What’s it: The business sector is a private economic actor dealing with producing goods or providing services. It covers all businesses, from small to giant, across industries. Together with the household sector, it forms the private sector. And if we add it up with the government and external sectors, they form the macroeconomic sector.
Businesses play an important role in product and factor markets (input markets). They act as suppliers and sell goods and services in the product market to other economic actors. Meanwhile, they act as buyers in factor markets such as the raw material and labor markets.
The business sector often evolves during economic development. In the early stages, the economy relied on natural resources. Thus, most businesses operate to extract natural resources and process them into simple products. Then, as technology advances, manufacturing dominates the business sector. Then, business in the service sector is growing rapidly and dominates the economy’s output.
What is the role of the business sector in the economy?
Economists divide economic actors into three sectors, namely:
Apart from these three, there is also the external sector. Nonetheless, it also basically consists of the above three sectors.
The household sector plus the business sector make up the private sector. However, the two sectors play opposite roles in the product and factor markets. In the product market, households act as buyers. Meanwhile, in factor markets, they act as sellers or suppliers. In contrast, the business acts as a supplier in the product market and as a buyer in the factor market.
Some businesses produce goods. Their output represents tangible products where we can see and touch them. Some may simply extract natural resources – such as mining for minerals and growing crops and vegetables – into raw materials or for direct consumption. Others process raw materials into output, which can be semi-finished or finished goods.
Meanwhile, some businesses provide services. Unlike goods, services cannot be seen or touched, but we can only feel the benefits. Their services may be related to finance, as insurance, banks, and pension funds provide. Alternatively, they provide other services such as transportation, hospitality, education, and retail.
Capital investment in aggregate demand
Businesses produce goods and services by utilizing the factors of production. They are generally profit-oriented. So, when the demand for their products increases, they will try to increase production. They will operate production facilities near full capacity. If the capacity utilization rate is already high and demand remains strong, they start investing in capital goods to increase production capacity.
Businesses invest capital goods, for example, by buying machinery and equipment. Or they set up a new factory. Such investments allow them to produce more output.
Capital investment may be financed through internal sources, namely from retained earnings. But, often, that is not enough. Thus, businesses will usually raise funds from external sources, for example, by issuing shares or bonds.
Business investment plays an important role in the economy. It forms aggregate demand with household consumption, government spending, and net exports.
- Aggregate demand = Household consumption + Business investment + Government spending + Net exports
Aggregate demand represents the total expenditure by economic actors. It would equal aggregate income and output, as economists explain in the circular flow model. To measure these aggregate figures, economists introduce gross domestic product (GDP) to represent the aggregate output.
Contribution of capital investment to economic growth
GDP is the main statistic for measuring economic growth. So, suppose we want to know what percentage of the economy is growing. In that case, we can calculate it from the time-to-time change in GDP, specifically, real GDP.
As an item in aggregate demand, business investment is a driver of economic growth. When capital investment increases, aggregate demand increases, stimulating the economy to grow higher. Conversely, if investment declines, it can cause the economy to slow down.
In addition, capital investment also plays a role in long-term economic growth. This is because it contributes to the accumulated capital stock in the economy. Thus, when the capital stock increases – for example, the production machines increase, the economy has a higher capacity to produce output.
In this case, we don’t just consider how much money the business spends (gross investment). However, we must also consider depreciation, i.e., the economic benefits lost to current capital assets due to problems such as wear and tear. In economics, we call this depreciation a capital consumption allowance.
The difference between gross investment and capital consumption allowance is called net investment. Thus, the capital stock in the economy increases only if the net investment is positive. That allows the economy to have a higher production capacity and increase potential output.
Fluctuation in GDP
GDP includes inventory investment (change in inventory) when calculating business investment. Different from investment in capital goods, inventory investment is highly volatile and is strongly influenced by the business cycle.
Businesses will usually change their inventory levels just before the economy changes course. For this reason, economists consider inventory investment contributing to output volatility and short-run fluctuations in GDP.
For example, as long as the economy is recovering and is heading for expansion, capital investment often does not increase immediately. Businesses will be cautious and seek to utilize existing resources to meet increasing demand. Thus, they optimize existing capacity while building inventory levels. If demand becomes stronger and the economy is headed for expansion, they will increase capital spending.
On the other hand, during the start of a contraction before heading into a recession, businesses will lower the pace of production. They began to increase efficiency and maximize sales by liquidating existing inventory. They may not immediately stop investing capital. Instead, they may cancel orders for heavy capital goods but still buy light equipment to support efficiency.
Who owns the business sector?
A command economy has a different ownership structure from a free market economy over the business sector. Under a command economy, the government has full control over the economy. The central government makes all economic decisions and controls the land and the means of production. In addition, the government also sets prices and production.
In contrast, a free market economy relies on the private sector. This is because the private sector owns the means of production. Supply and demand guide pricing and, therefore, guide the economy to operate. And the business sector operates freely without government intervention.
Then today, the modern economy combines the two systems, called a mixed economic system. The government sector and the private sector operate the economy.
In some countries, such as China, their economy inclines to a command economy where the government has a major power even though it allows the private sector to operate for profit.
On the other hand, some other countries – such as the United States and the United Kingdom – tend towards a free market economy. As a result, the private sector plays a more significant role in the economy, enabling multinational giants such as Google, Facebook, and Amazon, to thrive.
Under a mixed economy, the ultimate owner of the business sector is the household sector. But, we might think, don’t some companies also control other companies by becoming major shareholders?
Yes, a company may have a majority stake in another company if we look at the financial statements. However, if we trace it down to the last shareholder chain, we will eventually find that the shareholders are ultimately entrepreneurs from the household sector.
What are the types of business in the business sector?
Different businesses operate in business sectors with different operation scales, ranging from small to large businesses. In the general classification, they usually include:
- Limited liability company
- sole proprietorship
Limited liability company
A limited company is a single legal entity and separates from its owners. Owners have limited liability, limited to their shareholding in the company. Thus, they are not responsible for the company’s obligations. And when a company goes bankrupt, they may only lose as much as their investment in the company without losing any personal assets. That’s because they have no personal liability for the company’s debts.
Limited companies issue transferable shares, thus allowing owners to change. Some may be offered through a public offering on a stock exchange – a public limited company or a listed company. Others may not – it’s called a private limited company.
Limited companies are subject to double taxation. The government levies taxes on corporate income. In addition, the government also imposes income tax on owners. Thus, if a company pays dividends to owners, it incurs a tax liability, even though the government has levied taxes at the corporate level.
In a partnership, two or more people – called partners – share the business’s resources, ownership, and profits. They also share responsibility for managing the company.
Unlike corporations, partnerships are not taxed on profits. Instead, they are only taxed when profits are paid to partners.
A partnership may be a limited partnership where the partners have limited liability or a general partnership where the partners have unlimited liability. Variations can be a Limited Liability Partnership (LLP) and a Limited Liability Limited Partnership (LLLP).
A sole proprietorship is the simplest structure. A business has one owner, neither of which are considered legally separate entities. Thus, the owner is not only fully personally responsible for the operation. But, they are also responsible for all business obligations incurred because they have unlimited liability. As a result, if a business has debt, they may lose personal assets to pay off the business debt.
Business functions are usually not regulated separately. Thus, the owner manages all functional areas, assisted by several employees.
In addition, sole proprietorships operate on a limited scale. Generally, they are small with few employees and usually serve the local market.