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Business · Understanding external influences on business

The economy and business

No small business can control the economy, but every one is affected by it: unemployment, consumer incomes, inflation, interest rates, taxation and exchange rates all change how much customers spend and how much a business pays.

  • 9 key terms
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Last Lesson

Answer from memory before the answers appear.

  • Under consumer law, what three things must goods be?

    Of satisfactory quality, fit for purpose and as described.

  • What can a customer get within 30 days for faulty goods?

    A full refund.

  • Name the four areas of employment law.

    Recruitment, pay, discrimination and health and safety.

  • Give one consequence of breaking the law.

    Fines, compensation, bad publicity or closure.

Learning Objectives

  1. 1Explain how unemployment and changing consumer incomes affect businesses.
  2. 2Explain how inflation affects businesses.
  3. 3Explain how changes in interest rates affect businesses.
  4. 4Explain how government taxation affects businesses.
  5. 5Explain how changes in exchange rates affect businesses that import or export.

The Economic Climate

The economic climate is the state of the economy as a whole - whether people have jobs, money to spend and confidence.

  • Outside the business's control

    A small business cannot change the economy; it can only respond to it.

  • Good times

    Most people have jobs and rising incomes, so they spend more and businesses sell more.

  • Hard times

    Jobs are lost and incomes fall, so customers cut back and many businesses struggle.

  • Some businesses gain

    In hard times, discount shops and repair services may do better as customers look for cheaper options.

Unemployment

Unemployment is when people who want to work cannot find a job.

  • Less spending

    Unemployed people have less income, so they spend less - especially on luxuries such as meals out and holidays.

  • Lower sales

    Businesses selling non-essentials see sales fall.

  • Easier to recruit

    More people are looking for work, so a small business can find staff more easily and may not need to raise pay.

  • Cheaper goods do better

    Businesses selling cheaper alternatives may gain customers.

Changing Levels of Consumer Income

Consumer income is the money people have to spend after tax.

  • Rising income

    Customers spend more, and buy more luxuries and higher-quality products. Sales rise.

  • Falling income

    Customers cut back, look for cheaper options and delay big purchases. Sales of luxuries fall.

  • Different businesses, different effects

    A budget supermarket may gain customers when incomes fall; an upmarket restaurant may lose them.

  • The business's response

    Adjust the marketing mix - value deals when incomes fall, premium products when they rise.

Inflation

Inflation is the rise in the general level of prices over time, usually measured as a percentage each year.

  • Higher costs

    A business pays more for materials, energy and stock, and staff ask for higher wages to keep up.

  • Pressure on prices

    To protect its profit, the business raises its own prices - but customers may buy less.

  • Customers cut back

    If wages rise more slowly than prices, customers' real incomes fall and they spend less.

  • Planning is harder

    Rising costs make it harder to forecast costs, prices and profit.

Calculating a Percentage Price Rise

Edexcel often asks for percentage changes. Show your working.

A café's coffee beans cost £12.00 a bag last year. This year they cost £13.20. Calculate the percentage increase.

  1. 1 Find the change £13.20 - £12.00 = £1.20
  2. 2 Divide by the original £1.20 ÷ £12.00 = 0.1
  3. 3 Multiply by 100 0.1 × 100 = 10%

AnswerThe price rose by 10%.

Changes in Interest Rates

The interest rate is the cost of borrowing money, and the reward for saving it. The Bank of England sets the Bank Rate, which banks follow.

  • Borrowing costs more

    When interest rates rise, loan and overdraft repayments go up, increasing a business's costs and reducing profit.

  • Customers spend less

    Customers with mortgages and loans pay more interest, so they have less to spend.

  • Saving is more attractive

    Higher rates encourage people to save rather than spend.

  • The reverse

    When interest rates fall, borrowing is cheaper, customers have more to spend, and businesses are more willing to borrow to grow.

When Interest Rates Rise

One change, felt all the way down the chain.

  1. 1 Interest rates rise

    The Bank of England raises the Bank Rate.
  2. 2 Borrowing costs more

    Customers' mortgage and loan repayments rise, and so do the business's.
  3. 3 Customers spend less

    They have less money left over for non-essentials.
  4. 4 Sales fall and costs rise

    The business sells less and pays more interest.
  5. 5 Profit falls

    The business may delay plans, cut costs or look for new customers.

