Business 101 Notes Chapter 1 Understanding the Canadian Business System Don Wagner, July 28, 2008

Transcription

1 Free Enterprise Business 101 Notes Chapter 1 Understanding the Canadian Business System Don Wagner, July 28, In most countries, anybody can set up a new business. In Canada the freedom to do so is quite extensive. In fact, many students have already engaged in free enterprise. Have you? For example, have you mowed grass for neighbours, or participated in a Junior Achievement enterprise? - Even in communist countries a certain degree of free enterprise may be permitted. Over half of China s GDP 1 is now produced by the private sector. 2 Some countries, however, suffer from much greater restrictions. An example is Cuba, where almost all business is conducted by government-owned enterprises and the government has little tolerance of free enterprise. In 2005 Fidel Castro closed down 2,000 street vendors of sandwiches, pizzas and the like, so that a government enterprise could control the sale of those products. 3 - In non-communist countries, almost anybody can set up almost any kind of business. Yet, there are restrictions even in the freest and most developed countries. For example: o Some types of businesses are illegal (e.g. selling heroin). o Some governments may not allow foreigners to operate certain types of businesses. For example, the U.S. does not allow foreigners to own military equipment producers within the US. Canada does not allow foreigners to operate bookstores in Canada. Why do you think governments make it illegal for foreigners to own certain types of businesses? o Some businesses require licensing or permits. Such requirements can range from the reasonable to the ridiculous. An example of a reasonable restriction is Canada s requirement that only qualified dentists can operate a dentistry business. But some countries require so many licenses, permits and approvals that most potential entrepreneurs do not bother setting up a legal business. They are either dissuaded from setting up their business, or they run it illegally. - Nevertheless, while a few restrictions exist, in Canada the legal right to set up a new business is mostly wide open. - There are over two million businesses in Canada. 4 The vast majority of these businesses are small (such as farms and restaurants), but a few are very large with billions of dollars in sales. 1 GDP stands for Gross Domestic Product, and is a measure of a country s economic output. 2 The Economist, October 9, 2004, Investing in China: Milking it, page The Economist, June 25, 2005, Cuba s economy: Unappetising, page Based on Statistics Canada s Business Register per accessed on July 28,

2 The Pursuit of Profits - Most privately-owned operations seek to earn a profit. - Some people have a very negative view of people who pursue profits. Do you think there is anything immoral about pursuing profits? - Profits are generally regarded as the reward to owners for providing capital and for risk-taking. If the owner actively manages the business, part of the profits might also be a reward for labour that the owner contributes to the business. - The profit motive is one of the main reasons that entrepreneurs establish new businesses. What are some other reasons? - But earning profits is not easy. Businesses need resources (the textbook refers to these as factors of production ). o Labour: All businesses need labour. In some cases the entrepreneur provides all the labour himself/herself, but often the business hires employees to do the labour. Since people are free to choose whether or not to work for a particular business, the business has to provide wages and a working environment that entice employees to work there. (The business has to simultaneously find ways to motivate employees to work effectively for the success of the business.) o Capital: Businesses need capital. For example a lawn-mowing business needs a lawn-mower. An auto manufacturer needs a factory, and also needs money to pay for up-front costs that will not be recovered until later, such as wages, supplies, research and development, and marketing costs. This capital may come from existing owners, new owners or lenders (such as banks). Lenders must be paid back with interest, while owners expect to get a share in future profits. Since people with money are free to choose where to invest, the business needs to offer a sufficient interest rate or profit potential to obtain those funds. o Supplies: Most businesses need to buy products from other businesses. For example, a lawn-mowing business needs gas. An auto manufacturer needs parts. Again, supplier businesses will only choose to sell if they can receive a high enough price. o Know-how and data: To succeed in a competitive environment, the business needs to know what it is doing. It needs to provide a product or service that the customer cannot produce himself/herself at the same price. The necessary know-how and data is accumulated through effort and experience. - So, in a free country, a business needs to make customers better off, employees better off, suppliers better off, and investors better off. Accomplishing all that while earning a profit at the same time is challenging. But millions of businesses all over the world succeed! - This course covers the basics of the business activities that are required. We will cover numerous topics that address the above issues. For example: o marketing focuses on how businesses reach the customer; o human resource management focuses on the business interaction with labour; 2

