Understanding that Businesses Operate within an External Environment

How the External Environment Can Affect Costs and Demand

The external environment contains all the elements that impact on the business which are outside its direct control. In this section, we will look at the possible impacts on costs and demand. In later chapters, we will see how these affect all functions of a business and its objectives and strategy.

Business Operations – Internal Environment


Depending on the nature of the product and the size of the business, it will have some or all of these costs:

Wages, rent, fuel/energy, materials, cost of equipment/premises/transport, insurance, marketing costs (advertising), interest payments, foreign transaction costs


Demand drives sales and potential sales for the business’s output. While the business can control the price and decide on the quality, promotion and where’s it’s going to be sold, the customers are influenced by additional factors, factors that impact on their need, desire or ability to buy the product, now or in the future.

External Environment


All businesses face some form of competition for the customers’ cash. The competition will try to persuade these customers to buy their competing products.

If there is an increase in competition, making inroads into a particular market for a business’s products, demand may fall. On the other hand, an increase in competition in the market of a company that supplies materials could result in a fall in costs for the business buying those materials.

Market Conditions

Some markets are more competitive than others. It depends on the size and number of firms and the type of product. In the petrol market, there are a small number of large firms selling a very similar product. They will compete mainly on price. In the car market, there are more firms selling a large range of transport options. While price will be a factor, quality and marketing will be important.

In a highly competitive market, businesses have to work hard to reduce costs to keep prices down. Or, spend time developing their brand or Unique Selling Points (USPs). USPs identify the distinctive quality of their products compared with competitors.


Generally, an increase in disposable incomes for customers with potential to buy a product will lead to an increase in demand. Increases in disposable incomes can arise from a variety of factors such as tax cuts, higher employment levels or an increase in economic activity.

Interest Rates

Interest rates are the cost of borrowing money or the return on saving.

An increase in interest rates tends to reduce spending power. This is because borrowing is more expensive and loans have higher repayments. Also saving is more attractive and potential customers might prefer to save rather than spend. Therefore, customers (who could be households or other businesses) have less spare cash. That will lead to a fall in demand.

Also, costs to the business increase because their interest payments on outstanding loans will increase.

Demographic Factors

There are three principal demographic factors - the size, make up and distribution of the population. They can be further subdivided into segments such as age, gender, race or location. Though the changes are quite slow moving, they can have a long-term effect on demand for particular products or services where, for example, the distribution of specific age groups changes. So, changes in the nature of target markets can alter demand patterns. They might also impact on labour costs, where, for example, the distribution of specific skills changes.

Environmental Issues and Fair Trade

Businesses may change their purchasing and operating policies to be environmentally friendly. In most cases, this will mean an increase in costs as they move to more expensive materials or methods of production.

They may also choose to import goods which are judged to be fairly traded. Fair Trade exists where businesses in more developed countries pay a fair price for goods from less developed countries. Producers in those less developed countries may have weaker market power and, without Fair Trade arrangements, their selling prices can be forced down to economically unsustainable levels.

Impact on a Business

In all cases, you need to consider some of the following factors to judge their impact:

  1. The nature of the product: good or service, hi or low tech, how easy it is to transport.
  2. The customer: household, business or government.
  3. Location of business and where it sells the product.
  4. Now or later: how will any change impact on the business now and in the future.


Interest ratesCost of borrowing or the return on savings
CompetitionBusinesses who sell similar products in your marketplace
Disposable incomesThe amount of income left to spend by households after tax and other essential expenditure
Demographic factorsMovements and changes in the makeup of a population
Fair tradeBusinesses from more developed countries making ethical business deals with businesses from less developed countries