CHAPTER FOUR Economic Indicator by mikeholy

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									                      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 Moscow
restaurant in 1991. Currently McDonald’s 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 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


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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 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 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.

II. 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. [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.



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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 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 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. [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


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     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
     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.
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
     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.
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 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



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         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.
    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 country’s economic activity, states that producers are


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        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 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.
   [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




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       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. [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 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
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



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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
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 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 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.



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2.   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.

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 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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_________________________

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



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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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