Revision Unit 3 Topic 2 3.3.

2 Key players in the world economy

This section of Unit 3 looks at how firms and businesses may be affected by the growing economic power of India and China and how a national business may seek to trade with them. 3.3.2(1) What will be the likely impact of the growing economic power of India and China? Ranking Top ten GDP/ by GDP countries by head in (out of GDP/head US $ 228) 1. Liechtenstein 118,000 165 2. Qatar 111,000 69 3. Luxembourg 81,200 97 4. Bermuda 69,900 162 5. Norway 6. Kuwait 7. Jersey 8. Singapore 9. Brunei 10. USA 59,500 57,500 57,000 51,600 51,300 44,600 41 58 159 47 123 1

Top ten GDP in Ranking countries US $ by GDP by GDP trillion /head (out of 228) 1. USA 14.4 10 2. China 8.0 133 3. Japan 4.3 37 4. India 3.3 167 5. Germany 2.9 33 6. Russia 2.3 73 7. UK 2.2 32 8. France 2.1 39 9. Brazil 2.0 102 10. Italy 1.8 41

Q1. Does GDP or GDP/head give a better guide to economic power (see previous tables)?

A: GDP gives the better guide Comment: A country is economically powerful if it produces more goods than others. This is measured by GDP. By contrast, GDP/head is a guide to the standard of living as it measures output per person. Because of wildly different population sizes there is little connection between the two measures, as the previous tables show.

TABLE 3.3 Top ten countries by GDP, using market exchange rates 1. USA 2. Japan 3. China 4. Germany 5.France 6. UK 7. Italy 8. India 9. Canada 10. Spain

GDP in 2008 as % of world GDP 25.5 10.3 6.4 6.3 4.6 4.2 3.8 2.7 2.5 2.4

TABLE 3.4 Top ten countries by GDP, using Purchasing Power Parity exchange rates 1. USA 2. China 3. Japan 4. India 5. Germany 6. Russia 7. UK 8. France 9. Brazil 10. Italy

GDP in 2008 as % of world GDP 20.6 11.4 6.2 4.7 4.2 3.2 3.2 3.0 2.8 2.6

Note: World GDP in 2008 was US$70.1 trillion (PPP exchange rates) Q2: What is the difference between market exchange rates and Purchasing Power Parity (PPP) exchange rates? A: Market rates are the rates at which currencies may be traded in the open market. PPP rates are the rates at which you could buy the same typical basket of goods in different countries Comment: If all products could be freely traded the two rates would be very similar. In practice, most services cannot be traded internationally.

Q3: Why does it matter which rate we use? A: PPP exchange rates give a much better indication of purchasing power, and so of economic power Comment: If you compare China and Japan in the previous set of tables Japan appears to produce almost double the GDP (10.3/6.4) using the market exchange rate whereas in reality it is producing roughly half the GDP (6.2/11.4) Q4: Why does using PPP exchange rates show countries with low standards of living narrowing the gap with rich countries? A: Because poor countries have low wages which are reflected in low prices for labourintensive services. Market exchange rates do not reflect this because most services cannot be traded internationally Comment: For example, a porter in India cannot sell his services at the going rate in a rich country.

TABLE 3.6 Rank order by GDP in 2008

GDP in 2008 - mkt exchange rates: US $ bn 1. USA 14440 2. Japan 5838 3. China 3617 4. Germany 3546 5.France 2635 6. UK 2382 7. Italy 2170 8. India 1527 9. Canada 1428 10. Spain 1340

Annual Population GDP / head real growthin millions (US $ mkt of GDP: (2008/09) exch rate) 97-08 2.6% 1.4% 9.7% 1.5% 2.1% 2.6% 1.2% 8.0% 2.9% 3.5% 307 127 1339 82 64 61 58 1166 33 41 47,000 46,000 2,700 43,200 41,200 39,000 37,400 1,300 43,300 32,700

Q5: Why is it possible for a country to achieve long-term rapid economic growth when its GDP per head is much lower than that of developed countries? A: All the country has to do is catch up by using technology and economic management techniques which already exist Comment: From the previous table, we see that India and China both have low GDP/head, so their rapid growth may continue for many decades. Q6: To what extent does China rely on Exports? A: Both China and Germany are unusual in being very large economies with around 50% of their GDP being exported (46% in the case of China)

