MEB (2024-25) Handout 01

Economic Environment of Business, Economic Systems, Classification of

Economies

ECONOMIC ENVIRONMENT OF BUSINESS

The term ‘business environment’ connotes external forces, factors, and institutions
that are beyond the control of the business, and they affect the functioning of a
business enterprise. These include customers, competitors, suppliers, government,
social, political, legal, technological, etc. Thus, the business environment may be
defined as the total surroundings which have a direct or indirect bearing on the
functioning of businesses. It may also be defined as the set of external factors, such as
economic factors, social factors, political and legal factors, demographic factors,
technological factors, etc., which are uncontrollable in nature and affect the business
decisions of a firm.

Confining the business environment to uncontrollable external factors may be

classified as an economic environment or a non-economic environment. The economic
environment includes economic conditions, economic policies, and the country's
economic systems. The non-economic environment comprises social, political, legal,
technological, demographic, and natural environment. All these have a bearing on the
strategies adopted by the firms, and any change in these areas is likely to have a far-
reaching impact on their operations. The main factors that affect the economic
environment of business are given below:

1. Economic Conditions: The economic conditions of a country refer to a set of

economic factors that greatly influence business organizations and their
operations. These include gross domestic product, per capita income, the market
for goods and services, availability of capital, foreign exchange reserves,
growth of foreign trade, the strength of capital markets, etc. All of these help in
improving the pace of economic growth.

2. Economic Policies: All business activities and operations are directly influenced
by the economic policies framed by the government from time to time. Some of
the important economic policies are:
a. Industrial policy: The industrial policies of the government cover all
those principles, policies, rules, regulations, and procedures, that direct

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 and control the industrial enterprises of the country and shape the pattern
of industrial development.
b. Fiscal policy: It includes government policy in respect of public
expenditure, taxation, and public debt.
c. Monetary policy: It includes all activities and interventions that aim to
ensure a smooth supply of credit to businesses and boost trade and
industry.
d. Foreign Investment policy: This policy aims to regulate foreign
investment inflow in various sectors to speed up industrial development
and take advantage of modern technology.
e. Export-Import policy: This policy aims to increase exports and bridge the
gap between exports and imports. Through this policy, the government
announces various duties/levies. Nowadays, the focus is on removing
barriers and controls.

3. Economic System: The world economy is primarily governed by three types of

economic systems, viz., Capitalist or Market economy, Socialist or Command
economy, and Mixed economy.

ECONOMIC SYSTEMS
1. All societies have an economy or economic system or macro-economy – an
organized way of providing for the wants and needs of their people.

2. How these provisions are made determines the type of economic system they have.

3. Three major kinds of economic systems exist – command, market, and modern
mixed.
a. Command economies: A central authority makes all economic decisions.
Current close examples include China, North Korea, Cuba, Libya, Belarus,
etc.
i. Advantages:
1. It can change direction drastically in a relatively short time;
2. Health and public services are available to everyone at little or
no cost regardless of income.
ii. Disadvantages:
1. It is not designed to meet the wants of consumers, even though
many basic needs are provided;

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 2. The system does not give people the incentive to work. Many
people work just hard enough to fill the production quotas set
by the planners;
3. Requires large decision-making bureaucracy;
4. It does not have the flexibility to deal with minor, day-to-day
problems;
5. People with new or unique ideas find it difficult to get ahead in
a command economy

b. Market economies: In a free market economy, people and firms make

economic decisions in their own best interests. Examples include Singapore,
Hong Kong, Australia, the UK, and the USA.
i. Advantages:
1. It can adjust to change;
2. High degree of freedom;
3. Relatively small degree of government interference;
4. Decision-making is decentralized, not in the hands of a few;
5. Variety of goods and services available to consumers;
6. High degree of consumer satisfaction
ii. Disadvantages:
1. It does not provide for the basic needs of everyone in society;
2. It does not provide enough of the services that people value
highly (e.g., justice, defence, etc.);
3. Relatively high degree of uncertainty that workers and
businesses face as a result of change;
4. Market economies can fail if three conditions are not met:
a. Markets must be reasonably competitive;
b. Resources must be reasonably accessible to move from
one activity to another;
c. Consumers need access to adequate information to weigh
the alternatives and make wise choices.

c. Modern mixed economy: This is a combination of command and market

economies. Most of the world's economies are mixed economies.
i. A command economy approach is adopted in the case of
goods/services in which private players will not be interested but
are important from the nation’s and people’s viewpoints.

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 ii. A market economy approach is adopted in those goods/services in
which private players will be interested because they can produce,
sell, and earn profit.

