3.1: How Business and Economics Work

3.1: How Business and Economics Work

To appreciate how a business functions, we need to know something about the economic environment in which it operates. We begin with a definition of economics and a discussion of the resources used to produce goods and services.

A business’s success depends in part on the economic systems of the countries where it is located and where it sells its products. A nation’s economic system is the combination of policies, laws, and choices made by its government to establish the systems that determine what goods and services are produced and how they are allocated. Economics is the study of how individuals, businesses, governments and nations allocate their limited resources to satisfy their unlimited wants and needs. It is how a society uses scarce resources to produce and distribute goods and services. The resources of a person, a firm, or a nation are limited, and in economics this limitation is known as scarcity. An example of scarcity would be if food was limited throughout a geographic region due to a drought or a harsh winter. Scarcity is one of the key concepts of economics. It means that the demand for a good or service is greater than the availability of the good or service.

Hence, economics is the study of choices—what people, firms, or nations choose from among the available resources. Every economy is concerned with what types and amounts of goods and services should be produced, how they should be produced, and for whom. These decisions are made by the marketplace, the government, or both.

Farmland in Canada—An Example of Scarcity

A great example of scarcity in Canada is the limited availability of good farmland. Despite Canada’s vast size, only about 5% of the land is suitable for crop production.^[1] This scarcity of fertile land means that farmers must make careful decisions about what crops to grow and how to use their land most efficiently.

Resource Allocation: Scarcity forces farmers to prioritize which crops to plant based on factors like market demand, soil quality, and climate conditions.
Economic Trade-offs: Farmers might have to choose between growing high-value crops that require more resources or lower-value crops that are easier to cultivate.
Impact on Prices: Limited farmland can lead to higher prices for agricultural products, as the supply is constrained while demand remains high.

Artificial Intelligence Disclosure: Example 3.1 was created with the assistance of Microsoft Copilot, an AI-based tool designed to generate text based on user inputs. In accordance with the current guidance from Creative Commons, the content created using Generative AI tools is shared under a CC1.0 Universal Deed.

Microeconomics is the study of individuals and business decisions. Macroeconomicslooks at the decisions of countries and governments. These two branches of economics appear to be different, but in reality, they’re interdependent and complement each other. You probably know more about economics than you realize. Every day, many news stories deal with economic matters—a union wins wage increases at General Motors, the Bank of Canada lowers interest rates, Wall Street has a record day, the prime minister proposes a cut in income taxes, consumer spending rises as the economy grows, or retail prices are on the rise, to mention just a few examples.

Resources: Inputs and Outputs

The allocation of resources is concerned with the production, distribution and consumption of goods and services. Resources are the inputs used to produce outputs.

Resources may include any or all of the following and their connections with one another:

land and other natural resources
labour (physical and mental)
capital, including buildings and equipment
entrepreneurship
knowledge

Resources are combined to produce goods and services. Land and natural resources provide the needed raw materials. Labour transforms raw materials into goods and services. Capital (equipment, buildings, vehicles, cash, and so forth) is needed for the production process. Entrepreneurship provides the skill, drive, and creativity needed to bring other resources together to produce a good or service that can be sold in the marketplace.

Because a business uses resources to produce things, we also call these resources factors of production. For example, the factors of production used to produce a shirt would include the following:

the land that the shirt factory sits on, the electricity used to run the plant, and the raw cotton from which the shirts are made;
the labourers who make the shirts;
the factory and equipment used in the manufacturing process, as well as the money needed to operate the factory; and
the entrepreneurship skills and production knowledge used to coordinate the other resources to make the shirts and distribute them to the marketplace.

Input and Output Markets

The circular flow model is simply a way of depicting how money circulates through the economy from individuals to firms in the form of labour and buying goods and services. Then, from firms to individuals in the form of wages and providing goods/services.^[2] Many of the factors of production are provided to businesses by households. For example, households provide businesses with labour (as workers), land and buildings (as landlords), and capital (as investors). In turn, businesses pay households for these resources by providing them with income, such as wages, rent, and interest. The resources obtained from households are then used by businesses to produce goods and services, which are sold to provide businesses with revenue. The revenue obtained by businesses is then used to buy additional resources, and the cycle continues. This is described in Figure 3.1, “The Circular Flow of Inputs and Outputs”, which illustrates the dual roles of households and businesses:

Households not only provide factors of production (or resources) but also consume goods and services.
Businesses not only buy resources but also produce and sell both goods and services.

Diagram showing business outputs flowing to households, and inputs flowing from households to businesses. See image description. — Figure 3.1: The circular flow of inputs and outputs. [See image description.]

The circular flow of inputs and outputs illustrates the dual roles of households and businesses. Households not only provide factors of production (or resources) but also consume goods and services. Businesses not only buy resources but also produce and sell both goods and services. Outputs include goods and services (or products). Inputs include labour, capital, land, and entrepreneurship.

This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labour markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).

Productivity

Productivity refers to how efficiently goods and services are being produced. Productivity increases when more output is produced with the same amount of inputs or when the same amount of output is produced with fewer inputs.

Labour productivity is the most common productivity measure—it’s defined as economic output (gross domestic product, or GDP) per hour worked. Labour productivity is typically the biggest determinant of economic and wage growth in the long term. And over time, labour productivity and real wages are closely—though not exactly—linked. Labour productivity tends to rise with increases in technology.

Economists measure other types of productivity, too. Capital productivity is a measure of how well physical capital, such as real estate, equipment, and inventory, is used to generate output such as goods and services. (Capital productivity and labour productivity are frequently considered together as an indicator of a country’s overall standard of living.) Total factor productivity is the portion of growth in output not explained by growth in labour or capital. This type of productivity is sometimes called “innovation-led growth.”^[3]

Your Role in the Canadian Economy

Curious about your role in the Canadian economy? Plug in a few facts about yourself and compare them with national and regional data from across Canada. At the end, your profile, as well as your place in the economy, will be revealed. Figure 3.2 shows a results page after taking the “Your Role in the Canadian Economy” Quiz. Give it a try! You will see how you compare to other Canadians.

Figure 3.2: Your role in the Canadian economy quiz. [See image description.]

Media Attributions

Image Descriptions

Figure 3.1

A circular diagram shows the reciprocal relationship between businesses and households in the economy. It features two main sections: “Businesses” on the left, depicted by a black and white icon of buildings, and “Households” on the right, depicted by a house. Under Businesses are listed “Produce and sell products to households” and “Buy inputs from households.” Under households are listed “Buy products from firms” and “Provide inputs to firms.”. Two orange arrows depict the flow of resources and money, one showing “Pay revenues for outputs” from households to businesses, and another “Pay incomes for inputs” from businesses to households. The caption on the top lists “Outputs” as “Goods” and “Services,” and the caption at the bottom lists “Inputs” as “Labour,” “Capital,” “Land,” and “Entrepreneurship.”

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Figure 3.2

A screen capture of the “Your Role in the Canadian Economy” quiz, with a stylized, cartoon-like character with a blue body, black shirt, sunglasses, and vibrant blue and purple hair, standing within a large light purple circular background against a dark blue backdrop. The character holds an Ontario flag. Surrounding the character are three circular elements: one on the top right with the text “You are a student,” another on the bottom right stating, “You are living in Ontario,” and a third on the left with an icon of a document above the text box. A rectangular text box below this icon states, “Your education, public health and public administration sector makes up 19% of Canada’s economy—that’s 361 billion dollars!”