Economic issues | IGCSE Class 10 Business Studies Notes

This note covers the business cycle (growth, boom, recession and slump) and its impact on businesses through changes in employment, inflation and Gross Domestic Product (GDP); the main objectives of government economic policy; and how changes in taxation, government spending and interest rates affect businesses, with examples of how businesses might respond to each change.

What is the business cycle?

The business cycle describes the regular pattern of ups and downs in the level of economic activity in a country over time.

The level of activity is usually measured by changes in Gross Domestic Product (GDP), the total value of goods and services produced in a country in a year.

The business cycle moves through four main stages: growth, boom, recession and slump, and then growth begins again. No two cycles are identical in length or severity, but the same general pattern tends to recur.

Governments, consumers and businesses all respond differently depending on which stage of the cycle the economy is in.

A business that understands the business cycle can plan its production, staffing and spending decisions ahead of the stage that is coming, rather than reacting to it after it has already caused problems.

Draw a horizontal axis for time and a vertical axis for the level of economic activity (real GDP).

Draw a wavy line rising through growth to a peak (boom), then falling through a downturn to a trough (recession and slump), then rising again into the next period of growth. Mark the four stages along the curve.

What happens in each stage of the business cycle?

Each stage has typical features that affect how easy or difficult it is for businesses to sell, to hire workers and to borrow money.

• Growth: national output, incomes and spending start to rise; businesses increase production and begin to take on more workers.
• Boom: economic activity is at its highest; demand, output and employment are high, but shortages of workers and materials can push up wages and prices (inflation).
• Recession: output, spending and confidence fall; demand for goods and services drops and unemployment starts to rise.
• Slump: economic activity is at its lowest; unemployment is high, spending is low and many businesses struggle to survive before growth eventually begins again.

How do changes in employment levels affect businesses?

When the economy is growing or booming, employment levels rise and unemployment falls. This gives consumers more income, which usually increases consumer spending and so increases demand for a business's products.

At the same time, low unemployment can make it harder for a business to recruit and keep workers, because there are fewer unemployed people looking for jobs, and workers may ask for higher wages, which raises the business's costs.

During a recession or slump, unemployment rises. Unemployed people have less income to spend, so demand for many products falls, particularly for goods that are not essential.

However, a business may find it easier to recruit workers in a downturn, and existing workers may be more willing to accept lower pay rises, which can help to keep labour costs down.

Rising unemployment can also mean a loss of skilled staff from an industry if workers are made redundant and move to other types of work.

How does inflation affect businesses?

Definition: Inflation. A sustained rise in the general level of prices in an economy over time, which reduces the purchasing power of money.

High inflation rates generally create constraints for businesses because they increase the various costs of doing business, such as the cost of buying raw materials or machinery and the cost of paying wages and salaries to employees.

If a business's costs rise faster than the prices it can charge, its profit margins are squeezed.

Inflation also affects customers. If prices rise faster than incomes, consumers have less real spending power, and demand for non-essential goods can fall.

Businesses may respond to inflation by raising their own prices to protect profit margins, but this risks losing customers to competitors if rivals do not raise their prices by as much.

Inflation can also make it harder for a business to plan ahead, because future costs and revenues become less certain.

How do changes in GDP affect businesses?

A rise in a country's Gross Domestic Product tends to be linked to a rise in the disposable income of people in that country, which creates increasing demand for products.

When GDP is growing, businesses usually see rising sales, can expand production and may take on more staff or invest in new capacity with greater confidence about future demand.

When GDP growth slows or GDP falls (a recession), demand for many goods and services falls with it.

Businesses selling non-essential or expensive products, such as cars or holidays, are often affected more severely than businesses selling essential goods, such as basic foodstuffs, because consumers cut back on non-essential spending first when their confidence in the economy falls.

What are the government's economic objectives?

Governments set economic objectives that they try to achieve through their policies. One important objective is increasing GDP, since higher GDP generally means higher output, higher incomes and more jobs in the economy.

Governments also generally aim to keep inflation low and stable, to keep unemployment low, and to keep their trade with other countries in a healthy position.

A government may not be able to achieve all of its objectives at the same time; for example, policies that encourage fast growth in GDP can also increase inflation.

To achieve its objectives, a government uses economic policy tools that affect the whole economy, mainly changes in taxation, changes in its own spending, and changes in interest rates.

These tools can be used to speed up a slow economy or to slow down an economy that is growing too fast and risks high inflation.

How do changes in taxation affect businesses?

Definition: Taxation. Compulsory payments made by individuals and businesses to the government, used to raise revenue for government spending and to influence economic activity.

If a government cuts income tax, consumers are left with more disposable income after tax, which tends to increase consumer spending and so increase demand for businesses' goods and services. If a government raises income tax, consumers have less disposable income, and spending and demand are likely to fall.

A government can also change taxes that affect businesses directly, such as taxes on company profits.

Higher business taxes reduce the amount of profit a business keeps after tax, which can reduce the funds it has available to invest in new equipment or to expand.

Lower business taxes leave a business with more after-tax profit, which can encourage investment and expansion.

How does government spending affect businesses?

