be able to explain what exchange rates are

8. Be able to calculate the impact of exchange rate changes on costs and prices for businesses and

consumers

9. Be able to explain how changes in the exchange rate affect small firms that trade abroad or face

competition from abroad

10. Understand that economic activity tends to rise and fall (the business cycle)

11. Know that changes in the level of economic activity can have serious effects on small businesses

12. Be able to list stakeholders in named businesses

13. Be able to outline the ways that business decisions might impact different stakeholders

14. Know how conflicts of interest might occur

Name:

The economy

Draw the circular flow of income below:

Write a brief explanation of how money moves around our economy:

What are commodity markets?

You have already learned the difference between goods and services, and the importance of differentiating the ‘product’ that you sell from your competitors in order to gain a competitive advantage. Now you need to understand the difference between commodity markets and normal markets.

Commodity markets

Commodities are raw materials like potatoes, copper, steel, oil, cocoa and wheat. These are products that are very hard to differentiate and which are sold in large quantities on organised, global commodity markets. A commodity market is a place where the sellers of a commodity (farmers, miners etc.) and the buyers (who want the commodity to use as a raw material – for example to produce cars or computers, or to turn into chocolate) come together and decide on a price for the commodity. Because there are so many buyers and sellers, each individual has to take the price that is set by the commodity market. This is different to normal markets where individual traders can choose what price they want to set.

What factors affect the price of commodities?

The price of commodities can change all the time. A seller may get more or less for their product from one day to the next. The price changes because of the interaction of supply and demand.

Demand

Demand for a commodity or a normal good is the amount that buyers are willing and able to buy at a certain price. In general, there will be more demand if the price is lower and less if the price rises. Other factors also affect demand as well as price: the number of individuals wanting the product, the number of substitutes available and the income of potential consumers.

Complete the table below:

Factor Impact on demand

Chinese incomes are rising so Chinese people can afford to eat more meat

For meat:

Wheat is used to make bread. The Atkin’s diet means eating no bread.

This was a very popular diet a few years ago in the UK.

For wheat:

Mad Cow Disease in the 1990s meant that for a while sales of British beef

were banned in the UK

For lamb:

Supply

Supply of a product is the amount that sellers are willing and able to sell at any given price. In the same way as with demand, there can often be hundreds of thousands of small suppliers (farmers, miners etc.) who together make up the total supply.

Supply is affected by price – the more that sellers think they can get for a product, the lower the opportunity cost of supplying it, so they are more likely to want to supply it (for example, as the world price for cocoa rises, more farmers would prefer to grow cocoa than bananas, so the supply of cocoa is likely to increase). Other factors also affect supply. These include:

Social factors – e.g.

Legal factors – e.g.

Economic factors – e.g.

Political factors –e.g.

Technological factors – e.g.

Chinese herbal medicine is used by lots of people to treat a range of illnesses. You might have seen small businesses on your local high street offering herbs and tablets to the general public. A change in the law in April 2011 means that it is no longer legal to sell herbal medicine as dried herbs in the UK. This has led to a decrease in the supply of herbal medicine in the UK. This is a LEGAL factor.

New technology in farming has included machines for digging and harvesting produce as well as automatic irrigation equipment. At the same time, advances in seed technology have increased yields. This has led to farmers increasing their output with the same amount of land. This means that overall supply has increased because of TECHNOLOGICAL factors.

Shortage

When there is more demand than supply, there isn’t enough of the product to satisfy all of the buyers who want to buy it. This leads to a shortage. When there is a shortage of something, the price tends to rise because some buyers are willing to pay more to get it.

Examples of products where a shortage has led to an increase in prices, or has meant that the seller can charge more to begin with: the iPad, tickets for the 2012 Olympics, tickets sold outside a football cup final for more than the face value.

Shortages can be caused by an increase in demand or a fall in supply.

Surplus

Where supply exceeds demand, there are not enough buyers to buy all of the products that suppliers have to sell. This is called surplus. In this situation the price will fall to encourage more buyers so that the suppliers can get rid of their stock.

