UNIT – III: Economic Environment: Introduction - Economic environment of Business - Economic systems -

Macroeconomic parameters and their impact of business - Economic policies - Five Year Plans in India.

Economic Environment: Introduction

Economic environment of a country encompasses external factors which have a significant effect on the creation and
dissemination of wealth. The demand and supply of a firm are directly influenced by such economic factors. From the
financial point of view, it also justifies the viability of a country regarding the carrying out of business practices.
The economic environment of a firm comprises various external factors like economic conditions, economic system and
economic policies. A country’s economic condition can be explained in the form of the income distribution, per capita
income, economic nature, economic resources, and so on.
Demand is a very important element of the economic environment. The demand for products of a firm is influenced by
the confidence or insecurities of consumers and their buying ability. Hence, the economic environment has a crucial
role to play in the decision making of a business.
The economic system acts as the basis for determining the degree of private business. There are several types of
economic system followed across nations. Some nations have free market economies or capitalist economies whereas
some have centrally planned economy or socialist economy. There are also some countries which follow the mixed
economy, i.e., carrying characteristics of both capitalist and socialist economies.

Economic Environment - Meaning and Concept

A qualitative evaluation of several key economic factors are undertaken in order to predict the success of a business
venture or to evaluate the amount of risk involved in economic activities in general. The economic environment may
include factors such as unemployment percentages, consumer confidence measurements, and the values of
market indexes.

So far as the economic environment is concerned, it is affected by the total or overall economic system of the
economy, i.e., whether capitalist or social system. Country’s system of economic planning and control, such as
Government’s fiscal or monetary systems, commercial
and industrial policies of the Government, commercial and industrial laws, of the country are all
important elements of the economic environment. Every such element affects the functioning of
the business.
The economic environment consists of external factors in a business' market and the
broader economy that can influence a business. You can divide the economic environment into
the microeconomic environment, which affects business decision making - such as individual
actions of firms and consumers - and the macroeconomic environment, which affects an entire
economy and all of its participants. Many economic factors act as external constraints on your
business, which means that you have little, if any, control over them. Let's take a look at both of
these broad factors in more detail.
Macroeconomic influences are broad economic factors that either directly or indirectly
affect the entire economy and all of its participants, including your business. These factors
include such things as:
Interest rates
Taxes
Inflation
Currency exchange rates
Consumer discretionary income
Savings rates
Consumer confidence levels
Unemployment rate
Recession
Depression

Microeconomic factors influence how your business will make decisions. Unlike
macroeconomic factors, these factors are far less broad in scope and do not necessarily affect the
entire economy as a whole. Microeconomic factors influencing a business include:
Market size
Demand
Supply
Competitors
Suppliers
Distribution chain, such as retailer stores
Elements of economic environment
Economic environment refers all economic surroundings that influence organization
activities. It consists of economic parameters. It is concerned with the nature and direction of
economy in which the organizations operate. Important elements of economic development are :
1. Economic systems :
Economic system determines the scope of private sector ownership of the factors
of production and market forces. The models of economic systems are:
A) Free market economic :
This system is based on private ownership of the factors of production. Profit serves as
the driver of economic engine. The competitive market mechanism guides business
decisions. There is freedom of choice. Individual initiative is encouraged.
B) Centrally planned economy :
This system is based on policy ownership of the factors of production. The economy is
centrally planned, controlled and regulated by the government. There is no consumer
sovereignty. Policy enterprises play a dominant role.
C) Mixed economy :
This system is a mix of free market and centrally planned economics. Both public and
private sectors coexist. The public sector has ownership and control of basic industries
including utilities. The sector owns agriculture and other industries but is regulated by the
state.

2. Economic policies:
Policies are guidelines for decision making and action. Economic policies of the
government significantly influence and guide organizations. Key economic policies influencing
organization are :
A) Monetary policy-
It is concerned with money supply, inflation rates, interest rates and credit availability. It
influences the level of spending through interest rates. Cheap money reduces cost, dear money
increase cost. Foreign exchange rates affect imports and exports.
B) Fiscal policy :
It is concerned with the use of taxation and government expenditure to regulate economic
activity, tax on income, expenditure and capital influence business decisions.
C) Industrial policy :
It is concerned with industrial licensing location, incentives, facilities, foreign investment,
technology transfer and nationalization.
3. Economic conditions :
They indicate the health of the economy in which the organization operate. The factors
affecting economic conditions are :
State of economic development: An economy can be least developed developing and
developed. Organizational activities are influenced by the stage of economic
development.
Income: The level of employment affect expenditure, saving and investment. They
together influence the economic conditions of organization.
Employment: The level of employment affects organization. It determines availability
of labour.
Business cycle: The stages of business cycle can prosperity, rescission and recovery.
They affect the health of the organization.
Influence: It is rise in price level. It influences costs, price and profit of organization.

