Chapter 2: Environmental Analysis and

Markets
Economics of
Business
Strategy
Learning Outcomes
1. identify the macro environment that an organisation is operating
within
2. be able to list the key factors that influence an organisation’s macro
environment
3. be able to explain the dynamic nature of the market environment
4. assess the implications of the environment on the organisation’s
strategy
Recommended Reading
•Economics of Strategy, Besanko chapter 7
•The Strategy Process, Mintzberg et al chapter 3
•Competitive Strategy, Porter chapters 1 & 8

•Teaching materials available:

•https://drive.google.com/drive/folders/1tP2FG3B-3CPvU9MvYdc1dj5wZWJR39UI?usp=sharing
•(Google account is required)
Business Environment
1. The environment is what gives organisations their means of
survival…...However, the environment is also the source of threats.(Johnson, G.,
Whittington, R. and Scholes, K. 2009)

1. All the internal and external factors that affect how the business functions
◦ Macro-environment
◦ Micro-environment

4
Layers of the Business Environment

5
Business Environment
1. The macro-environment consists of broad environmental factors
◦ Here PESTEL framework can be used to identify the trends of marco-
environment.
2. Industry or Sector is made up of organisations producing the same products or
services.
◦ Here the Porter’s Five Forces framework is useful.
3. Market Analysis
◦ Competitors and Markets are the most immediate layer surrounding
organizations
◦ The concept of strategic groups can help identify close and more remote
competitors.
◦ Product life cycle explain the historical pattern of a successful products
passing through certain recognizable stages.
6
 Stable, Dynamic or Complex Environment?

Nature of
Environment

7
Nature of Environment: Stable Environment
•Few forces are changing over time
•The rate of change is slow (Infrequent changes)
•Easy to predict changes
•Example: Soft drinks and Education Services.

• Develop the
business strategy
on the basis of
historical and past
trends.
Example: Education Services in Hong Kong

1. The number of primary school students

has been rising and the number of
secondary school students has been falling
sharply since 2012.
2. The Education Bureau closed down many
primary schools in the last decade due to
the decreasing number of students.
3. But as the number of such children is now
increasing, the education sector is facing
the problem of insufficient primary schools
and teachers.

9
Nature of Environment
•Dynamic Environment

• Speedy and challenging changes

Recognition
• Fast-moving conditions and factors
• Technological innovation In the age of of future
• New competitors globalization, is there possibilities!
• Globalisation such thing as a stable
• Consumer preferences
business environment?
• Past experiences do not provide such a
good guide to the future
• Some degree of unpredictability
Nature of Environment: Complex Environment
•An extension of dynamics environment.
•The influences at play in the environment also interact with each other
•Complex means Interconnected parts; or difficult to analyse, understand or explain.

• Scenario building or
simulation modelling

• Can develop a number

of outcomes based on
“what if” scenarios
Business Environment and Uncertainty
Compare the following industries in terms of their level of uncertainty

Electricity Supply Financial Markets Channel Tunnel

12
Electricity Supply
1. The industry is mature, it has an established system and in many countries, it is regulated by
the government.
2. Any changes that take place are normally predictable or are signalled well in advance. This is
partly due to the long lead times required in the development and building of any new
technologies.
3. Also the demand for the product can also be reasonably easily forecast.

13
Financial Services Industry
1. Rapid changes in technological developments (FinTech)
◦ Processing Transactions
◦ Marketing
◦ Decision-making
2. In addition the use of information technology to allow different modes of delivery of financial
products and services is changing the pattern of usage of many of the products.
3. Finally it can be seen that there are many more competitors entering the market and the
market itself is becoming more global in nature.

14
Channel Tunnel
There were numerous issues to be addressed:
1. the different rail systems in use on either side of the tunnel
2. the different objectives and perceptions of the different governments
3. the demand for this type of travel
4. the acceptability to the public to travelling under a large expanse of water
5. choice of location
6. the skills required to engineer the project
7. the transport infrastructure needed to link up the tunnel to the existing transport networks.

Numerous issues needed to be tackled, and many of these issues would interact with each other, making
analysis even more difficult.

