Economics and Emerging Markets 4 Economics and Emerging Markets Welcome to Chapter 4, Economics and Emerging Markets. Copyright © 2014 Pearson Education, Inc.

Chapter Objectives Describe what is meant by a centrally planned economy and explain why its use is declining Identify the main characteristics of a mixed economy and explain the emphasis on privatization Explain how a market economy functions and identify its distinguishing features Describe the different ways to measure a nation’s level of development Discuss the process of economic transition and identify the obstacles for business In this chapter, you will learn about different economic systems and their effect on international business. You will also: Recognize the importance of economic development. Understand how nations are classified as developing, newly industrialized, emerging, or developed. And learn about the process of economic transition and how countries implement market-based economic reforms. Copyright © 2014 Pearson Education, Inc.

Infosys Infosys is a global provider of IT services India has organic-led path to development Brainpower is driving development India’s organic-led path to economic growth gave rise to Infosys, a global provider of information technology services. Infosys has benefited from the fact that India has long had the basic foundations of a market economy. These features include private enterprise, democratic government, a transparent legal system, and Western accounting practices. India’s bottom-up approach to development and the brainpower of its people looks set to spawn many more homegrown firms in knowledge-based industries. Copyright © 2014 Pearson Education, Inc. 4 - 3 3

Economic Systems Centrally Planned Mixed Market Government ownership of economic resources and state planning Mostly private (individual or business) ownership of economic resources The term economic system refers to the structure and processes a country uses to allocate its resources and conduct its commercial activities. Just as every culture reflects a mix of individual and group orientations, every economy displays a blend of individual and group values. Judging by the levels of government and private ownership in an economy, we can categorize it as a (1) centrally planned economy, (2) mixed economy, or (3) market economy. Government and private ownership of economic resoures split rather evenly Copyright © 2014 Pearson Education, Inc.

Range of Economic Systems We can arrange national economies on a horizontal scale based on their tendencies toward individualist or collectivist economic values. We see the hard-line communist nations of Cuba and North Korea on the far left of the diagram, and see the United States on the far right. Copyright © 2014 Pearson Education, Inc.

Centrally Planned Economy Government owns most land, factories, and other economic resources and plans nearly all economic activity Asia Central Europe Eastern Europe Latin America Russia (1917) China (1949) Cuba (1959) Welfare of the group is paramount Economic and social equality is the goal “Communist” system is needed In a centrally planned economy, government owns most economic resources and plans nearly all economic activity. The ultimate goal is to achieve political, social, and economic objectives focused on group welfare rather than individual well-being. By the 1970s, central planning prevailed across Eastern Europe, Asia, Africa, and Latin America. Copyright © 2014 Pearson Education, Inc.

Decline of Central Planning Central planning failed to: Create economic value Provide incentives Achieve rapid growth Satisfy consumer needs Nations that relied on central control of their economies failed to achieve their objectives. Specifically, they: Failed to create economic value by failing to produce quality products efficiently. Failed to provide incentives to maximize the benefits from resources, which slowed economic growth and lowered living standards. Failed to achieve rapid economic growth and witnessed themselves falling quickly behind other nations. And failed to satisfy consumer needs for even basic necessities. Copyright © 2014 Pearson Education, Inc.

North Korea As the world’s most closed economy, North Korea has earned its nickname, “The Hermit Kingdom.” Its policy of self-reliance causes extreme hardship for North Korea’s citizens. The combination of recurring floods and droughts, a shortage of fertilizers, and a lack of farm machinery restrain the nation from reaching its peak food-production potential. As a result, North Korea often relies on aid from abroad to feed its people. Copyright © 2014 Pearson Education, Inc. 4 - 8 8

Chinese characteristics: Focus on China Socialism with Chinese characteristics: Communist after civil war ended in 1949 Agricultural reforms began in 1979 Township and Village Enterprises legal in 1984 Aggressive reforms since Challenges ahead: Political problems and social unrest Unemployment and migrant labor Eventual(?) reunification with Taiwan China describes its economic system as “socialism with Chinese characteristics.” China turned communist in 1949 but in 1979 allowed families to grow the crops they wanted and to sell their produce at free-market prices. It then legalized township and village enterprises in 1984, which laid the groundwork for a market economy. Several challenges lie ahead for China: First, restriction of a true democracy means that political and social unrest arises sporadically. Second, slow economic progress and high unemployment in rural areas encourages a large migrant worker class. And third, both China and Taiwan are rather wary of reunification with the other. Copyright © 2014 Pearson Education, Inc.