Economic Environment on Business

Impact of Economic Environment on Business
The economic environment can have a major impact on businesses by affecting patterns
of demand and supply. Companies need to keep a track of relevant economic indicators and
monitor them over time.
1. Income :
One of the most important factors in the economic environment is the income of
customers. This indicates their ability to spend on the products sold by the marketer. The
marketer not only needs to estimate the income of customers, but he also has to decipher the
products on which the customer would be willing to spend his money.
The proportion of money spent by a customer on various products varies across cultures.
Some products, for instance, dishwashers, which are considered to be necessities in western
markets, do not even fall into the consideration set of consumers in the Indian market. Therefore,
despite having a higher income, customers will not spend on products that are not considered to
be desirable.
2. Inflation:
Inflation is an important economic indicator of an economy. Inflation refers to an
increase in prices without a corresponding increase in wages, resulting in lower purchasing
power of consumers. An economy should try to achieve low rate of inflation. The best way to
achieve a low rate of inflation is to ensure that products and services are produced efficiently.
When costs of production go up, companies should try to withhold increasing prices as
long as possible, since customers do not start valuing the product more because it is more costly.
In the long run, companies will have to look for better methods of production and cheaper inputs
so that the cost of production can be brought down. If inflation exists because the supplies are less than the
demand, the money supply can be restricted in the short run, but in the long run,
companies will have to expand capacities and increase their supplies.
3. Recession:
Recession is a period of economic activity when income, production and employment
tend to fall and demand for products and services are reduced. Specific activities cause recession.
The slowdown in the high-tech sector, rising fuel prices, excessive consumer credit and terror
attacks resulted in recession in America in 2001.
Companies selling to consumers have special responsibility during recession. Once
consumers start buying, businesses will start buying automatically. Therefore companies selling
to consumers should generate confidence among them by offering them high quality products
and services at reasonable prices and also extend credit to them. Companies should be prepared
to do whatever it takes to make the consumers buy from them.
4. Interest Rate:
If interest rate in an economy is high, businesses will borrow capital at a higher rate and
they will set up new businesses only when they are convinced that they can earn at a rate higher
than the interest rate they are paying on the capital.
If the interest rates are high, new businesses will not come. Even among existing
businesses, operating costs would go up as their working capital requirements will attract higher
interest rates. Therefore, companies will be able to produce products and services at higher costs
and will sell them at higher prices.
Lower interest rate is one sure way to spur consumer purchases. Also, consumers are not
too keen to save because their money will not grow rapidly due to lower interest rate. They
would be keener to spend their money. And when they invest, they are more likely to do so in
equity markets because they are more likely to get higher returns there. Therefore business will
get impetus because finance in the form of equity capital will be available to them.

5. Exchange rate:
Exchange rate becomes a very important driver of performance when a company exports
its products, and when it imports materials and components for making its products. It is more
profitable to export when the currency of the exporting country is weaker than the currency of
the importing country. But this advantage is nullified if materials and components are imported
from a country whose currency is stronger. A company will run its most profitable operations
when it exports its product to a country whose currency is stronger, and imports material and
components from a country whose currency is weaker.
Exchange rate has become more important, as supply chains of most companies are
becoming global in scope, i.e., companies are locating their manufacturing and distribution
centers throughout the world, depending upon the advantages of each location.

Economic systems

An economic system can be referred to as a system that encompasses the methods of production, distribution and
exchange of goods and services (excluding their consumption). The different economic systems differ on the basis of
means of establishment of ownership.
CAPITALIST ECONOMY
Capitalism is an economic system in which the industries, trade and production means are completely owned by
private bodies. This type of economy is also known as a capitalist economy or a free-market economy. This type
of economy involves no governmental interference. There are many developing as well as developed nations which
follow the capitalist economy system such as Germany, U.S., etc.
The production task of a capitalist economy is completely controlled by firms and industries. The market
mechanism, decision-making process, the means of production carried out for the supply of products in the market are
owned by private organisations.
In the words of Karl Marx, “Capitalism is a particular mode of organisation of production which is characterised by
wage slavery, production of profit, and creation of surplus value”.

