INTERNATIONAL BUSINESS MANAGEMENT
LESSON 18
THE ECONOMIC ENVIRONMENT
Poverty does not destroy virtue, nor does wealth bestow it.
- Spanish Provers
Learning Objective
• To learn the criteria for the dividing countries into different
economic categories
• To learn the difference among the world’s major economic
systems
• To discuss key economic issues that influence international
business
• To assess the transition process certain countries are
undertaking in changing to market economic-and how this
transition affects international firms and managers
CASE Study
McDonald’s Corporation in Emerging Markets
Nearly everyone has an opinion about McDonald’s, including
Jerry Seinfeld. In one of his live standup acts, he relayed the
following observations.
Why McDonald’s Still counting? How insecure is this company?
40 million, 80 jillion, billion, zillion, killion, tillion. . .. Is
anyone really impressed anymore? “Oh, 89 billion sold . . ..
alright, I’ll have one. I’m satisfied.” . . . Who cares?
I would love to meet the chairman of the board of McDonald’s
and just say to him, “Look, We all get it. OK, you’ve sold a lot
of hamburgers, whatever the number is. Just put on the sign,
‘McDonald’s-We’re doing very well: We are tired of hearing
about every dang one of them.”
What is their ultimate goal, to have cows just surrendering
voluntarily or something? Showing up at the door: “We’d like
to turn ourselves in. We see the sign. We realize we have very
little chance out there. We’d like to be a Happy Meal® if that’s at
all possible.”
With 30,000 outlets in 121 countries, McDonald’s Corporation
is “doing very well” by many measures. It has taken an aggres-
sive growth stance by entering into risky emerging markets and
riding on the eco-nomic growth spurt of the 1990s. But as the
world slipped into an economic recession in 2001, McDonald’s
has felt the blow, showing six consecutive quarters of declining
results. Although prosperous in some emerging markets, like
Russia and China, it has done poorly in others, like Turkey,
Malaysia, and the Philippines, where it closed 163 unproductive
stores at a cost of $91 million in 2001. As the world economy
has taken a downward turn, McDonald’s is facing risks and
challenges that raise questions and doubts about the future of
its worldwide operations.
McDonald’s entry into Russia in 1990 exemplifies the process
and difficulties it has encountered in most developing countries
where it has begun operations. During the 1976 Olympics in
Montreal, George A Cohon, president of McDonald’s Canadian
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subsidiary, made the first contact with Soviet officials. They
began lengthy negotiations, which lasted until 1988 when a
formal agreement was signed. In the mean-time, McDonald’s
had opened restaurants in Hungary and Yugoslavia, thus
providing the company with valuable experience in operating in
communist countries. By the mid-1980s, the company was
expanding more rapidly outside the United States than inside,
and company executives reasoned that if they were to meet the
company’s rapid growth objectives, that trend must continue.
Although the Moscow City Council was a partner of
McDonald’s in the Russian joint venture, the com-pany
repeatedly ran into negative responses, such as “Sorry, you’re not
in my five-year plan,” when it attempted to obtain such
materials as sand or gravel to build the restaurant. The company
had to negoti-ate to ensure it would be allocated, in the then-
Soviet Union central plan, sufficient sugar and flour, which were
in chronically short supply. Even for some products in sufficient
supply, such as mustard, government regulations prevented
Soviet manufacturers from deviating from standard recipes in
order to comply with McDonald’s needs. In other cases, strict
allocation regulations dictated that Soviet plants sell all output
to existing Soviet companies, thus leaving them no opportunity
to produce products for McDonald’s. Yet another problem was
that some supplies simply were not produced or consumed in
the Soviet Union, including iceberg lettuce, pickling cucumbers,
and the Russet Burbank potatoes that are the secret behind
McDonald’s French fries.
To handle these problems, McDonald’s scoured the country for
supplies, contracting for such items as milk, cheddar cheese, and
beef. To help ensure ample supplies of the quality products it
needed, it undertook to educate Soviet farmers and cattle
ranchers on how to grow and raise those products. In addi-
tion, it built a $40 million food-processing center about 45
minutes from its first Moscow restaurant.
