Levels of analysis
As indicated above, economics is concerned with the study of how society deals with the problem of scarcity and the resultant problems of what to produce, how to produce and how to distribute. Within this broad framework the economist typically distinguishes between two types of analysis:
1 Microeconomic analysis, which is concerned with the study of economic decision taking by both individuals and firms.
2 Macroeconomic analysis, which is concerned with interactions in the economy as a whole (i.e. with economic aggregates).
The microeconomic approach is exemplified by the analysis of markets and prices undertaken which shows, for example, how individual consumers in the market for beer might be affected by a price change. This analysis could be extended to an investigation of how the total market might respond to a movement in the price, or how a firm’s (or market’s) decisions on supply are affected by changes in wage rates or production techniques or some other factor. Note that in these examples, the focus of attention is on decision taking by individuals and firms in a single industry, while interactions between this industry and the rest of the economy are ignored: in short, this is what economists call a ‘partial analysis’.
In reality, of course, all sectors of the economy are interrelated to some degree. A pay award, for example, in the beer industry (or in a single firm) may set a new pay norm that workers in other industries take up and these pay increases may subsequently influence employment, production and consumer demand in the economy as a whole, which could also have repercussions on the demand for beer.
Sometimes such repercussions may be relatively minor and so effectively can be ignored. In such situations the basic microeconomic approach remains valid.
In contrast, macroeconomics recognizes the interdependent nature of markets and studies the interaction in the economy as a whole, dealing with such questions as the overall level of employment, the rate of inflation, the percentage growth of output in the economy and many other economy-wide aggregates exemplified, for instance, by the analysis of international trade and by the macroeconomic model discussed below. It should be pointed out, however, that while the distinction between the micro and macro approaches remains useful for analytical purposes, in many instances the two become intertwined. UK Chancellor Nigel Lawson’s decision (in 1988) to cut the top rate of income tax from 60 per cent to 40 per cent was presented at the time as a means of boosting the economy by providing incentives for entrepreneurs clearly a macroeconomic proposition. However, to investigate the validity of the Chancellor’s view, it is necessary to lean heavily on microeconomic analysis to see how lower taxation might influence, say, an individual’s preference for work over leisure. Given that macroeconomic phenomena are the result of aggregating the behaviour of individual firms and consumers, this is obviously a common situation and one which is useful to bear in mind in any study of either the firm or the economy as a whole.
The ‘flows’ of economic activity
Economic activity can be portrayed as a flow of economic resources into firms (i.e. productive organisations), which are used to produce output for consumption, and a corresponding flow of payments from firms to the providers of those resources, who use them primarily to purchase the goods and services produced. These flows of resources, production, income and expenditure accordingly represent the fundamental activities of an economy at work. In Figure illustrates the flow of resources and of goods and services in the economy what economists describe as ‘real flows’.
In effect, firms use economic resources to produce goods and services, which are consumed by private individuals (private domestic consumption) or government (government consumption) or by overseas purchasers (foreign consumption) or by other firms (capital formation). This consumption gives rise to a flow of expenditures that represents an income for firms, which they use to purchase further resources in order to produce further output for consumption. This flow of income and expenditures is shown in Figure
The interrelationship between income flows and real flows can be seen by combining the two diagrams into one, which for the sake of simplification assumes only two groups operate in the economy: firms as producers and users of resources, and private individuals as consumers and providers of those resources. Real flows are shown by the arrows moving in an anti-clockwise direction; income flows by the arrows flowing in a clockwise direction. Despite a degree of over-simplification, the model of the economy illustrated in Figure is a useful analytical tool which highlights some vitally important aspects of economic activity which are of direct relevance to the study of business.
The model shows, for example, that:
1 Income flows around the economy, passing from households to firms and back to households and on to firms, and so on, and these income flows have corresponding real flows of resources, goods and services.
2 What constitutes an income to one group (e.g. firms) represents an expenditure to another (e.g. households), indicating that income generation in the economy is related to spending on consumption of goods and services and on resources (e.g. the use of labour).
3 The output of firms must be related to expenditure by households on goods and services, which in turn is related to the income the latter receive from supplying resources.
4 The use of resources (including the number of jobs created in the economy) must also be related to expenditure by households on consumption, given that resources are used to produce output for sale to households.
