Effect of the exchange rate on business

Readers Question: What are the effects of the exchange rate on UK businesses?

The exchange rate will play an important role for firms who export goods and import raw materials. Essentially:

  • A depreciation (devaluation) will make exports cheaper and exporting firms will benefit.
    • However, firms importing raw materials will face higher costs of imports.
  • An appreciation makes exports more expensive and reduces the competitiveness of exporting firms.
    • However, at least raw materials (e.g. oil) will be cheaper following an appreciation.

Effect of depreciation in the exchange rate

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If there is a depreciation in the value of the Pound, it will make UK exports cheaper, and it will make imports into the UK more expensive.

In this example:

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  • At the start of 2007, the exchange rate was £1 = €1.50.
  • By Jan, 2009, the Pound had fallen in value so £1 was now only worth €1.10 (a depreciation of 26%)

Impact on British exporters

Suppose a British car costs £4,000 to build and sells for £5,000 in the UK.

  • In 2007, the European price of this car would be €7,500 (5,000 *1.5)
  • In 2008, the European price of this car would be €5,500 (5,000 *1.1)

The 26% depreciation means that European consumers now find British goods much cheaper. The cost of producing the car stays the same (assuming parts are not imported), but the effective market price in Europe has fallen. This should increase demand for British goods.

Increase profit margin or reduce the foreign price?

A British firm has a choice, it can reduce the European price from €7,500 to €5,500; this should lead to an increase in the quantity sold, and increase UK exports.

Alternatively, the firm could keep the price at €7,500 and just make a bigger profit margin. It is a good choice for exporters to have – reduce European price and sell more or keep price the same and make a bigger profit margin.

Impact on importers of raw materials

The downside of a depreciation is that British firms who import raw materials will see an increase in the cost of buying raw materials. If the British car company imports engines from Germany to make the car, it will have to pay more to buy the engines. This will reduce its profit margin.

Suppose an engine costs €1000 to import from Germany. In 2007, this costs £666 (1,000/1.5). In 2009, with the fall in the value of the Pound, they will have to spend £909 (1,000/1.1) to buy the same German engine.

Impact on incentives

In the long term, it is argued that a depreciation may reduce the incentives for exports to cut costs. The depreciation enables an ‘easy’ increase in their profit margin. As a result, there may be less incentive to cut costs and boost productivity. If a firm is facing an appreciation, then they may face a greater incentive to cut costs.

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Stock market explained

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How does US / China trade war affect EU, Asia and Africa?

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Costs and benefits of globalisation

impact-of-globalisation

Globalisation is a complex and controversial issue. This is a look at some of the main benefits and costs associated with the greater globalisation of the world economy.

Definition of Globalisation The process of increased integration and co-operation of different national economies. It involves national economies becoming increasingly inter-related and integrated.

Globalisation has involved:

  • Greater free trade.
  • Greater movement of labour.
  • Increased capital flows.
  • The growth of multi-national companies.
  • Increased integration of global trade cycle.
  • Increased communication and improved transport, effectively reducing barriers between countries.

Summary of costs/benefits

BenefitsCosts
Lower prices/ greater choiceStructural unemployment
Economies of scale – lower pricesEnvironmental costs
Increased global investmentTax competition and avoidance
Free movement of labourBrain drain from some countries
May reduce global inequalityLess cultural diversity

Benefits of globalisation

1. Free trade is a way for countries to exchange goods and resources. This means countries can specialise in producing goods where they have a comparative advantage (this means they can produce goods at a lower opportunity cost). When countries specialise there will be several gains from trade:

  1. Lower prices for consumers
  2. Greater choice of goods, e.g food imports enable a more extensive diet.
  3. Bigger export markets for domestic manufacturers
  4. Economies of scale through being able to specialise in certain goods
  5. Greater competition

See: Benefits of Free Trade

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Scarcity in economics

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Definition: Scarcity refers to resources being finite and limited. Scarcity means we have to decide how and what to produce from these limited resources. It means there is a constant opportunity cost involved in making economic decisions. Scarcity is one of the fundamental issues in economics.