15
Need for Macro-environment Analysis: Mesch Criteria – 7 Questions

1. Does the external business environment influence capital allocation and the decision making
process?
2. Have previous long range plans been crapped because of unexpected changes in the
environment?
3. Have there been unpleasant surprises in the external business environment?
4. Is competition growing in the industry?
5. Is the business more marketing oriented and more concerned about the ultimate customer?
6. Do more and different kinds of external forces seem to be influencing decisions and does there
seem to be more interplay between them?
7. Is management unhappy with past forecasting and planning efforts?
PESTEL(PEST)
Analysis

17
PESTEL Analysis
What are the “Headwinds and Tailwinds” in your industry?
1. Political
2. Economic
3. Socio-cultural
4. Technological
5. Environmental(Green)
6. Legal
What were the significant world events during the past 12
months?
1. Political
◦ War in Ukraine
◦ Increasing international tensions between China and the western countries;
2. Economic
◦ The effect of monetary tightening in US;
◦ High Inflation and slow down of the global economy – Stagflation again?
◦ China’s “zero COVID” policy – global supply chain
3. Socio-cultural: Refugee crises; Rising unrest around equality
4. Technological: Remote working tech; Blockchain and decentralization; Internet of Things
5. Environmental: Green concerns
6. Legal: Higher regulatory standard in environmental protection, financial stability and health
standard

19
Political Factors
Key drivers might include change in:
◦ Government stability
◦ Government leadership
◦ Corruption levels
◦ Bureaucracy
◦ Government preferences
◦ Rent Seeking behaviours(lobbyist)

20
War in Ukraine
Russia and Ukraine are major exporters of several commodities.

Russia(% of global exports) Ukraine (% of global exports)

◦ Wheat 18% 7%
◦ Natural gas 25%
◦ Palladium 23%
◦ Nickel 22%
◦ Fertilizers 14%
◦ Coal 18%
◦ Platinum 14%
◦ Crude Oil 11%
◦ Aluminum 10%
◦ Seed Oil 40%(global production)
◦ Neon gas(chipmaking) 50%(global production)
◦ Corn 13%

Energy and agricultural commodity prices have surged.

War in Ukraine - Global commodity markets
1. Energy and agricultural commodity prices have surged.
2. The rise in commodity prices comes on top of sharp increases since January 2022.
3. Europe’s dependence on Russia for energy renders its economy vulnerable.
4. Some developing countries rely heavily on Russia and Ukraine for food and fertilizer
War in Ukraine
Global Trade flows
1. The war has disrupted trade, including global transport routes, and adding stress to existing
supply disruptions.
Global financial markets
1. Equity market volatility has risen markedly, especially in Europe
2. Sovereign borrowing costs have increased since the start of the war
3. For some financial institutions, a recession in Russia is likely to result in substantial losses.

The war has eroded near-term global economic prospects, point to difficult times ahead.
Geopolitical tensions and higher uncertainty
Higher inflation and accelerated monetary policy tightening
The changing world order - AN ONLINE SERIES BY RAY DALIO

Source: https://www.principles.com/the-changing-world-order/#chapter3Last500In4000
24
COUNTRY RISK ASSESSMENT MAP — JUNE 2022

25
The Impact of the US-China Trade War
1. Significant increases in the prices of goods and services
2. Decrease in the firm’s profit margin
3. Substantial changes to the global supply-chain network
4. Reductions in availability of imported goods
5. Reduction in real income

Please read the following Research Briefs

Trade War Results in Substantial Losses for U.S. & Other Countries
http://wws.princeton.edu/news-and-events/news/item/trade-war-results-substantial-losses-us-
other-countries

26
Summary of Marsh Political Risk Map Report: Hong Kong
Countries Risk Index (CRI) falls from 78.4 to 75.3 in 2020
Short-term Political Risk Index is 68.5
Hong Kong experienced the second largest deterioration in STPRI score globally, as the territory
was beset by months of disruptive, violent protests, which strained Hong Kong’s relationship with
mainland China.
The government is unlikely to meet protesters’ demands in 2020, and if unrest continues there is a
growing risk of Chinese military intervention in Hong Kong.
Questions
How does political instability affect business?
How do you need to adapt your business strategy to survive?

