Chapter 4

The Economic Environment





!                   Learn the criteria for dividing countries into different economic categories.

!                   Learn the differences among the worlds major economic systems.

!                   Discuss key economic issues that influence international business.

!                   Assess the transition process certain countries are undertaking in changing to market economies—and how this transition affects international firms and managers.



Chapter Overview


When companies source, produce and/or market products in foreign countries, they often encounter challenging economic environments. Chapter 4 first considers the economic environments of countries in which an MNE might want to operate by describing countries by income level and type of economic system. Then it examines key macroeconomic indicators, such as economic growth, inflation and the surpluses and deficits reflected in the balance of payments. Finally, the process and progress of the transition to a market-based economy by many former centrally planned and other countries is discussed.



Chapter Outline


OPENING CASE: McDonalds Corporation in Emerging Markets

This case exemplifies the challenges of global expansion during times of economic uncertainty as well as the risks of entering emerging markets. Despite enormous start-up challenges, McDonalds has done well in Russia and China. On the other hand, it was forced to closed 163 unproductive stores in Turkey, Malaysia and the Philippines in 2001 at a cost of $91 million. In addition, the worldwide economic downturn continued to pressure McDonalds overall corporate profitability. To counter this trend, McDonalds refocused its expansion strategy by dedicating 60 percent of its efforts to the United States, Canada and Europe, where economies are relatively stable and returns are strong. Expansion will also continue in China, where growth potential is enormous. The case concludes by pondering the extent of McDonalds future worldwide operations.


Teaching Tip: Carefully review the PowerPoint slides for Chapter 4. For an additional visual summary of key chapter points, also review text Figure 4.1—Physical and Societal Influences on International Business. Finally, note the U.S. Balance of Payments Appendix on text pages 136-137.



Understanding the economic environments of foreign countries and markets is vital to helping managers predict the ways in which trends and events will likely affect their firms future performance there. Questions to be addressed include both the size and the nature of the market. Answers are often complex.



Companies do business abroad for a variety of reasons. Factor conditions (production factors) include essential inputs to the production process such as human resources, physical resources, knowledge resources, capital resources and infrastructure; they are crucial for investments made for production purposes. Demand conditions (market potential) include the composition of local demand (quality of demand), the size and growth of local demand (quantity of demand) and the internationalization of basic demand; they are crucial for market-seeking investments. Location-specific advantages incorporate the combination of factor and demand conditions, plus other relevant qualities.

A.                Countries Classified by Income

Size of national demand is indicated by Gross National Income (GNI), previously referred to as Gross National Product (GNP). The broadest measure of economic activity, GNI represents the market value of final goods and services newly produced by domestically owned factors of production. Gross Domestic Product (GDP) represents that value of production that takes place within a nations borders, without regard to whether the production is carried out by domestic or foreign factors of production. Per capita GNI is computed by dividing GNI by a countrys population. Because nominal exchange rates (unadjusted market rates) do not always reflect international differences in prices, purchasing power parity (PPP) is used as an indicator of the number of units of a countrys currency required to buy the same amounts of goods and services in its domestic market. The World Bank refers to low- and middle-income nations as developing countries, which are also known as emerging countries (a term also used to describe the capital markets in such countries). While developing countries in Asia and Latin America are generally moving forward, those in Africa are not making much progress. High-income nations are referred to as developed or industrialized countries.

B.                 Countries Classified by Region

MNEs tend of organize their operations along geographic lines. Major geographic regions of the world include: East Asia and the Pacific, Europe and Central Asia, Latin America and the Caribbean, the Middle East and North Africa, and Sub-Saharan Africa.

C.                Countries Classified by Economic System

Every government struggles with the right mix of ownership and control of its economy. Ownership refers to the ownership of resources engaged in economic activity—the public sector (government), the private sector, or both. Control refers to the allocation and control of resources engaged in economic activity. Just as there is a relatively high correlation between economic freedom and political freedom, there is also a relatively high correlation between economic freedom and economic growth.

