4 The Company in the Economic Environment

4.1 The Workings of the Economy

Several reasons for analysing and trying to understand the economy

• Must understand which events are in control of company vs. out of company’s
control
• Must be aware of whether economic changes represent opportunities or threats
• Understanding how the economy works enables more accurate predictions

Macroeconomics covers:

• GNP generated from demand and supply

• Role of expectations
• Money support and the rate of interest
• The rate of interest and investment expenditure
• Factors affecting the demand for and supply of imports and exports
• Exchange rate and international financial flows

4.2 Supply and Demand in Economy

GNP (Gross National Product) – total value of goods and services produced in one year.
Maximum output is constrained by the resources available.
Potential or full employment GNP – when labor force is fully employed.
Actual output – might be different than potential output.
Can actual output exceed potential output? Yes, if there are shortages of labor and a
great deal of overtime.

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 Excess demand can increase inflation rate.
The effect on the unemployment rate depends on the relative rates of growth of potential
and actual output.
There are three types of unemployment:
• Structural unemployment – large disruptions in the economy when whole industries
close down e.g., miners
• Frictional employment – people changing jobs, little can be done about this in short
term.
• Demand related unemployment – caused by difference between actual and potential
output, varies a lot in the short term

4.3 The International Economy

Those which sell directly in foreign markets are continuously exposed to changes in
trading conditions. Companies which sell only in domestic markets are open to
competition from imports.

Relative Inflation Rates:

There can be substantial differences in the inflation rates in different countries which
are not compensated for by changes in the exchange rate. If domestic rate continues at
a higher level than the foreign rate, domestic costs can be expected to increase relative
to foreign costs. What might be an attractive market at the moment may contain the
seeds of disaster as relative costs increase.

Exchange Rate Fluctuations:

Exchange rate used to be determined by the demand and supply of the currency for
imports and exports. Nowadays, however, the demand for and supply of currencies is
dominated by international capital flows, which are currently about 80 times the value
of payments for real trade flows. Exchange rates can change independent of the balance
of trade. There is no guarantee that differences in relative inflation rates will be
compensated for by changes in the exchange rate, and that the exchange rate will take
care of costs disadvantages caused by a higher domestic price level. Exchange rates
will consistently ‘overshoot’ and ‘undershoot’ because of capital flows.

There are various methods of hedging bets in relation to exchange rates, for example
buying currency forward. This makes it possible to predict some future cash flows, but
it means that the company will not gain from any favorable movements in the exchange
rate. It is not possible for a company to cover future exchange rates entirely, because
cash flows will extend for years in the future, and these cash flows are difficult to
predict with any degree of certainty.

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4.3.1 The Competitive Advantage of Nations (Porter's Diamond Framework)

The Porter Diamond Theory of National Advantage, is a model that is designed to help
understand the competitive advantage that nations or groups possess due to certain
factors available to them, and to explain how governments can act as catalysts to
improve a country's position in a globally competitive economic environment.

The Porter Diamond model explains the factors that can drive competitive advantage
for one national market or economy over another. It can be used both to describe the
sources of a nation's competitive advantage and the path to obtaining such an advantage.
The model can also be used by businesses to help guide and shape strategy regarding
how to approach investing and operating in different national markets.
According to the model, there are four factors that determine national competitive
advantage. Porter represented these four determinants as a diamond namely: factor
conditions demand conditions, related and supporting industries and firm strategy,
structure, and rivalry. These are the major determinants in the model, but they are not
the only ones. The model also shows that there are two extra determinants that can
influence any or all of the four determinants. The two extra determinants are
government policy and chance conditions.

1. Factor conditions: this refers to the different types of resources available to the
nation as a function of its location. Some of these factors are created such as skilled
labor forces, infrastructure, and capital, while other factors are natural such as raw
material, land, weather conditions, etc. According to Porter, the created factor
conditions are more important than the natural ones as they cannot be duplicated
and hence help the nation’s competitive advantage.

