This chapter discusses analyzing the economic environments of foreign countries. It outlines key dimensions of international economic analysis including gross national income, economic growth rates, inflation, unemployment, debt, and balance of payments. The chapter also profiles different types of economic systems from command to market economies and discusses the transition from centrally planned to market-based systems. Factors that influence economic transition include privatization, liberalization, and establishing appropriate legal and market frameworks.

1. 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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2. 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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3. 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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4. 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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5. 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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6. 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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7. 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
41

8. 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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9. 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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10. _________________________
CHAPTER TERMINOLOGY:
factor conditions, p.124
gross national income (GNI), p.125
gross domestic product (GDP),
p.125
GNI per capita, p.126
purchasing power parity (PPP),
p.128
Human Development Index, p.129
inflation, p.131
Consumer Price Index (CPI), p.132
unemployment rate, p.133
misery index, p.134
debt, p.134
internal debt, p.134
external debt, p.134
Heavily Indebted Poor Countries
Initiative, p.134
income distribution, p.135
poverty, 136
balance of payments (BOP), p.137
current account, p. 137
capital account, p.137
trade surplus, p.137
trade deficit, p.137
economic system, p.140
market economy, p.141
laissez-faire principle, p.141
command economies, p.141
mixed economies, p.142
Economic Freedom Index, p.143
privatization, p.148
deregulation, p.148
antitrust laws, p.149
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
44

11. 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.
45