Effective decision making is impossible when running your business without a basic understanding of some important economic concepts. You may intuitively understand some of these, like supply and demand, but fail to appreciate the importance of this kind of knowledge when making decisions. Learning more about fundamental economic ideas can help you be a more effective leader and decision-maker, producing better business outcomes and happier employees. Below, we explore some of the most important concepts from the field of economics that every decision-maker needs to know.
What are economic concepts?
Economics is a field of study within the social sciences. It examines the production, distribution and consumption of goods and services within societies and the transfer of money between agents.
Economic concepts are key ideas from the field that explain various phenomena and help people understand the economy and the behavior of those operating within it. There is also various terminology from the field that allows professionals to convey and understand technical meanings. Having a good understanding of what economics is and its key terminology and concepts can help you better understand the business landscape and identify risk and opportunity more effectively.
As such, business administrators with strong economic knowledge can make for highly effective business decision-makers, like those who’ve completed an MBA programme online at an institution such as Aston University. These courses can help you develop a leader’s mindset and gain a competitive edge in business. Combine this with a general understanding of economic principles and ideas, and you can become a highly valuable business asset.
Important terminology in economics
In economics, professionals use various terms and phrases to describe different technical meanings and better understand subjects. Here are some examples you might encounter:
- Economic growth. This term refers to an increase in production over a period of time within an economy. There are various ways to measure economic growth, such as by comparing GDP at different points in time, like the beginning and end of a financial year. High economic growth correlates with high standards of living and typically means consumers have more money to spend.
- Bull market. A bull market is one that has a positive outlook, with bbbprices rising or expected to rise. Bull markets can apply to stock, housing and currency markets, to name a few. A market can typically be called a bull market when prices rise significantly over time and not when the prices of stocks and other traded goods fluctuate in the short term.
- Bear market. A bear market is the exact reverse of a bull market. When investors lose faith in companies and when companies’ profits and cash flow drop, stock prices tend to decline. The term bear market describes the pessimistic outlook that accompanies these occurrences and is characterized by declining prices of traded goods sustained over a significant period of time.
- Security. Securities are financial instruments or assets that are available for purchase and trading, and they have a monetary value attached to them. The main types of securities are debt, equity and hybrids.
- Fiscal policy. This describes government decisions on spending and taxation that directly and indirectly impact economic performance. These policies also affect individuals and other economic agents operating within a jurisdiction. The two primary types of fiscal policy are contractionary fiscal policy and expansionary fiscal policy. The former aims to restrict economic growth to combat inflation, whereas the latter seeks to expand the economy to reduce things like unemployment.
- Free market. A free market is an economic system that’s free from any major governmental control and operates according to the law of supply and demand. Laws are used to protect property and the rights of citizens to spend their money freely in free market economies. Instead of the government controlling and determining production, consumer spending habits determine what goods and services are produced within the economy.
- Equity. This is a portion of a company or asset, also known as a share. Accountants and economists can measure a company’s equity by subtracting its liabilities from the sum of its assets. The remaining amount is how much equity the company has to distribute to shareholders, and each shareholder receives a proportional amount based on how many shares they own.
- Commodity. Commodities are resources that are completely fungible, meaning the market treats them equally regardless of who produces them. This includes raw materials like oil and copper, for example. These items are not only important items of trade within the economy but also power the economy, as items like corn and coal are essential to everyday life.
- Business cycle. A business cycle, trade cycle or economic cycle is a measure of the rise and fall of GDP across periods within financial years. Free market economies naturally expand and contract according to the law of supply and demand. It’s important for business leaders to understand these cycles so that they can make appropriate decisions in terms of policy and procedures.
- Inflation. This is when the purchasing power of a particular currency reduces, causing the cost of living to rise for people using that currency. To illustrate, if you have $10 and inflation is at 5%, the same $10 will be worth $9.50 by the end of the financial year. However, inflation can be beneficial to some areas of the economy, as asset owners benefit from their assets increasing in value.
