The Economic Environment 4-1

Chapter Objectives Learn differences among the world’s major economic systems Learn criteria for dividing countries into economic categories Discuss economic issues that influence international business Assess the transition process for market economies 4-2

Economic Issues for International Businesses What type of economic system does the country have? What is the size, growth potential, and stability of the market? Is the company’s industry in that country’s public or private sector? If public, does the government allow private competition? If private, is it moving towards public ownership? 4-3

Economic Issues for International Businesses, cont Does the government view foreign capital as competition with or in partnership with public or local private enterprises? How does the government control the nature and extent of private enterprise? How much of a contribution is the private sector expected to make in assisting the government formulate overall economic objectives? 4-4

Key Economic Forces General economic framework Economic size and stability Existence and influence of capital markets Factor endowments Indicators Growth Inflation Surpluses Deficits Economic transitions Availability of economic infrastructure 4-5

Economic System Structure and processes that a country uses to allocate its resources and conduct commercial activities. Connection between political ideology and economic systems Countries where individual goals are given primacy free market economic systems are fostered Countries where collective goals are given primacy there is marked state control of markets

Economic Systems Market economy: what is produced & in what quantity is determined by supply/demand and signaled to producers through a price system Command economy: planned by government Mixed economy: a balance of both of the above

Economic Systems Laissez-Faire Economics Market Economy: resources are primarily owned and controlled by the private sector, not the public sector Consumer sovereignty is the right of consumers to decide what to buy Companies have the ability to decide what to produce and in which market to compete Prices are determined by supply and demand Laissez-Faire Economics 4-14

Government Role in Market Economy Preserving Property Rights Enforcing Antitrust Laws Providing a Stable Fiscal & Monetary Environment Preserving Political Stability

Enforcing Antitrust Laws The goals of antitrust (or antimonopoly) laws is to encourage the development of industries with as many competing businesses as the market will sustain

Preserving Property Rights By preserving and protecting individual property rights, governments encourage individuals and companies to take risks such as investing in technology, inventing new products, and starting new businesses.

Providing Stable Fiscal & Monetary Environment Encourages commerce in a nation because it improves its reputation as a place to do business To reduce high inflation and unemployment, governments can help control inflation through effective fiscal policies (policies regarding taxation and government spending) and monetary policies (policies controlling money supply and interest rates).

Preserving Political Stability A market economy depends on a stable government for its smooth operation and, indeed, for its future existence. Political stability helps businesses engage in activities without worrying about terrorism, kidnappings, and other political threats to their operations.

Command Economy (Centrally Planned Economy): all dimensions of economic activity, including pricing and production decisions, are determined by a central government plan Government owns and controls all resources Prices are determined by government Welfare of the group is paramount Economic and social equality is the goal 4-15

Decline of Central Planning Central planning failed to: Create economic value Provide incentives Achieve rapid growth Satisfy consumer needs

Mixed Economy: Some degree of government ownership and control The goal is to achieve low unemployment, low poverty, steady economic growth and equitable distribution of wealth. No economy is purely market or command Economic systems are along a spectrum of freedoms Most command economies are moving towards a market economy 4-16

CLASSIFICATION OF THE COUNTRIES Countries Classified by Economic System Economic system—based on government’s mix of ownership and control of the economy Ownership—who owns the resources engaged in economic activity Most countries are a mixture of public and private ownership state-owned enterprises—ownership by public sector Most countries with significant state-owned enterprises are moving toward less, not more, public ownership privatization

Factor Conditions Inputs to the production process Human resources Physical resources- weather, existence of waterways, availability of mineral and agricultural products Knowledge - research and development Capital - availability of debt and equity capital Infrastructure - roads, port facilities, energy, and communications Factor conditions are especially critical for the production of goods 4-6

Demand Conditions Market potential Composition of home demand (nature of buyer needs) Size of home demand Growth of home demand Internationalization of demand Demand conditions are especially critical for market-seeking investments Combination of factor and demand conditions contribute to the location—specific advantage that a country has to offer domestic and foreign investors 4-7

Economic Development Economic well-being of one nation’s people relative to another nation’s people Economic output (agricultural, industrial, service) Infrastructure (communications, transportation, power) People (physical health, education level) Productivity is key Ratio of outputs (that created) to inputs (resources used to create output)

Differences in Economic Development Different countries have dramatically different levels of economic development Two common measurements of economic development Gross National Income (GNI) superseded Gross National Product or GNP Purchasing Power Parity (PPP) which accounts for differences in the cost of living

Gross National Income Tool to measure one country against another Size Demand Gross National Income (formerly the Gross National Product) GNI is the market value of final goods and services newly produced by domestically owned factories of production. Countries with high populations and high per capita GNI are most desirable in terms of market potential 4-8

Gross Domestic Product GDP: the value of production that takes place within a nation’s borders, without regard to whether the production is done by domestic or foreign factors of production Example - Both a Ford and Toyota manufactured in the United States counts towards our GDP A Ford produced in Mexico would not 4-9