27
China’s “zero COVID” policy
1. China’s “zero Covid” policies have triggered an economic slowdown
◦ China’s gross domestic product grew at 4.8 percent, below the official annual target of 5.5 percent.
2. High unemployment, especially the youth unemployment - China’s youth unemployment rate
hit 18 percent in May 2022
3. The policy is increasing ongoing disruptions to global supply chains and logistics.
◦ China's export growth slowed in April 2022 to its weakest level since June 2020.
Economics Factors
Key drivers might include change in:
◦ Inflation
◦ GDP growth rate
◦ Cost of living
◦ Exchange rate
◦ Fuel prices
◦ Finance and Credit
◦ Globalization

Useful Links:

1) https://www.stlouisfed.org/
2) http://hong-kong-economy-research.hktdc.com/ 29
FRED Economic Data
US Unemployment Rate(UNRATE)
https://fred.stlouisfed.org/series/UNRATE
University of Michigan: Consumer Sentiment (UMCSENT)
https://fred.stlouisfed.org/series/UMCSENT
Leading Indicators OECD: CLI Normalised for China (CHNLOLITONOSTSAM)
https://fred.stlouisfed.org/series/CHNLOLITONOSTSAM
Conference Board –Leading Economics Index
https://conference-board.org/data/bcicountry.cfm?cid=11

API for downloading data series

30
Social Factors
Key drivers might include change in:
◦ Lifestyle
◦ Social mobility
◦ Education
◦ Demographics
◦ Life Expectancy
◦ Ethics and religion
◦ Cross-cultural communications

31
How will aging problem affect the financial industry?

32
How will aging problem affect the financial industry?
The differences in financial or insurance needs
1. Degree of Risk Tolerance
2. Growth in capital vs Steady income
3. Coverage of Unexpected Expenditure

33
Redefining the workplace and how work is done after the pandemic
The pandemic accelerated existing trends in remote work, e-commerce, and automation, with
up to 25 percent more workers than previously estimated potentially needing to switch
occupations. (McKinsey & Co)

70% of respondents in the survey conducted by Deloitte say they expect their organization to
pivot to hybrid work.

There is an ongoing transition from traditional workplace to hybrid or remote work.

Technological Factors
Key drivers might include change in:
◦ Technological innovation
◦ Telecommunication network coverage
◦ Knowledge management systems
◦ Production efficiency
◦ Intellectual property
◦ Cyber Security

35
“Uberization”: Disintermediation
Uberization
“the act or process of changing the market for a service by introducing a different way of buying or
using it, especially using mobile technology”
- Cambridge Dictionary
Disintermediation
the situation in which manufacturers sell directly to consumers, rather than through stores, etc.
- Cambridge Dictionary

36
Environmental Factors
Key drivers might include change in:
◦ Cyclical weather
◦ Energy availability and cost
◦ Social implications
◦ Disposal of materials
◦ Ecological consequences
◦ Legislation and International agreement
◦ Paris Climate Accord
◦ Decarbonisation

38
Low Carbon Economy

Source: PwC
39
Renewable Energy Feed-in Program

40
41
Green Concern
Companies listed on the stock exchange are obligated to disclose environmental risks and
opportunities.
Industry bodies
◦ Task Force on Climate-Related Financial Disclosures (TFCD)
◦ Partnership for Carbon Accounting Financials (PCAF)
◦ Net-zero Banking Alliance

◦ They promote a more consistent standards to product an immediate and tangible impact on
environmental protection.
Legal Factors
Key drivers might include change in:
◦ Anti-trust law or Competition Ordinance
◦ Taxation
◦ Regulatory system
◦ Compliance
◦ Health and safety law
◦ Advertising

43
Competition Ordinance (Hong Kong)
I am a retailer and another
Four Don'ts competing retailer has lowered its
◦ DON'T fix prices price substantially. This retailer is
◦ DON'T restrict output harming my business. Are they
allowed to do this under the
◦ DON'T share markets Ordinance?
◦ DON'T rig bids