1.                  Market Economy. A market economy is one in which resources are primarily owned and controlled by the private sector. Key factors include consumer sovereignty (the right to choose what to buy), the freedom of market entry and exit and the determination of prices according to the laws of supply and demand.

2.                  Command Economy. A command economy (often referred to as a centrally planned economy) is one in which all dimensions of economy activity, including pricing and production decisions, are determined by central government planning authorities.

3.                  Mixed Economy. A mixed economy describes an economic system characterized by a mixture of market and command economies, including a combination of public and private ownership. Market socialism is characterized by the state ownership of significant resources, but the allocation of those resources comes from the market price mechanism, and prices are determined by the laws of supply and demand.



Macroeconomic factors can have a major impact on both the profitability and the operating strategy of MNEs. Three key issues are economic growth, inflation and surpluses and deficits.

A.                Economic Growth

While history is often used to forecast future economic trends, it is certainly not perfect. Further, there exists significant differences in growth rates throughout the world. The direct impact of events such as the Asian financial crisis, terrorist activities such as 9/11 and corporate scandals such as Enron and WorldCom spreads quickly to international markets, but the effects are uneven. Thus, future growth is bound to be variable by region, even in the high-income countries.

B.                 Inflation

            The inflation rate represents the percentage increase in the change in prices from one period to the next, usually a year. A common indicator of inflation is the consumer price index (CPI), which measures the cost of a fixed basket of goods and services and compares the price from one period to the next. Inflation occurs because aggregate demand is growing faster than aggregate supply. Ultimately it affects interest rates, exchange rates, the cost of living and the general confidence in a countrys political and economic systems.

C.                Surpluses and Deficits

Internal and external deficits are important indicators of a countrys economic strength and stability. Surpluses are rarely a problem. An internal deficit indicates that a governments expenditures exceed its revenues; an external deficit indicates that a countrys cash outflows (payments) exceed its inflows (receipts).

1.                  The Balance of Payments. The balance of payments account records commercial transactions and other financial flows between the residents of a given country and the rest of the world.

a.                   The current account includes trade in goods and services and income from assets abroad and payments on foreign-owned assets in the country. The merchandise trade balance reflects a countrys deficit or surplus with respect to trade in goods. The service account reflects transactions such as transportation and other international services and royalties and fees on licensing agreements. (Unilateral transfers include government and private relief grants and income transferred abroad.)

b.                  The capital account records transactions in real or financial assets between residents of a given country and the rest of the world. An inflow of capital is a positive transaction; an outflow is a negative transaction. Also included in the capital account are changes in the official reserve assets of a country, such as gold, special drawing rights and foreign currencies.

2.                  External Debt. External debt consists of money borrowed from foreign institutions. It can be measured in two ways: the total amount of the debt and debt as a percentage of GDP. The larger these two numbers, the more unstable an economy will become and the more likely economic growth will slow.

3.                  Internal Debt and Privatization. Government budget deficits result from an excess of government expenditures relative to revenues and contribute to a countrys overall debt position. As countries move to reduce their deficits, the privatization of state-owned enterprises may occur, thus relieving the government of the need to subsidize inefficient operations.



            Many countries are undergoing the transition from command economies to market economies because of the failure of the central planning process to generate satisfactory economic growth. In general, transition implies the liberalization of economic activity, the reallocation of resources to their most efficient use, macroeconomic stabilization, the privatization of state-owned assets, budgetary constraints and the development of an institution and legal framework to protect property and individual rights.

A.                The Process of Transition

The transition process can provide significant opportunities for MNEs as markets are opened and foreign direct investment opportunities expand. For Russia, the transition to a market economy has been especially difficult because the government has been trying to simultaneously change the countrys economic and political systems. The Chinese transition has been much more controlled—a change in that countrys political system is not part of the process.

B.                 The Future of Transition

In the short-term, major challenges confronting the transition economies will include continued macro stability, economic growth, improvement in institutional and structural areas and the solution of social issues such as poverty, child welfare and HIV/AIDS. In the long-term, however, the challenges to the transition economies will virtually be the same as those of other developing economies.