Government spending on areas such as infrastructure, education, health and defence puts money directly into the economy and can create demand for businesses that supply goods and services to the government or to government-funded projects, such as construction companies building roads or schools.

A rise in government spending can therefore increase orders and sales for such businesses, and the wages paid to people working on government-funded projects can also increase consumer spending more widely in the economy.

A cut in government spending has the opposite effect: businesses that rely on government contracts may see fewer orders, and workers affected by spending cuts, for example in the public sector, have less income to spend, which can reduce demand for other businesses as well.

How do changes in interest rates affect businesses?

Definition: Interest rate. The cost of borrowing money, or the reward for saving money, expressed as a percentage of the amount borrowed or saved.

Short and long term interest rates significantly affect the demand for products and services. Low interest rates mean it is cheaper for a business to borrow money to invest in new equipment, premises or stock, and cheaper for consumers to borrow to buy expensive items.

For example, in the case of construction companies and automobile manufacturers, low long-term interest rates are beneficial because they result in increased spending by consumers for buying homes and cars on borrowed money.

High interest rates make borrowing more expensive, which discourages businesses from investing and discourages consumers from buying goods on credit, so demand for many products falls.

High interest rates also increase the cost of any existing loans a business has to repay, reducing the funds it has available for other purposes.

Savers, on the other hand, benefit from higher interest rates, which can reduce how much they spend and increase how much they save instead.

Advantages of government intervention through these policy tools

• Cutting taxes or interest rates, or raising government spending, can increase demand when the economy is in recession or slump, helping businesses to recover and protecting jobs.
• Raising taxes or interest rates, or cutting government spending, can help to control inflation when the economy is overheating in a boom.
• Targeted government spending on infrastructure can directly create new business opportunities and jobs.

Limitations of government intervention through these policy tools

• Changes in taxation, spending or interest rates take time to affect the economy, so a government's response to one stage of the cycle may only take effect once the economy has already moved to the next stage.
• Different objectives can conflict; for example, cutting taxes to raise GDP can also raise inflation.
• Not all businesses are affected in the same way, so a policy that helps one type of business, such as construction, may do little for another, such as a business selling essential goods.

How might businesses respond to these economic changes?

Businesses cannot control the business cycle, taxation, government spending or interest rates, because these are part of the wider economic environment, the forces outside a business's control that may affect its performance. A business can only choose how to respond.

1. Monitor economic indicators such as GDP growth, inflation, unemployment and interest rates so that changes can be identified early, giving the business an early warning signal rather than a surprise.
2. Adjust production levels and stock holding, increasing output ahead of an expected boom and reducing it ahead of an expected recession, to avoid holding unsold stock or missing demand.
3. Review pricing policy, for example raising prices carefully to protect profit margins during inflation, or offering discounts and credit terms during a recession to maintain sales.
4. Manage staffing levels carefully, for example being cautious about new recruitment during a boom when wages are rising, and planning ahead for possible redundancies before a downturn becomes severe.
5. Review borrowing and investment plans, for example taking advantage of low interest rates to borrow for expansion, or delaying investment and paying off debt when interest rates are high.
6. Diversify products or markets so that the business is not entirely dependent on demand from consumers who are most affected by a particular stage of the cycle.

Glossary

• Business cycle: the regular pattern of growth, boom, recession and slump in the level of economic activity in a country.
• Growth: the stage of the business cycle when output, incomes and spending start to rise.
• Boom: the stage of the business cycle when economic activity is at its highest and inflation risk is greatest.
• Recession: a stage of the business cycle when output, spending and confidence fall and unemployment rises.
• Slump: the stage of the business cycle when economic activity is at its lowest.
• Gross Domestic Product: the total value of goods and services produced within a country in a year.
• Inflation: a sustained rise in the general level of prices over time.
• Disposable income: the income left for a person to spend or save after tax has been deducted.
• Interest rate: the cost of borrowing money or the reward for saving, shown as a percentage.
• Taxation: compulsory payments to government by individuals and businesses, used to raise revenue and influence the economy.
• Government spending: money spent by government on areas such as infrastructure, health and education.
• Economic objectives: the economic goals a government aims to achieve, such as increasing GDP or controlling inflation.
• Unemployment: the state of people who are willing and able to work but cannot find a job.
• Business environment: the individuals, institutions and forces outside a business's control that may affect its performance.

Common errors and misconceptions

• Misconception: A boom is always good for businesses. Correct: A boom can bring labour shortages, rising wages and inflation, which raise costs even as demand is high.
• Misconception: A recession and a slump are the same thing. Correct: A recession is a period of falling economic activity; a slump is the stage when activity has fallen to its lowest point.
• Misconception: Lower taxes always help every business equally. Correct: The effect depends on which tax is cut and how much disposable income or profit a particular business's customers or the business itself gains.
• Misconception: Higher interest rates only affect people with loans. Correct: Higher interest rates can also reduce consumer spending generally, since borrowing for big purchases becomes more expensive and saving becomes more attractive.
• Misconception: Government spending cuts only affect government workers. Correct: They can also reduce orders for private businesses that supply goods or services to government-funded projects.
• Misconception: GDP measures only how much money people earn. Correct: GDP measures the total value of goods and services produced in a country, which is linked to, but not the same as, personal income.
• Misconception: Businesses can control the business cycle. Correct: The business cycle is part of the external economic environment; a business can only respond to it, not control it.

