The Impact of the External Environment on Business Firms

On pp. 31-48 of Business Essentials, 5th Canadian edition, the various "environments of business" are discussed. These include the economic, technological, socio-cultural, political-legal, global, and business environments. The managers in business firms must think carefully about how these environmental factors will affect the organization they work for because these factors are complex and they present both challenges and opportunities. The following examples demonstrate the importance of the external environment.

One area that is becoming increasingly important to business firms is the political-legal environment because it presents certain risks (for example, terrorism) that must be dealt with. Lloyd's of London is a famous insurance company that is one of the world's largest underwriters of terrorism insurance. In a speech in Toronto in November 2007, a Lloyd's spokesman warned about terrorism and political risk, and said that it is not simply a threat to governments, but also to businesses. The global economy means that Canadian businesses are operating in some dangerous places and their assets are difficult to protect. In a typical year, there are 150-200 incidents of terrorism against businesses worldwide. The most at-risk businesses in Canada are hydro and nuclear plants and oil pipelines.

In the socio-cultural environment, there is increasing activity by various pressure groups who have concluded that business firms cannot be counted on to behave in a socially responsible fashion. For example, in 2007 Greenpeace—a well-known environmental pressure group—launched a media campaign against AbitibiBowater Inc., a large Canadian forest products company. As part of the campaign, it put up a banner at the company's head office that read "Looters of our Forest." In the Netherlands in October 2007, it blocked the unloading of a ship containing newsprint made by AbitibiBowater. Greenpeace has also pressured the company to adopt forest management guidelines set by the Forest Stewardship Council (FSC) rather than the Canadian Standards Association (CSA) guidelines that the company has been using. The campaign is having an effect, since FSC has more global credibility with environmental groups than CSA does.

But FSC has problems of its own. Its standards vary from one region of the world to the next, and FSC has admitted that some of the companies using its logo are not using sustainable forestry practices. Even some environmentalists are unhappy with FSC. They claim that one company in Southeast Asia that has permission to use the FSC logo has destroyed a large section of Indonesian rainforest and threatened the habitat of orangutans. After these claims were publicized, FSC rescinded the company's certification. The forestry practices of Canadian companies like AbitibiBowater—which are quite good generally—may actually be superior to those of a foreign company that is FSC-certified. These complexities and uncertainties make it difficult for managers in forestry companies to know what the optimal decision is in a given situation.

These examples demonstrate that the external environment is complicated and full of uncertainty. But that's not all. Managers must also recognize that "the environment" is not limited to just the factors in areas like the political-legal or socio-cultural environment. Another very important "environment" for many business firms is the physical environment. The most highly publicized physical environment issue at the moment is global warming. There is a consensus that global warming is occurring, but there is an intensifying debate about what is causing it. Many scientists are convinced that global warming is the result of human activity, specifically the emission of so-called "greenhouse gases," and the United Nations Intergovernmental Panel on Climate Change (IPCC) has taken the position that greenhouse gases are the cause of global warming. But many other scientists disagree, arguing that the UN is using unreliable data and is exaggerating the amount of warming that has occurred. These dissenting scientists—including editors of scientific journals, directors of centers for climate research, and professors of climatology, wildlife biology, marine geophysics, geology, mathematics, atmospheric science, computer modeling, physical geography, chemistry, and meteorology—argue that climate variability is a natural phenomenon, and that it has affected humanity throughout recorded history. They argue that we need to equip people to deal with climate change, not introduce programs to reduce greenhouse gases without good evidence that they are really the culprit. With regard to the physical environment, if managers are going to do their job effectively, they must sort out what is fact and what is opinion in the debate about the causes of global warming. This is particularly true since global warming presents both challenges and opportunities.

Challenges. Global warming presents many challenges to business firms. Consider the forestry industry. If climate predictions are accurate, B.C.'s forestry companies will be significantly affected by global warming because different species of trees thrive at different latitudes. The predicted temperature change will mean that a tree that does well today in Prince George will grow best north of the Yukon border in 80 years. Whitebark pine, for example, will almost disappear from its current range, and lodgepole pine, white spruce, sitka spruce, and western hemlock will all decrease in importance over the next 80 years. By contrast, ponderosa pine will triple, and Douglas fir and western red cedar will both increase substantially. These are dramatic changes that forestry companies will have to take into account, particularly since they have such a long planning horizon.

Global warming also means that new tree diseases will have to be dealt with. Whitebark pine, for example, can't fend off insects and fungus that exist in a warmer climate. Tree companies are now conducting tests to determine if the tree can be planted much further north to reduce the threat from insects. The most significant tree disease at the moment is the mountain pine beetle, which has killed millions of acres of trees in B.C. The warming climate has allowed the beetle population to explode, and the infestation threatens to destroy jobs, communities, and companies that are dependent on forestry. By 2013, as much as 80 percent of the lodgepole pine will be dead as a result of the beetles' boring activity. What's worse, the infestation is spreading into neighbouring Alberta.