One problem McDonald’s did not encounter was attracting
employees and customers. The company placed one small help-
wanted ad and received about 27,000 Russian applicants for its
605 positions. McDonald’s did no advertising prior to its
Moscow opening. However, Russian television covered the
upcoming event extensively. When the restaurant’s doors
opened for the first time in January 1990, it was almost
impossible to accommodate the crowd, even though it was the
largest McDonald’s in the world. An estimated 30,000 people
were served the first day, eclipsing the previous daily record of
9,100 set in Budapest. The crowds continued to arrive, even
though the price of a Big Mac, French fries, and soft drink
equaled a Russian worker’s average pay for four hours of work.
In contrast, lunch at a state-run or private sector cafe cost 15 to
25 percent as much as a meal at McDonald’s.
The entry of McDonald’s into China in 1990 resembled its
experience in Russia. However, the Chinese government moved
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 faster and was more accommodating than the Russian govern-
INTERNATIONAL BUSINESS MANAGEMENT
ment had been. China’s government wanted to establish its
fast-food market and felt that Western companies like
McDonald’s could take the risks in proving its success.
McDonald’s encountered similar roadblocks in China, such as
lack of quality supplies and distribution difficulties, and it has
found analogous benefits, like high volumes of cus-tomers and
employees.
In 1997, the Asian financial crisis hit, devastating most of the
economies in Asia: However, China’s economy, including its
catering industry, kept growing. In fact, the Chinese government
in 1998 designated the catering industry as a new economic
growth sector, growing at an annual rate of 20 percent in the
1990s. Because China avoided most, f the economic turmoil its
neighboring countries experienced, McDonald’s prospered.
Much of this growth is attributed to increases in individual’s
income, changing con-sumer patterns, development of the
tourism sector, and overall growth in the fast-food industry-all
signs of a growing economy.
McDonald’s success in China has continued into the twenty-first
century. In the first six months of 2001, McDonald’s opened 96
restaurants in China, totaling 430 restaurants altogether. It plans
to open 100 stores each year from 2003 to 2013. McDonald’s
record of success in Russia did a turnaround in 1998 when the
Russian economy collapsed because of the devaluation of the
ruble. However, with, sales and growth on the rebound in
Russia, McDonald’s had 73 stores by the end of 2001. In fact, it
is McDonald’s success in China, Russia, and a couple of
European countries that is one of the few positive notes in
McDonald’s 2001 annual report. The 2001 letter to shareholders
written by the chairman and CEO of McDonald’s opens by
saying, “From many different perspectives, 2001 was one tough
year.” He goes on to say, “Our 2001 performance was hampered
by the strong U.S. dollar and weak economies in many countries
in which we operate.” The continued economic crisis in Asia
and Latin America and the economic recession in the United
States led to reduced profits. In 2001, McDonald’s was forced to
close down 163 unproductive stores in countries whose
economies are struggling.
When questioned about how world economic situations affect
the company’s expansion plans, Matt Paull, the chief financial
officer (CFO) of McDonald’s replied,
When planning openings, we consider each market’s current
economic conditions, long-term demo-graphic and lifestyle
trends, competitive environment and stage of development, as
well as the poten-tial effect on existing McDonald’s restaurants
and returns.
Based on these criteria, we reduced the number of restaurant
additions over the past few years and expect to add 1,300 to
1,400 McDonald’s restaurants in 2002. About 60 percent of
these open-ings will be in the U.S., Europe, and Canada, where
economies are relatively stable and returns are strong. We also
are adding restaurants in China, where the near- and long-term
growth potential is enormous.
At the same time, we are reducing openings iii-markets with
weak economic environments until we see signs of improve-
ment. Since we already have a clear competitive lead in these
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countries, this tem-porary slowdown makes good business
sense.
What will be the future of McDonald’s worldwide operations?
Will it continue to focus more on the
United States, Canada, and Europe as stated earlier, or will it
return to the emerging markets where growth is higher,
although more unstable? Will McDonald’s management be able
to choose the right countries, commit the right amount of
resources, and provide a strategy for sound economic growth
for the future?
Introduction
Understanding the economic environments of foreign coun-
tries and markets can help man-agers predict how trends and
events in those environments might affect their companies’
future performance there. In this lesson, we discuss the
economic environments of the countries in which an MNE may
want to operate. An MNE such as McDonald’s knows how to
operate in its home-country economic system. However, when
such a company wants to do business in another country for
the first time, it needs answers to questions such as these:
1. Under what type of economic system does the country
operate?