Examples of scarcity

  • Land – a shortage of fertile land for populations to grow food. For example, the desertification of the Sahara is causing a decline in land useful for farming in Sub-Saharan African countries.
  • Water scarcity – Global warming and changing weather, has caused some parts of the world to become drier and rivers to dry up. This has led to a shortage of drinking water for both humans and animals.
  • Labour shortages. In the post-war period, the UK experienced labour shortages – insufficient workers to fill jobs, such as bus drivers. In more recent years, shortages have been focused on particular skilled areas, such as nursing, doctors and engineers
  • Health care shortages. In any health care system, there are limits on the available supply of doctors and hospital beds. This causes waiting lists for certain operations.
  • Seasonal shortages. If there is a surge in demand for a popular Christmas present, it can cause temporary shortages as demand as greater than supply and it takes time to provide.
  • Fixed supply of roads. Many city centres experience congestion – there is a shortage of road space compared to number of road users. There is a scarcity of available land to build new roads or railways.

How does the free market solve the problem of scarcity?

If we take a good like oil. The reserves of oil are limited; there is a scarcity of the raw material. As we use up oil reserves, the supply of oil will start to fall.

Diagram of fall in supply of oil

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If there is a scarcity of a good the supply will be falling, and this causes the price to rise. In a free market, this rising price acts as a signal and therefore demand for the good falls (movement along the demand curve). Also, the higher price of the good provides incentives for firms to:

  • Look for alternative sources of the good e.g. new supplies of oil from the Antarctic.
  • Look for alternatives to oil, e.g. solar panel cars.
  • If we were unable to find alternatives to oil, then we would have to respond by using less transport. People would cut back on transatlantic flights and make fewer trips.

Demand over time

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In the short-term, demand is price inelastic. People with petrol cars, need to keep buying petrol. However, over time, people may buy electric cars or bicycles, therefore, the demand for petrol falls. Demand is more price elastic over time.

Therefore, in a free market, there are incentives for the market mechanisms to deal with the issue of scarcity.

Causes of scarcity

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Scarcity can be due to both

  1. Demand-induced scarcity
  2. Supply-induced scarcity

and a combination of the two. See more at: Causes of scarcity.

Scarcity and potential market failure

With scarcity, there is a potential for market failure. For example, firms may not think about the future until it is too late. Therefore, when the good becomes scarce, there might not be any practical alternative that has been developed.

Another problem with the free market is that since goods are rationed by price, there may be a danger that some people cannot afford to buy certain goods; they have limited income. Therefore, economics is also concerned with the redistribution of income to help everyone be able to afford necessities.

Another potential market failure is a scarcity of environmental resources. Decisions we take in this present generation may affect the future availability of resources for future generations. For example, the production of CO2 emissions lead to global warming, rising sea levels, and therefore, future generations will face less available land and a shortage of drinking water.

The problem is that the free market is not factoring in this impact on future resource availability. Production of CO2 has negative externalities, which worsen future scarcity.

Tragedy of the commons

The tragedy of the commons occurs when there is over-grazing of a particular land/field. It can occur in areas such as deep-sea fishing which cause loss of fish stocks. Again the free-market may fail to adequately deal with this scarce resource.

Further reading on Tragedy of the Commons

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Giffen Good Definition

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Definition of a Giffen Good. A good where a higher price causes an increase in demand (reversing the usual law of demand). The increase in demand is due to the income effect of the higher price outweighing the substitution effect. The concept of a Giffen good is limited to very poor communities with a very limited …

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Factors affecting economic growth

policies-for-economic-growth

Economic growth is an increase in real GDP; it means an increase in the value of goods and services produced in an economy. The rate of economic growth is the annual percentage increase in real GDP. There are several factors affecting economic growth, but it is helpful to split them up into: Demand-side factors (e.g. …

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Shift in Demand and Movement along Demand Curve

shift-in-demand

A shift in demand means at the same price, consumers wish to buy more. A movement along the demand curve occurs following a change in price. Movement along the demand curve A change in price causes a movement along the demand curve. It can either be contraction (less demand) or expansion/extension. (more demand) Contraction in …

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