How Much Economic Assistance Is Too Much?

A major issue of economic social responsibility concerns the obligation of high-income countries to assist developing nations. There are several areas of concern. First, in order to participate in the trade process, emerging economies must have access to high-income markets, i.e., discriminatory barriers should be abolished. Second, foreign aid can be used as a tool for economic development, but not all people share that view. Third, the forgiveness of loans to developing countries by high-income governments could be part of the solution to the debt crisis. Such actions are appropriate for governments, but it is unlikely that the private sector would participate in these measures.



A Global Economy in the New Millennium

As the twenty-first century dawned, the global economy seemed to be strengthening, but then a serious economic downturn in 2001-2002 threatened continued growth. Because the U.S. accounts for nearly a third of the total global economic activity, the rest of the world followed it into recession. Most people are looking for recovery to occur in the U.S. and Europe in the not-too-distant future, but Asias progress is expected to be slower because of Japans recession and banking crisis. Latin American and African countries look to the IMF for assistance in lowering inflation, reducing government spending, and reducing their dependence upon foreign capital.




Teaching Tip: Visit for additional information and links relating to the topics presented in Chapter 4. Refer your students to the on-line study guide, as well as the Internet exercises for Chapter 4.



CLOSING CASE: The Daewoo Group and the Asian Financial Crisis


1.         How would you describe Koreas economic system? What are the key elements in that system? How would you describe the interaction between politics and economics in Korea?

Although falling into the category of mostly free, there is significant government intervention in the South Korean economy. Modeled after the Japanese system, South Korea has targeted export growth as the key to its economic development. Historically, strong ties existed between the government and the Korean chaebol (diversified business conglomerates that include a trading company and are held together by cross ownership and family ties). When negotiating with the IMF for loans to help deal with the effects of the Asian financial crisis, the Korean government agreed to a number of financial and other reforms, including the restructuring of the chaebol. The previously close relationship between the government and the chaebol was cause for frequent suspicion of corruption.


2.                  Does Korea look like a good place to invest? Why or why not?

The position one takes with respect to this question depends upon the particular sector involved and the reason for the investment. Many view a time of economic crisis and currency weakness as a good time to invest if appropriate opportunities can be found. On the other hand, others will feel that economic risk in Korea is still relatively high and that better opportunities can perhaps be found elsewhere.


3.                  What are the key mistakes Kim Woo-Chung made in formulating and implementing Daewoos strategy, and how did the economic crisis in Korea and the rest of Asia affect that strategy?

Kim Woo-Chungs major mistake in implementing Daewoos strategy was the assumption of debt, which in 1998 equaled 13 percent of South Koreas entire GDP. Not only was the firms debt-to-equity ratio higher than the average of other large chaebols, but a good share of the debt was owed to overseas creditors. In spite of the warning signs that accompanied the Asian financial crisis, President Kim continued to expand the firms operation at a time when Samsung and LG were cutting back.


4.                  What risks does GM face in taking over Daewoo Motor?

GM faces major risks in the marketplace. By selling Daewoo cars in Europe and the U.S., GM risks the cannibalization of its own brands. In addition, the effect of the Asian financial crisis and the downfall of Daewoo upon Korean demand for Daewoo products is as yet unclear.



Additional Exercises: Economic Realities


          Exercise 4.1. Ask students to explain why per capita income is often an inadequate indicator of national wealth. Be sure they cite examples of particular countries to support their points. Then ask them to explain why a particular government would select gross domestic product (GDP) as a measure of domestic economic activity, rather than gross national income (formerly gross national product).


Exercise 4.2. Ask students to consider the following statement: As a countrys political system changes from a more repressive to a more representative form of government, its economic system will necessarily change as well. Then ask them to consider whether the complete privatization of all state-owned and controlled assets is necessary for an economic transition to be successful.


Exercise 4.3. In a day of global recession, many wonder if it is necessary or desirable to have national economies linked to 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 MNEs is necessarily the same as the impact on countries. If not, why not?