Exam-style questions with model answers

Q1. State two stages of the business cycle. [2 marks]

1. Boom.
2. Recession.

Q2. Define inflation. [2 marks]

1. Inflation is a sustained rise in the general level of prices in an economy over time, which reduces the purchasing power of money.

Q3. The government of a country has just raised interest rates because it is worried about rising inflation. Explain two ways this might affect a car manufacturer. [4 marks]

1. Higher interest rates make it more expensive for customers to borrow money to buy cars on credit, so demand for new cars is likely to fall as fewer customers can afford the higher repayments.
2. Higher interest rates also increase the cost of any loans the manufacturer itself has taken out, for example to buy machinery, reducing the funds available for other purposes such as investment or wages.

Q4. Explain two reasons why a government might increase its own spending when the economy is in recession. [4 marks]

1. Increasing government spending, for example on infrastructure projects, puts more money directly into the economy, creating orders for businesses such as construction companies and increasing employment on those projects.
2. Workers employed on government-funded projects earn wages, which increases their spending on other goods and services, helping demand recover more widely across the economy during the recession.

Q5. A country's GDP has been falling for several months and unemployment is rising. Explain two ways a furniture-making business might respond. [4 marks]

1. The business could reduce production and stock levels to avoid being left with unsold furniture as consumer demand for non-essential items falls during the downturn.
2. The business could review its pricing and offer discounts or credit terms to maintain sales, since customers with lower incomes are likely to delay or reduce spending on furniture.

Q6. Explain the difference between a recession and a boom in terms of their effect on employment and prices. [4 marks]

1. In a boom, economic activity is at its highest, so employment is generally high and labour can become scarce, pushing up wages; strong demand can also push up prices, creating a risk of inflation.
2. In a recession, economic activity, spending and confidence are falling, so employment falls as businesses reduce production and demand for goods and services weakens, and the rate of price rises generally slows.

Q7. Discuss how a government might use changes in taxation and interest rates together to try to increase a country's GDP, and explain one limitation of this approach. [6 marks]

1. A government could cut income tax, leaving consumers with more disposable income, which tends to increase consumer spending and therefore demand for businesses' goods and services.
2. A government could also cut interest rates at the same time, making it cheaper for both consumers and businesses to borrow, encouraging consumers to buy expensive items on credit and businesses to invest in new equipment or expansion.
3. Together, lower taxes and lower interest rates can raise overall demand in the economy, encouraging businesses to increase output and employment, which raises GDP.
4. One limitation is that these changes take time to work through the economy, so by the time higher demand appears, the economy may already be moving towards a boom, risking rising inflation rather than the slow, steady growth the government intended.

Q8. Explain two reasons why rising unemployment during a slump might benefit as well as harm a business. [4 marks]

1. It can harm the business because unemployed consumers have less income to spend, reducing demand for many of the business's products, particularly non-essential goods.
2. It can also benefit the business because a larger pool of unemployed workers can make it easier to recruit staff, and existing workers may accept smaller pay rises, helping to control labour costs.

Key takeaways

• The business cycle has four stages: growth, boom, recession and slump, each with different effects on businesses.
• Rising employment and GDP usually increase consumer spending and demand for businesses' products.
• High inflation raises business costs, such as raw materials and wages, and can squeeze profit margins.
• Government economic objectives include increasing GDP, controlling inflation and keeping unemployment low.
• Lower taxes leave consumers and businesses with more money to spend or invest, raising demand.
• Higher government spending can create direct orders for businesses and raise wider consumer spending.
• Low interest rates encourage borrowing and investment; high interest rates discourage them and encourage saving.
• Businesses cannot control these economic changes but can respond through production, pricing, staffing and investment decisions.

Test yourself

Name the four stages of the business cycle in order.

Growth, boom, recession and slump, after which growth begins again.

Why might a boom lead to inflation?

Very high demand during a boom can create shortages of workers and materials, pushing up wages and prices faster than usual.

How does a cut in income tax usually affect consumer spending?

It leaves consumers with more disposable income, which tends to increase their spending and so increase demand for businesses' products.

Why are construction and car companies often helped by low long-term interest rates?

Low interest rates make it cheaper for customers to borrow to buy homes and cars, increasing demand for these businesses' products.

Give one government economic objective named alongside GDP in this unit.

Controlling inflation, keeping unemployment low and maintaining a healthy balance of trade are objectives named alongside increasing GDP.

How might higher government spending on infrastructure help a private construction business?

It can create new orders and contracts for the business to build roads, schools or other projects, directly increasing its sales.

Why might a business be cautious about recruiting new staff during a boom?

Labour can become scarce during a boom, so wages tend to rise, making it more expensive to recruit and retain workers.

Why do higher interest rates tend to reduce demand for goods bought on credit?

Borrowing becomes more expensive, so monthly repayments rise, making credit purchases less affordable for consumers.