Comment: They run large current account surpluses (i.e. the excess of Exports over Imports. Q7: How do political arrangements differ between India and China? A: India is the worlds largest democracy; China is a one-party state run by the Communist party Comment: China has largely embraced a capitalist, free-market economic model. However, many large companies are still state-owned and there is less freedom of expression than in India or in a Western democracy. Q8: What opportunities exist within China for UK firms to outsource manufacturing? A: Most low-technology manufacturing that used to be done in Britain has shifted to South-East Asia (and China in particular) where wages are much lower and quality is of a similar standard Comment: This is reflected in the growth of Chinese imports to the UK from 5% to 9% of all imports over the last decade. We might expect this trend to continue. Q9: Apart from the legal barriers, what barriers to market entry exist for UK firms attempting to sell into China? A: For example, China restricts the import of creative content (books, CDs and videos) - in the case of film, to just 20 a year. Yet it makes little attempt to enforce copyright, so effectively China pirates creative content and gets it for free Comment: The WTO has ruled against these practices but its sanctions are slow to take effect. Q10: What opportunities exist in China for UK firms to market their products? A: Chinese success in penetrating the British market has not been matched by anything like an equivalent penetration of the Chinese market by Britain.

TOPIC 3 3.3.3 How does a company decide which countries to target?

This section of Unit 3 looks at how companies seeking to expand overseas go about choosing which of the 200-plus countries they should consider investing in. It also introduces the theory of comparative advantage, the traditional explanation of why countries as a whole gain from specialisation followed by international trade. 3.3.3(1) Assessment of country markets Q1: What is any commercial company looking for when it invests in a foreign country? A: A profit, normally measured in terms of the annual percentage return on capital employed (ROC) Comment: This is measured by the annual operating profit expressed as a percentage of the original investment (i.e. capital employed) made.

Q2: How, therefore, might a company rank a number of different investment projects across a range of countries? A: In the order of the likely ROC on each project Comment: Other broad considerations will be the size of potential projects (large firms are likely to favour large investments); the degree of risk entailed and the firms attitude to risk; and wider strategic objectives e.g. gaining knowledge of how to do business in a country. Q3: Why do companies that go overseas to buy raw materials (or manufacture goods), and those that go to market their products both need to invest? A: Companies looking for raw materials or manufacturing facilities may wish to buy up local assets e.g. the right to prospect for oil (or build an oil refinery). Those intent on marketing their products will invest in office and retail space, advertising campaigns, and management time. Q4: For which type of company will the availability of natural resources be a key factor? A: Primary (extractive) industries such as agriculture, mining and oil companies Comment: One notable feature of Chinas expansion over the past decade has been its rush to invest in Africa to secure the raw materials it needs for its growing manufacturing sector. Q5: What will be the impact of commodity prices within the primary sector on a firms decision to invest? A: New investments in mining and agriculture are far more likely to come when prices look set to remain high the returns on the investment will be that much greater. Comment: Recent Chinese economic expansion has fuelled an upward trend in commodity prices. Q6: For which type of company will the size and wage level of the potential labour force be of particular interest? A: Labour-intensive industries such as low-technology manufacturing and lowtechnology services such as call centres. Comment: The availability of large numbers of well-disciplined and cheap workers is a necessary condition behind Chinas and Indias rapid economic growth. Q7: For which type of company will the level of technology be of particular interest? A: For high-technology companies involved in design and research & development and advanced manufacturing. Comment: These activities are typically located in developed countries where there are lots of workers with the required skill base and practical experience not only in the Western world but increasingly in Asia as well. Q8: What does the HDI (Human Development Index) measure? A: A combination of three things: life expectancy, education & literacy and GDP per head (using PPP exchange rates) on a scale of 0 to 1 Comment: The practical effect of using HDI rather than GDP per head to compare countries is that HDI favours countries where income is redistributed extensively (such as Scandinavia) over more capitalist models (such as the USA)

