1.6 Microeconomic and Macroeconomic Matters

Microeconomics

In the business setting, finance is the intersection of economics and accounting. Financial decision makers rely on economic theory and empirical evidence combined with accounting data to make informed decisions for their organization. Economics is the study of the allocation of scarce resources. Economists attempt to understand the how and why of human and financial capital allocation to governments, businesses, and consumers.

We typically separate economics into two major areas, microeconomics and macroeconomics. Microeconomics is devoted to the study of these decisions of allocation by individual businesses, persons, or organizations. Microeconomics helps us understand incentives and behavior, consumer choices and consumption, and supply and demand.

Our understanding of microeconomics aids in financial forecasting, planning, and budgeting by understanding how individuals are likely to respond to changes in product or service functionality, price, supply, quality, marketing, or other firm-induced stimulus. Empirical research by individuals, businesses, academics, and government provide evidence of what is going on and suggest what may change or stay the same.

Macroeconomics

Whereas microeconomics studies the decisions of individuals, macroeconomics examines the decisions of groups. Macroeconomic areas of study and concern include inflation, income, economic growth, and unemployment. When Bacon Signs developed a financial and operating plan to expand the business, the firm had to consider unemployment and inflation when estimating its price of labor and materials. Bacon Signs also had to consider interest rates when estimating the cost of borrowing money to expand the business.

Macroeconomic modeling is limited because models cannot capture every variable in testing and application. However, financial forecasting must incorporate macroeconomic assumptions and expectations into individual firm and industry forecasts. Economic Foundations expands on our discussion of micro- and macroeconomics.

Importance of Macroeconomic Variables in Financial Markets

To make financial forecasts, managers need good information to understand the relationship among several economic variables. Working from small to large, sales forecasts estimate the likely price and quantity of goods sold. In doing so, the forecaster will consider local, regional, state, national, and international economic conditions. Inflation is an important macroeconomic variable that influences prices. Every quarter, financial information hubs, such as the Wall Street Journal (WSJ), and government agencies and regulatory bodies, such as the Treasury Department and the Federal Reserve, release estimates about expected and current inflation. This information informs policy makers how to adjust the money supply to meet target objectives. Financial forecasters pay close attention to current and expected interest rates, as they have a fundamental impact on the cost of raising money and determining the required rate of return for investment.

The unemployment rate helps inform financial forecasters about the expected cost of labor and the ability of employers to hire people if a firm plans to increase the production of goods or services. The stock market is a forward-looking macroeconomic variable and measures investor expectations about future cash flows and economic growth. Political economic variables such as changes in regulation or tax policy can also affect forecasting models.

Each of the variables we have identified—inflation, interest rates, unemployment, economic growth, the stock market, and government fiscal policy—are macroeconomic factors. They are beyond the scope and influence of individual firms, but combined, they play a critical role in establishing the market in which firms compete. A better understanding of the interaction of these macro variables with each other and with individual micro or firm-specific variables can only strengthen financial forecasting and management decision-making.

Relationship between Microeconomics and Macroeconomics

In the parable, a group of blind people happen upon an elephant for the first time, and they each touch one part—but one part only—of the elephant. Subsequently, when they each describe what they have discovered, the descriptions are vastly different. The group's members become upset, accusing one another of inaccurate descriptions or worse. The parable demonstrates how individuals can make absolute truths from their own limited and subjective information. Financial decision makers run a similar risk, if they choose to recognize only their own findings and ignore other microeconomic or macroeconomic information and the interaction of these factors.

A common view to understanding economics states that macroeconomics is a top-down approach and microeconomics is a bottom-up approach. Financial decision makers need to see both the forest and the individual trees to chart a course and move toward a strategic objective. They need both the macro data, so important for strategic thinking, and the micro data, required for tactical movement. For example, the national rate of unemployment may not have been much help when Bacon Signs was searching for skilled laborers who could form neon signs. However, the unemployment rate helped inform the company about the probability of demand for new businesses and the signs they would need.