Example of products where a surplus has led to falling prices:

Surpluses can be caused by an increase in supply or a fall in demand.

The difference between commodity markets and normal markets

Read page 117 and complete the table below:

Factor Commodity markets Normal markets

Prices Change all the time

Seller’s control over prices Sellers can choose what to charge

Differentiation of product

Extension – work through the questions at the end of this chapter

The impact of changing commodity prices

Because commodities are used as raw materials, businesses which use commodities will be affected when their price on international markets changes. For example, a jeweller will have higher costs when the price of gold increases, and a local baker will be happy if the price of wheat falls.

Customers don’t like prices changing all the time – imagine how you would feel if today a can of drink costs £0.60 and tomorrow you are charged £1! This means that small businesses have to plan ahead for their costs and set their prices accordingly. If their costs go up and down because of commodity markets, this could have a big impact on their profits, but they can’t necessarily just pass on all of their costs to their customers.

The amount of impact that changing commodity prices will have on a small business depends on:

The size of the increase or decrease The % of their total costs that is made up of the commodity Whether or not the business can pass on the increase to their customers (can they put up

their prices when their costs increase?)

TEST YOURSELF:

Water pipes are made from copper. In 2010, increased demand for piping because of building in countries such as China led to a large increase in the demand for copper. Which of the following is the most likely effect of this increase in demand on plumbers? Select one answer:

A the price of copper pipes will fall C the price of copper pipes will rise

B the demand for water will increase D the demand for copper will fall

Harriet runs a souvenir shop in London. In 2010 Prince William announced his engagement to Kate Middleton, which is attracting many more tourists to London. Which of the following is the most likely effect of this news on Harriet’s business? Select one answer:

A the cost of her souvenirs will increase C Demand for Harriet’s souvenirs will fall

B demand for Harriet’s souvenirs will increase D Harriet will reduce her prices

Cocoa is used to make chocolate. Which of the following is the most likely factor that would lead to a fall in world cocoa prices? Select one answer:

A a bad harvest of cocoa C the development of drought-resistant cocoa seeds

B the discovery of a new cocoa pest D increased demand for chocolate

Interest rates

What is the interest rate?

Some businesses and individuals need to raise finance to pay for certain actions such as buying a house or investing in new capital equipment. One way of doing this is to take out a loan or an overdraft. A loan is an amount of money borrowed from a lender for a period of time. An overdraft is a flexible loan where the bank allows the individual to spend more money than is in their bank account.

The lender will want a reward for lending their money, because there is an opportunity cost involved for them. If they lend the money, they can’t spend or save it. The reward for lending is the interest that they charge.

The borrower will expect to pay for the benefit of borrowing the money. As well as paying back the loan they will pay back some extra to the lender. This cost of lending is the interest that they pay.

How is the interest rate set?

A lender can choose the rate that they charge to a borrower. Usually, this will be based on the base rate set by the Bank of England but will be higher than this rate. The lender will charge more if they think that there is a higher chance that the borrower won’t pay the money back. This is one reason why small businesses often face high interest rates for overdrafts and bank loans, because lots of small businesses fail each year.

Variable and fixed interest rates

Fill in the table below:

Variable rate Fixed rate

Definition

If the Bank of England increases the base rate...

If the Bank of England decreases the base rate...

Effect on business planning for the future (e.g. writing a cash flow forecast)

Interest rate

This is the cost of borrowing, or the reward for lending.

How does the interest rate affect businesses?

Businesses and individuals borrow money in the form of loans, overdrafts and mortgages. They also save money in bank accounts and spend their money on goods and services.

When the interest rate is high, businesses will be put off borrowing more money to invest in new technology, expanding the business etc. Customers may have to pay back more on their loans, so they could have less disposable income left to spend. They might also be less keen to take out new loans for big purchases such as cars or new household items, so the demand for the products of some businesses is likely to fall.

When interest rates are high, saving is more attractive because the bank will give a higher payment for any money saved. This also affects businesses because potential customers might choose to save their money rather than spend it.