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 Porter also found that countries with factor disadvantages were forced to innovate
to overcome these problems. Selective factor disadvantage stimulates innovation to
deal with problematic factor
▪ E.g. Japan: ideographic language => fax
▪ E.g. Sweden: short building season = prefabricated buildings
▪ E.g. US: great inter-city distances => telephone, railway, aircraft, car
▪ Converse: US: Low fuel price => fuel-inefficient cars
▪ No guarantee, not all factor disadvantages are converted into
competitive advantage
• Difficult to forecast
2. Related and supporting industries: the presence of related and supporting
industries within the nation itself is important for a business to grow, innovate,
provide more value to the customers and become more competitive globally.
According to Porter, the success of one industry is dependent on the success of its
related and supporting industries, as internationally competitive suppliers can
provide cost-effective access to inputs.
3. Demand conditions: this explains the demand for the product or service in the home
market. Such demand from local customers compels companies to improve quality,
innovate and grow. This will allow companies to gain early insight into future needs
of customers and innovate faster hence giving them a competitive advantage over
their foreign rivals.
4. Strategy, structure, and rivalry: a country which fosters competition at home
potentially breeds a strong core of companies which is capable of competing in the
international arena. There are few instances of powerful international companies
emerging from protected or subsidized home markets.

In addition to the above-mentioned determinants Michael Porter also mentions factors

like Government and chance events that influence competition between companies.

a) Government: Governments can play a powerful role in encouraging the

development of industries and companies both at home and abroad. Government’s
finance and construct infrastructure (roads, airports) and invest in education and
healthcare. Moreover, they can encourage companies to use alternative energy or
alternative environmental systems that affect production. This can be effected by
granting subsidies or other financial incentives.

b) Chance: Michael Porter also indicates that in most markets chance plays an
important role. This provides opportunities for innovative companies that are not
afraid to start up new operations. Entrepreneurs usually start their companies in
their homeland, without this having any economic advantages, whereas a similar
start abroad would provide more opportunities.

A company must understand if it has a country specific or a company specific

advantage. If the advantage is country specific, then foreign markets can be exploited
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 by exporting. If the advantage is company specific, it can invest in the country
concerned provided that these advantages can be transferred from one country to
another (management skills, production techniques).

4.4 Forecasting: What Will Happen Next?

There are a great number of forecasts available, but they all share the same poor track
record. There are a number of approaches to forecasting, ranging from the intuitive to
the highly quantitative. There is virtually no connection between the statistical
complexity of the forecasting models and their accuracy.

The simplest approach to forecasting is to discover one statistic which serves as a

reasonable indicator of what is likely to happen next, and this statistic is known as a
leading indicator. A leading indicator is a statistic which signals when changes are
about to happen in the economy, or in a particular industry.

One approach is to think in terms of business cycles. A period of boom tends to be

followed by period of depression, resulting in a cyclical pattern which is repeated over
and over again. The business cycle has three components: the general trend over time
(a positive or negative line), the underlying smooth cycle (the “real” cycle), and random
fluctuations (ups and downs along the smooth cycle).

Although no one is able to predict the business cycle with any degree of accuracy, it is
possible to form a rational view as to whether the economy is in the upswing or the
downswing.

4.5 PEST Analysis

Trends and events in the national and international economy need to be monitored
because of their impact on the company.
PEST analysis looks at:
(1) the political environment, e.g., Changes in regulations.
(2) The economic environment, e.g., The five forces model.
(3) The social environment, e.g., Demographic changes or changes in attitudes and
values.
(4) The technological environment where changes may be gradual or in leaps.

4.6 Environmental Scanning

The PEST analysis deals with what is known about the environment, but it is possible
to take this a step forward by speculating about the future, given the limited information
available at the moment.

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 Environmental scanning is in a sense an attempt to predict well beyond the
extrapolations of short-term forecasting and market research type information. It serves
as a kind of early warning system which, when it is correct, easily justifies the resources
which it uses.

4.7 Scenarios

Once some projections of possible futures have been made, they can be used as the
basis of scenarios. Scenarios is not a forecast, but an attempt to investigate the
implications of possible futures for the company. In some instances, it may be based on
a short run issue, such as the likely impact of a price reduction by a major competitor.

4.8 The Economy and Profitability

Factors like economic activity, inflation rate, exchange rate, affect profitability.

GNP elasticity: the impact of changes in economic activity on the sales of a product. A
product is elastic with respect to GNP when a 1% change in GNP leads to a greater
than 1% change in the demand for the product. It is inelastic when the change is less
than 1%. Example: potatoes are less affected by changes in GNP than high tech
products. When product is elastic and GNP goes down, the only way to keep revenues
is to increase market share.
When the economy starts to grow strongly, an effective response might well be to
concentrate resources on those products with a relatively high GNP elasticity.
It is not only the size of GNP which is important, but also the distribution of national
expenditure among its components. For example, a reduction in income tax, which
leads to an increase in disposable incomes and hence to consumption expenditure, may
be accompanied by a reduction in government expenditure, the net effect of which is to
leave GNP unchanged.
Increase of interest rate affects the demand for investment goods.