The Figures Behind the Chart

  • 2020

    Inflation (CPI, annual average): 0.9%. Bank Rate (end of year): 0.1%

  • 2021

    Inflation (CPI, annual average): 2.6%. Bank Rate (end of year): 0.25%

  • 2022

    Inflation (CPI, annual average): 9.1%. Bank Rate (end of year): 3.5%

  • 2023

    Inflation (CPI, annual average): 7.3%. Bank Rate (end of year): 5.25%

  • 2024

    Inflation (CPI, annual average): 2.5%. Bank Rate (end of year): 4.75%

Government Taxation

Taxes are payments to the government that businesses and customers must make.

  • VAT

    A tax added to the price of most goods and services - 20% at the standard rate. A rise makes products more expensive, so customers may buy less.

  • Income tax

    A tax on people's wages. Higher income tax leaves customers with less to spend.

  • Taxes on business profits

    Sole traders pay income tax on their profits; companies pay corporation tax. Higher taxes leave the owners with less profit.

  • Employer costs

    Businesses also pay National Insurance on their employees' wages, so a rise increases the cost of employing staff.

Changes in Exchange Rates

The exchange rate is the value of one currency in terms of another, for example £1 = €1.15.

  • Importing

    A small business that buys supplies from abroad - a café importing Italian coffee, a shop buying stock from China - pays in foreign currency.

  • Exporting

    A small business that sells abroad - such as an online shop with customers in Europe - is paid in foreign currency or sets prices in it.

  • A stronger pound

    Buys more foreign currency, so imports become cheaper, but UK exports become more expensive for foreign customers.

  • A weaker pound

    Buys less foreign currency, so imports become more expensive, but UK exports become cheaper for foreign customers.

SPICED: Strong Pound, Imports Cheap, Exports Dear

When the pound is STRONG

  • £1 buys more foreign currency.
  • Imports are cheaper: good for a business buying supplies from abroad.
  • Exports are dearer (more expensive) for foreign customers.
  • A business selling abroad may lose sales.

When the pound is WEAK

  • £1 buys less foreign currency.
  • Imports are dearer: bad for a business buying supplies from abroad.
  • Exports are cheaper for foreign customers.
  • A business selling abroad may gain sales.

Exchange Rates in Action

To convert pounds to euros, multiply by the exchange rate.

A UK online shop sells a handmade bag for £40 to customers in France. The exchange rate changes from £1 = €1.10 to £1 = €1.20. Calculate the price in euros before and after, and explain the effect.

  1. 1 Price before £40 × 1.10 = €44
  2. 2 Price after £40 × 1.20 = €48
  3. 3 The effect The pound has strengthened, so the same bag now costs French customers €4 more

Answer€44 before, €48 after - the stronger pound makes the export dearer, so sales may fall.

Winners and Losers

For each change, name one small business that would suffer and one that might benefit, and explain why: unemployment rises; interest rates rise; inflation reaches 10%; the pound gets weaker against the euro.

1. Name a business that suffers, and explain why.

2. Name a business that benefits, and explain why.

A good answer shows: A loser and a winner for each change, with a chain of reasoning - e.g. a weak pound hurts a café importing Italian coffee but helps a UK gift shop selling online to European customers.

Can I...?

  1. 1Explain the impact of unemployment.
  2. 2Explain the impact of changing consumer incomes.
  3. 3Explain the impact of inflation.
  4. 4Calculate a percentage change.
  5. 5Explain the impact of interest rate changes.
  6. 6Explain the impact of taxation.
  7. 7Explain the impact of exchange rate changes.
  8. 8Convert a price using an exchange rate.

Summary & Exam Focus

  • Rising unemployment and falling incomes cut customer spending.
  • Inflation raises costs and makes customers cut back.
  • Higher interest rates raise borrowing costs and reduce customer spending.
  • Higher taxes leave customers and owners with less money.
  • A strong pound makes imports cheap and exports dear (SPICED).