2. What are the size, growth potential, and stability of the
market?
3. Is the company’s industry in that country’s public or private
sector?
4. If it is in the public sector, does the government also allow
private competition in that sector?
5. If the company’s industry is in the private sector, is it
moving toward public ownership?
6. Does the government view foreign capital as being in
competition with or in partnership with public or local
private enterprises?
7. In what ways does the government control the nature and
extent of private enterprise?
8. How much of a contribution is the private sector expected to
make in helping the gov-ernment formulate overall economic
objectives?
These questions appear simple to answer. However, because of
the dynamic nature of political and economic events, the
answers are complex-or yet to be seen. For example, foreign
companies have continued to invest in Hong Kong since the
United Kingdom returned Hong
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A global concern is the growing gap between rich and poor,
especially in many developing countries. The photo shows the
stark contrast between urban slums and upper-income housing
in Caracas, Venezuela.
Kong to China in 1997, even though the business world is
wondering whether China will sti-fle some of Hong Kong’s
economic freedoms. Companies like McDonald’s, which invest
in emerging markets, are experiencing enormous difficulties
because the changes taking place in those countries are so rapid
and unpredictable. The question is whether today’s global
compa-nies can keep up with the world’s changing economic
landscape.
As Figure7.1 notes, economic forces are an important part of
the physical and societal factors that help comprise the external
influences on company strategy. Economic forces include such
issues as the general economic framework of a country,
economic stability, the existence and influence of capital
markets, factor endowments, the size of the market, and the
availability of a good economic infrastructure, such as transpor-
tation and communica-tions. Managers need to understand the
nature of the world’s economies if they are going to make wise
investment decisions. To provide them with a frame of
reference, we will first describe countries by income level,
location, and economic system. Then we will look at key
economic indicators, such as economic growth, inflation, and
surpluses and deficits that affect the decision of management
on where to commit MNE resources and efforts. Finally, we will
examine the potential of the major geographic regions in the
world, with special emphasis on countries in economic transi-
tion.
An Economic Description of Countries
There are 207 countries in the world with populations of more
than 30,000. Which of those countries are the ones where
managers should commit resources? Although the answers vary
by company, it is true that companies do business abroad for a
variety of reasons, such as access to factors of production or
demand conditions. Factor conditions, or production fac-tors,
include essential inputs to the production process, such as
human resources, physical resources, knowledge resources,
capital resources, and infrastructure. Physical resources include
weather, the existence of waterways to get goods to and from
market, and the avail-ability of crucial minerals and agricultural
products. Knowledge resources are best represented by research
and development conducted by companies and governments.
For example, the Silicon Valley in the United States is a hotbed
of high-tech research. The U.S. government has also poured
significant resources into the U.S. aviation industry for the
development of mili-tary aircraft, and this technology has been
helpful in developing the civilian aircraft industry as well. Capital
resources include the availability of debt and equity capital that
firms can use to expand. Infrastructure includes roads, port
facilities, energy, and communications.
Figure 7.1 Physical and Societal Influences on International
Business
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INTERNATIONAL BUSINESS MANAGEMENT
Demand conditions, also known as market potential, include
three dimensions: the composition of home demand (or the
nature of buyer needs), the size and pattern of growth of
home demand, and the internationalization of demand. The
composition of demand is mown as the quality of demand,
and size is known as the quantity of demand. Factor condi-
tions are especially crucial for investments made for the
production of goods, but demand conditions are crucial for
market-seeking investments. The combination of factor and
demand conditions, along with other qualities, makes up the
location-specific advantage that a country has to offer domestic
and foreign investors.
Countries Classified by Income
Although we can classify countries along any of the dimensions
mentioned earlier, the key dimension we use to distinguish one
country from another is the size of demand, or gross national
income (GNI), formerly referred to as gross national product
(GNP). In particular, we classify countries according to per capita
GNI, or the size of GNI of a nation divided by its total
population. Those countries with high populations and high
per capita GNI are most desirable in terms of market potential.