Q9: What is the fundamental difference between GDP and HDI as a measure of a countrys development? A: HDI is a per capita measure whereas simple GDP is not. Q10: What do you know about the geographical distribution of Economically Less Developed Countries (ELDCs)? A: Sub-Saharan Africa contains most of the worlds very poor nations. Comment: Asia and South America contain mostly middle-income countries and show every sign of following Japan, South Korea and Singapore into the ranks of the developed world. Q11: For which type of company will economic development (as measured by GDP per head or HDI) be of particular interest? A: Companies seeking to sell their products overseas will seek markets able to afford them. Comment: Simple GDP will also be of interest. For example, China scores low on GDP/head (and HDI) but nonetheless is so large that it has a substantial middle class in absolute numbers interested in buying luxury brands. Q12: Why is growth in GDP (and GDP per head) of particular interest to companies looking to enter an overseas market? A: It is always easier for a company to enter a market if it doesnt have to take market share away from others to do so. An expanding market offers this type of opportunity Comment: As with any investment, the ideal is to get in at the bottom i.e. to invest in shares (or in a country) just before rapid growth occurs. Q13: Why is geographical proximity a much less important factor than it once was? A: The container revolution of the past 30 years has dramatically reduced both transport costs, and door-to-door transport times (and so both lead times and inventory costs). Comment: The whole globalisation phenomenon (including cheaper air travel and communications) is another way of saying that geographical proximity matters much less than it did. Q14: For which companies will geographical proximity nonetheless remain an important consideration? A: For perishable goods (such as newspapers and flowers) and for low-value high-bulk goods (such as coal) though all these goods are in fact commonly traded between continents Comment: Membership of a trade bloc is normally connected to geographical proximity and this may often prove the more important factor Q15: What impact do exchange rate movements have on a firms willingness to invest in a country? A: It is easy to hedge (i.e. insure) against unfavourable exchange rate movements though this adds to the cost of doing business

Comment: The more volatile a currency, the more it will cost to insure against unfavourable movements. Volatile currencies are associated with small and weak economies. Q16: What bearing does the legal system of a country have on multinationals willingness to invest? A: Businesses want to know that their assets (including intellectual property) are effectively protected by the police and legal system and that contracts are enforceable quickly and cheaply. Comment: A country where large amounts have to be spent on private security raises the cost of doing business. Q17: How does the political system affect a companys willingness to invest? A: Firms want political stability. This is best provided by mature democracies, though enlightened dictatorships as in Singapore may also provide stability and rapid economic growth. Comment: Political transitions are dangerous for business. Political instability e.g. in much of the Middle East and much of Africa is a key reason why investment (and so growth) are hindered. Q18: How may government policies affect the willingness of a company to invest? A: This part of the specification covers a wide range of policies. It includes a favourable tax regime, an ability to get money out of the country easily, the minimum of onerous regulation in the areas of Health & Safety, employment and the environment Comment: There may be a direct conflict between ethical standards and profitability. Country Number of procedures needed by an investor seeking a business license from the government South Korea 10 USA 19 Angola 12 China 37 Cameroon 15 Average number of days taken to complete these procedures 17 40 119 336 426

Q19: How may govt administrative efficiency affect the willingness of a firm to invest? A: Basic levels of efficiency are as important as the overall regulatory burden Comment: Looking at Table given above, the attractions of doing business in South Korea or the USA are obvious. Medium-to-large companies may be prepared for a 10month wait to get into China but is Cameroon really worth a 15-month wait? For most companies, probably not. Q20: What connection do you see in Table given below between the perceived level of corruption in a country and its GDP per head? A: There is a clear inverse relationship with developed countries having low levels of perceived corruption and the poorest nations in Africa and the Middle East having the highest

Comment: High standards of living, low corruption and open democratic societies appear to go hand-in-hand

The map below shows Transparency Internationals Corruption Perception Index, with the darker the shade indicating the greater perception of corruption in that country

Q21: Why should a high level of corruption make a business less willing to invest in a country? A: First, it increases the cost of doing business through the need to offer bribes. Second, it increases uncertainty how do you know who to bribe, and how much? Comment: We might guess that India and China will have to clean up their act if they wish to catch up with Japan, Germany and the US all of whom demonstrate low levels of corruption. 3.3.3(2) Comparative advantage and the role of specialisation by countries Q22: What is the definition of Comparative Advantage?