The problems caused by the pine mountain beetle are not restricted to the forestry industry. For example, the Eagle Point golf course just outside Kamloops had to cut down 15,000 trees that were killed by the beetles. One bright spot is that tree cutting services are doing a brisk business. Eldorado Enterprises, for example, has 30 trucks and 100 employees to handle tree-cutting activities.

To complicate matters further, a dispute has erupted about how to deal with the beetle infestation. Lumber companies want to cut vast swaths of dead pine because it still has some market value. Environmentalists oppose such massive cutting, and some even argue that nothing at all should be done and that nature should be allowed to take its natural course. They accept that the pine beetle may eventually destroy 30 percent of Alberta's pine trees, but they say that's better than having logging companies cut 100 percent of them. Homeowners in areas that are infested have their own agenda. They know that if dead pine trees are not cut, an increased fire risk will develop which will threaten their homes. All of these conflicting views have created a significant challenge for companies in the forestry business.

Opportunities. Global warming may also provide opportunities for Canadian businesses. Consider the wine industry. The highest quality grapes historically have been grown in France, Spain, Australia, and California, where the climate was just right for them. But with global warming, excessive heat is beginning to be a problem in these areas. Global warming means that grapes can now be grown further and further north. In Tappen, B.C., for example, Gary Kennedy is experimenting with growing Pinot Noir grapes at a latitude where they formerly could not have survived. Grapes of this variety can survive winter temperatures down to about minus 20 degrees Celsius. Fifty years ago, it was not uncommon for temperatures to drop that low in the Okanagan Valley, but during the last decade temperatures almost never dropped that low. This has opened up a whole new geographical area for growing high-quality grapes, and the number of B.C. wineries has increased from 17 in 1990 to 136 in 2007. Wines made in this region are starting to win gold medals at European wine competitions.

The examples described above indicate that the external environment presents immense complexities, uncertainties, challenges, and opportunities for Canadian business firms. These environmental factors cannot be ignored because they have such a big potential effect on businesses. Business managers must therefore expend considerable time and energy in planning how to deal with the complexities and uncertainties, deciding how they are going to cope with the challenges, and deciding how they are going to capitalize on the opportunities that are presented by the external environment.

Questions for Discussion

1. Describe in general terms how each element of the external environment (economic, technological, socio-cultural, political-legal, global, and business) affects business firms.
2. Choose a specific industry (for example, automobile, fashion, construction, fast food, etc.) and describe how each element of the external environment is likely to affect firms in that industry.
3. Can managers in business firms control the elements in the external environment, or do they simply have to react to changes that are beyond their control? Give examples that support your conclusion.
4. Explain how the factors in Porter's Five Forces Model (rivalry among competitors, threat of potential entrants, suppliers, substitutes, and buyers) differ from the other environmental elements (economic, technological, socio-cultural, political-legal, and global).

Sources: "Don't Fight, Adapt," National Post, December 13, 2007, p. FP15; Ross McKitrick, "Contaminated Data," National Post, December 5, 2007, p. FP19; Diane Francis, "Be Very Afraid, Lloyd's Warns Us," National Post, November 29, 2007, www.nationalpost.com/story-printer.html?id=130604; Konrad Yakabuski, "Greenpeace Swinging Its Axe in the Wrong Forest," The Globe and Mail, November 15, 2007, p. B2; Tom Wright and Jim Carlton, "FSC's Green Label for Wood Product Gets Growing Pains," The Wall Street Journal, October 30, 2007, pp. B1-B2; Douglas Belkin, "Northern Vintage: Canada's Wines Rise With Mercury," The Wall Street Journal, October 15, 2007, pp. A1, A20; George Koch, "Careful With That Axe," Canadian Business, October, 2007, pp. 44-51; Nathan VanderKlippe, "Forest for the Trees," National Post, September 15, 2007, p. FP3; Barry McKenna, "Global Warming a Farmer's Bane?," The Globe and Mail, September 12, 2007, p. B3; Sean Silcoff, "Canada's Money Trees," National Post, September 8, 2007, pp. FP1, FP5; Wendy Stueck, "The Mighty Are Falling," The Globe and Mail, September 1, 2007, pp. B4-B5; Kathryn Young, "Organic Wine: It's a Money Thing," National Post, September 1, 2007, p. FP3.

Answers to Questions for Discussion

1. Describe in general terms how each element of the external environment (economic, technological, socio-cultural, political-legal, global, and business) affects business firms.

   The economic element has perhaps the most obvious impact on businesses through the effect of the business cycle (pp. 32-33 in the text). During periods of expansion, many new businesses come into existence and existing businesses prosper. During periods of recession, business failures increase and it becomes more difficult for businesses to be profitable. Many of the other aspects of the economic environment that are discussed are evidence of the various stages of the business cycle.

   The technological element may not have an obvious impact on a given business at any one time, but a new technological development may suddenly present opportunities for some firms (and individuals) and threaten the survival of others. There are countless examples of this. In the late 1920's, for example, the advent of talking movies meant that people who used to be employed as piano players to play appropriate background music in movie houses were no longer needed. More recently, developments in computer technology meant that Microsoft could introduce Encarta (an encyclopedia) which caused the sales of long-time leader Encyclopaedia Britannica to drop sharply. Students should be encouraged to come up with other examples, since this will increase their understanding of this important environmental element.