Mixed Economy Noble goals: But stagnant: Government and private parties share ownership of land, factories, and other economic resources rather evenly Noble goals: But stagnant: Low unemployment and poverty Steady economic growth Equitable distribution of wealth State-owned businesses less competitive Prices and taxes higher, living standards mixed In a mixed economy, ownership of economic resources is split rather evenly between private and government entities. Government controls the economic sectors important to national security and stability and provides generous unemployment programs. Mixed economies strive for low unemployment and poverty, steady economic growth, and an equitable distribution of wealth. Many mixed economies are hampered by government ownership that is less efficient than private ownership, and hurt by higher prices and taxes that lower living standards. Copyright © 2014 Pearson Education, Inc.

Benefits of Privatization Privatization aims to: Increase economic efficiency Boost productivity Raise living standards Privatization involves the sale of government-owned economic resources to private companies and individuals. Mixed economies use privatization to increase economic efficiency, boost productivity, and raise standards of living. Copyright © 2014 Pearson Education, Inc.

Discussion Question A __________ economy is one in which government and private parties share ownership of economic resources rather evenly. a. Centrally planned b. Systemic c. Mixed A __________ economy is one in which government and private parties share ownership of economic resources rather evenly. a. Centrally planned b. Systemic c. Mixed Copyright © 2014 Pearson Education, Inc.

Answer to Discussion Question A __________ economy is one in which government and private parties share ownership of economic resources rather evenly. a. Centrally planned b. Systemic c. Mixed The correct answer is c. Mixed Copyright © 2014 Pearson Education, Inc.

Market Economy Supply Demand Private parties (individuals or businesses) own most land, factories, and other economic resources Supply Quantity producers will provide at a specific selling price Demand Quantity buyers will purchase at a specific selling price In a market economy, we find that private businesses and individuals own most economic resources. The price of a good or service is dictated by two forces that comprise the price mechanism: supply and demand. Copyright © 2014 Pearson Education, Inc.

Laissez-Faire Economics Less government interference in business Free choice Alternative purchase options Free enterprise Firms choose products and markets Price flexibility Prices follow supply and demand In a market economy, the entire group is thought to benefit when individuals receive rewards for acting in their self interests. Market economies are grounded on the principle of little government interference. The three key features of a market economy are: Free choice, which gives individuals access to alternative purchase options. Free enterprise, which lets companies decide what to produce and which markets to compete in. And price flexibility, which allows most prices to rise and fall according to the forces of supply and demand. Copyright © 2014 Pearson Education, Inc.

Government’s Role in a Market Economy Enforce antitrust laws Preserve property rights Provide fiscal and monetary stability Preserve political stability In a market economy, government has four primary roles: Enforce antitrust (antimonopoly) laws Preserve property rights Provide a stable fiscal and monetary environment And preserve political stability Let’s examine each of these four roles. Copyright © 2014 Pearson Education, Inc.

Enforce Antitrust Laws Encourages development of industries with as many competing businesses as market will sustain In a market economy, government is to enforce antitrust (antimonopoly) laws. This encourages the development of industries with many competing businesses, and prevents trade-restraining monopolies that can raise prices and exploit consumers. Keeps consumer prices in check Prevents growth-stunting monopolies Copyright © 2014 Pearson Education, Inc.

Preserve Property Rights Encourages risk-taking by people and business as claims to assets and future earnings are protected Governments in market economies also strive to preserve property rights. Strong property rights protection ensures that people and businesses enjoy the fruits of their labor. This encourages individuals and firms to create and to invest in new technologies because their efforts are rewarded by the income that these technologies generate. Strong property rights also encourage entrepreneurs to start new businesses because their claims to assets are secure. Market economy needs strong property rights Firms create new technologies and products Entrepreneurs start new businesses Copyright © 2014 Pearson Education, Inc.

Provide Fiscal & Monetary Stability Encourages commerce in a nation because it improves its reputation as a place to do business Fiscal policies (taxation, government spending) Monetary policies (money supply, interest rates) Reduces overall uncertainty Improves business forecasts Holds inflation and unemployment low The government in a market economy is to provide a stable fiscal and monetary environment. This is achieved through effective management of fiscal and monetary policies. Stability reduces overall risk in an economy, improves business forecasts, and helps control inflation and unemployment rates. Copyright © 2014 Pearson Education, Inc.

Preserve Political Stability Encourages businesses to engage in activities without fear of disrupted future operations Promotes economic growth generally Reduces worries of political risk Improves chances for business survival Finally, government in a market economy is to preserve political stability. This encourages the smooth operation of a market economy. Political stability promotes economic growth, reduces worries over political risk, and improves chances for business survival. Copyright © 2014 Pearson Education, Inc.

