THE ECONOMIC ENVIRONMENT

INTRODUCTION
When companies source, manufacture, and/or market products in foreign countries, they
encounter fascinating and often challenging economic environments. 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 conditions represent available inputs to the
production process, such as human, physical, knowledge, and capital resources, as well as
infrastructure.

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.

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.

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.

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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.

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 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.

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.)

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. 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.)

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

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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.

Debt
Debt is 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 debt is the portion of the government debt
that is denominated in the country’s 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 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.

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 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.

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 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

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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.

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.

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.

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

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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.

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.

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 today’s
realization that economic growth is a function of economic freedom, countries across the
entire spectrum are moving toward increasingly freer markets.

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 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.

D. Transition to a Market Economy

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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.

E. The Means of Transition

The shift from a command or mixed economy to a freer market economy largely depends
on how well a country’s 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 government’s
ability to liberalize economic activity, reform business practices, and establish
appropriate legal and institutional frameworks.

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 market-based 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

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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.

CLOSING CASE: Meet the BRICs [See Fig. 4.5.]

Over the next 50 years, changes in the relative performance, scale, and scope of the
world’s economies will be dramatic. Most notably, data indicate that the combined
economies of Brazil, Russia, India and China—the so-called BRICs—should 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 world’s 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 world’s 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 world’s emerging economies
come into their own.

Questions

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 country’s domestically-owned
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
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 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

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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 country’s standard of living
that incorporates both economic and social variables.

Map the proposed sequence of the evolution of the BRIC’s economies. What indicators
might companies monitor to guide their investments and organize their local market
operations?
The BRIC’s economies are on the verge of the rapid growth of their consumer markets.
(Experience indicates that consumer demand takes off when GNI per capita 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.

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 student’s 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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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 country’s 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 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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