   The socio-cultural element of the external environment may be the most interesting to students because they are very sensitive to issues like consumer preferences and tastes, as well as the concept of business ethics. This element of the external environment also has a big effect on business firms. It is probably most effective to ask students to come up with examples of changes in consumer preferences. Once they begin thinking about the power of peer pressure in determining what is fashionable (particularly in products like clothing and electronic products like MP3 players, digital cameras, and cell phones), they will be able to see how changes in consumer preferences can have a big impact on business firms. It is important to emphasize that these rapid changes present both opportunities and challenges to business firms. The issue of business ethics should also be pursued, and the point made that poor ethical practices can threaten the survival of a business (for example, Arthur Andersen).

   The political-legal element of the external environment deals with both the relationship between business and government within a country, as well as political differences between countries that may cause problems for business firms. With regard to the former, students should be reminded of the detailed discussion on business-government relations on pp. 10-13 of the text. Government legislation, for example, can have a very large impact on business firms (for example, cigarette companies). With regard to political differences between countries, various issues—terrorism, political instability in oil-rich countries, corruption, and differences in political ideologies in various countries—inhibit business activity.

   The global element of the external environment focuses on the opportunities and challenges that Canadian business firms face when operating internationally. Remind students that Chapter 5 contains many examples of Canadian business firms that have experienced successes (and failures) in the global environment, and the factors that led to those successes or failures.

2. Choose a specific industry (for example, automobile, fashion, construction, fast food, etc.) and describe how each element of the external environment is likely to affect firms in that industry.

   Student answers will obviously vary widely here, but whatever industry they choose, they should systematically examine the impact of each element in the external environment. For example, if they choose the automobile industry, they should note that the economic environment has a big impact on new car sales because cars are big-ticket items. They could also note some less obvious facts (for example, during a downturn in the business cycle new car sales decline, but car repair shops should do well because people will keep their old cars longer and those vehicles will need repairs). Comments about the other elements of the environment should follow along the same lines. In the automobile industry, the following points could be made about the various environments: the political-legal environment (government legislation on emissions), the technological environment (development of hybrid cars and the attempt to develop the hydrogen fuel cell), the socio-cultural environment (changes in preferences for car styles away from SUV's and toward smaller cars), and the global environment (increased competition from foreign car makers).

3. Can managers in business firms control the elements in the external environment, or do they simply have to react to changes that are beyond their control? Give examples that support your conclusion.

   Some students will take the position that business firms heavily influence their external environment because of their power and wealth. They will say things like "business firms manipulate consumers into buying what the company wants to produce, not what the customer really wants." Other students will take the position that business firms are at the mercy of the external environment because no one firm has enough power to force anyone to do anything. They will say things like "in a democratic society where consumers have freedom of choice, businesses have no alternative but to produce what consumers want." Both of these viewpoints have some merit, but a broader and more balanced view is that in some cases businesses can strongly influence the external environment, and in other cases they cannot.

   This question provides an opportunity for a wide-ranging discussion on the power and role of business firms in Canadian society. There are numerous examples that can be used to demonstrate the broader, more balanced point of view. For example, it is quite clear that business firms cannot control the business cycle, but instead have to adapt to it. Indeed, recent events have shown that even strong actions by the federal governments of Canada and the U.S. may not control the business cycle. On the other hand, businesses do not have to sit back and do nothing about environmental elements; they should actively research what is going on and act accordingly. For example, companies that devote resources to R & D and to the assessment of consumer preferences through market research are likely to cope much more effectively with environmental changes than companies that do not do these things. Ask students to come up with examples demonstrating this point. If they have trouble doing so, start the discussion by using the Levi's example on p. 366 of the text.

   The goal of the wide-ranging discussion envisioned here is increased understanding by students that the interaction between businesses and their environment is very complex. The notion that businesses are either helpless or all-powerful in relation to their environment does not capture the reality of modern business. The goal of the discussion is to develop reasonable expectations on the part of students about what business can and cannot do. Student activity as managers after they leave school should be more satisfying and effective if they have reasonable expectations.

4. Explain how the factors in Porter's Five Forces Model (rivalry among competitors, threat of potential entrants, suppliers, substitutes, and buyers) differ from the other environmental elements (economic, technological, socio-cultural, political-legal, and global).

   In answering this question, it will be helpful to ask students to differentiate between environmental factors that very specifically affect a business, as opposed to those that only generally affect a business (the task environment and the general environment, respectively). Thus, the environmental elements that are extensively discussed in Chapter 2 in the text relate to the general environment, while the factors in Porter's Five Forces Model relate to the task environment.

   As noted on pp. 43–44 of the text, each company operates in a specific industry, and each industry has different characteristics. Porter's model helps us analyze the factors that influence business firms in a specific industry. Obviously, the other more general environmental factors will continue to have an effect. For example, even if a given company deals effectively with the factors in Porter's model, that will not insulate it from a general economic downturn, or from changes in consumer preferences, or changes in government legislation, or the introduction of new technologies.