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:McDonald’s and russia’s 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, McDonald’s has managed to succeed in Russia since finally opening its first Moscowrestaurant in 1991. Currently McDonald’s employs 17,000 people at 127 restaurants located in 37 Russian cities. In fact, Russiahas become its fifth most profitable market in Europe. Along the way, various transition crises in the Russian economyhavepresented major hurdles. However, by freeing prices from government control, introducing major changes in the Russian ruble, and establishing exchange rate and banking reforms, the Russiangovernment 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 Russia’s economic growth and stability. “McComplex,” the company’s food processing and distribution center located outside of Moscow, now supplies locally produced food to McDonald’s restaurants across western Russia and 21 other European countries. Seeing great promise in Russia, McDonald’s 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 Table4.3 on text p. 137; it deals with the USbalance 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 firm’s 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.
- INTERNATIONAL ECONOMIC ANALYSIS
There is no universal scheme with which to assess the performance and potential of a nation’s 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 conditionsrepresent 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 country’s 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 country’s domestically-owned firms in a given year. Gross domestic product (GDP) measures the value of production generated by both domestic and foreign-owned firms within a nation’s borders in a given year.
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 high-income countries accounted for less than 15 percent of the world’s population but nearly 80 percent of the world’s GNP. [See Map 4.2.]
2.Rate of Change. Generally, the GNI growth rateprovides 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 country’s 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 country’s 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 Indexmeasures 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.
- 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. Amongother 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 raterepresents 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 joblessness and the productivity of those who work are distorted. The misery index represents the sum of a country’s inflation and unemployment rates.
C.Debt
Debtis the sum total of a government’s financial obligations; its measures the state’s borrowing from its population, from foreign organizations, from foreign governments, and from international institutions. Internal debtis the portion of the government debt that is denominated in the country’s own currency and is held by domestic residents. External debtis 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 Countriesinitiative 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.
D.Income Distribution
Income distribution describes what share of a country’s 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.
E.Poverty
Povertyis 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 world’s 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.
F.The Balance of Payments
The balance of payments (BOP), officially known as the Statement of Inter-national Transactions, records a country’s 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 areincome 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 accountare 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 exceeds the value of exports. The statistical discrepancy reflects the difference between the sums of the credits and debits. [See Table 4.3.]
POINT—COUNTERPOINT: Trade Deficits—Advantage 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 nation’s 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.
- 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 country’s economic activity, states that producers are driven by the profit motive,while consumers determine the relationship between 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.
B.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 today’s 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.]
C.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 Indexapproximates the extent to which a government intervenes in the areas of free choice, free enterprise, and market-driven 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.]
D.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.