Introduction to Economic Theory

Economic elements that influence business and consumer behaviour are referred to as the economic environment. The economy of a country has an impact on investment decisions. There are several factors, both internal as well as external  that affect the economy.

Elements of Economic Environment

Several external factors have a significant influence on a country’s economy. These factors play a huge role in deciding consumer behaviour and financial flow of a country, thereby affecting its economic activities. All these elements together constitute the economic environment definition.

These elements of economic environment are as follows –

• Gross Domestic Product (GDP)

Gross Domestic Product is the total value of all products and services produced in a country. Therefore, the growth of GDP signifies that the economy of a country is stable and improving. It also means that people have more disposable income that, in turn, leads to increased demand for products and services.

It evaluates the financial worth of final goods and services—those that are purchased by the end user—produced in a country over a specific time period (say a year). It includes all of the output generated within the country. GDP  also includes non-market production, for example, education services which are provided by the government itself.The GDP growth rate measures the economic reports and amount of a country ’s economic growth (or contraction). Faster growth in the gross domestic product (GDP) expands the overall size of the economy and strengthens fiscal conditions.

• Unemployment

A high level of unemployment in a country means that such an economy is not using its resources to its full potential. At the same time, it would negatively impact individual disposable income that will result in lower demand. It affects the commercial aspect of an economy significantly. This phenomenon is markedly noticed in the existing economic environment in India.

The individuals not only lose income but also face other hurdles financially as well as mentally. Government expenses extend further than the provision of benefits to the loss of worker output, which  eventually reduces the gross domestic product (GDP) which in turn leads to economic issues and then poverty. It will lead to lower GDP growth and fall in tax revenue for the government.

• Inflation

When the overall prices of goods and services increase in a given period, it is known as inflation. It happens when even though the prices of goods and services are rising the general income level of consumers stays the same. Therefore, individuals have less money at their disposal. Small businesses and cottage industries are also affected as prices of raw goods and labour increase, resulting in smaller profit margins.

The propensity for the price level to rise over time is referred to as inflation. Inflation boosts prices and has the potential to reduce the purchasing power of consumers. People buy more than they need to avoid paying higher costs tomorrow, which drives up demand for products and services. Suppliers are unable to keep up. Worse still, neither can salaries. As a result, most individuals are unable to afford common products and services. Inflation reduces the value of pensions and savings.

• Government Policy

Government policies also play a huge role in influencing the economy of a country. Government policy can have a major influence on the economic environment. This can include fiscal or monetary policy. An example of monetary policy is a reduction in interest rates on bank loans which encourages consumers’ demand for loans. An example of fiscal policy would be when the government decides to reduce income tax.  Both of these policies attempt to gradually increase individual disposable income and encourage consumers to spend more, thus boosting commercial activities.

It can influence interest rate, taxation and a rise, which tends to increase the borrowing cost. Consumers will spend less if the interest is higher but if the interest rate is lower it might attract investments. In general, a government’s active role in responding to the economic circumstances of a country is for the purpose of preserving important stakeholders' economic interests. 

• Reforms in the Banking Sector

The banks are considered to be one of the most crucial aspects of the Indian economy. As a consequence, any reforms in this sector will have a huge impact on the economy.

The banking sector plays a vital role in the betterment of the economy. By boosting the quality of financial services and increasing money accessible, banking sector openness may directly improve growth.

• Role of the Public and Private Sector

India has a mixed economy where both the private and public sector plays a significant role. While the public sector plays a valuable role in carrying out plans and reforms, developing infrastructure and building a strong industrial base, the private sector is responsible for generating employment opportunities. About 80% of the population is working in either organised or unorganised private sectors.

The public sector promotes economic development at a rapid pace by filling gaps in the industrial structure. It reduces the disparities in the distribution of income and wealth by bridging the gap between the rich and the poor. Agriculture and other activities like dairying, poultry come under the private sector. It plays an important role in managing the entire agricultural sector.