WORLD BANK CLASSIFICATION OF ECONOMIES:

Each year, on July 1, 2021, the World Bank revises its analytical classification of the
world's economies based on gross national income (GNI) per capita estimates for the
previous year. The updated GNI per capita estimates are also used as input to the
World Bank's operational classification of economies that determines lending
eligibility. World Bank's classification of economies is based on GNI per capita in
current US dollars (calculated through the atlas conversion factor). GNI per capita-
based criteria are given below:
Low-Income Lower Upper High-Income
countries Middle- Middle- countries
Income Income
countries countries
GNI per capita ≤ $1045 $1046 - $4096 - $ > $12695
$4095 12695

With a GNI per capita of $1900 in 2020, India belongs to the Lower Middle-Income
group of countries. Until 2006, India belonged to the Low-Income group, after which
she joined the Lower Middle-Income group.

Note: The Atlas conversion factor for any year is the average of a country's exchange
rate for that year and its exchange rates for the two preceding years, adjusted for the
difference between the country's rate of inflation and international inflation; the
objective of the adjustment is to reduce any changes to the exchange rate caused by
inflation.

Web links:
https://blogs.worldbank.org/opendata/new-world-bank-country-classifications-
income-level-2021-2022

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INDUSTRIAL POLICY

Industrial policy is the set of standards and measures set by the government to
evaluate the progress of the manufacturing sector, which ultimately enhances the
country's economic growth and development.

The government takes measures to encourage and improve the competitiveness and
capabilities of various firms.

Objectives of Industrial Policy

 To maintain steady growth in productivity.

 To create more employment opportunities.
 Utilize the available human resources better
 To accelerate the progress of the country through different means
 To match the level of international standards and competitiveness
Industrial Policy in India

The various industrial policies introduced by the Indian government are as follows:

Industrial Policy Resolution, 1948

 It declared the Indian economy as a Mixed Economy

 Small-scale and cottage industries were given the importance
 The government restricted foreign investments
 Industries were divided into four categories
The exclusive monopoly of central government (arms and ammunitions, production of
atomic energy, and management of railways)

New undertakings undertaken only by the state (coal, iron and steel, aircraft
manufacturing, shipping, building, telegraph, telephone, etc.)

Industries to be regulated by the government (Industries of basic importance)

Open to private enterprises, individuals, and cooperatives (remaining)

Industrial Policy Resolution, 1956 (IPR 1956)

 This policy laid down the basic framework of Industrial Policy

 This policy is also known as the Economic Constitution of India
 It is classified into three sectors
Schedule A – which covers Public Sector (17 Industries)

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Schedule B – covering Mixed Sector (i.e., Public & Private) (12 Industries)

Schedule C – only Private Industries

 This has provisions for Public-Sector, Small-Scale Industry, and Foreign

Investment. To meet new challenges, from time to time, it was modified
through statements in 1973, 1977, and 1980.
Industrial Policy Statement, 1977

 This policy was an extension of the 1956 policy.

 The main was employment to the poor and a reduction in the concentration of
wealth.
 This policy majorly focused on Decentralization
 It gave priority to small-scale Industries
 It created a new unit called “Tiny Unit”
 This policy imposed restrictions on Multinational Companies (MNC).
Industrial Policy Statement, 1980

 The Industrial Policy Statement of 1980 addressed the need for promoting
competition in the domestic market, modernization, selective Liberalization,
and technological up-gradation.
 It liberalized licensing and provided for the automatic expansion of capacity.
 Due to this policy, the MRTP Act (Monopolies Restrictive Trade Practices) and
FERA Act (Foreign Exchange Regulation Act, 1973) were introduced.
 The objective was to liberalize the industrial sector to increase industrial
productivity and competitiveness of the industrial sector.
 The policy laid the foundation for an increasingly competitive export-based and
for encouraging foreign investment in high-technology areas.
New Industrial Policy, 1991

 The New Industrial Policy, of 1991 had the main objective of providing
facilities to market forces and increasing efficiency.
 Larger roles were provided by
L – Liberalization (Reduction of government control)

P – Privatization (Increasing the role & scope of the private sector)

G – Globalization (Integration of the Indian economy with the world economy)