Discussion Question What are the three required features and four expected roles of government in any market economy? What are the three required features and four expected roles of government in any market economy? Copyright © 2014 Pearson Education, Inc.

Answer to Discussion Question Three key features of a market economy: free choice, free enterprise, and price flexibility. Four roles of government in a market economy: enforce antitrust laws, preserve property rights, provide fiscal and monetary stability, and preserve political stability. Answer: The three key features of a market economy are free choice, free enterprise, and price flexibility. The four roles of government in a market economy are to: enforce antitrust laws, preserve property rights, provide fiscal and monetary stability, and preserve political stability. Copyright © 2014 Pearson Education, Inc.

Economic Freedom & Wealth The connection between political freedom and economic growth is not certain or guaranteed. But as this graph shows, greater economic freedom tends to coincide with higher living standards. Source: Index of Economic Freedom (Washington, D.C.: Heritage Foundation, 2006), (www.heritage.org). Copyright © 2014 Pearson Education, Inc.

Economic Development Economic well-being of one nation’s people relative to another nation’s people Economic output (agricultural, industrial, and service) Infrastructure (communications, transportation, and power) People (physical health and education level) Economic development is a measure for gauging the economic well-being of one nation’s people as compared with that of another nation’s people. It captures several economic and human economic indicators, including: Economic output, both agricultural and industrial. Infrastructure, including power and transportation facilities. And a people’s physical health and level of education. Productivity Ratio of outputs (that are created) to inputs (resources used to create output) Copyright © 2014 Pearson Education, Inc.

National Production GDP is the value of goods and services that a nation produces during a one-year period (GNP adds international activities) * POTENTIAL PROBLEMS * Overlook certain transactions Ignore economic growth rates There are several problems related to using GNP and GDP as indicators of economic development. First, they overlook certain transactions, including volunteer work and unreported cash transactions. Second, GNP and GDP ignore economic growth rates because they do not indicate whether an economy is growing or shrinking. Third, per capita figures are averages that can disguise high- or low-growth regions. Fourth, they may ignore national differences in purchasing power because comparisons at official exchange rates do not reflect local prices. Averages can disguise regions May ignore purchasing power Copyright © 2014 Pearson Education, Inc.

Purchasing Power Parity Relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries To correct for the inability to compare purchasing power across countries, we turn to another measure of economic development called purchasing power parity. Purchasing power parity refers to the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. Copyright © 2014 Pearson Education, Inc.

National Wealth at PPP PPP Estimate of GDP per Capita GDP per Capita Country (U.S. $) (U.S. = 100) United States 39,700 39,700 Switzerland 47,900 34,700 Australia 32,400 32,400 Canada 30,600 31,800 United Kingdom 35,600 30,800 Japan 36,500 29,600 Czech Republic 10,600 18,600 Hungary 10,000 15,900 Mexico 6,600 10,200 Turkey 4,200 7,600 Source: Based on data from Organization for Economic section (www.oecd.org). Cooperation and Development (OECD), “Statistics” We can use purchasing power parity to compare the wealth of nations. If we convert Swiss francs to dollars at official exchange rates, Switzerland’s GDP per capita is $47,900. This is higher than the official GDP per capita of the United States at $39,700. This is shown in the first column of the chart. But when we adjust Switzerland’s GDP per capita for PPP we obtain a revised GDP per capita of just $34,700, which is lower than the U.S. GDP figure of $39,700. This is shown in the second column of the chart. Why the difference? GDP per capita at PPP is lower in Switzerland because of that nation’s higher cost of living. It simply costs more to buy the same basket of goods in Switzerland than it does in the United States. The opposite situation occurs in the case of the Czech Republic. Because the cost of living there is lower than in the United States, the Czech Republic’s GDP per capita rises from $10,600 to $18,600 when PPP is considered. Copyright © 2014 Pearson Education, Inc.

Human Development Index The human development index measures the extent to which a people’s needs are satisfied and addressed equally across a nation's entire population. This index measures the extent to which a nation provides its people with a long and healthy life, an education, and a decent standard of living. There often is a disparity between wealth and the level of human development in a nation. In other words, high national income alone does not guarantee human progress. Copyright © 2014 Pearson Education, Inc.