Predatory pricing occurs where an undertaking with

substantial market power charges below its own cost,
making a loss for a sufficient duration to force one or
more undertakings out of the market and/or to
otherwise “discipline” competitors.
Low pricing vs. predatory pricing
44
Competition Ordinance (Hong Kong)
The existence of the same or similar prices If all suppliers in a market are
for a product is not necessarily evidence of charging the same price, or increase
a price fixing cartel. their price at the same time or offer
the same discount, does this mean
In markets where the product sold is the they are engaging in price-fixing and
same or very similar (such as fuel, or collusion?
vegetables in a wet market), competitors’
prices may be the same or very similar
even in the absence of an anti-competitive
agreement.

All suppliers charging the same prices

45
Taxation: TVC and QDAP
Tax deductible MPF voluntary contributions (TVC)
Qualifying deferred annuity policies (QDAP)

46
Anti-money Laundering
FATA 40+9 Recommendations

United Nations Sanctions Ordinance (Cap.

537)
Example: List of persons and entities
published pursuant to section 29 of the
United Nations Sanctions (Somalia)
Regulation 2019
https://www.hkicpa.org.hk/en/Standards-
and-regulation/Anti-money-laundering

47
Financial Regulation

Regulatory hot issues

https://www.pwchk.com/en/financial-services/financial-services-risk-and-regulations/financial-
services-regulatory-hot-issues-mar2019.pdf

48
Benefits
1. Firms can scan for warning signs and environmental changes that
could affect the business

1. Trends and patterns which have already been identified are

monitored

1. It focuses the organisation on the direction of the changes

1. It assesses current and future trends and their effects on the

performance of the business
Two points that you should be aware of
1. A great deal of information can be
generated, but if it is left as a listing of
influences, it is of little strategic value.

1. Managers faced with the day to day

problems of running a business may fail to
address the long term strategic problems
raised by the analysis, and the strategy may
become a short term response rather than a
long term development approach.
Market or Business environment

51
Market Definition
In economics, there are four broad classes of market structure

1. Perfectly competitive market

1. Monopolistic competitive market

1. Oligopoly

1. Monopoly

52
Perfectly competitive market
A perfectly competitive market has the following characteristics:
1. There are many buyers and sellers in the market.
2. The goods offered by the various sellers are largely the same.
3. Firms can freely enter or exit the market.
4. All buyers and sellers have perfect Information.

53
Monopoly
A firm is considered a monopoly if . . .
1. it is the sole seller of its product.
2. its product does not have close substitutes.

54
Imperfectly Competitive Markets
Types of Imperfectly Competitive Markets
◦ Oligopoly
◦ Only a few sellers, each offering a similar or identical product to the
others.
◦ Monopolistic Competition
◦ Many firms selling products that are similar but not identical.

55
Oligopoly
• Firms in concentrated markets(Oligopoly) often compete on product
development and branding, rather than product prices.

• Price wars will significantly reduce the firms' profits.

• Firms in concentrated markets have to consider their rivals' response

when they make their own decisions.

56
Monopoly
Monopolists are price makers
They can set the price for their good but not
price and quantity.
As price goes up, the quantity-demanded will
decrease.
An important issue for a monopolist is how to
maintain their market share.

57
Perfect Competition
The assumptions together implies that the frim must produce
efficiently to stay in business in the long run.
Firm under perfect competition have to accept the market price for
their goods or services

58
Monopolistic Competition
Firms have some market power to set the price of goods or services.
However, the demand for the goods are relatively elastic.

The theory of market structures gives us bench marks against which we

can compare real industries.

These models are not detailed enough to give us a full picture of an

industry or firm within that industry.

We want to be able to predict changes in the market structure.