Because of LPG, old domestic firms must compete with New Domestic firms, MNC,
and imported items
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  The government allowed Domestic firms to import better technology to improve
efficiency and to have access to better technology. The Foreign Direct
Investment ceiling was increased from 40% to 51% in selected sectors.
 The maximum FDI limit is 100% in selected sectors like infrastructure sectors.
Foreign Investment Promotion Board was established. It is a single-window
FDI clearance agency. The technology transfer agreement was allowed under
the automatic route.
 The Phased Manufacturing Program was a condition on foreign firms to reduce
imported inputs and use domestic inputs, it was abolished in 1991.
 Under the Mandatory convertibility clause, while giving loans to firms, part of
the loan will/can be converted to equity of the company if the banks want the
loan in a specified time. This was also abolished.
 Industrial licensing was abolished except for 18 industries.
 Monopolies and Restrictive Trade Practices Act – Under his MRTP commission
was established. MRTP Act was introduced to check monopolies. The MRTP
Act was relaxed in 1991.
 On the recommendation of the SVS Raghavan committee, the Competition Act
2000 was passed. Its objectives were to promote competition by creating an
enabling environment.
Review of the Public sector under this New Industrial Policy, 1991 are:

 Public sector investments (Disinvestment of Public sector)

 De-reservations –Industries reserved exclusively for the public sector were
reduced
 Professionalization of Management of PSUs
 Sick PSUs to be referred to the Board for Industrial and financial restructuring
(BIFR).
 The scope of MoUs was strengthened (MoU is an agreement between a PSU
and a concerned ministry).
Way Forward

It is time to replace the 32-year-old Industrial policy and draft a new policy for better
strategic engagement with the world. The Government is working on a new industrial
policy that would be a road map for all business enterprises in the country.

ORIGIN AND SUBJECT MATTER OF MACROECONOMICS

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1. Macroeconomics is a study of the behavior and performance of the economy or
economic system or macroeconomics as a whole which has many interrelated,
interlinked, interdependent, and interactive elements.
2. To study a macroeconomic phenomenon, macroeconomists divide the entire
economic system into different sectors with common features and characteristics.

3. Microeconomics and macroeconomics are recognized by most economists as the

two major branches of economics studies for both analytical and practical
purposes. Macroeconomics is also justified as a separate branch of economics
based on macroeconomic paradoxes or more appropriately micro-macro paradoxes.
The micro-macro paradoxes refer to paradoxical facts that are true in the case of
individual economic units and quantities but are not true in the case of economic
aggregates and for the economy as a whole. Three important micro-macro
paradoxes are discussed below:

a. Savings and Investment: If an individual saves and invests more his/her

income increases. But it is not true for the economy as a whole. The reason
is if all the individuals with a given income decide to save more and more,
the consumption expenditure will decrease by the same amount. A decrease
in consumption expenditure reduces aggregate demand. This reduces the
prospect of investment. The aggregate investment may even decrease which
will reduce the level of income.

b. Cash holding: If all individuals decide to hold a larger amount of cash, the
total individual cash holding increases. But the stock of money remains the
same for the economy as a whole.

c. Profit and wages: At the micro level, one intends to accept the proposition
that the distribution of national income between wage incomes and profits
depends on the relative bargaining power of labor and the employers.
However, it depends on a combination of other factors, the most important of
which are decisions of management to invest, i.e., to accumulate real assets,
and the complex decision of the whole society about liquidity preference.

4. The foundation of macroeconomics as a separate branch of economics was laid by

a British economist, John Maynard Keynes in his revolutionary book ‘The General

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 Theory of Employment, Interest, and Money (1936). The origin of
macroeconomics lies in the collapse of classical economics.

5. According to classical economists, if market forces – demand and supply – are

allowed to work freely, the following macroeconomic features are witnessed:
a. There will always be full employment in the long run, unemployment if ever,
will be a short-run phenomenon.
b. The equilibrium level of national income is determined at the level of full
employment and national income is equal to the total cost of production.
c. The economy is always in equilibrium in the long run and there is neither
overproduction nor underproduction in the long run.

6. The macroeconomic postulates of classical economists prevailed till 1929 – the

year in which the Great Depression of the 1930s had started. The collapse of
classical economics created a big gap between classical economics and the
economic realities of the day. Having pointed out the deficiencies and inadequacies
of classical economics, Keynes constructed his macroeconomic theories related to
national income, employment, and the money market.

7. The central theme of Keynesian macroeconomics may be summarized as follows:

a. The level of output and employment in the economy is determined by the
aggregate demand for goods and services, given the resources of the country.
b. Money market equilibrium and interest rates are determined by the aggregate
demand for money, given the money supply. Unemployment in any country
is caused by a lack of aggregate demand and economic fluctuations are
caused by demand deficiency.
c. The demand deficiency can be removed through compensatory government
spending. Keynesian economics stresses the role of demand management by
the government for the stable growth of the economy.