A: Country A is said to have the comparative advantage over country B in the production of Good X if country B is relatively more efficient in the production of Good X compared with other products Comment: It is not necessary for country A to have the absolute advantage in the production of X i.e. to use fewer resources in its production. Q23: If person A can deliver newspapers twice as fast as person B, and person A can flip hamburgers four times as fast as B then who has the comparative advantage in i) delivering newspapers and ii) flipping hamburgers? A: Person A flipping hamburgers. Person B newspaper delivery Comment: Although B is slower than A at delivering newspapers, yet B is relatively more efficient at newspaper delivery i.e. relative to flipping burgers. Q24: What conclusion does the theory of comparative advantage lead to? A: That all countries will stand to gain if they specialise (in part or in full) in those products in which they have a comparative advantage, and then trade with each other Comment: This explains why teenagers dominate newspaper delivery. They may be slower at the job than adults but not nearly as much slower than they would be at the jobs that adults do. Q25: Why is the theory of comparative advantage good news for poor countries (& poor people)? A: You can still make a living even if there are other countries (people) that could do what you do more quickly. You simply need to find the products (or job) at which you are least bad or most good Comment: Because of the way comparative advantage is defined, every country (& person) must have some comparative advantages in the worst case, you have to be least bad at something! Q26: The gains from trade generated from specialisation followed by international trade will not be realised unless they are great enough to overcome what additional costs? A: The management and transport costs associated with international trade, and the risks associated with relying on overseas markets and supplies Comment: As previously discussed these costs have fallen very fast over the last 30 years a key reason why intl trade has grown so rapidly. Q27: What determines which countries have the comparatives advantage in which goods and services? A: The key phrase is relative factor endowment e.g. countries with a relatively large amount of the factor of production land will have the comparative advantage in landintensive industries primarily farming. Comment: This works with (for example) Sudan, Australia, New Zealand, Brazil and Argentina. Q28: Use the theory of comparative advantage to explain why at present the USA dominates industries reliant on science research, and China dominates low-technology manufacturing

A: The USA is relatively well-endowed with the factors of production needed in this area capital and skilled labour. China is relatively well-endowed with the unskilled yet disciplined labour needed for low-tech manufacturing. Q29: Is a countrys relative factor endowment (and so comparative advantage) fixed over time? A: Not at all. Those countries whose GDP per head is growing faster than average will have the opportunity to invest the extra resources into capital equipment and also into labour skills (sometimes known as human capital) Comment: There is a well-trodden development path whereby countries move from low-tech to high-tech manufacturing and service industries. Q30: Which economic agents receive the gains from international trade? A: Initially the business sector, which is driven by the profit motive to seek these gains. However, competitive pressures will force prices down and spread these gains among consumers and also the state sector through additional tax revenue Comment: Within each country there will be industries which lose out, but every country will in total gain from free international trade. Q31: What other gains from international trade exist apart from those generated by comparative advantage? A: International trade leads to more competitive market structures in every industry it touches. This is particularly beneficial in industries where cost structures lead to monopoly-like markets within individual countries, such as steel or vehicle manufacturing. Comment: These gains accrue mainly to consumers. TABLE - UK physical goods (visible trade), X and M, 2008 Source: ONS UK Exports 2008, Top 12 bn physical goods, by value 1. Oil 2. Road vehicles 3. Pharmaceuticals 4. Power generating equip. 5. Misc. manufactures 6. Gen. industrial machinery 7. Electrical machinery 8. Other transport equip. 9. Organic chemicals 10. Specialised machinery 11. Office machines 12. Non-ferrous metals Total, all physical exports 31.9 22.5 17.2 15.1 14.2 10.4 9.9 9.2 8.4 7.7 7.1 6.9 251

UK Imports 2008, Top 12 physical goods, by value 1. Oil 2. Road vehicles 3. Misc. manufactures 4. Telecoms equip. 5. Office machines 6. Electrical machinery 7. Clothing 8. Gen. industrial machinery 9. Power generating equip. 10. Meat, fruit & veg 11. Pharmaceuticals 12. Other transport equip. Total, all physical imports

bn 37.8 33.9 18.1 16.3 15.3 14.6 13.2 12.1 11.8 11.7 11.0 10.6 344

Q32: In table above, the UKs top 8 visible export categories also feature in the list of our top imports. Why is this? A: The costs of doing business internationally are now such a small proportion of total costs that it makes commercial sense to export and import many items which are very similar Comment: For example, the UK exports light crude oil from the North Sea while importing the more viscous heavy crude.