Those with low per capita GNI and low popula-tions are least
desirable, and the other countries fit somewhere in between.
What is GNI? It is the broadest measure of economic activity.
It is the market value of final goods and services newly
produced by domestically owned factors of production. For
example, the value of a Ford car manufactured in the United
States and the portion of the value of a Ford manufactured in
Mexico using U.S. capital and management counts in U.S. GNI.
However, the portion of the value of a Japanese Toyota
manufactured in the United States using Japanese capital and
management would not be counted in U.S. GNI, but it would
be counted in Japanese GNI. The World Bank and other
institutions now use GNI, but the definition and measure-
ments remain the same as GNP used previously. An alterna-tive
to GNI is 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. So both a Ford and a Toyota
manufactured in the United States would be counted in U.S.
GDP, but a Ford produced in Mexico would not be.
Why do we use GNI to describe countries? The World Bank
(www.worldbank.org), a multilateral lending agency, uses per
capita GNI as a basis for its lending policies. The World Bank
Group was founded in 1944 by the United Nations. It consists
of five closely associated institutions: the International Bank for
Reconstruction and Development (IBRD), the International
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 Development Association (IDA), the International Finance
INTERNATIONAL BUSINESS MANAGEMENT
Corporation (IFC), the Multilateral Guarantee Agency (MIGA),
and the International Center for Settlement of Investment
Disputes (ICSID). The World Bank is comprised of 183
countries, and its major objective is to provide development
assistance to countries, especially the poorest of the poor. It
uses the measure per capita income to identify those countries
that need the most help. In particular, its programs include
• Investing in people, particularly through basic health and
education.
• Focusing on social development, inclusion, governance, and
institution-building as key elements of poverty reduction.
• Strengthening the ability of the government to deliver
quality services, both efficiently and transparently.
• Protecting the environment.
• Supporting and encouraging private business development.
• Promoting reforms to create a stable macroeconomic
environment, one that is conducive to investment and long-
term planning?
The activities of the World Bank are important to MNEs,
because they build infrastruc-ture and promote economic
growth and stability, thus improving the quality and quantity of
demand. In particular, the World Bank is most interested in
eliminating poverty and its demand-reducing influences. The
World Bank classifies economies into one of the following
categories according to per capita GNI.
Low income $755 or less in 1999
Middle income $756-$9,265
Lower middle income $756-$2,995
Upper middle income $2,996-$9,265
High income $9,266 or more
The World Bank refers to the low- and middle-income coun-
tries as developing countries, even though it recognizes that not
all “developing” countries are alike-nor are they all “developing.”
Developing countries are also known as emerging countries, a
term also used to distinguish the capital markets (debt and
equity markets) in those countries from the cap-ital markets in
the more advanced countries. In addition, the World Bank’s
terminology does not imply that the high-income countries
have reached some preferred or final stage of development.
High-income countries are also sometimes called developed
countries or industrial countries. Initially, this was because those
countries had a relatively high percentage of their GNP and
employment from industry rather than from agriculture. Now,
however, these countries have a larger percentage of their GNP
and employment tied up in services rather than industry. But
the term industrial country is still popular. The developing
countries; adude different types of countries-some with large
populations, such as China (1.2 billion people) and India (997
million people), and others with small populations, such as
Guyana (697,181 people). These countries also include counties
in economic transition to a market economy, such as China,
Poland, Russia, and Vietnam. Some developing countries, espe-
cially those in Asia and Latin America, are generally moving
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forward, whereas others, especially some in Africa, are not
making much progress.
The high-income countries are clustered in just a few geographic
areas, whereas the developing countries are found in all areas of
the world the relative imbalance among the low-, middle-, and
high-income countries in terms of number of countries, total
GNI, and population. The high-income countries generate
nearly 80 percent of the world’s GNI, but they represent a
relatively small number of countries and population. This
illustrates the quandary that manager’s face. The high-income
countries are a natural place to do business because of the
quality and quantity of demand, but the developing countries
exhibit tremendous potential because of the sheer size of the
population-74.8 percent of the total number of countries and
85 percent of the total population. It might be safer to focus on
the high-income countries because of their relative political and
economic stability, but the future is in the developing countries,
and managers must establish a strategy for penetrating them in
the short and long-term.