Importance of Per Capita GNI Low Income 755 or less (in 2000) Developing/Emerging Country High Income 9,266 or more Developed/Industrial Country Upper Middle Income 2,996-9,265 Middle Income 756-9,265 Lower Middle Income 756-2,995 World Bank Category Per Capita GNI ($) Common Name 4-10

One common measure of economic development is a country’s gross national income per head of population. GNI is regarded as a yardstick for the economic activity of a country; it measures the total annual income received by residents of a nation (GNI superseded gross national product, or GNP). Map 2.1

World bank multilateral lending institution that provides investment capital to countries Uses per capita GNP as a basis for lending policies Goal is to provide development assistance Build infrastructure, promote economic growth and stability, improve quality and quantity of demand

Purchasing Power Parity PPP is the number of units of a country’s currency required to buy the same amounts of goods and services in the domestic market that $1 would buy in the United States PPP is a useful measure since it accounts for international differences in price Example: China has a higher PPP than Japan 4-11

Differences in Economic Development: Purchasing Power Parity Country GNI per Capita GNI PPP per Capita GDP Growth Rate 1993-2003(%) Brazil $2,710 $7,480 2.6% China $1,100 $4,990 9.3% Germany $25,250 $27,460 1.2% India $530 $2,880 6.1% Japan $34,510 $28,620 Nigeria $320 $900 3.1% Poland $5,270 $11,450 4.8% Russia $2,610 $8,920 0.1% Switzerland $39,880 $32,030 0.9% United Kingdom $28,350 $27,650 2.8% United States $37,610 $37,500 3.2% As can be seen, there are striking differences in the standard of living. Table 2.1 suggests that the average Indian citizen can afford to consume only 7.7 percent of the goods and services consumed by the average U.S. citizen on a PPP basis.

Big Mac index The Economist's Big Mac index is based on the theory of purchasing-power parity (PPP), the idea that exchange rates should move to equalize the prices of a basket of goods and services across different countries. Our basket is the Big Mac. For example, the cheapest burger in the chart is in China, at $1.26, compared with an average American price of $3. This implies that the yuan is 58% undervalued relative to its Big Mac dollar-PPP. On the same basis, the euro is 25% overvalued, the yen 17% undervalued.

                                     

Economic Factors International Businesses Must Address Economic Growth Inflation Surpluses Deficits Balance of Payments External Debt Internal Debt Privatization 4-17

Key Macroeconomic Issues Affecting Business Strategy Global economy can affect company profits and operating strategies Management must learn to scan the environment Economic growth There are significant differences in growth rates worldwide Affects the degree to which investments in or sales to a country can affect the bottom line of a company drop in economic growth can have detrimental effects on investments new investors reluctant to bring in money existing investors forced to cut back operations and may pull out Difficult to forecast economic growth

Key Macroeconomic Issues (cont.) Inflation—a condition in which aggregate demand grows faster than aggregate supply Inflation rate—the percentage increase in the change in prices from one period to the next Consumer price index (CPI)—index of inflation measures a fixed basket of goods and compares its price from one period to the next

Key Macroeconomic Issues (cont.) External deficit— country’s cash outflows exceed its inflows Balance of payments—record of a country’s international transactions current account—comprised of: trade in goods and services and income from assets abroad merchandise trade balance—country’s trade deficit or surplus exports considered to be positive imports considered to be negative Services—transactions such as travel, passenger fares, other transportation income receipts—payments on assets unilateral transfers—government and private relief grants and income transferred by guest workers

Key Macroeconomic Issues (cont.) Balance of Payments (cont.) Capital account— transactions in real or financial assets between countries transactions include foreign direct investments Companies monitor the balance of payments to watch for factors that could lead to currency instability or government actions to correct an imbalance External debt—results from borrowing money abroad Measured in two ways total amount of the debt debt as a percentage of gdp The greater the external debt, the more unstable the economy Countries with small market conditions and political instability must rely on external debt

Key Macroeconomic Issues (cont.) Internal debt— result of an excess of government expenditures over revenues Internal deficits—excess government expenditures over tax receipts deficits result from: poorly run tax system that fails to collect all the revenues due expensive government programs state-owned enterprises operated in the red Privatization—the sale of state-owned enterprises to the domestic or foreign private sector Helps governments reduce internal debt A complicated political and economic process Key is availability of capital Enable foreign companies to acquire assets and gain access to markets through acquisition

Transition to a Market Economy Most command economies are undergoing transition to market economies Transition a result of the failure of central planning Transition implies: liberalizing economic activity, prices, and market operations developing indirect, market-oriented instruments for macroeconomic stabilization achieving effective enterprise management and economic efficiency imposing hard budget constraints establishing an institutional and legal framework to secure property rights, the rule of law, and transparent market-entry regulations

Obstacles to Transition Capital shortage Lack of managerial expertise Environmental degradation Cultural differences