Which businesses do you think will be most affected by an increase in interest rates? Why?

Complete the card-sort activity and use the results to fill in the table to show the impact of interest rate changes:

Interest rates rise Interest rates fall

Extension: turn to page 122-3 and work through the questions here

TEST YOURSELF:

Pippa has an overdraft of £10,000 which she is using to manage the cash flow of her new tanning salon. Which of the following best describes the impact on her of an increase in the interest rate? Select one answer:

A her cash flow will worsen C her prices will increase

B her costs will decrease D she will want to borrow more money

Luxury Loafers sells handmade shoes to wealthy individuals. The owners recently took out a bank loan to fund the purchase of a new leather cutting machine. Which of the following is the most likely effect on the business of a fall in the interest rate? Select one answer:

A the cost of making the shoes will increase C no impact on the business

B fixed costs will fall D fixed costs will increase

Exchange rates

What is the exchange rate?

Different countries use different currencies. If you want to buy goods or services in a country, you need to have some of that currency. To get currency you have to buy it – it’s just another good that you can spend your £s on.

The ‘cost’ of foreign currency is the exchange rate. If a currency, such as the $ or the euro, is strong, it costs a lot to buy. This means that buying a $ will cost more £s than when the $ is weak. A weak currency isn’t very expensive to buy, so a £ can buy a lot of that currency.

Businesses in the UK need foreign currency to buy raw materials from overseas, such as maple syrup from America. This is called IMPORTING.

Businesses overseas which buy from UK businesses need to use £s to make the purchase. They therefore need to buy the £s before they can make their purchases. This is called EXPORTING.

Remember...

when we import into the UK, goods come in and money goes out of the country. This is bad because the money is lost from our economy.

when we export from the UK, goods go out and money comes into the country. This is good because more money comes into our economy.

Calculating the cost of foreign exchange

Work through the ppt presentation with the class. Write the rules for calculating exchange rates below:

What does it mean if the £ is appreciating?

What does it mean if the £ is depreciating?

Changing exchange rates

Changing exchange rates can have a significant effect on possible sales. They can be either reduced or increased - it just depends on which way exchange rates are moving.

Try these exercises

A UK fruit wholesaler buys bananas from a supplier in Honduras. The Honduran seller wants to be paid in US dollars. A bunch of ten bananas is currently selling for $20 each. The exchange rate is currently £1 = $1.75.

Q1. How much does the UK buyer have to pay, in pounds, for each bunch of bananas?

Q2. The exchange rate between the pound and the dollar changes. The pound has appreciated against the dollar and is now standing at £1 = $1.80. How much will a bunch of bananas now cost the UK importer?

Q3. Given your answer to the question above, what do you think might be the effect on the UK importer of the change in the exchange rate?

A UK wine merchant buys high quality red and white wine from a vineyard in France. The price per bottle of red in France is €35 and the price of a bottle of white, €30. The exchange rate is currently standing at £1 = €1.50.

Q4. How much will the UK importer have to pay to buy each bottle of red and white wine in pounds?

Q5. The exchange rate now changes to £1 = €1.40. How much do a bottle of red and a bottle of white now cost the UK importer?

Q6. Given your answer above, what effect do you think this might have on the UK wine merchant?

A UK business sells insurance policies to foreign businesses to protect them against damage to business premises caused by fire. The average price of each policy is £500 per year. The exchange rate is currently £1 = $1.82 and £1 = €1.48.

Q7. How much would the policy cost to a US business and a business in Portugal?

Q8. The exchange rate now alters to £1 = 1.80 and £1 = €1.50. How much do the businesses in the US and Portugal now has to pay for their policies?

Q9. What might the effect of the change in exchange rates have to the UK business if they are operating in a very competitive market where there are lots of sellers of this type of insurance?

The impact of changes in the exchange rate

Businesses which import Businesses which exportThe £ appreciates (becomes stronger. This means that it can buy more foreign currency)

£1 = $ lots

This is good because...

The £ depreciates (becomes weaker. This means that it can buy less foreign currency)

£1 = $ not as much

This is good because...