As per Louks and Hoots, “Capitalism is a system of the economic organisation featured by the private ownership
and the use for private profit of man-made and nature made capital.”

In a free-market economy, there is no ownership of government as all the activities of production are owned by private
bodies. The productive activities are not controlled or planned by anyone instead they are decided by the demand and
supply of products and the price mechanism. In this type of economy, the consumers are sovereign. If the demand
for products exceeds the supply, then prices increase and producers raise their level of production. On the other
hand, if the supply of products exceeds the demand, then the prices of products decrease and producers reduce
their level of production.

Features of Capitalism
Capitalism can be explained as the economy which utilises its capital optimally in the process of production.
Technically, in capitalism, capital and goods are privately owned by businesses or individuals. Capitalism has the
following features:
 Private property: The setting up of private property acts as the basis of economic life in
the modern world. Therefore, private property is regarded as the terra ferma of
capitalism. In capitalism, it is a fundamental right of all the individuals to be the owner of
private property.
 Large scale production: Industrial revolution gave a boost to capitalism along with the
commencement of large-scale production. The installation of large plants and the
division of labour resulted in increased levels of production. As a result, high production
led to proper capital utilisation and a huge amount of profits.
 Profit institution: Profit institution is a significant characteristic of capitalism. Here,
capitalists earn profits by making investments. Therefore, the process of production is
 oriented towards profit.
 Competition: A capitalist economy has to face strong competition in the market. This
results from the artificial rise in the demand and reduction in the supply. Therefore,
competition is regarded as an indivisible constituent of a capitalist economy.
 Price mechanism: In capitalism, the prices of goods and services are decided by their
demand and supply. Production cost is not taken into consideration while setting the
prices of goods and services.
 Wage institution: Workers are exploited under the system of capitalism. The rates of
wages of workers are largely bargained. Here, the capitalist tries to extract maximum
possible output from the workers and pays very less wages in return.
 Money and credit: Credit institutions sanction loan to capitalists for the purposes of
investment. Capitalists establish their business and generate profit on the basis of credit.
It further assists the capitalists in the expansion of their property.
 Business organisation: Presence of large business organisations with widespread
business structures is another characteristic of a capitalist economy. Therefore, an
enormous industrial infrastructure can be set up by combining a huge amount of funds
from them and similarly from other shareholders too.
  Market Economy: The process of production, distribution and exchange under a capitalist economy is
governed by the market forces. There is interference of government over such activities.
The economy of the market is greatly dependent on the law of demand and supply.
Hence, it is also referred to as a free or liberalised economy.

6.3.2SOCIALIST ECONOMY
Socialism is an economic system where ownership and regulation are under the government. All the activities of
production and other functions like allocation of resources, consumption, distribution of income, investment pattern,
etc., are under the direction and control of the government. It is also referred to as the socialist or command economy.
In contrast to capitalism, socialism ensures public welfare and equality among people.
The communist countries are the origin of socialist economies. In these nations, the common interest of the entire
community was preferred over the interest of the individuals. After the 1980s, the number of communist nations
started to reduce. But there are still some democratic nations which are presently run by governments which are
socialist-inclined. They have adopted some components of a command economy. For example, India and France both
function under the planning system of the government.
In socialism, enterprises which are owned by the government have limited access to incentives for cost control
since they cannot go past their policies of the business. This is against the socialist economy’s objective which makes
sure resource mobilisation for the society’s welfare. Under socialism cater to the needs of the consumers. Therefore,
command economies are not innovative and dynamic which may bring the economy to a standstill.

In the words of Leftwitch, “In socialism the role of the state is central. It owns the means of production and directs
economic activity.”

As per H.D. Dickinson, “Socialism is an economic organisation of society in which the material means of production are
owned by the whole community and operated by the organs representative of and responsible to the community
according to a general economic plan, all members of the community being entitled to benefit from the results of
such socialised production on the basis of equal right.”

Features of Socialism
The salient features of a socialist economy are as follows:
 Social ownership: In socialism, there is no private ownership since all the production
means such as banks, railways, mines, factories, farms, etc., belong to the society. A
person can only possess a private property by way of consumer goods, furniture,
residence, and so on.

