CHAPTER FOUR THE ECONOMIC ENVIRONMENT

OBJECTIVES
To appreciate the importance of the economic analysis of foreign markets To identify the major dimensions of international economic analysis To compare and contrast the economic indicators of countries To profile the characteristics of the types of economic systems To discuss the idea of economic freedom To profile the idea, drivers, and constraints of economic transition

CHAPTER OVERVIEW
When companies source, manufacture, and/or market products in foreign countries, they encounter fascinating and often challenging economic environments. Chapter Four first explores the economic environments of countries in which an MNE might want to operate by discussing the importance of economic analysis and identifying the major dimensions of that process. It then compares and contrasts key macroeconomic indicators, such as economic growth, inflation, and the surpluses and deficits reflected in the balance of payments. Finally, it reviews the characteristics of the major types of economic systems, explores the principles of economic freedom, and concludes by examining the idea, the drivers, and the constraints associated with the transition from a centrally-planned to a market-based economy.

CHAPTER OUTLINE
OPENING CASE: MCDONALDS AND RUSSIAS ECONOMIC TRANSITION [See Map 4.1.] This case exemplifies the extraordinary challenges of operating in a transition economy. In fascinating detail it explains how, despite enormous start-up costs and difficulties, McDonalds has managed to succeed in Russia since finally opening its first Moscow restaurant in 1991. Currently McDonalds employs 17,000 people at 127 restaurants located in 37 Russian cities. In fact, Russia has become its fifth most profitable market in Europe. Along the way, various transition crises in the Russian economy have presented major hurdles. However, by freeing prices from government control, introducing major changes in the Russian ruble, and establishing exchange rate and banking reforms, the Russian government has slowly replaced an inflexible centralized planning system with a budding capitalist economy. Further, increasing oil revenues and inflows of foreign direct investment continue to contribute to Russias economic growth and stability. McComplex, the companys food processing and distribution center located outside of Moscow, now supplies locally produced food to McDonalds restaurants across western 35

Russia and 21 other European countries. Seeing great promise in Russia, McDonalds plans to establish an additional 100 restaurants there by the end of 2007. TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Four. Also, review the corresponding video clip, China Inc., IBM Sells PC Division [World News Tonight, 2:10]. Finally, note Table 4.3 on text p. 137; it deals with the US balance of payments.

I. INTRODUCTION
The importance of this chapter follows from the simple fact that all countries differ in terms of levels of economic development, performance, and potential. A firms managers must understand the economic environments of those countries in which it operates, as well as those of countries in which it does not, in order to predict how trends and events the world over will likely affect firm performance. In addition, a fuller understanding of the process of economic transition and development will help managers reach decisions that benefit not only their firms, but also the countries in which those firms operate, and ultimately, the people of the world.

II.

INTERNATIONAL ECONOMIC ANALYSIS

There is no universal scheme with which to assess the performance and potential of a nations economy. Not only is it difficult to specify a definitive set of economic indicators, but it is often difficult to understand the systematic relationship of one variable to another. However, by reducing the economic environment to its fundamental components, it is possible to begin to determine (i) how they shape the market and (ii) how they subsequently interact with one another. Key economic factors include: the general economic framework of a country, its degree of economic stability, the existence and role of capital markets, the presence of factor endowments, market size, and the existence of economic infrastructure. Factor conditions represent available inputs to the production process, such as human, physical, knowledge, and capital resources, as well as infrastructure. [See Fig. 4.1.]

III. ELEMENTS OF THE ECONOMIC ENVIRONMENT

Economic analysis often begins by examining a countrys gross national income, (GNI) i.e., the monetary value of the total flow of goods and services within its economy. Then related measures such as growth rates, income distribution, inflation, unemployment rates, debt, and the balance of payments are considered. A. Gross National Income Gross national income (GNI) measures the income generated both by total domestic production plus the international production activities of national firms, i.e., it is the market value of all final goods and services newly produced by a countrys domestically-owned firms in a given year. Gross domestic product (GDP) measures the value of production generated by both domestic and foreignowned firms within a nations borders in a given year.