3 o finance focuses on understanding the financial aspects of business and its interaction with investors; and o accounting focuses on understanding data that measure the business performance. Business is a multi-faceted discipline that requires competence in all of these areas. Free Markets - In 1776, the Scottish economist/philosopher Adam Smith published a famous book entitled The Wealth of Nations. 5 In this book, he claimed that a free market, in which everyone behaves self-interestedly, produces socially desirable results. That is, products are priced correctly and the proper quantities of goods are produced, even though there is no master-planner directing and coordinating the economy. The economy works as if controlled by an invisible hand. - Further refinement of Adam Smith s ideas led to the concepts of supply and demand, which determine the appropriate price and production volumes. In a competitive environment, prices and production volumes will be such that supply equals demand. - In class we will do an exercise that illustrates this. Government Intervention - Based on the concept of the invisible hand, some people believe that governments should adopt a laissez-faire policy, and not intervene in the economy. No country, however, is completely laissez-faire. There are a number of ways in which free markets can fail to produce optimal results. Consequently, governments intervene to try to rectify these failures. Monopoly Power - A monopoly is a situation in which one company is the sole supplier of a product. An example is Maritime Electric, which is the sole supplier of electricity in PEI. Can you think of other monopolies? A monopsony is a situation in which one company is the sole buyer of a product. An example is the Canadian Wheat Board, which buys all wheat produced by Canadian farmers. - Consider the monopoly first. When one company is the only supplier of a product, that company has an incentive to raise prices above those that would exist if there were competitors. The higher prices make that particular company much more profitable, but leave the customers worse off. All the customers that continue to buy end up paying a higher price than they otherwise would have paid. In addition, there are some lost customers who would have been willing to buy at a price above the cost of production, but are not willing to pay the price set by the monopolist. 5 Actually, the full name of the book is An Inquiry into the Nature and Causes of the Wealth of Nations, but people commonly refer to the book by the shorter title. 3

4 - There are a number of ways in which governments address the problem of monopolies. o Price regulation. In some industries dominated by a monopolist, governments regulate the prices to prevent the monopolists from charging excessive amounts. Examples include PEI s regulation of gasoline prices and PEI s regulation of electricity prices. o Protecting competition. Governments have also enacted laws to encourage competition. Anti-competitive practices that are illegal include price fixing (making an agreement with competitors to keep prices up), predatory pricing (charging unreasonably low prices when new competitors come along in order to drive them out of business), and resale price maintenance (dictating high prices to the retailers of your product). (Hard question: Why does this practice need to be outlawed? Why would a company even want to engage in resale price maintenance?) In addition, governments sometimes block mergers and acquisitions that would have enabled a company to monopolize an industry. Monopsony Power - Now consider monopsonies. If you think of employers as buyers of labour, some employers could be considered monopsonies, particularly in towns dominated by one company. A large dominant employer could use its size to keep wages unreasonably low. - This pattern was common in 19 th century Europe, and led Karl Marx to his ideas on communism. He believed that the business owners (the capitalists) abused their powers at the expense of workers, and that workers must take control. Communism ultimately took hold in Russia and later in numerous Eastern European countries, China, and several other countries. Under pure communism, the state controls the entire economy. Prices, wages and production are all planned centrally. Communism ended up not being an effective solution to the problems of free markets, because central planners are less effective at selecting prices and production volume than free markets are. Moreover, communism tends to be a repressive system, as the system tries to preserve itself by stamping out any entrepreneurial activity that seeks to profit by filling a need where central planning has failed. - In Canada, the solution to large dominant employers has been the rise of labour unions. Governments have introduced laws that govern what employers can and cannot do to block the development of unions. Rules on Information - Businesses usually know more about their product than their customers do, and this lack of information can disadvantage the customer. Some government interventions that address this problem include: o Approvals: Many products must meet government safety requirements before they are permitted on the market. An example is drugs. Pharmaceutical companies (i.e. drug companies) must demonstrate that the drugs are sufficiently safe before they are allowed to sell them. 4

