7. The Basics of Economics

COURSE POINTS

• Microeconomics deals with how households and firms use limited resources to effect the supply and demand of goods and services.
• Macroeconomics is the sum of total economic activity of a region (like the US) that takes into account growth, inflation, government regulations, etc.
• Analysis of supply and demand curves drive microeconomics
• The policies of governments (both local and world wide), along with consumer and corporate consumption all tie into macroeconomic analysis.
• Understanding both micro and macro trends allows you to better plan your business.
• All businesses have cycles. Learn yours and plan for the peaks and valleys

DISCUSSION

To start, we will focus on microeconomics and the main theory behind it — supply and demand. Supply is the amount of goods for sale while demand is the requested amount of such goods. Both values form curves with quantity on the X-axis and price on the Y-axis. They are typically drawn together to form a supply and demand curve (see this article) for an example curve). These two curves describe the quantity and price dynamics that supply and demand have on the product or service. When they are in equilibrium (i.e. the supply and demand stay constant over a period of time) then the resulting price obtained is the market clearing price. Now, it might seem like an impossible feat but this condition happens all the time. That is how transactions get done and the premise behind efficient markets (since the market knows what price will create equilibrium and wants to achieve it).

WHAT EFFECTS SUPPLY AND DEMAND?

Lots of things but mostly, the wants and needs of consumers and businesses. These needs drive more (or less) production which effects prices. These effects are captured, per market, in elasticities of supply and demand. Elasticity of demand is the decrease in quantity desired given a small percentage increase in price. Elasticity of supply is similar. It’s the measure of the change in supplied goods given a small increase in price. What happens is these two elasticities push and pull against each other, fighting for equilibrium. When that happens, everyone is happy and transactions occur. That’s why it’s important to understand these elasticity numbers for your particular market since that will drive how much you supply. Lets look at some market examples of supply and demand in action.

• Baseball Cards: We all wish we kept those childhood baseball cards because now, they are rare and in demand. Any kind of limited run or memento, if it has any following, will usually appreciate in price as time goes on (since they become rarer and rarer).
• Sport Utility Vehicles(SUVs): SUVs were in huge demand when gas was cheap. When oil (and therefore gas) started to hit $4.00 a gallon, demand went away and most suppliers had an over supply. This crashed the price to clear out the inventory.
• Oil: This one is the classic in terms of supply controls since OPEC sets production levels (which in the US would be considered racketeering or collusion. Basically, illegal). We can all relate to the seemly random gas prices that seem to always increase in summer and decrease during the winter.
• Home Sales: Real estate markets are fickle and highly effected by the location, location and location. Again, classic supply and demand in terms of demand to live in a nice area and the limited supply of housing (e.g. only so much land). The converse is true in undesirable areas. Not a lot of demand, so prices are low and the supply is not as constrained. Local zoning laws also constrain supply, which in term can effect prices.

ECONOMIC INDICATORS

Now, lets look at Macroeconomics. Macroeconomics relies a lot on economic indicators. These indicators, be it official government or based on popular culture, drive the outlook for what the overall economy will do next month or next year. It’s important to be aware of the overall health of the economy and how your business is effected by it. All business is effected by the overall economy, so being “recession” proof sounds like a great idea but in reality, not many businesses can claim that. So, let’s take a look at some US economic indicators to see how they may predict the economic conditions for your business.

1. Gross Domestic Product (GDP): the output of goods and services produced by labor and property located in the United States. Basically, everything the US makes.
2. New Residential Construction: this includes permits, starts and completion of new construction projects.
3. New Residential Sales: the sales of those completed homes. This drives interest rates and additional new construction.
4. Interest Rates: like the Prime Rate, Federal Funds Target Rate, 15/30-year Fixed Mortgage and US Savings bonds. These rates are critical to the availability of capital for consumers and businesses.
5. International Trade (Imports & Exports): Imports (what we bring in) and exports (what we send out) is a key indicator of business activity. The difference between them, is our trade deficit (or surplus).
6. Rate of Inflation:the rate at which the cost of widely available goods and services increases in the marketplace. Usually, it’s calculated monthly and yearly. Inflation is an important indicator because it shows how fast costs are increasing, which relates to consumer buying power (e.g. the same basket of goods costs more than it did the previous time).
7. National Budget Deficit: is the amount of money that needs to be borrowed to sustain government spending. The inverse would be a surplus. The deficit is funded by government bonds (i.e. print more money) that require interest payments to investors. A big deficit restricts the amount of credit that other countries might be willing to give.
8. Unemployment Rate: is the percentage of the labor force that is unemployed. This can be seasonally adjusted and has a lot to do with how the total employable people are counted. Since unemployed people don’t earn any money (and can be on assistance), a high value tends to show signs of a weak economy.

There are many more indicators but these are the ones that most newspapers write about. And for good reason. GDP is driven by consumers since US consumer spending is 70% of GDP. Residential construction and sales drive homeownership as well as home value, which ties into consumer spending. Interest rates and the availability of credit is the lubrication that keeps the economic gears turning. Without access to capital (both private and commercial), spending grinds to a halt.

THE BUSINESS CYCLE

Now that we have discussed both micro and macro economics, it’s time to put them together and see how the mixture of the two effects your business cycle. All businesses have a cycle. Figuring yours out requires asking a few simple questions, which include:

1. Do the yearly seasons effect my product or sales? This is a seasonal business cycle (like Halloween or Christmas) or maybe your grow a crop and harvest it at certain times.
2. Does raw material production or price influence your production? If a sudden change in the price of oil or the availability of rubber makes your business adjust it’s output, then those events will influence your business cycle.
3. Do government regulations impact your operations? This could be as simple as when crab season opens or the bidding cycle for a government contract or preparing tax returns. Governments do effect all businesses but some have more dependency than others.

Predicting how the overall economy will effect your business is more art than science. Part of the problem is predicting the future based on the data available today. The economy is a complex, non-linear system that defies even the smartest economists. This does not mean it’s not worth pursing some type of predicting. The way you should think about forecasting is what could effect your business and what do I need to do about it. These contingency plans are critical to smoothing out your business cycle.

THINGS TO DO

1. Look up the latest economic indicators for your country. Compare them to a year ago. How does it compare? Write a paragraph on how the latest indicators will effect your business.
2. Research a product that is in high demand. How does the price fluctuate as the supply is increased? What effects the supply of this high demand product?
3. Find the unemployment rate in your city. How does it differ from the rest of your country or state? How does that effect your local economy?
4. They say that a butterfly flapping its wings in Brazil could cause a hurricane in Florida. Try and prove this with a product or service that has recently slumped or taken off. How many degrees can you get to? How far away, both geographically and intellectually, is the farthest degree?
5. Find a well know business cycle. What does it look like? What effects it?