Important economic concepts to know for effective decision making
Professionals use economic concepts to describe and understand different phenomena relating to the economy. These ideas explain economic occurrences and help economists make sense of the choices and behaviors of economic agents, which are entities, such as consumers and businesses, that engage in producing, buying or selling. Here are some key concepts to understand if you’re in a decision-making role within a business:
Supply and demand
This is one of the most fundamental and well-understood economic concepts, and successful business owners must possess either an intuitive or logical understanding of it. Supply and demand is a model of price determination, and it suggests that the prices of goods are determined once an equilibrium is reached between the quantity of supply and the quantity of demand. If supply outweighs demand, prices decrease, whereas if demand outweighs supply, prices rise. This is relatively easy to understand, as the rarer goods or services are, the more valuable they are to consumers, as there’s competition to access them.
When demand exceeds supply, this is known as ‘scarcity.’ Business owners need to understand supply and demand to execute successful pricing strategies properly. Understanding the relationship between supply and demand helps you set prices that consumers are willing to pay and maximize profits. For this reason alone, it’s crucial for decision-makers within businesses to understand this economic concept.
A SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis, sometimes called a situational analysis, is another important concept for business owners and decision-makers to understand. It’s a strategic management and planning technique that enables leaders to identify strengths, weaknesses, opportunities and threats pertaining to a project or plan. It’s a decision-making tool that helps businesses evaluate their position and identify factors that can either help or hinder their objectives, minimizing the chances of failure as a result. It’s an effective method for identifying competitive advantages and potential obstacles, and professionals begin the process by asking questions.
These questions help generate insights when doing strategic planning, and it’s a tried-and-tested method that business owners have used for a long time. Having a firm understanding of this concept can help you drive success when making crucial business decisions. Some economists and business leaders criticize this form of analysis for its limitations, with some suggesting that SOAR (Strengths, Opportunities, Aspirations and Results) analyses are more effective. Many project managers also use SVOR analyses, which examine Strengths, Vulnerabilities, Opportunities and Risks.
Willingness to pay (WTP)
This is the highest possible amount your customers will pay for your product or service. You can also conceptualize willingness to pay as a range of prices to account for differences in your consumer base. It’s important to understand WTP, as this informs various important decisions, such as how much to spend on manufacturing a product or what features to include in a service, for example. Understanding WTP enables you to deliver a profitable product or service because you know what customers are definitely willing to spend. WTP varies between individual customers.
There are two main types of factors influencing WTP, and these are extrinsic and intrinsic factors. Extrinsic factors are ones you can observe, like age, gender, social status, education level and race. Intrinsic factors are ones you can’t see and must figure out by asking questions and conducting other forms of research. Intrinsic factors include things like risk tolerance and interests.
As the name suggests, market demand describes how much demand there is for a product or service within a given market. That is, how many people want to purchase a product or service within a market. Understanding this concept is crucial, as there’s no reasonable way to develop a marketing strategy and launch a product or service without first understanding how much demand there is. Having an idea of the level of demand enables you to predict success and how much you stand to make, which increases your likelihood of generating positive ROIs.
Businesses can gauge market demand in various ways, such as by conducting customer surveys and interviews, analyzing competitors and analyzing third-party data. This helps businesses paint an accurate picture of what markets want and tailor their offerings accordingly.
Porter’s Five Forces
This is a business framework created by Harvard professor Michael Porter, and it helps organizations analyze competition and opportunities within markets and industries. The measure of these five forces reveals how competitive a particular business landscape is, which reveals opportunity and potential profitability. Highly competitive markets are less attractive because they offer less profit potential, and less competitive markets offer the greatest opportunity. The five forces are:
- Threat of new entrants. This relates to other businesses trying to enter a market and gain a share, which puts pressure on existing organizations and their prices.
- Threat of substitute products or services. These are different products or services that satisfy the same economic need as your product or service using different technology, thus threatening to replace your product or service.
- Bargaining power of suppliers. This is when suppliers have a lot of power over businesses, and this is often high when businesses have few alternatives. When suppliers have a lot of bargaining power, they can demand higher prices.
- Bargaining power of customers. This is the ability of customers to put businesses under pressure, which is typically high when customers have multiple choices available. This gives customers the ability to demand lower prices.
- Competitive rivalry. This is a multifaceted measure of the competition that exists among businesses within a market. Competition can be intensified when a business invests more in its advertising efforts or product innovation, for example.
Understanding Porter’s Five Forces can help decision-makers identify lucrative opportunities and secure larger shares of markets, leading to more profitable and safe business ventures.