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B. Improving the Power of GNI Managers improve the usefulness of GNI by adjusting it for the population of a country, its growth rate, and the local cost of living. 1. Per Capita Conversion. GNI per capita is the value of all goods and services produced in the economy divided by the population. In 2004 highincome countries accounted for less than 15 percent of the worlds population but nearly 80 percent of the worlds GNP. [See Map 4.2.] 2. Rate of Change. Generally, the GNI growth rate provides a broad indicator of economic potential; if GNI grows at a higher (lower) rate than the population, standards of living are said to be rising (falling). 3. Purchasing Power Parity. While exchange rates define the number of units of one currency that are required to purchase one unit of another currency, they do not determine what a unit of currency can buy in its home country, i.e., exchange rates do not incorporate differences in the cost of living. Purchasing power parity (PPP) represents the number of units of a countrys currency required to buy the same amount of goods and services in the domestic market that one unit of income would buy in another country. PPP is estimated by calculating the value of a universal basket of goods that can be purchased with one unit of a countrys currency. [See Map 4.3.] 4. Degree of Human Development. The Human Development Index combines indicators of real purchasing power, education, and health in order to give a more comprehensive measure that incorporates both economic and social variables. Specifically, the Human Development Index measures longevity, knowledge (primarily the adult literacy rate), and standard of living and is designed to capture long-term progress rather than short-term changes. (Note: the UN also reports a development index that adjusts for both gender-related inequalities and for poverty.) [See Map 4.4.]

IV. FEATURES OF AN ECONOMY

Managers often study many second-order indicators of economic performance and potential, including inflation, unemployment, debt, income distribution, poverty, and the balance of payments. A. Inflation Inflation is the pervasive and sustained rise in the aggregate level of prices as measured by a cost of living index. When aggregate demand grows faster than aggregate supply, i.e., when prices rise faster than incomes, the effects can be dramatic. Among other things, high inflation results in governments setting higher interest rates, installing wage and price controls, and imposing protectionist trade policies and currency controls. (The Consumer Price Index (CPI) measures the average change in consumer prices over time in a fixed market basket of goods and services.) B. Unemployment The unemployment rate represents the number of unemployed workers divided by the total civilian labor force in a given country. However, given the wide differences in social policies and institutional frameworks, the meaning of the unemployment rate varies from one country to another. Often, the true degree of

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C.

D.

E.

F.

joblessness and the productivity of those who work are distorted. The misery index represents the sum of a countrys inflation and unemployment rates. Debt Debt is the sum total of a governments financial obligations; its measures the states borrowing from its population, from foreign organizations, from foreign governments, and from international institutions. Internal debt is the portion of the government debt that is denominated in the countrys own currency and is held by domestic residents. External debt is the portion of the government debt that is denominated in foreign currencies and is owed to foreign creditors. Internal debt results when a government spends more than it collects in revenues; the subsequent pressure to revise government policies often leads to economic uncertainty. External debt results when a government borrows money from foreign lenders. The Heavily Indebted Poor Countries initiative is designed to alleviate the severe external debt burdens of less developed countries, much of which was amassed during the oil shocks of the l970s and the 1980s. More recently, transition economies have also seen their rates of economic development slowed because of high external debt burdens. Income Distribution Income distribution describes what share of a countrys incomes goes to various segments of the population. It is a problem for countries rich and poor. There is a particularly strong relationship in skewed income distributions and growth in per capita income between those who live in urban settings, where growth is accelerating, and those who live in rural settings, where growth is nearly stagnant. Poverty Poverty is the state of having little or no money, few or no material possessions, and little or no resources with which to enjoy a reasonable standard of living. Globally, the world is about 78 percent poor, 11 percent middle income, and 11 percent rich. More pointedly, the richest 1 percent of the worlds population claims as much income at the bottom 57 percent and the gap is growing. In poverty-stricken countries, economic infrastructure and progress are minimal. The Balance of Payments The balance of payments (BOP), officially known as the Statement of International Transactions, records a countrys international transactions among companies, governments, and/or individuals. It reports the total of all money flowing into a country less all money flowing out of that country to any other country during a given period. The two primary accounts are: (a) the current account, which tracks all trade activity in merchandise and services, and (b) the capital account, which records transactions in real and/or financial assets between residents of a given country and the rest of the world. Also included in the current account are income and compensation receipts and payments as well as unilateral transfers, which reflect both government and private relief grants and income transferred abroad. Included in the capital account are changes in the official reserve assets of a nation, such as gold, special drawing rights, and foreign currencies. Whereas a trade surplus indicates that the value of exports exceeds the value of imports, a trade deficit indicates that the value of imports