Another measure of wealth, per capita GNI, is computed by
taking the GNI of a country and converting it into dollars at
market rates and then dividing the total by the population.
However, the World Bank points out that nominal exchange
rates (the actual market rates not adjusted for inflation) do not
always reflect international differences in prices. So the World
Bank has come up with GNI per capita in international dollars
converted at purchasing power parity (PPP) rates. 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 provides some striking
comparisons between GNI per capita and PPP GNI per capita
for a small sample of countries. Note how much higher PPP
income is for China and the Czech Republic than regular per
capita GNI and how much lower Japan’s PPP income is. In
China’s case, measuring its per capita income in PPP terms
would raise it from a lower-middle-income country to an
upper-middle-income country, which is more consistent with
people’s perceptions of economic improvements in China.
The United Nations publishes an annual report, the Human
Development Report that ranks countries according to the
Human Development Index. The index measures a coun-try’s
achievements by looking at life expectancy, education, and
income per person. The index does not include political
freedom or inequality measures. The index for 2002, as shown
in that the United States ranks second in per capita GDP but
only sixth in the Human Development Index; it is outranked
by neighboring country Canada.
Countries Classified by Region
Much of the World Bank data for developing countries is
provided by geographic region, and this factor will be especially
important as we discuss economic growth in a later section of
the lesson.
East Asia and Pacific
Latin America and the Caribbean
The Middle East and North Africa
South Asia
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Sub-Saharan Africa
These designations are important to MNEs, which tend to
organize their operations along geographic lines. Managers can
use the data compiled and disclosed by the World Bank to spot
trends in key markets. Investors can use the data to analyze
where potential growth and risks exist in the regions where their
companies operate.
Countries Classified by Economic System
A final way of classifying countries is by their economic system.
Every government struggles with the right mix of ownership
and control of the economy, as illustrated in Figure 7.2.
Ownership means those who own the resources engaged in
economic activity-the public sector, the private sector, or both.
Public sector ownership of economic activity refers to the
existence of state-owned enterprises. A good example would be
China prior to the reforms initiated in 1978 by Chinese leader
Deng Xiaoping. At that time, all enterprises in the coun-try were
owned by the state. Private enterprise was neither permitted nor
encouraged. The same could be said of all the countries under
the control of the Soviet Union, such as Poland and Czechoslo-
vakia (now the countries of the Czech Republic and Slovakia),
where state- owned enterprises generated most of the economic
activity of the country. However, state- owned enterprises are
not just a phenomenon of the communist countries. Countries
like Brazil in South America, India in South Asia, and France in
Europe also have large state -owned enterprises that are an
important part of the overall economy.
Hong Kong and the United States are examples of the absence
of state ownership in major economic activity. Although there
are extremes, most countries are a mixture of public and private
ownership of economic activity. The degree varies, but most
countries with sig-nificant state-owned enterprises, such as
those mentioned earlier, are moving toward less, not more,
ownership of enterprises. This is known as the process of
privatization, which we will discuss later in the lesson.
Control of economic activity refers to the fact that resources may
be allocated and controlled by the public or the private sector.
Each year, the Heritage Foundation and the Wall Street Journal
publish an index of economic freedom in which they rate
countries according to 50 variables organized into 10 economic
factors: trade policy, fiscal burden of government, government
intervention in the economy, monetary policy, capital flows and
investment, banking and finance, wages and prices, property
rights, regulation, and black markets. The study is helpful
insofar as it identifies ways that governments control economic
activity and the degree to which they do so.
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Figure 7.2 Relationships Between Control of Economic Activity
INTERNATIONAL BUSINESS MANAGEMENT
and Ownership of Production Factors
Their 2002 index classifies 156 countries as follows:
Categories Number of Countries Examples Of
Countries
Free 14 Hong Kong, Singapore, United
States
Mostly free 57 Czech Republic, Japan, Canada
Mostly unfree 72 Zambia, Russia
Repressed 13 Iraq, Cuba, North Korea
In most cases, countries at the top of the index also have a high
degree of political freedom; all of the countries at the bottom
of the index have no political freedom. In addition, there is a
high correlation between economic freedom and economic
growth: the freer an economy, the bet-ter off the people-at all
economic levels. Countries that are high in economic freedom
have more control in the private than in the public sector.