Exam focus

Explain one impact on a small business of a rise in interest rates. (3 marks) (3 marks)

Economic questions have two sides - the business's own costs and its customers' spending. The strongest answers pick one side and take it all the way to sales or profit.

Key terms

The vocabulary this lesson expects you to use. Each one is linked from the first place it appears above.

Economic climate
The state of the economy, including jobs, incomes and prices.
Unemployment
When people who want to work cannot find a job.
Consumer income
The money people have to spend.
Inflation
A rise in the general level of prices over time.
Interest rate
The cost of borrowing money, and the reward for saving it.
Taxation
Payments to the government, such as VAT and income tax.
Exchange rate
The value of one currency in terms of another.
Import
A good or service bought from another country.
Export
A good or service sold to another country.

Questions and answers

9 questions set on this lesson, with the mark schemes and model answers open.

1. Exam question Define 1 mark Foundation

Define the term 'inflation'.

Mark scheme — 1 mark available

  • Rising prices / increase in the general price level — 1 mark

Model answer

A rise in the general level of prices over time.

2. Exam question Calculate 2 marks Foundation

The price of a bag of flour a bakery buys has risen from £2.50 to £2.75. Calculate the percentage increase in price. You are advised to show your working.

Mark scheme — 2 marks available

  • Correct method: (new - old) ÷ old × 100 — 1 mark
  • Correct answer: 10% — 1 mark (award 2 marks for the correct answer with no working)

Model answer

(£2.75 - £2.50) ÷ £2.50 × 100 = £0.25 ÷ £2.50 × 100 = 10%

3. Exam question Calculate 2 marks Foundation

A UK business sells a jacket for £60 to customers in Germany. The exchange rate is £1 = €1.15. Calculate the price of the jacket in euros. You are advised to show your working.

Mark scheme — 2 marks available

  • Correct method: £60 × 1.15 — 1 mark
  • Correct answer: €69 — 1 mark (award 2 marks for the correct answer with no working)

Model answer

£60 × 1.15 = €69

4. Exam question Outline 2 marks Foundation

Outline one way rising unemployment could affect a small restaurant.

Mark scheme — 2 marks available

  • An effect identified, e.g. lower sales / easier to recruit staff — 1 mark
  • Developed in the context of a restaurant — 1 mark

Model answer

Its sales could fall (1), because people who have lost their jobs have less income and cut back on non-essentials such as eating out (1).

5. Exam question Explain 3 marks Foundation

Explain one impact on a small business of a rise in interest rates.

Mark scheme — 3 marks available

  • An impact identified, e.g. higher borrowing costs / customers spend less / delay expansion — 1 mark
  • First linked point of explanation — 1 mark
  • Second linked point of explanation — 1 mark

Model answer

The cost of its loan repayments would increase (1). If the business has borrowed money, it must pay more interest each month, raising its costs (1). This reduces its profit and could cause cash-flow problems if the business cannot increase its revenue (1).

6. Multiple choice 1 mark Foundation

What is inflation?

  1. A A fall in the number of people in work
  2. B A rise in the general level of prices Correct
  3. C The cost of borrowing money
  4. D The value of the pound against the euro

Why: Inflation is a rise in the general level of prices over time.

7. Multiple choice 1 mark Core

How does a rise in interest rates usually affect customers' spending?

  1. A It falls, because borrowing costs more Correct
  2. B It rises, because saving earns less
  3. C It stays exactly the same
  4. D It rises, because prices fall

Why: Higher mortgage and loan repayments leave customers with less to spend, and saving becomes more attractive.

8. Multiple choice 1 mark Core

The pound becomes stronger against the euro. What happens to a UK café importing coffee from Italy?

  1. A Its imported coffee becomes more expensive
  2. B It must stop importing
  3. C Its imported coffee becomes cheaper Correct
  4. D Nothing, because exchange rates only affect exporters

Why: A strong pound buys more euros, so imports become cheaper (Strong Pound, Imports Cheap).

9. Multiple choice 1 mark Stretch

Which business is most likely to BENEFIT when consumer incomes fall?

  1. A A luxury car dealership
  2. B An upmarket restaurant
  3. C A designer clothing boutique
  4. D A discount shop Correct

Why: When incomes fall, customers look for cheaper options, so discount and value businesses can gain customers.