59
The Level of Competition

60
Market Definition
Different approaches to define markets
1. Qualitative approach: consider products that are close substitutes for each
other.
◦ Products tend to be close substitutes when they have
◦ similar product performance characteristics
◦ similar occasions for use
◦ are sold in the same geographic markets
2. Quantitative approach: measure demand elasticity, price correlation for
substitute goods or trade flows and the availability of goods in different
areas
3. Standard industry classification
◦ Hong Kong Standard Industrial Classification (HSIC) Version 2.0 - Index of
Industry Codes
61
The Measures of Market Structure
How many is many?
Measures of competitiveness and concentration
1. # of firms

2. Concentration Ratio: CR4/5/8 or CRn ratios

3. Herfindahl-Hirschman-Index(HHI)

62
The Measures of Market Structure
Market forms can often be classified by their concentration ratio.
Listed, in ascending firm size, they are:
1. Perfect competition, with a very low concentration ratio,
2. Monopolistic competition, below 40% for the four-firm
measurement,
3. Oligopoly, above 40% for the four-firm measurement, (Example
automobile manufacturers)
4. Monopoly, with a near-100% four-firm measurement.

63
The Measures of Market Structure
Pitfall:
• Not all the firms’ Information is taken into account
• No indication if there is any dominant firm in the market
Consider the following cases with the same C6
Case 1: All six firms produce 15%, and
Case 2: One firm produces 80 % while the five others produce 2 % each.
We will assume that the remaining 10% of output is divided among 10 equally sized producers.

Case 1: C6 = 6*15% = 90%

Case 2: C6 = 80% + 5*2% = 90%

64
Herfindahl-Hirschman Index(HHI)
The major benefit of the Herfindahl index in relationship to such
measures as the concentration ratio is that it gives more weight to
larger firms. Take, for instance, two cases in which the six largest firms
produce 90 % of the output:

Case 1: HHI index = 6 * 0.152 + 10 * 0.012 = 0.136

Case 2: HHI index = 0.82 + 5 * 0.022 + 10 * 0.012 = 0.643

This behavior rests in the fact that the market shares are squared
prior to being summed, giving additional weight to firms with
larger size.
65
The Measures of Market Structure
The degree of market power depends on three factors
1. demand elasticity.
2. market concentration, and
3. collusive behavior.

• As the market becomes more concentrated then we would expect

that the firms in the market would have greater ability to control
prices.
• In principle, as the number of competitors goes up, the market
power of the firms would expect to fall.

66
 1) Product Life cycle
2) Porter’s evolutionary processes

Industry
evolution

67
 Product Lifecycle Model
Product lifecycle theory illustrates the industry evolution over time.
Product lifecycle based on the concept that an industry passes through a number of stages

1. Introduction

1. Growth

1. Maturity

1. Decline.

Reading:
https://hbr.org/1965/11/exploit-the-product-life-cycle
68
Characteristics of the product Lifecycle
Product Lifecycle Model
The advantages of the product life-cycle model are that
1. it is easy to understand;
2. it has clearly defined stages;
3. the characteristics at each stage can be clearly defined, thereby determining the type of competition
in the market and the types of strategy to be developed.

The disadvantages are that

1. the length of any given period in the lifecycle will vary from industry to industry, the growth does not
necessarily follow the S-shaped pattern depicted.
2. The shape of the lifecycle can also be altered by the actions of the firms and is therefore not static
over time.
3. the nature of competition may vary across different industries and the model does not provide any
indication of the progress of an industry through the different stages of the lifecycle.

70
Alternative approach: 14 evolutionary Processes
1. Long run changes in growth(External Factors)
◦ Demographics
◦ Trends in Needs
◦ The availability of Substitutes and Complements

2. Changes in buyer segments served

◦ Firms may create new products to serve a new buyer segments
◦ Related to economies of scale, capital requirements

3. Buyer’s learning
◦ Accumulation of knowledge about a product

4. Reduction of uncertainty
◦ Uncertainty about the potential size of the market, further product modification provides some
protection for the earlier movers
Alternative approach: 14 evolutionary Processes
5. Diffusion of proprietary knowledge
◦ New entrants learn the earlier movers’ proprietary knowledge
Alternative approach: Evolutionary Processes
6. Expansion or contraction in scale
◦ economies of scale, and use vertical integration

7. Changes in input or currency costs(exchange rate)

◦ Firms may increase the use of capital to replace labour if wages rate keeps rising.