5 Levels of income, output, expenditure and employment in the economy are, in effect, interrelated.
From the point of view of firms, it is clear from the model that their fortunes are intimately connected with the spending decisions of households and any changes in the level of spending can have repercussions for business activity at the micro as well as the macro level. In the late 1980s, for instance, the British economy went into recession, largely as a result of a reduction in the level of consumption that was brought about by a combination of high interest rates, a growing burden of debt from previous bouts of consumer spending, and a decline in demand from some overseas markets also suffering from recession. While many businesses managed to survive the recession, either by drawing from their reserves or slimming down their operations, large numbers of firms went out of business, as orders fell and costs began to exceed revenue. As a result, output in the economy fell, unemployment grew, investment by firms declined, and house prices fell to a point where some house owners owed more on their mortgage than the value of their property (known as ‘negative equity’). The combined effect of these outcomes was to further depress demand, as individuals became either unwilling or unable to increase spending and as firms continued to shed labour and to hold back on investment. By late 1992, few real signs of growth in the economy could be detected, unemployment stood at almost 3 million, and business confidence remained persistently low.
The gradual recovery of the British economy from mid-1993 brought about by a return in consumer confidence in the wake of a cut in interest rates further emphasizes the key link between consumption and entrepreneurial activity high-lighted in the model. Equally, it shows, as did the discussion on the recession, that a variety of factors can affect spending (e.g. government policy on interest rates) and that spending by households is only one type of consumption in the real economy. In order to gain a clearer view of how the economy works and why changes occur over time, it is necessary to refine the basic model by incorporating a number of other key variables influencing economic activity. These variables which include savings, investment spending, government spending, taxation and overseas trade are discussed below.
Changes in economic activity
The level of spending by consumers on goods and services produced by indigenous firms is influenced by a variety of factors. For a start, most households pay tax on income earned, which has the effect of reducing the level of income available for consumption. Added to this, some consumers prefer to save (i.e. not spend) a proportion of their income or to spend it on imported products, both of which mean that the income of domestic firms is less than it would have been had the income been spent with them. Circumstances such as these represent what economists call a ‘leakage’ (or ‘withdrawal’) from the circular flow of income and help to explain why the revenue of businesses can fluctuate over time.
At the same time as such ‘leakages’ are occurring, additional forms of spending in the economy are helping to boost the potential income of domestic firms. Savings by some consumers are often borrowed by firms to spend on investment in capital equipment or plant or premises (known as investment spending) and this generates income for firms producing capital goods. Similarly, governments use taxation to spend on the provision of public goods and services (public or government expenditure) and overseas buyers purchase products produced by indigenous firms(export spending). Together, these additional forms of spending represent an ‘injection’ of income into the circular flow.
While the revised model of the economy illustrated in is still highly simplified (e.g. consumers also borrow savings to spend on consumption or imports; firms also save and buy imports; governments also invest in capital projects), it demonstrates quite clearly that fluctuations in the level of economic activity are the result of changes in a number of variables, many of which are outside the control of firms or governments. Some of these changes are autonomous (i.e. spontaneous), as in the case of an increased demand for imports, while others may be deliberate or overt, as when the government decides to increase its own spending or to reduce taxation in order to stimulate demand. Equally, from time to time an economy may be subject to ‘external shocks’, such as the onset of recession among its principal trading partners or a significant price rise in a key commodity (e.g. the oil price rise in the 1970s), which can have an important effect on internal income flows. Taken together, these and other changes help to explain why demand for goods and services constantly fluctuates and why changes occur not only in an economy’s capacity to produce output, but also in its structure and performance over time (see Mini case: Global economic crisis).
It is important to recognize that where changes in spending do occur, these invariably have consequences for the economy that go beyond the initial ‘injection’ or ‘withdrawal’ of income. For example, a decision by government to increase spending on infrastructure would benefit the firms involved in the various projects and some of the additional income they receive would undoubtedly be spent on hiring labour. The additional workers employed would have more income to spend on consumption and this would boost the income for firms producing consumer goods, which in turn may hire more staff, generating further consumption and so on. In short, the initial increase in spending by government will have additional effects on income and spending in the economy, as the extra spending circulatesfrom households to firms and back again. Economists refer to this as the ‘multiplier effect’ to emphasize the reverberative consequences of any increase or decrease in spending by consumers, firms, governments or overseas buyers.
Multiple increases in income and consumption can also give rise to an ‘accelerator effect’, which is the term used to describe a change in investment spending by firms as a result of a change in consumer spending. In the example above it is possible that the increase in consumption caused by the increase in government spending may persuade some firms to invest in more stock and capital equipment to meet increased consumer demands. Demand for capital goods will therefore rise,and this could cause further increases in the demand for industrial products (e.g.components, machinery) and also for consumer goods, as firms seek to increase their output to meet the changing market conditions. Should consumer spending fall, a reverse accelerator may occur and the same would apply to the multiplier as the reduction in consumption reverberates through the economy and causes further cuts in both consumption and investment. As Peter Donaldson has suggested, everything in the economy affects everything else; the economy is dynamic, interactive and mobile and is far more complex than implied by the model used in the analysis above.
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