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exceeds the value of exports. The statistical discrepancy reflects the difference between the sums of the credits and debits. [See Table 4.3.] POINTCOUNTERPOINT: Trade DeficitsAdvantage or Crisis POINT: Many people believe that a trade deficit is a sign of a strong economy. They argue that as an economy grows, increases in disposable income lead to increased demand for imported products. (Some even believe that a trade deficit is an unimportant bookkeeping record.) The Bush administration claims that the current U.S. trade deficit is a sign that the U.S. economy is growing faster than the economies of its trading partners in the triad nations. Accordingly, responsibility for altering this imbalance lies not with the United States, but rather with its trading partners, who must improve their rates of economic growth and thus generate the resources with which to buy more. COUNTERPOINT: Others believe that a trade deficit is the sign of a crisis waiting to happen. They cite the loss of jobs to overseas competitors, lower wages for many U.S. workers, and increased economic uncertainty. As its now massive long-term deficit forces the United States. to increasingly rely upon foreign credit to finance its investment and consumption patterns, critics fear that the deficit is becoming increasingly unsustainable. Further, theory suggests that a trade deficit is a positive economic indicator only when it is due to firms importing technology and other capital goods that can be used to improve their productivity and international competitiveness.

V. INTEGRATING ECONOMIC ANALYSIS

Whereas high-income countries offer high levels of demand for a wide spectrum of consumer and industrial products, many developing countries exhibit tremendous potential because of the sheer size of their populations. A nations growth potential can be gauged by analyzing both its current economic system, as well as the transition process by which it may be moving from one type of system to another. A. Types of Economic Systems An economic system is the set of structures and processes that guides the allocation of scarce resources and shapes the conduct of business activities in a nation. The spectrum of systems is anchored on one end by centrally planned economies and on the other by free-market economies. [See Fig. 4.3.] 1. Market Economy. A market economy describes the system where individuals, rather than government, make the majority of economic decisions. Free-market (capitalistic) economies are built upon the private ownership and control of the factors of production. Key factors include consumer sovereignty, the freedom of market entry and exit, and the determination of prices according to the laws of supply and demand. Credited to Adam Smith, the laissez-faire principle, i.e., nonintervention by government in a countrys economic activity, states that producers are driven by the profit motive, while consumers determine the relationship between

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B.

C.

D.

E.

price and quantity demanded. Thus, scarce resources are allocated efficiently and effectively. 2. Command Economy. Also known as centrally-planned economies, command economies are built upon the government ownership and control of the factors of production. Central planning authorities determine what products will be produced in what quantities and the prices at which they will be sold. Most often, the totalitarian aims of communism gave the highest priority to industrial investments and military spending at enormous expense to the consumer sector. Most such economies are currently in the process of transitioning to more market-based systems. 3. Mixed Economy. Mixed economies fall between the extremes of market and command economies. While economic decisions are largely market-driven and ownership is largely private, government nonetheless intervenes in many economic decisions. The extent and nature of such intervention may take the form of government ownership of certain factors of production, the granting of subsidies, the taxation of certain economic activities, and/or the redistribution of income and wealth. Freedom, Markets, and Transition The recent emergence of freer markets has been largely powered by the failure of central planning authorities to deliver economic progress and prosperity. Given todays realization that economic growth is a function of economic freedom, countries across the entire spectrum are moving toward increasingly freer markets. [See Map 4.5.] Economic Freedom: Idea, Performance, and Trends Economic freedom is characterized by the absence of government coercion or constraint on the production distribution, and/or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. Thus, people are free to work, produce, consume, and invest in the ways they choose. The Economic Freedom Index approximates the extent to which a government intervenes in the areas of free choice, free enterprise, and marketdriven prices for reasons that go beyond basic national needs. Presently, countries are classified as free, mostly free, mostly unfree, and repressed. Determining factors include: trade policy, the fiscal burden of the government, the extent and nature of government intervention in the economy, monetary policy, capital flows and investment, banking and financial activities, wage and price levels, property rights, other government regulation, and informal market activities. Over time, more and more countries have moved toward greater economic freedom. Countries ranking highest on this index tend to enjoy both the highest standards of living as well as the greatest degree of political freedom. [See Maps 4.5, 4.6.] Transition to a Market Economy As market economies outperformed their mixed and command counterparts, it became apparent that government control and ownership create operational inefficiencies and strategic ineffectiveness. These limitations, in turn, decrease the risk-affinitive behavior of entrepreneurs and firms to pursue the sorts of innovations that have become the basis of economic growth and prosperity. The Means of Transition