8. Structural changes in adjacent industries

◦ Upstream and Downstream industry

9. Governmental policy change

◦ Pricing regulations, import tariffs, product safety regulations or licensing requirements,

10. Entries and exits

◦ Entry and Exit barriers

11. Accumulation of experience

◦ The learning or experience curve
Alternative approach: Evolutionary Processes
12. Product innovation
◦ Create new market segment
◦ Increase production differentiation

13. Marketing innovation

◦ Expand the product to new customer groups;
◦ Increase customers loyalty
◦ Avoid price competition

14. Process innovation

◦ change the balance between fixed and variable costs
◦ Increase efficiency
Alternative approach: Evolutionary Processes
What are the forces that shape the organisation’s industry structure over time?
◦ These evolutionary processes are the drivers that determine the speed and
direction of change within an industry.
◦ Industry growth is the key determinant the intensity of rivalry within an
industry
◦ It also has a significant impact on the balance of supply and demand within the
industry.
◦ It determines the attractiveness of the industry to new entrants.
◦ Changes in the structure of suppliers' and buyers' industries can have important
affects on the evolution of an industry.
◦ Product, marketing and process innovations create substitute products.
Revision

76
Tutorial Question
•Identify the main macro-environmental factors influencing the
Financial Services Sector in Hong Kong

Take-Home Exercise
•Discuss the main macro-environmental factors affecting the airline
industry.
PEST: Financial Services Sector
Political Factors
1. War in Ukraine
2. KYC, AML and other regulatory reporting
3. US sanction against China and Russia
◦ US Congress Approves Sanctions Bill Targeting
Human Rights Violators in China
◦ Sanctions on persons including several China
government officials responsible for certain
human rights violations and abuses committed
against Muslim minority groups in China.
◦ Be aware of the increasing tensions between the
United States and China.
Impacts
• Firms must proactively manage business risk and comply with the international regulations.
78
PEST: Financial Services Sector
Economics Factors
1. Global growth is expected to moderate from 5.9 in 2021 to 4.4
percent in 2022 and further slow to 3.8 percent in 2023.
2. Rising interest rate environment will continue
◦ Federal funds rate: The Fed has determine to raise its target for the federal
funds rate, the 3-mth HIBOR has increased to 1.75% in early July 2022.
◦ Interest income/net interest margins should remain suppressed.

Impacts
The financial institution should focus on noninterest income and fee-
based businesses.
Cost containment is required to prevent unnecessary spending to
improve profitability.

79
PEST: Financial Services Sector
Social Factors
Population Demographics
◦ Millennials and Baby Boomers, the two largest generational
populations, have strongly impacted financial companies.
◦ Most of the developed economies faces the challenges of an
ageing society.
◦ Millennials (Generation Y) are going to be the largest adult
segment by the end of the decade. Their expectations are not being
shaped by traditional banks, but are being shaped by Apple, Google,
Amazon or Taobao.
◦ demand for digital assets cryptocurrencies.

Impacts
• Baby Boomers, who was born between 1946 and 1964, will demand key services related to wealth
management and financial services related to healthcare.
• They will demand key services related to mobile application and digital self serve service.

80
PEST: Financial Services Sector
Social Factors
Green Concerns - FIs should establish tangible criteria to achieve their
emission-reduction goals.
Green Investing Trend – the rise in the demand for green products and
investments globally.
1. Develop green investment products, such as target-linked bonds or
sustainability-linked derivatives.
2. Reduce their portfolio exposure to carbon emissions.

81
PEST: Financial Services Sector
Technological Factors
1. The low-overhead non-bank companies that pose a rising threat to traditional
banking or financial services providers will emerge.
◦ MoneySQ (crowd funding)
◦ Apple pay (payment system)

2. Software robotics/AI
3. Ransomware attack – cyber risk and financial crime
4. Rising demand for digital assets
Impacts
• Update the operating system and adopting AI
• Develop software connect to anything, anywhere.(cloud-based applications)
• Enhance cyber-security
• Build the technology capabilities

82
Summary
Discuss the benefits and drawbacks of macro-
environmental analysis

Discuss the implications of the nature of the

environment on strategic analysis

Discuss the use of the life cycle model.