• Balance of Trade and Balance of Payment

Briefly, Balance of Trade (BOT) is the difference between the money value of a country's imports and exports of material goods only whereas Balance of Payment (BOP) is the difference between a country’s receipts and payments in foreign exchange. When the exports are greater than the imports, it leads to a favourable trade balance. It means there is a high demand for its goods offshores, and that increases the demand for its currency.  On another hand, when the outflow is greater than the inflow, there is a current account deficit.

BOT records only merchandise and doesn’t record transactions of a capital nature. BOP records transactions relating to both goods and services. BOP is a true indicator of the economic performance of an economy. 

• Consumer Confidence

The consumer is confident about his purchasing habits or decisions when they know they have income stability, and income is stable when the overall economy of a country is. It also affects the markets. For instance, if manufacturers and retail stores detect weak consumer confidence, they have to manage their inventory and cut back on production. Therefore, the economy will experience a slow down and ultimately, recession. A stable and growing economy usually boosts a consumer’s confidence.

The confidence of consumers impacts their economic decision and hence is a key indicator for the overall shape of an economy.

Role of Economic Policies

The basic purpose of economic policy is to help their country thrive economically through determining tax rates, money supply, government budgets, and interest rates, among other things.

Apart from the components of the economic environment, economic policies introduced by the government can also have an impact on markets. The components of economic policies are mentioned below.

Liberalisation

Liberalization is a broad phrase that refers to any process in which a government removes limitations on some individual person activities. It occurs when something which used to be banned is no longer banned. In simple language, you can say that Govt. eliminates regulation on private firms and trade.

Earlier it was restricted by the government for the production of goods and there is various permission that has to be taken from Govt. Due to this, there was a strong influence of the government in business.

This refers to when a state lifts the restrictions imposed on private business ventures so as to enable them to continue their operations without any hindrance and to facilitate economic growth. For instance, in 1991, the government of India removed some previously enforced restrictions on Indian companies. This includes –

• Removing almost all licenses except for a few

• Freedom in setting the price of products and services

• Reducing tax rates

• Relaxation on import and export of goods

• Allowing foreign investment in India

Some features of liberalisation in India are:

• Abolition of the existing License Raj in the country.  

• Reduction of interest rates and tariffs. 

• Removing the state sector's monopoly from several aspects of our economy.

 Privatisation

In general, privatisation involves transfer of all national economies from the public to the private sector. Privatization can take multiple forms, one of which is the 'partial or total denationalisation of assets.' Disinvestment of government’s equity in PSU’s and the opening up of hitherto closed areas to private participation is the meaning that economics generally specifies.

The privatization of government assets and functions are seen to generate savings for taxpayers by increasing efficiency, improving incentives, and reducing waste. 

This refers to when industries in the private sector are given more roles and the participation of the public sector decreases. Toward this, the Indian government took several steps like – 

• Migrating public sector organisations to the private sector

• Setting up a board to manage those public sector enterprises that are not performing well

• Selling off government-owned stakes to private organisations

Recently, The Centre had proposed to privatise the Indian Overseas Bank (IOB) and the Central Bank of India.

A recent example of privatisation would be when the Indian government opted to privatise Bharat Petroleum Corporation Limited in November 2019.

Globalisation

Globalisation refers to something that encompasses or connects the entire world rather than being limited to a single country.

We exist in a world that is now constantly linked. Our everyday lives are strewn with the imprints of other cultures, communities, and economies. The smartphone we use may be made in China, the clothing we wear could be made in Bangladesh, and the fast-food places we frequent could be from a little state in the United States.. It determines how quickly globalisation rates can move by allowing countries to expand their links for mutual benefit with other countries.

This refers to when the economy of a particular nation integrates with the world or global economy. This is done via increased trade with other countries, the use of technology, foreign direct investments, etc. The Indian economy was globalised in 1991 when it faced a severe economic crisis.

Impact of LPG Policies in India

The above economic policies were adopted by our government when India went through a major financial crisis in the year 1991. These policies impacted the business environment of our country in several ways. These include – 

• Indian companies faced increasing competition from foreign businesses.

• They had to adopt new technology into their business to keep up.

• Indian industries became more market-oriented, which means that they started manufacturing products based on customer demands.

• Companies focused on developing the skills of their employees. 

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