TEST YOURSELF:

The value of the £ falls against other currencies. This is likely to:

A decrease exports of goods C increase imports of goods by UK firms

B make UK firms more competitive in D make UK firms more competitive in the foreign markets domestic market

A bike shop needs to buy parts from America worth $6,000. The current exchange rate is £1:$1.50. How much in £ will the bike shop pay for the order? Select one answer:

A £6000 C £4000

B £8000 D £9000

The business cycle

You might be used to hearing words like ‘recession’ and ‘boom’ on the news, but not really know what they mean. They refer to stages in the business cycle. The business cycle describes the way that the level of economic activity in an economy changes over time.

Remind yourself...The economy is...

The size of the economy is measured by ...

When the economy is growing, this means that...

Once you’ve learned about the business cycle, try these questions:

Aziz’s record shop is suffering in the recession. He thinks it is because records are considered a luxury good by many people so they reduce their spending on records when their income falls. Which of the following would be the best course of action for Aziz? Select one answer:

A increase the price of his records C introduce a record library service

B advertise more D take on new staff

Candy Cabs is a taxi service run for women by women. During an upturn in the business cycle, which of the following is least likely to occur for the business? Select one answer:

A a new taxi firm enters the market C the number of customers falls

B they take on new staff D the number of bookings increases

These notes are from Tutor2u.com

The economy tends to experience different trends. These can be categorised as the business cycle and may feature boom, slump, recession and recovery

BOOM: A period of fast economic growth. Output is high due to increased demand, unemployment is low. Business confidence may be high leading to increased investment. Consumer confidence may lead to extra spending.

SLUMP: A period when output slows down due to a reduction in demand. Confidence may begin to suffer.

RECESSION: A period where economic growth slows down and the level of output may actually decrease. Unemployment is likely to increase. Firms may lose confidence and reduce investment. Individuals may save rather than spend.

RECOVERY: A period when the economy moves between recession and a boom.

WHAT HAPPENS IN A BOOM?

- Businesses produce more goods- Businesses invest in more machinery- Consumers spend more money. There is a FEELGOOD FACTOR- Less money is spent by the Government on unemployment benefits- More money is collected by the Government in income tax and VAT- Prices tend to increase due to extra demand

WHAT HAPPENS IN A RECESSION?

- Businesses cut back on production- Some businesses may go bankrupt- Consumers spend less money. Fall in FEELGOOD FACTOR- Individuals may lose their jobs- More money is spent by the Govt on unemployment benefits- Less money is collected by the Govt in income tax and VAT- Prices start to fall

Business decisions and stakeholders

What are stakeholders?

A stakeholder is not the same as a shareholder.

Add to the diagram below to show the main interests of each stakeholder in a typical business:

STAKEHOLDERS

customers

shareholders

employees

managerssuppliers

local community

government

A stakeholder is any person or group of people with an interest in the activities of a business, and who is affected by those activities.

TEST YOURSELF

Olu’s new takeaway food restaurant is doing really well, and is attracting lots of customers with his mix of delicious food and clubber-friendly opening hours.

Identify two potential conflicts of interest between stakeholders in Olu’s restaurant. For each, explain why this could occur:

1

2

Extension: turn to page 135 in your textbook and complete the questions on stakeholders.

WELL DONE...YOU’VE NOW COVERED ALL OF THE THEORY FOR UNIT 1. HOORAY!!!

Interest rates go up Interest rates fall ..so..

businesses have to pay more interest on their

loans

businesses have to pay less interest on their

loans

..so..

Businesses decide not toinvest in new machines

Businesses decide toinvest in new machines

..so..

Households decide to save more and spend

less

Households decide to save

less and spend more

..so..

Spending in the economy falls. Some

businesses fail

Spending in the economy rises. Some businesses

expand.…and..

Households are put off borrowing money

Households are morekeen to borrow money …and..

Households have to pay more on their mortgage and have less to spend

on luxuries

Households have to pay less on their mortgage

and have more to spend on luxuries

…and..