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The shift from a command or mixed economy to a freer market economy largely depends on how well a countrys government can dismantle certain features such as central planning systems, and create others, such as consumer sovereignty. Most notably, the success of the transition process appears to be intricately linked to the governments ability to liberalize economic activity, reform business practices, and establish appropriate legal and institutional frameworks. [See Fig. 4.4.] 1. Privatization. Privatization, i.e., the sale and/or legal transfer of government-owned resources to private individuals and/or entities, reduces government debt, on the one hand, and increases market efficiency on the other. A key factor is that private enterprises must compete in open markets for materials, labor, and capital; thus, they succeed or fail on their own merits. 2. Deregulation. Deregulation, i.e., the relaxation or removal of restrictions on the free operation of markets and business practices, allows businesses to be more productive and thus make investments in the innovations and activities that can lead to economic growth. 3. Property Rights. The protection of real (tangible) and intellectual (intangible) property rights permits individuals and for-profit and nonprofit business entities, rather than the state, to claim both the present and future rewards of their ideas, efforts, and risk. 4. Fiscal and Monetary Reform. The adoption of free market principles requires a government to rely upon market-oriented instruments for macroeconomic stabilization, set strict budgetary limits, and use marketbased policies to manage the money supply. Although such measures create economic hardships in the short run, in the long run they lead to economic stability that can, in turn, help attract the investment needed to finance economic growth. 5. Antitrust Laws. Because the anticompetitive practices of monopolies contradict the basic premise of a free market, antitrust laws that are designed to maintain and promote market competition must be enacted. LOOKING TO THE FUTURE: The Future of Transition Countries in transition must determine how to maintain political and macroeconomic stability, increase economic growth, improve legal and institutional policies, and resolve a host of social issues, such as health care, security, poverty, and child welfare. However, critics claim that when fully measured, the costs of transition to a market-based economy greatly exceed the benefits provided by a strong government in a mixed economy. They believe that market-based economies impose high social costs and create inequitable income distribution, i.e., that they foster the development of powerful self-interests that threaten social liberties and political rights. As social turmoil has made governments vulnerable to antiprivatization protests and forced foreign firms to retreat, it has become obvious that the road to greater economic and political freedom is uncertain.

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CLOSING CASE: Meet the BRICs [See Fig. 4.5.] Over the next 50 years, changes in the relative performance, scale, and scope of the worlds economies will be dramatic. Most notably, data indicate that the combined economies of Brazil, Russia, India and Chinathe so-called BRICsshould surpass those of the G7 nations by 2050 [see Fig. 4.5]. In fact, of the original G7 nations, only Japan and the United States will still rank among the worlds largest economies at that time. Thus, managers need to rethink their traditional views of the economic environment as they encounter fundamental shifts in investment and spending, increasing competition for inputs in the worlds commodity markets, and the rapid growth of consumer markets in many transition economies. Other significant impacts loom as the leaders of the BRIC nations seek to collectively develop their economies and political presence through the creation of a multilateral alliance amongst themselves. No matter what the outcome, the fallout will be momentous as the worlds emerging economies come into their own.

