Contents
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.
Understanding economic actors
Economists divide economic actors into three four, namely:
- Household sector: This sector represents individual consumers and families. They earn income through wages, salaries, and other means and spend that income on goods and services produced by businesses, both domestically and internationally (through imports).
- Business sector: This sector includes all private firms that produce goods and services. Businesses use factors of production (land, labor, capital, and entrepreneurship) to create these goods and services and sell them to consumers and other businesses, both domestically and abroad (through exports).
- Government sector: This sector encompasses government agencies and institutions. The government provides public goods and services, redistributes income, and regulates economic activity. It also plays a role in the external sector through international trade policies, foreign aid, and managing the exchange rate.
- External sector: This sector captures a country’s economic interactions with the rest of the world. It includes international trade (exports and imports of goods and services), foreign investment flows, and international borrowing and lending. The external sector significantly impacts a country’s economic growth, employment, and exchange rate.
The private sector consists of the household and business sectors. 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; we can only feel their 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.
The business sector’s roles
Production: As mentioned earlier, businesses play a crucial role in transforming factors of production – labor, capital, and land – into tangible goods and services that fulfill consumer needs. This production process involves utilizing labor to operate machinery and equipment (capital) on land to create the desired outputs. These outputs can be anything from cars and clothing (goods) to haircuts and financial advice (services).
Investment: Businesses don’t just produce; they also invest in their future growth and the overall economy. This investment comes in two main forms:
- Physical capital: Businesses invest in physical capital, such as machinery, equipment, and buildings. This allows them to increase production capacity, improve efficiency, and potentially offer new products or services.
- Human capital: Businesses also invest in human capital by training and educating their employees. This can involve providing on-the-job training, sending employees to workshops and conferences, or even offering tuition reimbursement programs. Investing in a skilled workforce allows businesses to be more productive and innovative.
Innovation and technological advancement: Businesses are often at the forefront of innovation and technological advancement. They invest in research and development (R&D) to create new products, improve existing ones, and develop more efficient production methods. These advancements can benefit not only the business itself but also the entire economy by leading to higher productivity, lower costs, and the creation of entirely new industries.
Impact on the macroeconomic performance
Businesses play a critical role in shaping a nation’s economic health. Their decisions regarding investment directly influence key macroeconomic indicators like aggregate demand and economic growth. Let’s delve into how business investment contributes to these vital aspects:
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 in capital goods, such as 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, when 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 usually change their inventory levels just before the economy changes course. For this reason, economists consider inventory investment to contribute 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.
Business ownership structures
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’s operation. 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.
Types of business
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
- Partnership
- sole proprietorship
Limited liability company
A limited company is a single legal entity separated from its owners. Owners have limited liability, limited to their shareholding in the company. Thus, they are not responsible for the company’s obligations. 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 and 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.
Partnership
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).
Sole proprietorship
A sole proprietorship is the simplest structure. A business has one owner, neither of whom is considered a legally separate entity. Thus, the owner is not only fully personally responsible for the operation but also for all business obligations incurred because they have unlimited liability. As a result, if a business has debt, the owner 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. They are generally small, with few employees, and usually serve the local market.
Global context
The role and operation of businesses can vary significantly across countries due to several factors:
- Economic systems: Free-market economies rely heavily on the private sector, with businesses having more freedom to operate and invest. In contrast, command economies have greater government control over businesses, dictating production levels and resource allocation. Mixed economies combine elements of both systems.
- Regulations: Government regulations can influence the business environment. Stringent regulations can increase operating costs and limit business flexibility, while more relaxed regulations can foster innovation but may raise concerns about environmental or labor standards.
- Technological advancement: A country’s level of technological advancement can impact the types of businesses that thrive. Developed nations with advanced infrastructure may see a dominance of technology and service-based businesses, while developing economies might focus on resource extraction or manufacturing.
The social responsibility of businesses
Businesses are no longer solely focused on profit generation. They increasingly recognize their broader social responsibility, which encompasses environmental, social, and governance (ESG) factors. Here’s how businesses can contribute to social good:
- Environmental practices: Implementing sustainable practices like reducing waste, minimizing pollution, and using renewable energy can lessen a business’s environmental footprint.
- Ethical labor standards: Businesses committed to ethical labor practices ensure fair wages, safe working conditions, and respect for employee rights.
- Community engagement: Businesses can support their communities through charitable giving, volunteering initiatives, and local sourcing of materials and labor.