 Social welfare: Social welfare is one of the crucial objectives of socialism. This is
achieved through proper resource utilisation and catering to the society’s needs
 and wants. It takes care of the economy’s benefits as a whole instead of the needs of some
individuals. Unlike a capitalist economy, where means of production is profit oriented, in socialism,
productive resources are utilised in order to produce goods and services for the purpose of attaining
social welfare. Here, the production of necessary goods is given more significance instead of the
luxury goods.
 Central planning: Under socialism, all the activities of production and their
associated goals and plans are designed by the Central Planning Authority. As
per these plans, various programmes and objectives are implemented by the
government.
 Equality of income and opportunity: Socialism strives to remove or reduce
disparities in income and wealth and offers equal opportunity to every
individual. Social ownership and production for the welfare of the society and
community abolish unequal distribution of wealth and income. It also offers
equal opportunity to every person by way of professional training, free
education, and so on. However, it is not possible to have absolute equality
since capabilities differ from person to person.
 Classless society: Contrary to capitalism, socialism is a classless society, where
there is no division of society into classes like labour class or elite class, etc. Here,
all the activities of production are carried out by the community as a whole and,
therefore class-conflict is very less likely to happen.

6.3.3MIXED ECONOMY
Mixed economy combines the characteristics of both capitalism and socialism. It is the aggregate of
both public and private ownership. A mixed economy offers private enterprises the freedom to function and
develop but also permits government interference in matters for maintaining economic objectives. The
combination of government interference and private sector varies from one nation to another. India is a
mixed economy and comprises all the relevant characteristics of capitalism and socialism for the regulation
and control of the economy.
The decisions pertaining to economic planning and resources allocation is undertaken by the Central
Government. The economy’s overall growth and development depend upon the achievement of its goals
through collaborative efforts of both the private and public firms. In a mixed economy, some areas are
operated by private firms, whereas some areas are reserved for the public firms. Also, there are few
areas, where both private and public sectors work in a collaborative way.
As per Samuelson, “Mixed economy is that economy in which both public and private institutions exercise
economic control.”

In the words of Pickersgill, “The primary difference between the mixed economy and market socialism is
the relatively greater importance of individual decision making, private property and the reliance on
market-determined prices to guide the allocation of resources. The mixed economy differs from
competitive capitalism with respect to the share of collective decision making in the economy.”

Features of Mixed Economy

The main features of a mixed economy are as follows:

 Co-existence of the public and private sector: In a mixed economy, both
public and private sectors operate independently but strive to achieve a single
objective. Public sectors operate for the society’s welfare while the private
sector is oriented towards earning profits. Therefore, the government has
 devised several economic policies in order to regulate and govern the economic
activities of the private sector. Such policies include monetary policy, fiscal
policy, taxation policy, etc.
 Individual freedom: Government imposes restrictions for ensuring the
welfare of the society. Hence, manufacturers have to abide by these rules and
regulations. For example, the government might put restrictions on the
production of harmful and hazardous goods. However, individuals are free to
buy any product. Therefore, despite all sorts of government control, people
have the freedom to purchase and choose the occupation or profession of their
own choice.
 Economic welfare: The primary purpose of a mixed economy is to ensure
economic welfare. This can be brought about by reducing regional imbalances
and by offering opportunities for employment. The government has taken
several steps towards society’s upliftment. The monetary and fiscal policies are
designed to govern and control the economic activities of the private sector.
 Economic planning: The Central Government devises economic plans and
direct the functions of both the public and private firms in view of that. The
public sector activities are directly regulated by the government whereas
different incentives and subsidies are offered to the private sector for
functioning as per the economic objectives.
 Price mechanism: Price system of the economy is regulated by the price
policy framed by the government. For offering commodities at economical rates
to the weaker sections of the society, the government provides financial and
economic aid to the producers. It offers subsidies to the target groups and also
provides material inputs below the market price or free of cost to various firms.
Therefore, under a mixed economy, people avail an enormous amount of
benefits and support from the government.
 Free and controlled economic development: Mixed economy is regarded as
the best alternative to the socialist and capitalist economies. It attempts to
eliminate all the issues and drawbacks associated with the sustainable growth
and development of the economy. It gives freedom of occupation and choice as
well as controls and governs the economic activities.
 Government intervention: Under the mixed economy, the government can
interfere in order to stabilise the economy, particularly during a crisis. For
example, during the global crisis of 2008, the governments of the United States
and other nations intervened into the affairs of the economy for controlling and
managing the effect of the crisis.