Questions
1. Debate the relative merits of GNI per capita versus the idea of purchasing power and human development as indicators of economic potential in Brazil, Russia, China, and India. Gross national income per capita (GNI per capita) represents the market value of all final goods and services newly produced in an economy by a countrys domesticallyowned firms in a given year divided by its population. Thus, GNI per capita serves as a very useful indicator of current individual wealth and consumption patterns; those countries with high populations as well as high per capita GNI are most desirable in terms of total market potential. Purchasing power parity (PPP) represents the number of units of a countrys currency required to buy the same amount of goods and services in the domestic market that one unit of income would buy in another country. PPP is estimated by calculating the value of a universal basket of goods that can be purchased with one unit of a countrys currency and thus serves as a useful indicator of international differences in prices that are not reflected by nominal exchange rates. The Human Development Index measures life expectancy, education (primarily the adult literacy rate), and income per person and is designed to capture long-term progress rather than short-term changes. Thus, by combining indicators of real purchasing power, education, and health, the index provides a comprehensive measure of a countrys standard of living that incorporates both economic and social variables. Map the proposed sequence of the evolution of the BRICs economies. What indicators might companies monitor to guide their investments and organize their local market operations? The BRICs economies are on the verge of the rapid growth of their consumer markets. (Experience indicates that consumer demand takes off when GNI per capita

2.

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reaches levels between $3,000 and $10,000 per year.) In Russia there is already significant evidence of the growth of consumerism during the past decade. There are also early signs of similar trends in China and India, where the growth of their middle classes is very rapid. It is expected that within a decade or so, each of the BRICs will show higher returns, increased demand for capital, and stronger national currencies. Thus, foreign firms will want to monitor major economic indicators such as GNI, PPP, and the Human Development Index, as well as developments in the cultural, political, and legal environments of those nations. 3. What are the implications of the emergence of the BRICs to careers and companies in your country? Responses will vary according to the level of economic development and the economic basis of a students home country. Those students from industrialized nations may feel challenged and express the fear of a decline in their standards of living due to increased pressures in the labor market and the declining cost competitiveness of their countries firms. On the other hand, students from developing countries may be hopeful that their countries will be able to successfully generate and/or compete for the investment capital and those business activities that lead to significant economic growth and the increasing global competitiveness of their countries firms. How-ever, there is ample room for exceptions to these feelings, given the present and future comparative advantages of particular nations.

WEB CONNECTION Teaching Tip: Visit www.prenhall.com/daniels for additional information and links relating to the topics presented in Chapter Four. Be sure to refer your students to the online study guide, as well as the Internet exercises for Chapter Four.

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_________________________ CHAPTER TERMINOLOGY: factor conditions, p.124 gross national income (GNI), p.125 gross domestic product (GDP), p.125 GNI per capita, p.126 purchasing power parity (PPP), p.128 Human Development Index, p.129 inflation, p.131 Consumer Price Index (CPI), p.132 unemployment rate, p.133 misery index, p.134 debt, p.134 internal debt, p.134 external debt, p.134 Heavily Indebted Poor Countries Initiative, p.134 _________________________ income distribution, p.135 poverty, 136 balance of payments (BOP), p.137 current account, p. 137 capital account, p.137 trade surplus, p.137 trade deficit, p.137 economic system, p.140 market economy, p.141 laissez-faire principle, p.141 command economies, p.141 mixed economies, p.142 Economic Freedom Index, p.143 privatization, p.148 deregulation, p.148 antitrust laws, p.149 BRICs, p.152

ADDITIONAL EXERCISES: Economic Factors Exercise 4.1. Select a triad economy such as Japan, the United Kingdom, France, or Germany, and select one of the BRICs (Brazil, Russia, India, China). Then ask students to compare the key elements of those two economic systems. Be sure they discuss the interaction between politics and economics in the two countries. Exercise 4.2. In a day of global uncertainty, many wonder if it is necessary or even desirable to have national economies linked so closely together. Ask the students to consider what, if anything, a country can do to protect itself from the impact of negative global economic events. Then ask them to consider whether the impact of global recession on transition economies is necessarily the same as the impact on the triad countries. If not, in what ways are they different and why? Exercise 4.3. Many people believe that as a countrys political system changes from a more repressive to a more representative form of government, its economic system will necessarily become freer. Ask students to consider the basic logic of that idea, as well as the belief that the complete privatization of all state-owned and controlled assets is necessary for an economic transition to be successful. Exercise 4.4. Managers often study many second-order indicators of economic performance and potential, including inflation, unemployment, debt, income

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distribution, poverty, and the balance of payments. Ask students to consider which of these indicators may be more relevant to the assessment of an industrialized economy as compared to the assessment of an emerging economy.

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