Classifying Countries Developed Country Emerging Market Newly Industrialized Country Developing Country Highly industrialized, highly efficient, and whose people enjoy a high quality of life Newly industrialized countries plus those with potential to be newly industrialized Recently greater national production and exports from industrial operations Poor infrastructure and extremely low personal income We can classify countries according to indicators such as GNP per capita, the portion of an economy devoted to agriculture, and the amount of exports in the form of industrial goods. Developed countries are highly industrialized, highly efficient, and whose people enjoy a high quality of life. People in these countries receive the finest health care and benefit from the best educational systems in the world. Newly industrialized countries have recently increased the portion of national production and exports that they derive from industrial operations. Emerging markets are newly industrialized countries plus those having the potential to become newly industrialized. Developing countries have poor infrastructures, extremely low personal incomes, lack key resources and skills, and rely on one or a few sectors of production, such as agriculture or mineral mining. Copyright © 2014 Pearson Education, Inc.

Discussion Question ___________ is the relative ability of two countries’ currencies to buy the same basket of goods in those two countries. a. Productivity b. Purchasing Power c. Purchasing Power Parity ___________ is the relative ability of two countries’ currencies to buy the same basket of goods in those two countries. a. Productivity b. Purchasing Power c. Purchasing Power Parity Copyright © 2014 Pearson Education, Inc.

Answer to Discussion Question ___________ is the relative ability of two countries’ currencies to buy the same basket of goods in those two countries. a. Productivity b. Purchasing Power c. Purchasing Power Parity The correct answer is c. Purchasing Power Parity Copyright © 2014 Pearson Education, Inc.

Economic Transition Reforms: Fundamental reorganization of an economy and the creation of new free-market institutions Reforms: Reduce budget deficits and expand credit Allow the “price mechanism” to determine prices and economic activity Legalize private firms and privatize state-owned assets within a property rights framework Remove barriers to trade and investment and eliminate currency controls Economic transition involves changing a nation’s fundamental economic organization and creating new free-market institutions. Countries undertaking transition must normally: Stabilize the economy, reduce budget deficits, and expand credit availability. Allow prices to reflect supply and demand. Legalize private business, sell state-owned companies, and support property rights. And reduce barriers to trade and investment and allow currency convertibility. Copyright © 2014 Pearson Education, Inc.

Obstacles to Transition Lack of managerial expertise Capital shortage Countries in transition can face several obstacles: First, is a lack of managerial expertise. Central planners had little need for management skills in areas such as strategy, production, distribution, or advertising. But the gap between managers from the former communist nations and Western nations is narrowing. Second, is a capital shortage. Transition is expensive and requires funding to develop a telecommunications and infrastructure system, to set up financial institutions, and to educate people in market economics. Third, are cultural changes. Transition causes cultural change and replaces dependence on the government with greater emphasis on individuals. Cuts are often needed in welfare, unemployment benefits, and guaranteed government jobs. Fourth, is environmental degradation. Economic and social policies of former communist governments were often disastrous for the natural environment. Environmental degradation Cultural changes Copyright © 2014 Pearson Education, Inc.

Focus on Russia Operated under a staunchly communist system for about 75 years Underwent a rough transition of simultaneous economic and political reform But the economy is improving and foreign investment is returning Challenges include developing managerial talent and fostering political and social stability Russia’s experience with communism began in 1917 and for 75 years the government controlled all aspects of the economy. Ordinary citizens have suffered during Russia’s transition, although some Russians retained their jobs in newly privatized businesses. Several challenges lie ahead for Russia: First, managers must improve their skills in every facet of management practice. Second, political instability and nationalism need to be better controlled and the nation’s nuclear weapons need to be secured. Third, the imprisonment of some well-known business leaders means that distrust characterizes relations between the government and business. Copyright © 2014 Pearson Education, Inc.

Discussion Question What is economic transition and what are the remaining obstacles in post-communist countries? What is economic transition and what are the remaining obstacles in post-communist countries? Copyright © 2014 Pearson Education, Inc.

Answer to Discussion Question Economic transition: Changing a nation’s fundamental economic organization and creating new free-market institutions. A country must: Stabilize the economy, reduce budget deficits, and expand credit availability; Allow prices to reflect supply and demand; Legalize private business, sell state-owned companies, and support property rights; and Reduce barriers to trade and investment and allow currency convertibility. Remaining obstacles: Lack of managerial expertise, Shortage of capital, Cultural changes, and Environmental degradation. Answer: Economic transition involves changing a nation’s fundamental economic organization and creating new free-market institutions. Essentially, it involves: Stabilizing the economy, reducing budget deficits, and expanding credit availability. Allowing prices to reflect supply and demand. Legalizing private business, selling state-owned companies, and supporting property rights. Reducing barriers to trade and investment and allowing currency convertibility. Remaining obstacles in transition countries include a lack of managerial expertise, a shortage of capital, cultural changes, and environmental degradation. Copyright © 2014 Pearson Education, Inc.

Copyright © 2014 Pearson Education, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2014 Pearson Education, Inc.