5 o Labeling: Businesses have an incentive to withhold information if they think that the information could impair sales. Governments therefore require businesses to disclose certain information that a consumer ought to be provided with. An example is the list of ingredients in food products. What are some other examples? Third Parties - In a free market, the customer will only buy the product if the purchase makes him/her better off, and the supplier will only sell the product if the sale makes him/her better off. That, however, does not imply that everyone is better off. Other people who weren t party to the deal (known as third parties ) might be worse off. - For example, when someone buys a car, third parties suffer a number of disadvantages, such as additional air pollution, additional traffic congestion, additional wear and tear on roads, and additional danger. Governments therefore impose various regulations to reduce these disadvantages, such as requiring environmentally-friendly technology, and imposing additional taxes to offset the costs to society. - Third party effects are not always bad. A deal between two people can sometimes affect third parties positively. For example, if one company builds an amusement park that draws tourists to the community, the neighbouring hotels and restaurants benefit from the increased volume of tourists. This principle undergirds the logic behind government activities aimed to develop new business ventures in the community. Honesty and fair practices - Governments also have numerous laws outlawing various dishonest practices, such as fraud, misleading advertising, and breach of contract 6. Free Riders - Some activities are costly to produce, but then subsequently provide benefits to many people, including people who did not pay for the product. People who take advantage of someone else s work without paying for it are called free-riders. - One example is the development of intellectual property. The cost of developing a new drug in the US (including the approval process) is now about $1 billion. Once a drug is developed, it would be easy for someone else to figure out the ingredients and then sell the same drug cheaply without having to recover the development costs. If this were allowed, pharmaceutical companies would have little incentive to develop new drugs. Consequently, governments allow inventors to apply for patent protection on their innovations. The patent-holder is the only one allowed to use the invention for the duration of the patent (up to 20 years). - Another example is copyright laws with respect to music. What do you think is the logic behind granting exclusive rights to musicians over the use of their music? Do you think this is a sensible rule? 6 Breach of contract occurs when somebody fails to do what he/she promised in a contract. 5

6 Taxes - Many government activities require money, which governments obtain by imposing taxes. The burden of paying and collecting taxes often falls on businesses, because it is easier for governments to impose on businesses than on individuals. For example, not only do businesses have to pay their own taxes, but they also have to deduct taxes from their employees pay and send it in. Similarly, businesses are the ones who have to do the collection and paper work for sales taxes. Advocacy - When companies do business in other countries, they often face barriers that they do not face at home. For example, the foreign country may have rules that discriminate against companies from outside that country. An example currently in the news is the softwood lumber dispute. For years the U.S. government imposed import duties (i.e. import taxes) on lumber coming from Canada. According to several NAFTA 7 rulings, these duties violated the NAFTA trade agreement signed by the U.S. government. Nevertheless, the U.S. government continued to impose these duties. Two years ago, on behalf of Canada s lumber industry, the Canadian government negotiated an agreement that hopefully will resolve this problem. The Canadian government is acting on behalf of these companies, because the government has much more clout than the lumber companies do. The Resulting Challenges to Businesses - In addition to having to keep customers satisfied, having to keep employees satisfied, and having to keep investors satisfied, businesses also must comply with the many government rules in place. As a result, doing business is very complex. - The challenges are increasing because of the competitiveness of today s world. As governments are increasingly promoting competition (both through laws governing competitive practices, and through opening the borders to foreign competition), businesses face stiff competition. - Another challenge we will address in this course involves ethics. In business, competing interests can make ethical decisions difficult. Moreover, since the pressures and rewards in business are often substantial, the monetary outcome of a decision can sometimes cloud managers judgment. - Despite the enormous challenges, the rewards of running a successful business can be terrific. The rewards include: o profits, o the satisfaction that comes from providing good jobs for employees, o the satisfaction that comes from providing a valuable product or service to customers, and o the satisfaction that comes from pulling it all off. 7 NAFTA stands for North America Free Trade Agreement, which was signed by the Canadian, US and Mexican governments. The agreement specifies how much these countries can charge in import taxes on products coming from the other countries in the agreement. 6