However, there are some advanced countries with significant
government interference in the economy. Two examples are
Japan and South Korea. After World War II, the Japanese
government intervened in the economy in a significant way,
even though it was not involved in the ownership of compa-
nies. For example, government agencies such as the Ministry of
Finance, the Bank of Japan, and the Ministry of International
Trade and Industry (MITI) helped establish a broad vision of
Japan’s future that rejected individualism and open mar-kets.
The government protected industry from outside competition;
supported funding of preferred industries; told private banks
which companies to lend to; and controlled access to technol-
ogy, foreign exchange, and raw materials imports. South Korea
and much of Asia followed that same model, also known as
state capitalism, by permitting government inter-vention in the
operation of the economy. This led to spectacular growth
during the decades of the 1970s, 1980s, and early 1990s.
Market Economy Now we need to take the concepts of
ownership and control and put them into the context of two
major economic systems: a market economy and a command
economy. A market economy is one in which resources are
primarily owned and controlled by the private sector, not the
public sector. The key factors that make the market economy
work are consumer sovereignty-that is, the right of consumers
to decide what to buy-and freedom for companies to operate in
the market. Prices are determined by supply and demand. In a
market economy, for example, the price of gasoline rises during
holidays because of the excess of demand over supply. Rising
prices bring supply and demand into balance. At higher prices,
consumers will eventually consume less, resulting in a drop in
demand to match existing supply.
Command Economy In a command economy, also known as
a centrally planned econ-omy, all dimensions of economic
activity, including pricing and production decisions, are deter-
mined by a central government plan. The government owns
and controls all resources. The government sets goals for all
business enterprises in the country-how much they pro-duce
and for whom. In this type of economy, the government
considers itself a better judge of resource allocation than its
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 businesses or citizens. To use the gasoline example described
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Notes -
earlier in the market context, the price of gasoline always stays
the same in a command econ-omy, because the government
determines its price. When supply becomes tight, people line up
and buy gasoline until the supply is exhausted, so supply is
allocated by the queue rather than by price. Before prices were
freed in Russia, people used to say that if they ever saw a line,
they just stood in it. When they got to the front of the line,
they bought whatever was being sold. Even if they didn’t need
the item, they figured that someone in their extended family
did, so they just bought it. When the supply ran out, there
wouldn’t be any more left, no matter what price you were
willing to pay.
Mixed Economy In actuality, no economies are purely market
or completely command. Most market economies have some
degree of government ownership and control, whereas most
command economies are moving toward a market economy
and away from command concepts. If you think of economic
systems as a spectrum with market on one end and com-mand
on the other, Hong Kong and the United States would
represent two of the countries at the market end of the
spectrum, and Vietnam and North Korea would represent two
countries at the command end of the spectrum. In Hong Kong
and the United States, the government plays a very small role in
economic activity, desiring instead to provide a stable environ-
ment in which economic activity can take place. In communist
countries such as Vietnam arid North Korea, the government
still owns and controls most aspects of economic activity. China
is an example of a communist country that is trying to move
from command to market.
Another example of a mixed economy is market socialism, in
which the state owns sig-nificant resources, but in which
allocation of the resources comes from the market-price
mechanism. France, as mentioned earlier, is a good case in
point. Although the government owns significant economic
resources, it allows supply and demand-rather than government
fiat-to set prices. Sweden is a country that owns few economic
resources, but it levies heavy taxes to fund an aggressive social
program. Although the market determines prices, a lot of
economic activity is controlled by government fiscal policies.
As mentioned in the eight questions raised at the beginning of
the lesson, managers need to be aware of both the type of
economic system in which they are doing business and what the
role of their companies is and is likely to become. Many
Western managers com-plain about the government bureaucracy
in China and the degree of influence of the Chinese govern-
ment in economic decision-making. However, China is going
through a transition, so it is important for managers to
understand the direction and speed of change and how their
own industries will be affected by these changes. The same is
true of any country, especially those going brough transition, so
managers need to understand the context of the owner-ship
and control of resources of the countries where they wish to
operate. In addition, the degree of interference by the govern-
ment may vary by state within a country, especially those that are
quite decentralized.

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